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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the release of the Financial Stability Report, Ottawa, Ontario, 9 May 2024.
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Tiff Macklem: Release of the Financial Stability Report Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the release of the Financial Stability Report, Ottawa, Ontario, 9 May 2024. *** Good morning. I am pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss the Bank of Canada's Financial Stability Report (FSR). Part of the Bank's mandate is to preserve and promote the stability of the Canadian financial system. A stable and resilient financial system means people can access credit and manage their assets safely and predictably in good times and in bad. It also reduces the need for authorities to intervene in periods of financial stress. In short, a stable financial system is critical to Canada's economic well-being. Every year the Bank publishes this Report to offer an assessment of the stability of Canada's financial system and highlight risks that could threaten that stability. To make the purpose of the Report clear, we've changed its name, from the Financial System Review to the Financial Stability Report. The Canadian financial system is highly interconnected. Stress in one sector can spread to others. So, the emphasis in the FSR is on risks that could ultimately affect the broader financial system and threaten its stability. The Report focuses in particular on risks that evolve with developments in the economy. We look at risks that could lead to system-wide stress, in four key sectors: households, businesses, banks and non-bank financial institutions-such as pension funds, insurance companies and fund managers. There are also important risks that are more operational or structural in nature, such as cyber attacks and risks related to climate change. We typically will discuss those on the Bank's Financial System Hub. But when major developments arise, they may appear in the FSR as well. So, what are the key messages from today's FSR? The first message is that Canada's financial system remains resilient. Over the past year, households, businesses, banks and other financial institutions have taken proactive steps to adjust to higher interest rates and to weather economic shocks. The second message is that this adjustment still has some way to go and continues to present risks to financial stability. I'll offer some context around this assessment and then the Senior Deputy Governor will touch on the risks in different sectors. 1/3 BIS - Central bankers' speeches Over the past year, the risk of recession has diminished in Canada and globally. Inflation in most economies has come down, and inflation targets are in sight. However, there could be volatility in markets as expectations shift about when and by how much central banks will lower their policy rates. And there continue to be important geopolitical and economic risks on the horizon. Against this backdrop, households and businesses continue to adjust to past interest rate increases. Some indicators of financial stress have risen. At the same time, the valuations of some financial assets appear to have become stretched. This increases the risk of a sharp correction that could generate system-wide stress. The recent rise in the use of leverage in the non-bank financial sector could amplify the effects of such a correction. What's most important is that to properly manage risks, financial system participants need to remain proactive. And financial authorities need to remain vigilant. Let me now pass things over to Carolyn. Thank you, Governor. Let me touch on each of the sectors we cover in the FSR. I'll start with households. So far, most households have proven resilient in the face of higher interest rates and inflation. Overall, we've seen households adjusting to higher debt-servicing costs. This does not mean the adjustment has been easy. Clearly, there are individuals and families who are feeling very stretched. What we're evaluating in the FSR are the indicators of overall stress in the system. Some of the indicators of household financial stress that fell during the pandemic are back to or above normal levels. Survey data suggest renters are experiencing the biggest increase in financial stress. After hitting historical lows during the pandemic, the share of households without a mortgage that are behind on credit card and auto loan payments has come back up to-or surpassed-typical levels. And over the past year, the share of borrowers without a mortgage who carry a credit card balance of at least 80% of their credit limit has continued to climb. Among mortgage holders, indicators of financial stress have remained relatively low even as many have been coping with higher mortgage payments. Since the Bank began raising its policy rate in March 2022, payments have increased for roughly half of all outstanding mortgages. Over the next two and a half years, most of the remaining mortgages will renew, and these borrowers are likely to face relatively larger payment increases. At the same time, many mortgage holders have also seen their wages go up. Some have proactively adjusted their spending to help offset higher debt payments. Many also report higher levels of savings available to offset increased payments. 2/3 BIS - Central bankers' speeches Overall, the evidence suggests that households have the flexibility to continue servicing their debt at higher rates. We will be watching the data closely for signs of increased financial strain among households, both mortgage holders and non-mortgage holders. We'll also be watching how the labour market evolves, since the biggest factor that determines whether someone can service their debt is if they have a stable income. Higher interest rates are also affecting businesses. Higher rates are slowing demand for the goods and services that businesses sell, while also increasing their financing costs. So far, the financial health of large businesses appears solid. But smaller businesses are showing more signs of financial stress. Insolvency filings by smaller firms have recently jumped after several years of below-average filings. There is some indication that this recent increase could be a catch-up or normalization, and the timing could be driven in part by the expiry of government support programs put in place during the pandemic. Turning to Canadian banks, overall, credit performance remains strong. Banks are proactively contacting customers who are facing payment increases at renewal and working with them on a payment plan. They have also been putting more money aside to cover future loan losses, and they continue to maintain healthy capital and liquidity buffers. This means that even if financial conditions and credit performance deteriorate, banks are positioned to absorb losses and continue to provide credit. In the non-bank financial sector, more frequent volatility in financial markets in recent years has led to an increased focus on liquidity risks. At the same time, some firms are increasingly using leverage, or borrowed money, to fund trading activities. This makes them more vulnerable in the event of large market swings. Let me close by repeating an important point the Governor made at the beginning: the connections in the financial system mean that if risks materialize in one sector, they can spread quickly. This puts a premium on preparedness. The proactive steps taken by financial system participants have been positive. And they need to continue. A stable and resilient financial system benefits all Canadians. The Governor and I will now be happy to take your questions. 3/3 BIS - Central bankers' speeches
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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 5 June 2024.
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Tiff Macklem: Release of the Monetary Policy Report Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 5 June 2024. *** Good morning. I'm pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss today's policy announcement. Governing Council decided monetary policy no longer needs to be as restrictive and lowered the policy interest rate by 25 basis points to 4.75%. We've come a long way in the fight against inflation. And our confidence that inflation will continue to move closer to the 2% target has increased over recent months. The considerable progress we've made to restore price stability is welcome news for Canadians. Since our Monetary Policy Report in April, underlying inflation has continued to ease and economic growth has resumed. With the economy in excess supply, there is room for growth even as inflation continues to recede. Let me provide a little more detail about these dynamics. After stalling in the second half of last year, economic growth picked up in the first quarter of this year. At 1.7%, growth was lower than projected in the April report. But consumption growth was solid at about 3%, and business investment and housing activity also increased. In the labour market, businesses are continuing to hire workers. Employment has been growing, but at a slower pace than the working-age population. This has allowed the supply of workers to catch up with job vacancies. Elevated wage pressures look to be moderating gradually. Inflation remains above the 2% target and shelter price inflation is high. But total consumer price index (CPI) inflation has declined consistently over the course of this year, and indicators of underlying inflation increasingly point to a sustained easing. I'll highlight four indicators in particular: CPI inflation has eased from 3.4% in December to 2.7% in April our preferred measures of core inflation have come down from about 3½% last December to about 2¾% in April the 3-month rates of core inflation slowed from about 3½% in December to under 2% in March and April the proportion of CPI components increasing faster than 3% is now close to its historical average, suggesting price increases are no longer unusually broadbased This all means restrictive monetary policy is working to relieve price pressures. And with further and more sustained evidence underlying inflation is easing, monetary policy no 1/2 BIS - Central bankers' speeches longer needs to be as restrictive. In other words, it is appropriate to lower our policy interest rate. If inflation continues to ease, and our confidence that inflation is headed sustainably to the 2% target continues to increase, it is reasonable to expect further cuts to our policy interest rate. But we are taking our interest rate decisions one meeting at a time. We don't want monetary policy to be more restrictive than it needs to be to get inflation back to target. But if we lower our policy interest rate too quickly, we could jeopardize the progress we've made. Further progress in bringing down inflation is likely to be uneven and risks remain. Inflation could be higher if global tensions escalate, if house prices in Canada rise faster than expected, or if wage growth remains high relative to productivity. In assessing where inflation is headed, we will continue to closely watch the evolution of core inflation. We remain focused on the balance between demand and supply in the economy, inflation expectations, wage growth and corporate pricing behaviour. With that summary, the Senior Deputy Governor and I would be pleased to take your questions. 2/2 BIS - Central bankers' speeches
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the 30th Conference of Montréal "International Economic Forum of the Americas", Montréal, Quebec, 12 June 2024.
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Tiff Macklem: Central banking - navigating in a new world Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the 30th Conference of Montréal "International Economic Forum of the Americas", Montréal, Quebec, 12 June 2024. *** Good afternoon. It's always great to be back in Montréal, my hometown. And I could not be more pleased to be here with Joachim Nagel, President of the Deutsche Bundesbank. Thank you for visiting us in Canada. Since I'm on my home turf, let me start us off with a few words about where we find ourselves in economic history. Key lessons from high inflation Canada and Germany have just come through the biggest inflation we've experienced in 40 years. And as painful as this has been, it has highlighted some lessons. I will focus on three in the Canadian context. First, we ignore the supply-side of the economy at our peril. As central banks, we tend to focus on the demand side because that's what we influence with interest rates. But coming out of the pandemic, we learned that it is much easier to restore demand than supply. High inflation was a stark reminder that supply shocks can cumulate and persistand when they intersect with periods of strong demand, the inflationary consequences can be large. Looking ahead, technological change, geopolitical tensions, climate change, and shifting trade and investment flows all suggest we may experience more supply shocks than we did in the past. Businesses and central banks need to be ready. Second, inflation is painful-that's not a new lesson, but for many of our citizens it was their first experience with high inflation. And it has been painful. Inflation harms people and the economy, and it corrodes trust in our market-based system. The rising cost of living made life harder for everyone, especially those who had less to start with. People were working hard, but their paycheques didn't buy what they used to. That made people feel cheated and angry. Recent history has been a stark reminder that inflation is our common enemy. The third lesson is the value of central bank credibility and public trust. We did not have that in the 1970s, and the costs of unwinding inflation were very high. This time, our track record on inflation control combined with our forceful monetary response brought inflation back down at much lower economic cost. But public trust and central bank credibility have been dented by the post-pandemic inflation. To keep the trust we have and to restore what trust we've lost, we need to continue delivering for our citizens. And we need to communicate clearly and broadly. We need to find ways to explain ourselves to a wide range of audiences-from financial market participants and business owners to families and individuals trying to navigate uncertain economic times. We need to meet people where they are and ensure that they understand what we're doing and why we're doing it. 1/2 BIS - Central bankers' speeches Current policy That brings me to the present and to the Bank of Canada's immediate focus. Monetary policy has cooled the economy, inflation has come down, and underlying inflation continues to ease gradually. Last week, the Bank cut its policy interest rate by 25 basis points to 4.75%. With further and more sustained evidence that underlying inflation is easing, monetary policy no longer needs to be as restrictive as it has been. And last week the European Central Bank also lowered its policy rate. We have come a long way in our collective fight against inflation. Adjustments ahead Looking ahead, we still need to get inflation down further to our targets. And I will say that the shared resolve to restore price stability across major central banks has helped us all get inflation down without causing large increases in unemployment. We've also learned some lessons from the post-pandemic inflation, and we will take these to heart. But the challenges of the future are rarely the same as those of the past. Supply shocks are more likely in the future. New technologies not only have the potential to increase prosperity but also to disrupt. Interest rates may be easing in many economies, but global interest rates are unlikely to return to pre-pandemic levels. The new normal won't be the old normal. And if we're not going back, we'll all need to adjust. These shared challenges are why discussions like this one are so important. They help each of us prepare to navigate in a new world. I look forward to our discussion. 2/2 BIS - Central bankers' speeches
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Remarks by Ms Sharon Kozicki, Deputy Governor of the Bank of Canada, at the Canadian Association of Business Economics, Ottawa, Ontario, 13 June 2024.
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Remarks by Sharon Kozicki Deputy Governor Canadian Association for Business Economics June 13, 2024 Ottawa, Ontario Exceptional policies for an exceptional time: From quantitative easing to quantitative tightening Good morning. Thank you, Bolanle, for your kind introduction. I am pleased to be here in my hometown of Ottawa with the Canadian Association for Business Economics. I always enjoy speaking to a room full of economists and business professionals who are interested in the economy. You’ve long been some of the most engaged consumers of central bank speeches. The COVID-19 pandemic and subsequent rise in inflation have broadened the audience for speeches like this one. Canadians have questions for us at the Bank of Canada, and we want to answer them. So today my overarching themes will be transparency and accountability. I will begin by taking you back to the start of the pandemic when the world faced a health and economic crisis like nothing we’d experienced before. I will walk you through what the Bank saw and how we interpreted that information. Then I will talk about some of the actions we took, particularly our use of two exceptional tools: quantitative easing, or QE, and extraordinary forward guidance. I’ll discuss some of the analysis we’ve done on the effectiveness of QE, which we used for the first time in the pandemic. I will also go into the unwinding of QE, known as quantitative tightening, or QT, which is a key part of the monetary policy cycle. In the second half of my speech, I will dive more deeply into the Bank’s efforts to assess our actions during the pandemic and learn from that analysis. I’ll talk about some of the lessons that we’ve already shared with Canadians. And I’ll give you some insight into a new review we are doing on our use of exceptional I would like to thank Sermin Gungor, Jonathan Witmer and Carly MacDonald for their help in preparing this speech. Not for publication before June 13, 2024 9:35 am Eastern Time -2monetary policy tools in the pandemic, including details on how we will communicate the results of that work. After an event like the COVID-19 pandemic, it is important to take a step back and learn from the experience. That way we can sharpen our response for the next crisis. Sharing what we learn with the public is critical so Canadians not only understand our actions, but also know we are accountable to them. We have a lot to talk about, so let’s dive in. A crisis like no other First, let me take you back to March 2020. As the COVID-19 pandemic took hold, large parts of the economy shut down and financial markets were severely shaken. Policy-makers here and around the world were worried we would see a repeat of the Great Depression. Confronted with an unprecedented crisis, the Bank took immediate action. We cut the policy rate to 0.25%, which is our effective lower bound. We also launched emergency liquidity facilities and programs to restore financial market functioning. And the Bank did not act alone. Governments in Canada did their part, as did governments and central banks around the world. By the summer of 2020, financial markets were functioning again, but Canada was still in a health and economic crisis.1 Millions of people had lost their jobs and we were facing the deepest economic decline in decades. Inflation had turned negative, and there were worries that deflation would take hold. We did not have a vaccine at that point, so there was no way to know when, or even how, the pandemic would end. Faced with the unknowable, Governing Council judged more stimulus was needed to revive the economy and sustainably return inflation to the 2% target. Interest rates were as low as they could go, so the next step was to look in our extended monetary policy tool kit.2 Two tools were well suited: QE and extraordinary forward guidance. Our exceptional actions Remember, monetary policy is all about shifting the timing of spending to stabilize economic activity and inflation. Central banks lower interest rates to encourage spending when the economy is weak. Whether it is individuals buying things such as home office furniture and fitness gear or a business investing in, say, new facilities or equipment—this spending protects jobs and ensures the economy won’t end up as weak as it could have been. 1 J. Fernandes and M. Mueller, “A Review of the Bank of Canada’s Support of Key Financial Markets During the COVID-19 Crisis,” Bank of Canada Staff Discussion Paper No. 2023-9 (April 2023). 2 G. Johnson, S. Kozicki, R. Priftis, L. Suchanek, J. Witmer and J. Yang, “Implementation and Effectiveness of Extended Monetary Policy Tools: Lessons from the Literature,” Bank of Canada Staff Discussion Paper No. 2020-16 (December 2020). -3But when policy interest rates are as low as they can go, central bankers need other tools to add stimulus. This is where QE and extraordinary forward guidance come in. Under QE, a central bank buys a lot more government bonds than usual. This bids up the price of the bonds and lowers their returns, or yields. Lower yields on government bonds pull down the lending rates that matter to households and businesses. This makes borrowing cheaper. Extraordinary forward guidance also helps bring down longer-term rates. The way it works is a central bank signals it will keep the policy rate at its lowest possible level until a specific condition is met or for a specific period, which is typically longer than financial markets would otherwise expect. By lowering borrowing costs, both QE and extraordinary forward guidance encourage spending and reduce the risk that inflation will fall short of the 2% target. These exceptional policies can also have an effect through the exchange rate. 3 All else equal, lower interest rates in Canada may prompt some investors to shift their funds out of Canadian dollars and into other currencies. This could lead the Canadian dollar to depreciate. A weaker currency makes Canadian exports more attractive, which boosts the economy. Let’s turn now to the effectiveness of QE and extraordinary forward guidance during the pandemic. One way to gauge the impact of exceptional policies is to look at how other interest rates moved compared with our policy rate. Here, I’ll compare how much five-year government bond yields fell relative to the decline in our policy rate. Let’s consider the last four periods when the Bank cut interest rates by 150 basis points (bps) or more: the mid-1990s, the early 2000s, the 2008–09 global financial crisis and, finally, the COVID-19 pandemic (Chart 1). Keep in mind, we could not lower the policy rate as much in the pandemic as in the other periods because we were already close to the effective lower bound. Despite this, fiveyear rates moved more relative to our policy rate during the pandemic. 3 S. Kabaca and K. Tuzcuoglu, “International Transmission of Quantitative Easing Policies: Evidence from Canada,” Bank of Canada Staff Working Paper No. 2022-30 (June 2022) Chart 1: The movement of long-term rates relative to the policy rate in recent easing cycles Ratio of change in the five-year Government of Canada bond yield to the total decline in the policy rate 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 1995–96 2000–02 2007–09 2019–20 Note: The five-year yield for the pandemic cycle peaked in December 2019, the month the first COVID-19 cases emerged globally. The decline in both the policy rate and the five-year rate is from their highest level to their lowest level within the easing period. Source: Bank of Canada The pandemic was the first time the Bank used QE and only our second time using extraordinary forward guidance. The higher movement of five-year rates relative to the policy rate during the pandemic suggests these exceptional policies were effective. Focusing in on QE, there are various ways researchers can assess the impact of large-scale bond purchases on yields. A common method is to use event studies, which look at how much bond yields move at the time central bank purchases are announced. Using this method, Bank staff estimate the impact of QE to have been about 20 bps on 10-year government bond yields. However, the impact may have been much larger. The same study finds that because there was some expectation the Bank would do QE even before purchases were announced, 10year bond yields could have been as much as 80 bps higher without QE. 4 For context, we would need to cut the policy rate by a lot more than 20 bps or 80 bps for it to have a similar impact on 10-year yields. This is because the effect of policy rate changes typically fades away after a couple of years. 4 For more, see Azizova, C., J. Witmer and X. Zhang, “Assessing the Impact of the Bank of Canada’s Government Bond Purchases,” Bank of Canada Staff Discussion Paper No. 2024-5 (June 2024). An earlier study looked at the impact of the initial announcement of the Government Bond Purchase Program. See Arora, R., S. Gungor, J. Nesrallah, G. Ouellet Leblanc and J. Witmer, “The impact of the Bank of Canada’s Government Bond Purchase Program,” Bank of Canada Staff Analytical Note No. 2021-23 (October 2021). Let me explain why bond yields would have been higher without QE. Early in the pandemic, governments were issuing far more bonds than usual. If investors were to purchase the higher volume of bonds over a short period of time, they would expect higher yields. But the Bank’s QE purchases meant that investors didn’t have to increase their purchases as the bonds were issued. This helped keep yields, and borrowing rates for households and businesses, from rising.5 Put another way, the Bank’s research suggests that without QE, longerterm interest rates would not have been as low as they were. Of course, many domestic and global factors affected bond yields early in the pandemic. This means estimates of QE’s impact on yields are imprecise. Likewise, it is difficult to be exact in estimating how QE affected the economy. Bearing that uncertainty in mind, the research I mentioned earlier finds that QE may have pushed up gross domestic product (GDP) by as much as 3% at its peak.6 So, let’s now look at how the economy actually fared during the pandemic (Chart 2). Recall that we were worried about a repeat of the Great Depression. Millions of people were out of work, GDP was cratering and inflation was well below target. There were concerns that making up lost ground would take years. 5 An evaluation of the economic impacts of QE based on this estimate could understate the effectiveness of QE. For instance, this estimate assumes the government bond demand curve is linear and may not fully capture the impact of QE on yields. 6 This number is based on QE having an 80-bps impact on bond yields. Estimates of the impact of these lower interest rates on the economy are sensitive to the model used. -6Chart 2: The economy recovered relatively quickly during the COVID-19 pandemic Real GDP, quarterly data, index: 2019Q4 = 100 Index Range of scenarios - April 2020 Monetary Policy Report Note: GDP is gross domestic product. In the April 2020 Monetary Policy Report, the Bank used scenarios rather than a base-case projection due to the uncertainty of the COVID-19 pandemic. Range of scenarios represents the plausible paths the economy could have taken based on those scenarios. Sources: Statistics Canada and Bank of Canada calculations and projections Real GDP Last observation: 2024Q1 Instead, the economy recovered relatively quickly. In Canada, vaccines were rolled out widely in the first half of 2021. GDP rebounded and reached its prepandemic level later that year, supported by monetary and fiscal policy. Another way to see the impact of our monetary stimulus is to look at growth rates of money and credit. There are many different measures of money. But let’s look at M1++, which includes currency in circulation—the bank notes in people’s purses, pockets or wallets—plus chequing and savings deposits. The growth rate of M1++ tends to reflect the impacts of all our monetary policy actions, including changes to the policy interest rate and our use of exceptional tools. During the pandemic, M1++ grew much faster than in other periods of monetary policy easing since 1990. That’s despite limits on how much the policy interest rate could be reduced (Chart 3). As monetary policy eases, it also stimulates borrowing by households and firms. This shows up in credit growth, with a lag relative to money growth. During the pandemic, credit growth also increased, though its higher growth rate was still within historical experience. Together, these data suggest our policies were effective in increasing borrowing. Chart 3: Money and credit growth rates increased in the COVID-19 pandemic Year-over-year growth rates, monthly data % -5 -10 Core CPI range M1++ Total household and business credit Note: Core CPI range is CPI-trim and CPI-median. M1++ is all currency in circulation as well as chequing and savings deposits. Sources: Statistics Canada and Bank of Canada Last observation: March 2024 Before moving on, I’d like to comment more generally on money growth and inflation. I’m not going to pretend that we got everything right in our pandemic response, but the evidence suggests that the run up in inflation that started in 2021 was mainly driven by supply-side issues, including commodity price swings and supply disruptions.7 When we look at the last three decades, we see very little correlation between money growth and inflation. With that said, let’s now move on to quantitative tightening. Our progress in unwinding QE By mid-2021, it was clear the economic recovery was happening faster than we expected. For its part, inflation had climbed above 3% and over the months that followed it began to broaden. It was getting closer to the time to start tightening. In October 2021, we were the first major central bank to end QE. We started raising the policy interest rate in March 2022. And then in April 2022, we began QT.8 As monetary policy tightened, money growth eased and then contracted (Chart 3). When we started QT, we said we would let bonds roll off our balance sheet as they matured and not replace them. This would allow our balance sheet to shrink 7 For more, see F. Bounajm, J.-G.-J. Roc and Y. Zhang, “Sources of pandemic-era inflation in Canada: an application of the Bernanke and Blanchard model,” Bank of Canada Staff Analytical Note No. 2024-13 (June 2024), and Y. Chen and T. Tombe, “The Rise (and Fall?) of Inflation in Canada: A Detailed Analysis of Its Post-pandemic Experience,” Canadian Public Policy 49, no. 2 (June 2023): 197–217. 8 See W. Du, K. Forbes and M. Luzzetti, “Quantitative Tightening Around the Globe: What Have We Learned?” National Bureau of Economic Research Working Paper No. 32321 (April 2024). -8predictably and has allowed government debt holdings to shift gradually from the Bank to the private sector. Since we began QT, our Government of Canada bond holdings have declined by about 45%, without disrupting financial markets (Chart 4). QT also proceeded smoothly through the tensions in the US banking sector in the spring of 2023. Chart 4: Changes to the Bank of Canada's balance sheet Monthly data Cad$ millions 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 Total Government of Canada direct and guaranteed securities Deposits by members of Payments Canada Source: Bank of Canada Last observation: May 2024 We expect QT to end sometime in 2025, which would also make us one of the first central banks to wrap up the normalization process. Why has QT been so smooth in Canada? I like to think it’s because we have been transparent. Information on our bond holdings and their maturities is publicly available. And we have provided regular updates to the public and market participants on where we are going and our progress in getting there. Being accountable to Canadians That brings me to transparency and accountability. Let’s briefly go back to the beginning of the pandemic. Try to remember just how little we knew about the virus and how it would affect our lives and the economy. In those early days, there was simply too much uncertainty for our standard analysis, and that is exactly what we told Canadians. We didn’t provide a basecase projection in the April and July 2020 Monetary Policy Reports. Instead, in April, we outlined various scenarios of how the crisis might play out. And in July, we used a central scenario to help explain our assumptions about the pandemic and the economy. In both cases, we were clear about what we didn’t know and about the range of possibilities we were considering. We were also transparent about the actions we were taking. For example, we released a summary of deliberations for the unscheduled rate decision on March 13, 2020, and we provided weekly balance sheet updates after rolling out largescale asset purchases to restore market functioning. -9As the pandemic progressed, we began to reflect on the effectiveness of our policy decisions and other actions. We shared those findings with the public. In the July 2022 Monetary Policy Report, when inflation was near its peak, we detailed the main factors behind our prior inflation forecasting errors.9 I want to highlight two key points about this. First, we did this work at a time when prices were still climbing sharply—in essence, we were reviewing our actions in real time. Second, we didn’t wait until the crisis was over to share our findings with the public. We put them out as quickly as we could. We did this because we wanted to be transparent with and accountable to Canadians. In December 2022, Governor Tiff Macklem spoke in detail about the lessons learned from the Bank’s experience with unexpectedly high inflation. He also touched on how those lessons would shape our decision-making process going forward.10 In March 2023, Deputy Governor Toni Gravelle gave a speech assessing the Bank’s market interventions during the pandemic.11 His remarks drew from a detailed review by staff of the emergency programs and facilities the Bank used to restore market functioning at the onset of the pandemic.12 Over the course of 2023, my colleagues and I continued to speak frankly about what we were seeing in the data and our takeaways. In his year-end speech, the Governor updated Canadians on how we were applying pandemic lessons to our work. And he detailed how the Bank was enhancing its models, surveys and analysis to sharpen our future responses, particularly in times of uncertainty.13 As well, I’d be remiss not to mention that my remarks today draw on research and analysis by Bank staff throughout the pandemic. This work is crucial to building our understanding of how the economy acts in unpredictable times and to ready us for the next crisis. So where are we now? Higher interest rates have worked, inflation is now below 3% and we are seeing more signs that underlying price pressures are easing (Chart 5). This makes it a good time to take stock of our pandemic response. 9 See Bank of Canada, “Appendix: Main factors behind inflation forecast errors,” Monetary Policy Report (July 2022). 10 T. Macklem, “Putting the resolute in resolutions: Looking ahead to lower inflation” (remarks to the Business Council of British Columbia, Vancouver, British Columbia, December 12, 2022). 11 T. Gravelle, “The Bank of Canada’s market liquidity programs: Lessons from a pandemic” (remarks to the National Bank Financial Services Conference, Montréal, Quebec, March 29, 2023). 12 G. Johnson, “A Review of the Bank of Canada’s Market Operations Related to COVID-19,” Bank of Canada Staff Discussion Paper No. 2023-6 (March 2023). 13 T. Macklem, “The path to price stability” (remarks to the Canadian Club Toronto, Toronto, Ontario, December 15, 2023). - 10 - Chart 5: Total and core inflation have eased but remain above the 2% target Year-over-year growth rates, monthly data % Inflation target set at 2% -2 Core CPI range Inflation target CPI inflation Note: CPI is consumer price index. Core CPI range is CPI-trim and CPI-median. Inflation targeting was introduced in 1991 and the target was gradually lowered from 4% in November 1991 to 2% in December 1995. Sources: Statistics Canada and Bank of Canada Last observation: April 2024 As I mentioned earlier, we are putting together an in-depth review of all our exceptional actions taken during the pandemic, including the market-functioning programs, QE and extraordinary forward guidance. This review will draw on analysis that’s already been done, and some that is in-progress. It will lay out our lessons learned, including some we’ve already shared, and identify questions that will guide future work. It is important that we learn from our own actions, but it is also important to get other perspectives. Therefore, this review will be assessed by external experts. We expect the final report to be published early next year. While this review is a significant step, it is not the final word. Questions will continue to be asked that may shape if and how we use our exceptional tools in the future. These questions are particularly valuable in a world where the next crisis may look different from those in the past. Conclusion To wrap up, the pandemic was a period defined by the unknowable. Uncertainty was particularly high. So, the Bank took a risk management approach to decision-making. We considered alternative futures and thought about the consequences of making policy errors. Governing Council then chose a policy course that accounted for those risks. Our research into our use of exceptional tools during the pandemic suggests those policies helped lower longer-term interest rates by increasing monetary policy stimulus even after the policy rate was brought as low as possible. The unwinding of QE through QT has gone smoothly. However, it is worth remembering that we faced an unprecedented shock when we decided to use QE. The bar for us to use QE again is very high. - 11 Last week, we cut the policy rate to 4.75%. If inflation continues to ease—and our confidence that inflation is headed sustainably to the 2% target continues to increase—it is reasonable to expect further cuts. But we are taking our interest rate decisions one meeting at a time. It is comforting to see inflation come down. But it is alarming that it rose as much as it did. Our focus now is on the lessons we can take from our pandemic experience and how those lessons will guide the future application of monetary policy. Thank you for your time. I’m happy to take any questions.
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 24 June 2024.
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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 24 July 2024.
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Tiff Macklem: Release of the Monetary Policy Report Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 24 July 2024. *** Good morning. I'm pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss the July Monetary Policy Report (MPR) and today's policy announcement. Today, we lowered our policy interest rate a further 25 basis points to 4.5%. This decision reflects three key considerations. First, monetary policy is working to ease broad price pressures. Second, with the economy in excess supply and slack in the labour market, the economy has more room to grow without creating inflationary pressures. Third, as inflation gets closer to the 2% target, the risk that inflation comes in higher than expected has to be increasingly balanced against the risk that the economy and inflation could be weaker than expected. Looking ahead, we expect inflation to moderate further, though progress over the next year will likely be uneven. This forecast reflects the opposing forces affecting inflation. The overall weakness in the economy is pulling inflation down. At the same time, price pressures in shelter and some other services are holding inflation up. We are increasingly confident that the ingredients to bring inflation back to target are in place. But the push-pull of these opposing forces means the decline in inflation will likely be gradual, and there could be setbacks along the way. If inflation continues to ease broadly in line with our forecast, it is reasonable to expect further cuts in our policy interest rate. The timing will depend on how we see these opposing forces playing out. In other words, we will be taking our monetary policy decisions one at a time. Let me highlight some of the economic dynamics covered more fully in the MPR. Economic growth in Canada has picked up but remains weak relative to population growth. Household spending has been soft. Pent-up demand for things like new cars and travel is fading. And many families are setting aside more of their income for debt payments, leaving less money for discretionary spending. In the labour market, employment has continued to grow more slowly than the labour force. Job seekers are now taking longer to find work, and the unemployment rate has risen to 6.4%. The job vacancy rate has come down significantly, and reports of labour shortages are now below normal. Overall, indicators suggest some slack in the labour market. Wage growth is also showing signs of moderating, although it remains elevated. 1/2 BIS - Central bankers' speeches Looking ahead, economic growth is expected to increase in the second half of 2024 and through 2025. This reflects stronger exports and a recovery in household spending as borrowing costs ease. Business investment is also expected to strengthen as demand picks up, and residential investment is forecast to grow robustly. Overall, with the economy strengthening, excess supply will be absorbed next year and into 2026. CPI inflation moderated to 2.7% in June after increasing in May, and broad inflationary pressures continued to ease. The Bank's preferred measures of core inflation have now been below 3% for several months and the breadth of price increases across components of the CPI is near its historical average. Corporate pricing behaviour has largely normalized, and near-term inflation expectations have come down, although they are still above normal. However, shelter price inflation remains high. Inflationary pressures are also evident in services that are closely affected by wages, such as restaurants and personal care. The Bank's preferred measures of core inflation are expected to slow to about 2½% in the second half of 2024 and ease further in 2025. CPI inflation is forecast to come down below core this fall and settle sustainably around the 2% target next year, but it's unlikely to be a straight line. As always, there are risks around our inflation outlook. Globally, geopolitical uncertainty is high. Here in Canada, the biggest downside risk is that household spending could be weaker than expected. On the upside, inflation in shelter and other services could prove more persistent. Let me conclude. With broad price pressures continuing to ease and inflation expected to move closer to the 2% target, Governing Council decided to reduce the policy interest rate by a further 25 basis points. In recent months, we have continued to make progress bringing inflation down. With the target in sight and more excess supply in the economy, the downside risks are taking on increased weight in our monetary policy deliberations. We need growth to pick up so inflation does not fall too much, even as we work to get inflation down to the 2% target. We are carefully assessing the downward pull on inflation from ongoing excess supply, and the pressures from shelter and other services that are holding inflation up. Monetary policy decisions will be guided by incoming information and our assessment of their implications for the inflation outlook. The Bank remains resolute in its commitment to restoring price stability for Canadians. With that summary, the Senior Deputy Governor and I would be pleased to take your questions. 2/2 BIS - Central bankers' speeches
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Canada-UK Chamber of Commerce, London, United Kingdom, 10 September 2024.
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Remarks by Tiff Macklem Governor of the Bank of Canada Canada-UK Chamber of Commerce September 10, 2024 London, UK Rewired, recast and redirected: Global trade and implications for Canada Introduction The last time a Bank of Canada governor spoke to the Canada-UK Chamber of Commerce it was 2018. My predecessor, Stephen Poloz, spoke to you about low global interest rates, the steady reduction of inflation risks and the successful conclusion of the North American trade negotiations. Brexit was in motion but not yet a reality. How the world has changed in just six years. The pandemic, Russia’s unprovoked invasion of Ukraine, and a global battle against inflation have altered the economic landscape. Concerns about national and economic security are changing trade, investment, and business decisions. Accelerating digitalization, particularly artificial intelligence (AI), is creating new competition for economic power. Geopolitical tensions are shifting economic relationships, and industrial policy is making a comeback. In my time with you today, I’ll talk about how trade is changing in response to these forces, both globally and for Canada. I’ll also discuss what international financial institutions and the Bank of Canada can do to safeguard stability and prosperity as the global economy shifts beneath our feet. While there are many uncertainties, one thing looks clear: international trade will be different in the years ahead. Canada needs to be ready for the opportunities and the disruptions. The benefits of open trade As World War II was ending, allied nations created the Bretton Woods institutions—the International Monetary Fund (IMF), the World Bank and what would eventually become the World Trade Organization (WTO). They wanted to avoid the protectionism and instability of the Great Depression. And they believed economic cooperation, including open trade, was the best way to sustain peace and build prosperity. I would like to thank Patrick Alexander, Daniel de Munnik, Jessica Lee, Olena Senyuta and Ben Tomlin for their help in preparing this speech. Not for publication before September 10, 2024 08:10 am Eastern Time -2For roughly the next 65 years, rising global trade and economic growth went hand in hand. Open trade brought specialization, innovation and economies of scale. It drove investment, efficiency and productivity. For consumers, open trade increased selection and lowered prices. Trade spurred income growth across countries, lowered global poverty and raised standards of living. Trade grew faster than GDP until about the global financial crisis in 2008–09.1 Now, some think we’ve entered a new period of “deglobalization.” Others see it as a slowdown in globalization—a “slowbalization.” The enormous disruptions caused by the pandemic make the recent trend hard to discern, but there’s no question global trade growth has at least slowed (Chart 1). 1 S. Aiyar, J. Chen, C. H. Ebeke, R. Garcia-Saltos, T. Gudmundsson, A. Ilyina, A. Kangur, T. Kunaratskul, S. L. Rodriguez, M. Ruta, T. Schulze, G. Soderberg and J. P. Trevino, “Geoeconomic Fragmentation and the Future of Multilateralism,” International Monetary Fund Staff Discussion Note No. 2023/001 (January 2023). -3That’s a big concern, especially for open economies like Canada and the United Kingdom. To some extent, a slowdown in global trade growth was inevitable. Once tariffs were substantially reduced and most economies were participating in global markets, the potential to expand trade by lowering tariffs further and including more countries became more limited. But recent events have exacerbated this slowdown. New global tensions have added trade frictions between competing countries. Public and political support for open trade is also waning, in part because the benefits have not been evenly shared. We’ve all benefited from a wider selection of goods and services at lower prices. But when lowcost importers undercut domestic producers, workers who lost their jobs lost more than they gained. With changing economics, new security threats, and waning support, global trade is being rewired, recast and redirected. Trade is being rewired by shifting international economics. China is no longer the lowest-cost global supplier of consumer goods. Production of many manufactured goods is moving elsewhere. As China moves up the value chain, it’s competing more directly with advanced economies. At the same time, the pandemic, Russia’s invasion of Ukraine, geopolitical conflict and climate change have all made supply chain resilience a greater priority, even at the cost of efficiency. Trade policy is being recast to encompass national and economic security and to foster leadership in strategically important industries. Trade and industrial policy are being used to make the supply of critical inputs more secure and protect and promote domestic production in key industries. Globally, trade is being redirected by import and export restrictions, tariffs and conflict. Trade in high tech is constricted by geopolitical concerns. The shift to cleaner growth is accelerating trade restrictions on raw materials needed for green energy. Climate change and conflicts threaten food security, prompting export restrictions on key staples. And Russia’s invasion of Ukraine has led to a multilateral expansion of the scope and reach of economic sanctions. How does an open economy like Canada best navigate this changing trade landscape? That’s a big question, so let me break it down into some manageable bites. Trends in global trade There are three global trends to highlight. First, global trade growth has slowed, and this slowdown is concentrated in advanced economies. Second, the growth we are seeing in trade is shifting from goods to services. And third, trade is fragmenting as China’s role changes. In sum, trade routes and trade partners are shifting, and the implications for our prosperity could be significant. Let me take each of those in turn. -4Advanced economies are driving the slowdown in global trade First, trade growth in advanced economies has slowed in the last decade, and this has pulled down global trade growth. But trade by and between emerging and developing countries has continued to grow (Chart 2). WTO Director-General Ngozi Okonjo-Iweala believes trade has entered a new, “more inclusive” phase, which she calls “reglobalization.” Over 25 years, the share of global trade among developed countries has declined, while the share among developing economies has more than doubled.2 As Dr. Okonjo-Iweala has stressed, preserving open trade is critical to raising incomes in developing economies and narrowing the gap with more advanced countries. Services trade is picking up as goods trade slows The second trend is that trade in services is picking up, even as goods trade is slowing. Globally, goods trade is a much bigger piece of the pie—more than three times larger than trade in services. So strong growth in services doesn’t fully offset weak growth in goods. But trade in services is gaining share. 2 United Nations Conference on Trade and Development, Trade and Development Report 2023: Growth, Debt, and Climate—Realigning the Global Financial Architecture (2024). -5Since about 2000, growth in services trade has outpaced goods, though the impact of the pandemic skewed both (Chart 3). Global demand for goods soared early in the pandemic when we were all stuck at home. Then when economies reopened, consumers turned to services, particularly all the ones we’d missed during lockdowns. But the pandemic may have also provided a more durable boost to trade in services. Because customers had to be served digitally during lockdowns, businesses invested in digital delivery, adding to supply along with demand. Increasingly, exporters deliver services through computer networks—via the internet, apps, emails, voice and video calls, and digital intermediation platforms. Trade volumes for commercial services have risen about 20% since 2019. Remote training, teaching and management services have risen sharply, as have financial and travel services. And digitalization continues—especially as AI creates new services and changes the way they’re delivered. Whether growth will continue at this rapid pace is an open question, but the seemingly vast potential of digitalization suggests future growth in trade will tilt to services. -6Global relationships are shifting The final global trend is the shift in global relationships. China is a big part of that story. Its exports have moved up the global value chain, and geopolitical tensions are altering key relationships. Rising wages, increased expertise and deliberate government policy have all pushed China into higher-tech electronics and advanced products. China is now the world’s biggest exporter of broadcasting equipment, computers, solar power and electric batteries. Its electric vehicle (EV) industry is the largest in the world, with over half of global production.3 These advances have sparked concern that Chinese technology could both displace local industry and compromise national and economic security. The United States has banned the use of some Chinese products and restricted the exports of leading technologies to China. Other countries, including Canada and the United Kingdom, have taken similar actions. In May, the United States announced it will quadruple its tariffs on Chinese EVs to 100%. Canada is following suit. The European Union is also applying higher tariffs on EVs. But the increased use of trade restrictions is much broader than China (Chart 4). 3 International Energy Agency, “Electric Vehicles” (June 6, 2024). -7Trade restrictions increased sharply around the world starting in about 2018. So did industrial policy to bolster domestic players against imports and respond to security concerns. Security risks are real and need to be addressed, but it is important they not become a pretext for inefficient protectionism. Trade is also being rerouted as businesses try to diversify supply chains and find friendlier partnerships.4 But the combination of more trade restrictions and shifting trade routes means supply chains have actually gotten longer—with products detouring through other countries such as Vietnam instead of going directly from China to the United States.5 Fragmentation has economic costs. Businesses have to focus on national security and geopolitical uncertainties, not just efficiencies and productive partnerships. The IMF estimates that costs of trade fragmentation could range from 0.2% to 7% of global GDP.6 But costs go beyond trade—and the losses are unlikely to be distributed evenly. The loss of knowledge spillovers, high-tech partnerships, critical imports and capital flows affect low-income economies in particular. The potential for trade and innovation to continue to lower global poverty will decline.7 Trends in Canada’s trade So those are the global trends. In many ways, Canada is a microcosm of these global shifts. Our overall trade growth has slowed in recent years. Our export growth has been coming increasingly from services. And global fragmentation is presenting new challenges and opportunities. Slowing trade growth Canada is a very open economy. Over the last decade, trade as a share of GDP has been about two-thirds—the second highest in the G7 and the fourth highest in the G20. We rely on exports for roughly one-third of our income. Imported components feed our industry, and imported final goods and services improve the lives of Canadians. The United States is, by far, Canada’s biggest trading partner—accounting for roughly 75% of Canada’s exports. Thanks in part to the Canada-US Free Trade Agreement in 1989, and updates in the years following, Canada and the United States benefit from the largest bilateral trade relationship in the world (Chart 5). Our biggest exports to the United States are oil and gas, and motor vehicles and parts. 4 See L. Alfaro and D. Chor, “Global Supply Chains: The Looming ‘Great Reallocation’,” paper prepared for the Jackson Hole Economic Policy Symposium: Structural Shifts in the Global Economy, August 24– 26, 2023. Jackson Hole, Wyoming: Federal Reserve Bank of Kansas City. 5 H. Qiu, H. S. Shin and L. S. Y. Zhang, “Mapping the realignment of global value chains,” Bank for International Settlements Bulletin No. 78 (October 3, 2023). 6 These are long-term costs estimates. See G. Gopinath, “Geopolitics and its Impact on Global Trade and the Dollar,” (speech delivered to the Stanford Institute for Economic Policy Research, Stanford, California, May 7, 2024) and Aiyar et al. (2023). 7 See Aiyar et al. (2023). But our trade agreements go well beyond the United States: in total, Canada has 15 trade agreements covering 51 countries and about two-thirds of world GDP.8 Together, these agreements cover 1.5 billion consumers worldwide. But even with this broad market access, growth in Canada’s exports has slowed over the past 10 years. The pandemic obscures the overall trend, but it’s clear that goods exports have not kept up with economic growth in Canada’s two biggest markets—the United States and the European Union (Chart 6). 8 The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) is a free trade agreement in place between Canada and 10 other countries in the Indo-Pacific region: Australia, Brunei, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam. On July 16, 2023, CPTPP members signed an Accession Protocol with the United Kingdom. The Canada-European Union Comprehensive Economic and Trade Agreement is a bilateral agreement between Canada and the European Union. The agreement covers virtually all sectors and aspects of Canada-EU trade with the goal of eliminating or reducing barriers. The slowdown is fairly widespread. Production and exports of machinery and equipment, motor vehicles and other non-energy goods have not expanded in more than a decade. Increasing strength in services Just as we’ve seen globally, where we have seen growth in Canada is in exports of services. As goods growth began to stall around the time of the global financial crisis, growth in services exports picked up (Chart 7). - 10 - As in other countries, digital delivery has helped drive Canada’s services exports— particularly computer, management and financial services, as well as research and development (Chart 8). - 11 That plays to Canada’s strengths, including our highly educated work force. Since 2019, real exports of commercial services have grown 17%, adding more than $15 billion to real Canadian GDP. Global fragmentation Canada is somewhat insulated from the third global trend—fragmentation—because so much of our trade is with the United States. But shifting supply chains present risks as well as opportunities for Canadian business. At the start of the millennium, Canada had the biggest share of US goods imports, at about 20%. By 2017, China had the largest share, and Canada had fallen to third place. As the United States finds new partners to supply the goods it once got from China, Canada is starting to reassert itself. In the first quarter of 2024, Canada was the second-largest source of US goods imports after Mexico, and exports were ticking up. Navigating the future That brings me to the challenge ahead. The trade landscape is shifting. How should Canada respond? We need to seize opportunities to secure our place in a rewired trade system. We need to be effective at the international table to influence how trade is recast and redirected. And we have to manage the shocks that are bound to come. Smart regional trade Fortunately, geography and history have given Canada significant advantages in global trade. With the Canada-United States-Mexico Agreement, we have a strong relationship with the biggest and richest market in the world—which sits right next door. Despite the shifting trade winds, 77% of Canadian goods exports still flow to the United States. And Canada is also the number one export destination for the United States, and the largest destination partner for 32 of its 50 states. The continued success of this trade relationship is in the interest of both countries. Beyond the United States, Canada has strong market access around the world, thanks to the trade agreements I mentioned earlier. But holding our ground won’t be enough. We need to build better relationships, produce the products people want to buy, build and maintain the infrastructure to get those products to market, and boost our productivity to compete globally. The Canada-UK relationship is an important one. The United Kingdom is Canada’s third-largest trading partner, with two-way trade of more than $50 billion. We’ve made progress toward a bilateral trade agreement. But sticking points remain—and until they are resolved, too many goods and services will remain outside the competitive, tarifffree supply chains we’ve established with other economies. There are benefits to getting this done for both our countries. Canada needs to be able to sell the products people want. We are a stable, responsible and technologically advanced energy producer. Our auto sector is globally competitive. And we have new and emerging areas of strength, including in green technology and electricity. - 12 To leverage these strengths, we need to invest in trade infrastructure and reduce trade barriers so that integrating Canada into the North American value chain is more attractive for businesses. This includes investing in our electricity grid and transportation infrastructure. And businesses need to invest in new equipment and innovation to be globally competitive. As trade is recast for security or strategic reasons, Canada is a trusted and reliable trading partner. Canada is not going to be the cheapest alternative. But we have a highly skilled labour force, reliable energy and transportation networks and solid financial institutions. Moreover, Canada has a stable democracy and strong rule of law. And we provide a reliable and important voice at the global table. Effective multilateral institutions That brings me to our second priority. We need to invest in effective multilateral institutions—they are more important than ever in this fragmented world. And they will be only as effective as members want them to be. It has never been easy to attain international economic cooperation, and open trade has come under particular pressure. But the trends I’ve just outlined increase the urgency. Our common interest is shared prosperity. We all benefit from a stable, open, rulesbased global order. We need to build it, protect it, adapt it and ensure the benefits are shared. Effective and legitimate multilateral institutions don’t just happen. They need good governance, adequate resources, talent and inspired management. Canada has long invested in the Bretton Woods institutions. We have a strong voice at the IMF and Financial Stability Board (FSB). We know the value of an effective WTO that can serve as a forum for negotiations, act as an arbiter of disputes and monitor the implementation of trade agreements. As Canada assumes the G7 presidency in 2025, we have a responsibility to lead difficult discussions. That includes trade, global financial stability and mitigating climate change. As central bankers, our particular focus is the IMF, the FSB and the international monetary order. We need to be sure that the international monetary and financial system is up to the task and is integrated with the other parts. The fundamentals of economics have not changed, but the need for resilience and agility has increased with changing economic circumstances. Managing disruption Finally, Canada needs to be ready for the trade disruptions that seem inevitable amid a changing trade landscape. The Bank of Canada doesn’t set trade policy. But we need to understand shifts in global trade because they affect lives and livelihoods, and they drive costs and inflation. Conclusion So let me conclude with the implications for monetary policy. The rapid globalization through the 1990s to around the global financial crisis significantly reduced the prices for many globally traded goods. This contributed to a lower cost of living for many households. Going forward, with globalization slowing, the - 13 cost of global goods may not decline to the same degree. All things equal, this could put more upward pressure on inflation. Trade disruptions may also increase the variability of inflation. The pandemic taught us a lot about supply shocks and how they can affect the volatility of prices. Supply chains are complicated, and shocks affect inputs and outputs in different ways. And while supply shocks are historically transitory, they can persist—and accumulate. We also learned that when the economy is already overheated, disruptions to supply can have an outsized effect on inflation. So what is the Bank of Canada doing to ensure we’re prepared for the supply shocks that come with trade disruptions? We’re investing in data and analysis to better understand supply chains, especially at the global level. We’re updating our models to use scenarios when periods of uncertainty make central forecasts less reliable. And we’re using more microdata to track and understand the consequences of trade and industrial policy. But even with a better understanding and better information, trade disruptions may mean larger deviations of inflation from the 2% target. Supply shocks present central banks with a difficult trade-off—monetary policy can’t stabilize growth and inflation at the same time. That means we have to focus on risk management, balancing the upside risks to inflation with the downside risks to economic growth. Most importantly, we must avoid adding uncertainty to an already uncertain environment. That means ensuring inflation is low, stable and predictable even as global trade is being rewired, recast and redirected. Thank you.
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the National Bureau of Economic Research, Economics of Artificial Intelligence Conference, Toronto, Ontario, 20 September 2024.
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Remarks by Tiff Macklem Governor of the Bank of Canada National Bureau of Economic Research, Economics of Artificial Intelligence Conference September 20, 2024 Toronto, Ontario Artificial intelligence, the economy and central banking Introduction Around the world, digitalization is pulling economies in new directions. Artificial intelligence (AI)—and particularly its offspring, generative AI (GenAI)—are accelerating this pull. It’s still early days, but AI is already disrupting existing industries and creating new ones. How AI will affect the global economy—and indeed humanity—is on all our minds. It’s easy to find enthusiasts who say AI will take us to a land of plenty. But it’s also easy to find doomsayers who say we are headed for a bleak world with a few big winners and many more have-nots. Be wary of anyone who claims to know where AI will take us. There is too much uncertainty to be confident. We don’t know how quickly AI will continue to advance. And we don’t know the timing and extent of its economic and social impacts. But that doesn’t mean we can’t gain insights into what could happen. The past is still a useful starting point. The laws of economics still matter. People will still respond to incentives—and that includes prices. As central bankers, we care a lot about prices. It’s in our mandates to keep price inflation low and stable. So what does the latest wave of AI, and more broadly, ongoing digitalization, mean for what we do at the Bank of Canada? There are two broad elements. First, we need to better understand how AI will affect workers, consumers, the economy and inflation. And second, we need to use AI ourselves to best deliver on our mandate for Canadians. In my remarks today, I will focus mostly on how AI could impact the economy through productivity, employment and price-setting behaviour. Then I will discuss some of the implications for monetary policy. Finally, I will say a few words about how we are using AI at the Bank of Canada. I would like to thank Eric Santor for his help in preparing this speech. Not for publication before September 20, 2024 8:15 am Eastern Time Productivity How we apply our monetary policy tools depends on our assessment of the broad price pressures in the economy and where we think inflation is headed. A key input is our estimate of the economy’s maximum non-inflationary growth rate. We call this potential. Potential growth depends on the supply of labour and the productivity of that labour. AI is expected to mainly impact productivity. When labour productivity is rising, the economy can grow more quickly without causing inflation. So the questions we need to tackle seem simple enough: How and when will AI affect labour productivity? AI has all the hallmarks of a general-purpose technology, or GPT—meaning a technology that can have significant and wide-ranging effects on an entire economy. But how large and how wide-ranging are hard to predict. And forecasting the timing is no easier. We know from history that it takes years for a GPT to diffuse through the economy. We also know that the first applications are typically less transformative than the new businesses and new business models that eventually emerge. This all suggests that we won’t see the full effects of this wave of AI anytime soon. Nevertheless, we are seeing encouraging early results from firm-level studies on AI adoption. In one study, German companies that used AI were found to be more productive.1 In another, consultants at a global firm were, on average, able to produce better work and do that work faster when they used AI.2 A third study found AI helped make call centre employees more efficient by sharing best practices.3 And some of the biggest gains can be seen in coding—where GenAI has halved the time needed to complete some coding tasks.4 Still, these studies can’t tell us how AI will affect the broader economy. To understand that we need to consider the productivity effect of AI across all major sectors. One estimate is that AI could automate 25% of all work tasks in the United States and 1 D. Czarnitzki, G. P. Fernández and C. Rammer, “Artificial intelligence and firm-level productivity,” Journal of Economic Behavior & Organization no.211 (2023): 188–205. 2 F. Dell’Acqua, E. McFowland III, E. Mollick, H. Lifshitz-Assaf, K. C. Kellogg, S. Rajendran, L. Krayer, F. Candelon and K. R. Lakhani, “Navigating the Jagged Technological Frontier: Field Experimental Evidence of the Effects of AI on Knowledge Worker Productivity and Quality,” Harvard Business School Working Paper No. 24-013 (September 2023). 3 E. Brynjolfsson, D. Li and L. R. Raymond, “Generative AI at work.” National Bureau of Economic Research Working Paper No. 31161 (April 2023). 4 S. Peng, E. Kalliamvakou, P. Cihon and M. Demirer, “The Impact of AI on Developer Productivity: Evidence from GitHub Copilot,” arXiv:2302.06590 (February 2023). boost total factor productivity (TFP) by 9% over the next decade.5 A similar sustained improvement in TFP in Canada would raise the average income per-person by roughly $4,000 a year. This productivity boost is not just from automating tasks. As workers in lower productivity jobs are replaced by AI, they are freed up to fill other, more productive jobs in the economy. And new products and services emerge. These latter two effects provide most of the positive impact on productivity.6 However, more pessimistic estimates suggest that AI might have only a modest impact on productivity.7 These assessments take the view that fewer tasks can be effectively automated. AI could also create negative outcomes, such as amplifying internet addiction and enabling malicious actors. These adverse effects could substantially decrease the net positive impact of AI. As we look at the effects of AI on the broader economy, we also need to ask if this technology will be transformative enough to significantly boost productivity growth. Or will AI simply be the latest innovation in a chain of innovations—like the invention of the sewing machine or the evolution of telecommunications—to keep productivity rising at its historical pace. This matters a lot because productivity growth plays a key role in determining how fast the economy can expand without sparking inflation. So what is actually happening? The infrastructure needed to make AI broadly available is being built quickly. AI platforms are sprouting up, and it is getting easier for businesses—large and small—to access the technology. But we are still looking for the new products and services—and the new business models—that will transform efficiency and productivity. Prices and inflation AI adoption—and its full effect on productivity—will play out over many years. In the long run, we can expect AI to boost productivity. Higher productivity allows for higher wages and more spending without pushing up inflation. But what about in the short run? Already, strong investment in AI technologies is boosting demand in the economy. The run-up in equity prices is supporting consumption, as is the hiring boom for workers with AI and related skills. Electricity demand is also surging as new data centres are built to accommodate the enormous computing requirements of AI. 5 This estimate assumes a certain number of tasks across the entire economy that can be done by AI and a rate of AI adoption. See Goldman Sachs, “Gen AI: Too much spend, too little benefit?,” Global Macro Research Top of Mind issue 129 (June 25, 2024). 6 See Goldman Sachs (2024). 7 D. Acemoglu, “The Simple Macroeconomics of AI,” Massachusetts Institute of Technology Working Paper (April 2024). This all suggests that, in the short run, AI could boost demand more than it adds to supply through faster productivity growth. And if that happens, AI adoption may add to inflationary pressures in the near term. Labour markets One of the biggest questions is whether AI will be something that helps people do their jobs better or something that simply replaces jobs? There is a lot of talk, and some good research, on this issue. Studies suggest that a significant share of all job-related tasks could be done by AI in the next few decades. Over the very long run, machines could be doing a lot of the tasks that people do now. Does this mean that we are doomed to a surge in long-term unemployment? Economic history offers us many lessons on the effects of technological change. Over the past 200 years the displacement effects, or the jobs lost due to changes in technology, have been outweighed by the countervailing effects, or the increases in labour demand arising from these innovations. This includes jobs that are created because of increased capital investment, the advent of new goods and services, and greater demand for tasks that can’t be automated. To put it another way, from the mechanization of agriculture to the emergence of the assembly line to the introduction of computing and the internet, technological change has ultimately been a net positive for overall employment. But some argue that this time is different. In an AI-dominated world, the displacement effects could be bigger and the countervailing effects more muted. AI could shrink the number of non-automated tasks so much that there isn’t enough work left for the displaced workers. And if many of the new goods and services are created by AI itself, the labour market may not benefit from increased demand. In addition, in past change cycles the technology was diffused over a prolonged period, so the labour force had time to adjust. But this time adoption may happen much faster, creating more disruption and a loss of livelihoods that will be difficult to replace. So far, we don’t have much evidence that labour is being displaced by AI at rates that would lead to declines in total employment. If anything, digitalization—and the commercialization of AI—have likely been net job creators in Canada. Employment in Computer systems design and related services, which is a proxy for digitalization, has risen 48% since the end of 2019, compared with a 6% increase in employment for the rest of the economy. This recent growth builds on an existing trend—while overall employment is up 17% over the past decade, employment in the digitalization-related segment has more than doubled. But we know there are probably more profound effects to come. As AI becomes more established in the economy and its impacts more transformative, it could end up destroying more jobs than it creates. And the people who lose their work to automation may struggle to find new opportunities. This is a concern for us all. Understanding and shaping the labour market impacts will be increasingly important as AI continues to advance and diffuse through our economies. Price-setting behaviour In addition to productivity and the labour market, AI may also affect how businesses set prices. There is already evidence that digitally intensive firms change prices more frequently than less digitally intensive firms.8 For us central bankers, this means the Phillips curve might be steeper than previously thought.9 When combined with a more shock-prone world, this suggests inflation could be more volatile than it was in the 25 years before the pandemic. AI could also affect the level of competition in the economy, although its impact is ambiguous. Initially, AI-intensive start-ups could seize market share by undercutting incumbents. This would increase competition and lower prices. However, AI could also result in markets dominated by a handful of companies with monopoly power. In this scenario, AI would ultimately lead to less competition and higher prices. The monopoly effect is easy to imagine, with several superstar firms already dominating their sectors. Fortunately, we have competition authorities to deal with undue market power. But authorities will need to keep pace. All this means central banks need to be closely attuned to how AI is affecting inflation, both indirectly through overall demand and supply and directly through price-setting behaviour. AI and central banks Navigating uncertainty We know that AI could have profound effects on the economy. But we also know that the timing, magnitude and even direction of these effects is uncertain. So how do monetary policy-makers manage this uncertainty? When you enter a dark room, you don’t go charging in. You cautiously feel your way around. And you try to find the light switch. That is what we are doing. What we central bankers need is more light. This means better information, along with research and analysis on how technology is diffused. Its impact on businesses and on workers. And its effect on the overall economy and inflation. To this end, I encourage academics to work with businesses and policy-makers to better understand and predict the impacts of AI. And I applaud the National Bureau of Economic Research and my former colleagues at the University of Toronto for this conference series, which is putting a spotlight on the economics of AI. We can also use scenarios to better understand the potential effects of AI and manage risks so that we can get more of the good with less of the bad. For example, in a recent 8 Y. Gorodnichenko and O. Talavera, “Price Setting in Online Markets: Basic Facts, International Comparisons, and Cross-Border Integration,” American Economic Review no. 107, issue 1: 249–282 (January 2017). 9 However, in an environment with greater competition, firms may adjust their prices by less because they don’t want their prices to differ too much from those of their competitors. This could make the Phillips curve flatter. speech, Gita Gopinath, Deputy Managing Director of the International Monetary Fund, explored how the adoption of AI could worsen the next recession for workers.10 She noted that in previous downturns, most automation-related job losses happened in the first year of the recession and those jobs never came back. Widespread adoption of AI could make this problem worse because more jobs could be ripe for automation. AI adoption could also lead to financial stability issues. Banks and financial institutions are investing in AI to improve customer service, to enhance compliance and risk management, and to better assess credit and liquidity risk. In principle, these investments should improve efficiency and stability. But there are pitfalls. Operational risks could become concentrated in a few third-party service providers and an event at one of them could quickly spread through the financial system. The predictive ability of AI can deteriorate unexpectedly, suffer from hallucinations or be biased and discriminatory. And AI makes everything move faster, which could amplify severe market runs and herding behaviour in times of market volatility.11 Scenarios help us ask tough questions about how monetary and financial policies should respond to the risks we are facing. They also help us be proactive in protecting our economies and financial systems. Using AI at central banks Finally, let me say a few words about the use of AI at central banks. AI is not just for start-ups and tech giants. Many central banks are already using AI as they strive to deliver on their mandates. At the Bank of Canada, we use AI to: • forecast inflation, economic activity and demand for bank notes • track sentiment in key sectors of the economy • clean and verify regulatory data • improve efficiency and de-risk our operations And we’ve only just begun to explore this technology. With very large and highly disaggregated data sets now available, there is huge potential to use AI to understand how consumers and businesses are behaving and how companies are setting their prices. But to take full advantage of the potential of AI, we will need to invest in data and computing power. We also need to ensure staff have the skills to make the most of that investment. And we will need to leverage outside expertise. This is why we’re so excited to be part of the new Toronto Innovation Centre run by the Bank for International 10 See G. Gopinath, “Crisis Amplifier: How to Prevent AI from Worsening the Next Economic Downturn” (speech to the AI for Good Global Summit, Geneva, Switzerland, May 30, 2024). 11 I have focused on the economic and financial system impacts of AI. Of course, even bigger risks exist that go beyond the economic and financial realm of central banks. Computer scientists, ethicists, businesses and governments need to work together to ensure that AI remains in the control of humans for the benefit of humans. This includes managing risks with respect to bias, privacy and disinformation, and ensuring AI's values are aligned with ours. Settlements. The Innovation Centre is designed to encourage collaboration among academics, the private sector and central banks to explore the latest technologies. As we deploy AI, we also need to consider the ethical implications. It is not always easy to strike a balance between moving forward and fostering innovation and taking the time and care to be responsible and secure. At the Bank of Canada, we have principles that guide our use of AI. For example, we need to be transparent when we’ve used AI for a task, and we need to have safeguards in place to ensure we are appropriately skeptical when we use it to generate content or analysis. Conclusion It’s time for me to wrap up. The recent rapid advances in AI, and GenAI in particular, have the potential to transform economies around the world. However, a lot of uncertainty remains. We all need more light. We need academics and businesses to work together to examine how technology is diffused through the economy. And we need to better understand how AI will affect productivity, employment, price-setting behaviour and inflation. This work will take time. In the interim, we should use increasingly informed scenarios to help manage our uncertainty. We are still in the early days of what could be a transformative technological shift. We don’t know yet what will come, but we can shape the future path. For central banks, that means maintaining price and financial stability in the face of disruptive technological change. And it means leveraging AI to do our jobs better. Thank you.
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Remarks by Mr Nicolas Vincent, Deputy Governor of the Bank of Canada, at the Chamber of Commerce of Sherbrooke, Quebec, 19 September 2024.
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Nicolas Vincent: Monetary policy decision-making - behind the scenes Remarks by Mr Nicolas Vincent, Deputy Governor of the Bank of Canada, at the Chamber of Commerce of Sherbrooke, Quebec, 19 September 2024. *** Introduction Good morning. It's a pleasure to be here with you today. I've done a lot of hiking, camping and skiing in the Eastern Townships. But this is the first time I've had a chance to spend time in Sherbrooke. I'm very much looking forward to spending the next two days in your lovely city. As Bruno mentioned, I'm a professor at HEC Montréal and an external Deputy Governor of the Bank of Canada. As an external Deputy Governor, I am a full member of Governing Council. I participate in all discussions related to monetary policy and financial stability. The Bank's aim in creating an external, part-time role was to get new perspectives from someone who isn't from the world of central banks but still knows a thing or two about economics. Thankfully, my teaching experience and academic research have come in quite handy in my role at the Bank, as has my early-career work in the public service. Even with my experience, however, I've had to learn a lot since joining the Bank in March 2023, particularly about the process involved in making interest rate decisions. At the beginning of September this year, in light of recent progress in the fight against inflation, the Bank announced a third consecutive cut of 25 basis points, bringing the policy rate to 4¼%. It will likely come as no surprise to any of you that it's more pleasant to announce cuts than it is to announce increases. In recent years, decisions by the Bank have been the subject of much attention, interest and debate. This is to be expected. The decisions have an impact on everyone, in many different ways, and we are well aware of that. We know that households are worried about the cost of living, their mortgage loan renewal, house prices, rent and the fact that it is getting harder to find a job. Given the importance of our decisions, they must not be taken lightly. And having been at the Bank for 18 months now, I can confirm that they are not. Interest rate decisions are based on an enormous amount of analysis and reflection. But how are decisions reached? What does the process look like exactly? Since becoming Deputy Governor, I have often been asked such questions. Generally speaking, there is considerable interest in and curiosity about our work and our responsibilities. That's why the Bank puts so much effort into making monetary policy understandable for everyone by communicating it in clear and simple terms. You can find detailed information on the Bank's website explaining our work and our decisionmaking process. We want people to understand what we do. Yet, for all our efforts, the truth is that most people know little about how we work and the steps we take in deciding whether to raise, maintain or lower the policy interest rate. 1/7 BIS - Central bankers' speeches That may even be the case for many of you here. And when I think about it, it's not particularly surprising. Even as a macroeconomist, I knew little about the process before starting at the Bank. Today I'd like to take you behind the scenes and speak about what happens behind closed doors. What are the steps in the process? What sources of data do we use? How do we make our projections? I'll also talk about the debates, the differences of opinion and the ways we reach a consensus. As you'll see, making a decision on monetary policy is much more complicated than pushing a button, and getting a computer to spit out calculations and having everything fall into place. I'll also talk about my own experiences, what's surprised me and what I've learned along the way. Analysis and consultations First, I'd like to start with a quick review of what monetary policy is and does. At its core, the Bank's mandate is to keep inflation low, stable and predictable, and centred on the 2% target. The Bank's main tool for doing this is the policy rate. Changes to the policy rate affect several other interest rates in the economy, notably mortgage rates and rates for business loans. If the Bank raises the policy rate in response to high inflation, the cost of borrowing increases. This lowers demand because people have less money to spend on things like eating out or clothing, while businesses defer spending on projects. When economic activity slows, inflation goes down, which shows that monetary policy is working. While that seems simple in theory, in practice it is rather more complicated because the effects of our actions are not felt immediately. I have been a Deputy Governor for 18 months, which is the period needed to observe the full effects of monetary policy on inflation. And because we are always making decisions about the future, the Bank must rely heavily on economic forecasting. In addition, the impacts of Bank decisions are complex and uncertain. Much like a business that faces many unknowns when deciding to adopt a new technology, the Bank also must make choices in the face of considerable uncertainty. This is why it's important to have good information and good advice. To get the best possible understanding of the economic situation, Governing Council members have access to an extremely large number of datasets, analyses and points of view. When I'm asked to summarize the work of a Deputy Governor, I often say that I am a big aggregator of information. I am part of a team whose job is to put together all the pieces of the puzzle to inform our decision-making. Today, I'd like to explain to you what that means in concrete terms. Every year, the Bank makes eight monetary policy decisions. That means eight times a year, the Bank must decide whether it will raise, maintain or lower the policy interest rate. Four of the eight decisions are accompanied by the Monetary Policy Report (MPR), published most recently in July. The MPR examines the global and Canadian economies in terms of production, spending, the labour market and, of course, inflation. It also includes the Bank's projections for growth and inflation and the risks to the projection over a two-year period. 2/7 BIS - Central bankers' speeches The decision-making process begins about a month before the announcement date, when Bank staff present an economic projection to Governing Council. We call this Case A. It draws on the Bank's macroeconomic models and surveys, its analysis of various sectors and components of the economy, and its assessment of financial stability and financial market activity. Since we don't have a crystal ball, we draw on the latest data and use our projection models to look into the future.1 For several hours, Governing Council members debate the assumptions and risks to the projection as well as alternative case scenarios prepared by staff. About 10 days later, Bank advisors and economists present Case B, a revised projection incorporating the comments of Governing Council members and, if any, new developments that occurred since Case A. We draw on that projection to make our policy rate decision. When there is a rate announcement without an accompanying MPR-as was the case two weeks ago-many of the same steps are involved, although staff do not make new projections. They report on new data released since the last policy decision and on how the economy as a whole performed against expectations. Although the amount of information we have access to differs between announcements with and without an MPR, all decisions are equally important. Throughout the process, Statistics Canada's data on inflation, gross domestic product and employment are an invaluable source of information to guide our decisions. But they also have limits. First, data tend to be aggregate, which can make it difficult to discern the full range of experiences Canadians are having. That is why we spend a lot of time diving deep into the data to analyze what concerns and affects people on a dayto-day basis: rent, house prices, mortgage renewal, the prices of gas and groceries, how long it takes to find a job, and so on. All these factors help us to predict the path of inflation in the months and years ahead. Second, hard data draw from the past. That is why the Bank conducts quarterly surveys on consumer expectations and the business outlook. The qualitative and forwardlooking nature of these surveys allows us to discover different points of view and obtain a more nuanced portrait of the future path of economic activity. Some of you may even have participated in these surveys; if so, I'd like to thank you for the contribution you've made to making monetary policy. We also engage with the public through outreach activities. The Bank needs to hear from a variety of participants in the economy to understand what is happening on the ground. Meeting with businesses, community groups and other organizations gives us an opportunity to listen, learn and deepen our understanding of their situation. The knowledge we gain helps us interpret the statistical data and contributes to our projections. This outreach also gives us an opportunity to explain the role of the Bank to Canadians. This is exactly what I will be doing during my time in Sherbrooke. I'll have the opportunity to participate in a round table with Entreprendre Sherbrooke, speak with university students and meet with local officials. Sometimes outreach activities even 3/7 BIS - Central bankers' speeches have unintended outcomes. Last spring, I took an outreach trip to Rimouski, where I grew up. After I was interviewed by local media, some childhood friends I had not heard from in years reached out and messaged me! As an aside, I'd like to point out that while the Bank seeks out views from a broad range of stakeholders, it makes monetary policy decisions independently. This protects the Bank from short-term political objectives and pressures from special-interest groups. The independence of a central bank is even more important when difficult decisions must be made, as has been the case in recent years. The next step in the decision-making process is the risk and recommendations meeting, which takes place about a week before the announcement date. Advisors and staff from economics departments share their points of view and debate the implications of raising, maintaining or lowering the policy rate. This culminates in a round-table discussion where each person puts forward a recommendation and its rationale. As you can imagine, we are never short on opinions. While Governing Council is ultimately responsible for making the decision, the decision is really the product of an enormous team effort. Once the members of Governing Council have heard from the advisors and studied their analyses and recommendations, they meet in private to evaluate everything they've learned and come to a decision. Now, I'll shed a bit of light on how that works. Deliberating the decision Before I talk about the deliberation process, I have to let you in on a little secret. At the Bank's head office, behind a massive wooden door, there is a room I like to call the Chamber of Secrets. It's formally known as the Rasminsky Room, after Louis Rasminsky, the Bank's third governor. All discussions and decisions about the policy rate take place in this room. It's a secure room where the blinds are always drawn, and access is controlled. From inside this room, no communication with the outside world is allowed, and the use of electronic devices is strictly regulated. When we say "private" deliberations, we really mean it! The Bank takes security very seriously-and with good reason. A leak could have serious consequences. Many stakeholders-financial market participants, in particular-are very eager to get news of the decision. Returning to the topic of our deliberations, once all the members of Governing Council are in the room, the Governor opens the meeting. The Governor acts as chair and shepherds the discussions. Each member is given the opportunity to present their views on economic developments in Canada and abroad, and on the outlook for growth and inflation. Another tidbit from behind the curtain: in Governing Council discussions, the Deputy Governors speak in reverse order of seniority, with newer members speaking first. This ensures their views are not influenced by those of more senior members. The Senior Deputy Governor speaks next, followed lastly by the Governor. They express their views, which leads to further discussions. We then go around the table again, with members presenting their opinions on monetary policy and debating the rate decision. 4/7 BIS - Central bankers' speeches The process is not set in stone. The content and format of our discussions are adapted to the situation and vary depending on our thinking about the economic environment and risk landscape. For example, when I started at the Bank in March 2023, a number of regional banks in the United States had just failed. Questions about financial stability were at the forefront of our discussions. In recent months, an important focus of our discussions has been the stickiness of inflation in prices for certain services, including shelter. But how is the decision actually reached after all of these deliberations? Unlike other central banks, such as the US Federal Reserve or the Bank of England, where members vote, the Bank of Canada makes decisions by consensus. Members must therefore all agree on the course of action, even if we had different points of view when we walked into the Rasminsky Room. And it might not come as a surprise that we do not always agree on everything. In fact, it's completely normal that members have differences of opinion. After all, each member of Governing Council has distinct expertise stemming from their past experiences and educational background. But the diversity of our expertise is exactly what makes it possible to have detailed and constructive discussions that lead to informed decision-making. So, how do we arrive at a consensus despite our differences of opinion? Here, the organic nature of our deliberations plays a key role. At times, points raised by other members may lead us to fine-tune or rethink the way we've interpreted the data. Or a colleague may raise a point or highlight issues that others had not originally considered. In my opinion, the need to arrive at a consensus strengthens our decision-making process. We must carefully consider the diversity of opinions within Governing Council and discuss among ourselves to arrive at a common position. I should also mention that reaching a consensus does not mean that all members of Governing Council share the same point of view on the economic outlook or the path for interest rates in the coming months. It means that members come to an agreement about the best decision to make at a particular moment in time.2 And the truth is that as new data are published and new information comes to light, differences of opinion tend to become less pronounced. Whatever shape the deliberations take, I can assure you that everyone around the table is always very conscious of the weight of these decisions. I fully felt this weight myself in June 2023 when I participated in my second round of monetary policy deliberations. In the year before my arrival, the Bank had decisively and forcefully raised the interest rate from 0.25% to 4.5% to combat the spike in inflation. At the beginning of 2023, the Bank indicated it would pause to evaluate the effects of the increases on the economy and inflation. But data released between April and June 2023 showed that the economy had been more robust than expected in the first quarter of the year and that inflation had even increased slightly. Given the situation, we reached the conclusion that we had to again raise the interest rate. But at the end of our Friday afternoon meeting, the Governor said, "Let's take the weekend and sleep on this decision and come back on Monday with clearer heads to discuss again." 5/7 BIS - Central bankers' speeches Over the course of that weekend, I came to fully feel the weight of the responsibility that came with my new role. I'd had countless discussions about monetary policy with colleagues and students over the course of my career as an academic. But as Deputy Governor, I found the discussions were no longer abstract or theoretical. I came to understand that I was one of six people whose decision would directly impact borrowing costs for millions of people like you and for businesses like yours. Believe me when I say that the realization made my head spin a little; it was really quite humbling. Communicating the decision One thing that may surprise you-as it did me-is that Governing Council's work does not end once the decision is made. Communicating the reasons that led to the decision is almost as important as the decision itself. The members of Governing Council work closely with the Bank's communications team to develop key messages and draft the press release and opening statement for the press conference. If only you knew how much time we spend trying to find the best ways to convey our message and looking for just the right words-in both official languages. With time, I've come to understand that this is not always an easy task. For example, at the July decision, we said downside risks to inflation were becoming increasingly important in our deliberations. Some people interpreted this to mean that we believed downside risks had strengthened. What we intended to communicate, however, was that, with the 2% target in sight, we gave increased consideration to the risk that inflation could fall below the target. As you can see, differences in interpretation can be very subtle, which makes choosing the right words all the more important. I'd like to think that all the years of explaining complex concepts to my students has given me a lot of practice in this regard. Even though I've been in this role for only a short time, I've been able to appreciate how the Bank's approach to communication is constantly evolving. In the past, press conferences were held only when the rate announcement was accompanied by a Monetary Policy Report. Starting this year, all eight rate announcements now feature a press conference. This gives the Bank the opportunity to share its assessment of the economic outlook with the public and explain the reasoning that led to the rate decision. Following the decision, Governing Council members host information sessions and regularly give interviews with the media. Since January 2023, a summary of deliberations is published online two weeks after every decision. This document is a record of Governing Council's assessment of the economic environment and the upside and downside risks to inflation. It also highlights where opinions converged and the topics that generated the most debate among members. The summary of deliberations for the September decision was published yesterday, in fact. Lastly, the Bank is always looking for new ways to communicate and for new channels to reach the widest audience possible. In fact, the Bank has accounts on YouTube, X, Instagram, Facebook and LinkedIn. Be sure to follow us. 6/7 BIS - Central bankers' speeches Conclusion It's time for me to wrap up. I've now participated in 12 rate decisions. Since arriving at the Bank, I've always felt my experiences and external point of view have been useful to my work and valued by the other members of Governing Council and the organization as a whole. I genuinely feel I'm contributing to the mission of a rigorous and conscientious institution that is mindful that its credibility is directly linked to the effectiveness of its actions. Credibility must be earned. The Bank's is founded on the trust that Canadians place in us and our actions. Even when those actions are difficult and have direct impacts, Canadians understand that we are always guided by our resolve to keep inflation low, stable and predictable. We are fully conscious of the responsibilities the Bank has toward all Canadians. To maintain the public's trust, we must be rigorous, professional, humble, honest and transparent. It is to contribute to this transparency that I've spoken to you today about the Bank's decision-making process. This process has allowed the Bank to weather many past storms, from recessions to economic crises and even a pandemic. And this process will keep us true to our promise to all Canadians: to bring inflation back to target and keep it there. That will always be the best way for the Bank to support the Canadian economy. Thank you. 1 For more detail, see S. Kozicki and J. Vardy. 2017. "Communicating Uncertainty in Monetary Policy." Bank of Canada Staff Discussion Paper No. 2017-14.[] 2 Macklem, T. 2002. "Information and Analysis for Monetary Policy: Coming to a Decision." Bank of Canada Review (Summer): 11–18.[] 7/7 BIS - Central bankers' speeches
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Institute of International Finance (IIF) and the Canadian Bankers Association (CBA) Forum, Toronto, Ontario, 24 September 2024.
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Tiff Macklem: Economic growth during uncertain times Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Institute of International Finance (IIF) and the Canadian Bankers Association (CBA) Forum, Toronto, Ontario, 24 September 2024. *** Good afternoon. I want to thank the Institute of International Finance and the Canadian Bankers Association for inviting me to take part in your 2024 Forum. Your focus on growth during uncertainty is timely. Uncertainty feels like the new reality: The uncertainty caused by war in Europe and in the Middle East. The uncertainties arising from geopolitical tensions and economic fragmentation. And the related uncertainties about supply chains, trading relationships and global investment risks. Rapid advances in new technologies, particularly artificial intelligence (AI) and its new offspring, Generative-AI, are disrupting business models and creating new uncertainties for firms and workers. Uncertainty surrounds the impacts of climate change and the policy frameworks to adapt to and mitigate it. There is political uncertainty. And fiscal uncertainty. As your theme implies, uncertainty and economic growth do not sit well together: uncertainty impedes growth. But with inspired policy, good business decisions and sound risk management, we can manage uncertainty and reduce its impact on households, businesses and growth. We have recent historical evidence. Sixteen years ago this month, Lehman Brothers failed, and the financial system froze because nobody knew which banks were safe. Today, the global financial system is much safer thanks to the implementation of sweeping global reforms to increase capital and liquidity buffers, and reduce leverage. With the rapid development of new vaccines and with exceptional fiscal and monetary policies, uncertainty about our health and the health of our economies has decreased dramatically since the depths of the COVID-19 pandemic. Thanks to decisive monetary policy action and the unblocking of supply chains, uncertainty about costs and inflation are much lower today than two years ago, when inflation peaked above 8% in Canada and was even higher in many other countries. In the past few weeks, I have given speeches on the shifting global trade landscape and the economic implications and risks of rapid advances in artificial intelligence. These are two key areas where we can reduce uncertainty through good policy and farsighted business leadership. 1/3 BIS - Central bankers' speeches At the same time, we need to recognize that new uncertainties are a new reality, and we must be ready for the inevitable shocks in a more turbulent world. That puts a priority on risk management and investments in resilience. A key function of financial institutions is to help households and businesses manage the risks they face. Financial institutions also have a responsibility to manage their own risks prudently so that they do not themselves become a source of uncertainty and instability. As Canada's central bank, we have a role to play in mitigating and managing risks and uncertainty. Our primary mandate is price stability-in other words, low, stable and predictable inflation. We also have mandates to foster a stable financial system and ensure safe and efficient payments. Let me say a few words on financial stability and payments. And then I'll finish with some thoughts on monetary policy. Our financial stability focus is on risks that could lead to system-wide stress. And we publish these findings in our annual Financial Stability Report (FSR).1 In our most recent FSR, published in May, we reported that Canadian mortgage holders had experienced a modest increase in levels of financial stress. Since then, we've observed that arrears on mortgages have continued to rise, although they remain below pre-pandemic levels. It also appears that these households have not leaned on revolving credit products such as lines of credit and credit cards to a greater degree than before the pandemic. But there is a notable increase in financial stress among borrowers without a mortgage, mainly renters. During the pandemic, for most credit products, the share of these borrowers missing payments reached historical lows. However, we're now seeing a larger share of these borrowers lagging behind on credit card and auto loan payments. Over the past year the share of borrowers without a mortgage who carry a credit card balance of at least 90% of their credit limit has continued to climb. And this share is now above typical historical levels. This is concerning. Our responsibilities related to payments require us to adapt to increasing digitalization. Innovation in payments continues to accelerate. In 2021, the Bank assumed a new mandate for the supervision of retail payment service providers. Starting November 1st of this year, more than 3,000 service providers will need to register with the Bank and follow new rules aimed at safeguarding consumers and protecting the integrity of retail payments. We are also looking at the bigger picture of payment innovation, both in Canada and around the world. As part of this work, in the past few years we've built an extensive body of knowledge about the framework and technology behind a possible central bank digital currency (CBDC), including the benefits and risks. But recognizing that there is not currently a compelling case to move forward with a CBDC in Canada, the Bank is scaling down its work on a retail central bank digital 2/3 BIS - Central bankers' speeches currency and shifting its focus to broader payments system research and policy development. The Bank will continue to monitor global retail CBDC developments. And the Bank will be ready to ensure Canadians always have a safe and secure supply of public money. Now, let me circle back to monetary policy. In June, we began lowering our policy interest rate. We cut the policy rate at our last three decisions, for a cumulative decline of 75 basis points to 4.25%. Our most recent decision on September 4th reflected two main considerations. First, we noted that headline and core inflation had continued to ease as expected. Second, we said that as inflation gets closer to target, we want to see economic growth pick up to absorb the slack in the economy. Since then, we've been pleased to see inflation come all the way back to the 2% target. It has been a long journey. Now we want to keep inflation close to the centre of the 1% –3% inflation-control band. We need to stick the landing. What does this mean for interest rates? With the continued progress we've seen on inflation, it is reasonable to expect further cuts in our policy rate. The timing and pace will be determined by incoming data and our assessment of what those data mean for future inflation. As always, we try to be as clear as we can about what we are watching as we chart the course for monetary policy. Economic growth picked up in the first half of this year, and we want to see it strengthen further so that inflation stays close to the 2% target. Some recent indicators suggest growth may not be as strong as we expected. We will be closely watching consumer spending, as well as business hiring and investment. We will also be looking for continued easing in core inflation, which is still a little above 2%. Shelter cost inflation remains elevated but has started to come down, and we are looking for it to moderate further. Our next decision is October 23rd. And we will have a revised economic outlook at that time. With those introductory thoughts, let's get the discussion started. I would like to thank Russell Barnett, Claudia Godbout and Brian Peterson for their help in preparing these remarks. 1 Financial Stability Report-2024 - Bank of Canada 3/3 BIS - Central bankers' speeches
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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 23 October 2024.
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Tiff Macklem: Release of the Monetary Policy Report Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 23 October 2024. *** Good morning. I'm pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss the October Monetary Policy Report and our policy decision. Today, we lowered the policy interest rate by 50 basis points. This is our fourth consecutive decrease since June and brings our policy rate to 3.75%. We took a bigger step today because inflation is now back to the 2% target and we want to keep it close to the target. In the past few months, inflation has come down significantly from 2.7% in June to 1.6% in September. Recent indicators suggest it will be around 2% in October. Price pressures are no longer broad-based, and both our measures of core inflation are now under 2½%. Our surveys also find that business and consumer expectations of inflation have shifted down and are nearing normal. All this suggests we are back to low inflation. This is good news for Canadians. Now our focus is to maintain low, stable inflation. We need to stick the landing. That means the upward and downward forces on inflation need to balance out. Household spending and business investment have picked up this year, but remain soft. This softness has helped take the remaining steam out of inflation. But with inflation back to 2%, we want to see growth strengthen. Today's interest rate decision should contribute to a pickup in demand. The Bank forecasts inflation will remain close to the target over the projection horizon. The upward pressure from shelter and other services is expected to gradually diminish. With stronger demand, the downward pressure on inflation is also forecast to dissipate, keeping the upward and downward forces roughly balanced. If the economy evolves broadly in line with this forecast, we anticipate cutting our policy rate further to support demand and keep inflation on target. The timing and pace of further interest rate cuts will depend on incoming information and our assessment of its implications for the inflation outlook. We will take our monetary policy decisions one at a time. Let me expand on what we're seeing in the economy, and how that played into our deliberations. After stalling in the second half of last year, the economy grew by about 2% in the first half of this year, and we expect growth of 1¾% in the second half. The economy remains in excess supply and the labour market is soft. The unemployment rate was 6.5% in September. Job layoffs have remained modest but business hiring has been 1/2 BIS - Central bankers' speeches weak, which has particularly affected young people and newcomers to Canada. Simply put, the number of workers has increased faster than the number of jobs. Looking ahead, GDP growth is forecast to gradually strengthen to around 2% in 2025 and 2¼% in 2026, supported by lower interest rates. This forecast largely reflects the net effect of a gradual pick up in consumer spending per person and slower population growth. We also expect growth in residential investment to rise as strong demand for housing lifts sales and spending on renovations. Business investment is expected to strengthen as demand picks up, and exports should remain strong, supported by robust demand from the United States. The decline in inflation in recent months reflects the combined effects of lower global oil prices, slightly lower shelter price inflation in Canada, and lower prices for many consumer goods like cars and clothes. Going forward, we can expect to continue to see some monthly fluctuations in inflation. But overall, inflation is expected to remain close to target over the projection horizon as upward pressure from shelter and other services gradually diminishes and excess supply in the economy is absorbed. There are risks around our inflation outlook. The biggest downside risk to inflation is that it could take longer than anticipated for household spending and business investment to pick up. Our recent surveys suggest businesses expect subdued sales and their hiring and investment plans are modest. On the upside, lower interest rates could fuel a stronger rebound in housing activity or wage growth could remain high relative to productivity. There is also elevated geopolitical uncertainty and the risk of new shocks. Overall, we view the risks around our inflation forecast as reasonably balanced. With inflation back to 2%, we are now equally concerned about inflation coming in higher or lower than expected. The economy functions well when inflation is around 2%. Let me conclude. High inflation and interest rates have been a heavy burden for Canadians. With inflation now back to target and interest rates continuing to come down, families, businesses and communities should feel some relief. The Bank is committed to maintaining price stability for Canadians by keeping inflation close to the 2% target. With that summary, the Senior Deputy Governor and I would be pleased to take your questions. 2/2 BIS - Central bankers' speeches
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Remarks by Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the Economic Club of Canada, Toronto, Ontario, 6 November 2024.
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Carolyn Rogers: Canada's mortgage market - a question of balance Remarks by Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the Economic Club of Canada, Toronto, Ontario, 6 November 2024. *** Introduction I'm glad to have the opportunity to speak with you today. Back in 2019, I spoke to the Economic Club of Canada about mortgages in my previous role as a bank regulator. Five years later I'm back, talking about mortgages again, this time from the point of view of a central banker. A lot has happened over the past five years, to put it mildly: we've seen a global pandemic, the sharpest economic downturn in a century followed by the fastest recovery on record, and a big spike in inflation. Lately, it's been good to see inflation return to our 2% target. Monetary policy worked: not painlessly, but it did get inflation under control without creating the sharp economic downturn that many feared. Interest rates have started to come down, and we have the prospect of further normalization ahead. And yet, for many Canadians, things don't feel like they are back to normal. While inflation has returned to target, the cost of many necessities is higher than it was before the pandemic. Wages have also increased, but for many, incomes haven't kept pace with prices. Housing also continues to be a big affordability challenge. This is true for people looking to buy a home, and it's also true for renters. For those who have a mortgage, the big worry is the interest rate they'll have to pay when they renew. There has been a lot of focus on what's been described as the mortgage renewal wall. More than 4 million mortgages-or about 60% of all outstanding mortgages-will renew over the next two years. A big portion of these have not renewed since interest rates started rising in 2022. Even with recent declines in interest rates, most of those borrowers will likely face a significant increase in their payment. At the Bank of Canada, we've done a lot of work to understand the risks around the rollover of these mortgages from a couple of perspectives. Higher payments could cause households to pull back on spending by more than we expect, slowing the economy. They could also lead to financial stress for borrowers and losses for lenders and mortgage insurers. And since many mortgages are securitizedbundled together and sold to investors-widespread losses in the mortgage market could also have implications for market liquidity and overall financial stability. Further, since mortgage insurance in Canada is backed by the federal government, large losses could have fiscal implications. 1/8 BIS - Central bankers' speeches That's a lot of doom and gloom, so let me be clear that these are tail risks-they're not our forecast. From a monetary policy perspective, our forecast includes the expectation that households will continue to adjust their saving and spending patterns to absorb the impact of higher mortgage payments. And as interest rates come down that impact will fade, and consumption will gradually pick up. From a financial stability perspective, Canadians have a long history of paying their mortgages. Even through the 2008–09 global financial crisis, Canada never saw a mortgage arrears rate above 0.5%. More recently, our mortgage market has fared well through a period of economic turbulence and a sharp rise in interest rates. Arrears rates have risen but remain near historically low levels. Given our recent experience, it's a good time to reflect. And even if the economy is getting back to something approaching normal, we're still expecting a future with more economic volatility and generally higher interest rates than we saw over much of the past two decades. Another reason it's a good time to reflect is that mortgage finance rules are one of the levers policy-makers sometimes use to deal with housing affordability. House prices are primarily a function of the balance between supply and demand. But since most people borrow to buy a house, prices are also affected by the cost and availability of housing credit. The cost and availability of housing credit are, of course, influenced by central bank policy rates. They're also influenced by government policy and regulations. So this is what I'm going to talk about today. I'll start with a few key concepts to make sure we're all on the same page. Then I'll offer a brief history lesson covering some important policy changes in Canada's mortgage market. Finally, I will draw out a few comparisons of mortgage finance in jurisdictions that do things differently than we do. The objective is to see what we can learn and where there might be opportunities for change. Mortgages 101 Home ownership is widely considered to be good for society, so governments in most countries like to provide incentives for it by ensuring that housing credit is available and affordable. At the same time, mortgages are the largest debt most people will take on in their lifetime, so governments also like to put laws in place to protect consumers and to make sure they understand the risks that go with mortgages. And bank regulators pay close attention to mortgages because they often represent a big portion of the assets in the banking sector. In Canada, residential mortgages make up about half the banking system's assets, so keeping mortgages safe keeps our banks safe. And a safe banking sector is a precondition for a stable economy. 2/8 BIS - Central bankers' speeches The policy objectives of governments and regulators can shift over time in response to changing conditions. As policies shift, so do the balance and distribution of risks. To understand this, it's helpful to keep in mind some basics of how mortgages work and who the different stakeholders are. A mortgage is simply a contract with a set of conditions that prescribe the obligations of both the lender and borrower-things like the interest rate, the term, the amortization period and the payment schedule. Once a mortgage is originated, the lender sometimes retains it as an asset or an investment. Other times they turn it into a security and sell it to an investor. If the lender doesn't sell the mortgage, they need to fund it. To reduce interest rate risk, they will want to fund it with a deposit that is about the same size and duration as the term of the mortgage. Lenders sell mortgages so that they have a variety of funding sources and don't find themselves constrained by the availability of the deposits they hold. So investors play an important role because they give lenders access to pools of capital that let them fund more mortgages. Whatever your policy objective, when you make changes to the mortgage market, it's important to keep these three groups-borrowers, lenders and investors-in mind. You need all three to have a healthy, functioning mortgage market. The challenge, of course, is that how you view a change will depend on whether you're a borrower, a lender or an investor. And sometimes, an attempt to improve conditions for one can negatively impact another. Borrowers want affordability and investors want an acceptable risk-adjusted rate of return. Features that reduce risk or flexibility for the borrower can increase risk or flexibility for the lender or investor and vice versa. The bottom line is that the mortgage market is a careful balance between a variety of policy objectives and a range of stakeholders. To illustrate how this balance has evolved over time in Canada, let me take a few minutes to walk you through a short history of changes to our mortgage market. A history of choices Government involvement in Canada's housing finance market can be traced all the way back to Confederation. Very few Canadians had a mortgage then. Those who did needed a 50% down payment, and their options were generally limited to five-year loans. Insurance and trust companies were the primary lenders, and the government's role was limited to setting out general rules for lending. One example is the Interest Act-a law that dates to the 1880s and is still on the books today, continuing to shape the mortgage market in Canada. I will come back to this point a little later. Starting in the 1930s, the federal government began to get more involved in the mortgage market. The motivation at that time was to boost the economy, so policies 3/8 BIS - Central bankers' speeches were targeted at housing construction. After the Second World War, there was a shortage of homes for returning veterans, so the government created an organization called Wartime Housing Limited to provide mortgage funding at favourable interest rates. Wartime Housing Limited would go on to become the Canada Mortgage and Housing Corporation (CMHC), and in 1954, the government passed the National Housing Act, enabling CMHC to insure mortgages against borrower default. Government-backed mortgage insurance has been foundational to housing finance in Canada ever since.1 Over the years, the features of mortgage insurance have varied significantly. Down payments have ranged from 0% to 25%, and maximum amortizations have ranged from 25 to 40 years. In the early days, only new homes were eligible, interest rates were capped, and the minimum term was 25 years. In the late 1960s, existing homes became eligible, interest rate caps were lifted, and shorter terms were introduced. These changes helped draw banks into the mortgage-lending business. Another significant change came in 1987 with the introduction of the National Housing Act mortgage-backed securities (NHA MBS) program. This was followed in 2001 by the Canada Mortgage Bond (CMB) program. Both programs were aimed at making more funding available for mortgage lending by expanding the secondary investment market for mortgages. Investors in both programs benefit from the fact that all the underlying mortgages are insured, and that the insurance is backed by the federal government.2 This helps attract a deep pool of investors and makes funding available to lenders at rates close to those at which the federal government borrows at. By reducing the cost of funding for lenders, these programs contribute to lowering mortgage costs for borrowers. The next set of major policy changes in Canada followed the 2008 mortgage meltdown in the United States and the ensuing global financial crisis. The government introduced changes aimed at reducing risks that had built up in the financial sector during a period of expanding access to credit and mortgage insurance. A cap on the price of a house eligible for mortgage insurance and stricter underwriting requirements, like the stress test, were introduced. These same events led to increased regulation for uninsured mortgages. In 2012, the Office of the Superintendent of Financial Institutions (OSFI) released Guideline B-20, setting out tighter expectations for mortgage underwriting and risk management for banks. And in 2018 OSFI added a stress test to Guideline B-20, similar to the one required for insured mortgages. During the COVID-19 pandemic, further changes to the insured mortgage stress test and to Guideline B-20 were made to ensure underwriting standards remained strong during a period of major economic upheaval and emergency-low interest rates. And finally, most recently, the government adjusted mortgage insurance rules to provide added support for borrowers facing affordability challenges, and OSFI has signalled a further review of Guideline B-20. So that's a bit of the history of Canada's mortgage market. It gives you a sense of how changes to policy objectives over the years have shifted the distribution and balance of 4/8 BIS - Central bankers' speeches risks and shaped the market we have today. Now, let's see what we can learn from how other countries deal with similar objectives and challenges. Do other countries do it better? The recent focus on the mortgage renewal wall has people talking about the United States, where 30-year mortgage terms are common. Imagine having locked in a 30year mortgage rate in the last couple of years, when rates were at rock-bottom levels. Sounds pretty good, doesn't it? But if you're a lender or a mortgage investor, it might not sound quite as good. The interest rate risk has shifted from the borrower to you. And we saw a few US banks fail in recent years when they mismanaged their interest rate risk. The 30-year mortgage has been a feature in the United States for a long time, though, so banks have had plenty of time to adapt their risk management and the vast majority do a good job. One way US lenders manage risks is by securitizing most of their mortgage loans. As a result, unlike Canadian banks, US banks don't hold most of the mortgages they write on their balance sheet. This is a feature of the US market that is generally thought to have contributed to the mortgage meltdown in 2008. Since US lenders didn't retain the mortgages they wrote, they had less incentive to maintain good underwriting standards. Government-backed mortgage insurance is also a feature in the United States. While it's not required on high-ratio mortgages the way it is here, many lenders make it a condition of approval. Caps on loan amounts for insurance eligibility exist in the United States but are set according to local market conditions. US borrowers also pay higher interest rates on their mortgages. Canadian fixed-rate mortgages are generally benchmarked off 5-year government bond yields, whereas the US benchmark is the 10-year Treasury. Prepayment penalties are more restrictive in the United States, but other flexibilities are also limited. US mortgages aren't portable, for example. So if you have a low mortgage rate but you get offered a job in another city with a big raise, you may have to give up your mortgage rate to get that raise. At the other end of the spectrum, in countries like Australia and Norway, most mortgages have a variable interest rate. This leaves all the interest rate risk with the borrower. Amortization periods in most countries range between 20 and 40 years, although a fewprimarily in Europe-have 50- and 60-year mortgages and some countries even feature 100-year mortgages, designed to be intergenerational. Interest-only mortgages are relatively common, especially in countries where interest is tax-deductible, such as Denmark, Norway and the Netherlands. And finally, flexibility options have become increasingly common in most countries in recent years. Here, I'm referring to options like skipping or adding a payment or features like a home equity credit line, which lets borrowers draw against their equity on 5/8 BIS - Central bankers' speeches demand. The exception is the United States, where mortgage flexibility was significantly curtailed in the Dodd-Frank Wall Street Reform and Consumer Protection Act that came into force after the global financial crisis. There's no free lunch So what lessons can we learn from this trip through history and around the world of mortgages? Let me suggest a few. One is that Canada's mortgage rules have changed over the years for all kinds of reasons, from encouraging housing construction and home ownership, to deepening the pool of investors, to curtailing risk and making the financial system more stable. Many different motivations have led to the mortgage market we know today. These changes have had important implications for the distribution of risks. Today, about one in four mortgages is insured at origination and about $590 billion-or about one-quarter of Canada's $2.4 trillion in outstanding mortgage debt-is backed by the federal government. It's not hard to see why a sound, well-functioning housing finance market is critical to Canada's economy. Another lesson is that policy changes introduce trade-offs. There's no free lunch. Steps to reduce the short-term cost of mortgages for borrowers can increase their long-term costs. A quick calculation using current interest rates and the average mortgage size in Canada shows that a borrower who stretches their amortization from 25 to 30 years can reduce their payment by $200 per month. But they will pay their lender an additional $50,000 in interest costs over the life of their mortgage. And while longer amortizations and smaller down payments will increase returns for lenders, they also increase risk for both the lender and the borrower because they reduce a buffer that can be used if a borrower runs into stress. Regulators may adjust to this risk by expecting more capital, and investors may adjust by expecting higher returns. This increases the cost for lenders, and that cost often gets passed on to the borrower in the form of higher interest rates. Now, let's come back to the mortgage renewal wall that I talked about at the beginning of my speech. It provides a great example of how the mortgage market is shaped by policy choices. In Canada, a typical mortgage is amortized over 25 years with a five-year term. This means the borrower will confront interest rate risk four times over the life of the mortgage, each time they renew their loan. In between renewals, the lender holds the interest rate risk, unless they sell the mortgage. The prevalence of the five-year mortgage is due, in large part, to the Interest Act that I mentioned earlier, the one dating back to the 1880s. It states that a borrower that takes out a mortgage with a term of more than five years has the right to repay the loan in full after five years, subject to a maximum penalty of three months' interest. However, for the first five years of a mortgage there is no limit, so most lenders charge what is called 6/8 BIS - Central bankers' speeches an interest rate differential penalty. Each lender calculates this penalty a bit differently, but generally the borrower ends up paying an amount close to the interest the lender expected to collect over the term of the mortgage. You can see why lenders prefer to keep mortgage terms under five years. They are not precluded from offering longer terms, and indeed some do. But since they hold more interest rate risk, they generally charge a higher interest rate. And so far, that seems to have limited the uptake by borrowers. In April 2021, for example, 10-year mortgages were available in Canada with an interest rate of 3.14%, while five-year mortgages were at 2.29%. About 80,000 borrowers opted for the five-year rate that month, while only 400 borrowers chose the 10-year term. Since then, of course, Canadians have lived through a period of rapid interest rate hikes. So there is reason to believe preferences may have changed. But to make longer term mortgages more available to Canadians, policy changes may be necessary. Conclusion I want to conclude by making three points. The first is that our mortgage market has, on balance, served us well across two important dimensions: financial stability and access to affordable credit for home ownership. Canada has one of the highest rates of home ownership and lowest levels of mortgage default among advanced economies.3 The impact of higher interest rates has been challenging for borrowers recently and will be challenging for many renewing their mortgage in the next two years. But policies that discouraged too much leverage and encouraged strong, dynamic underwriting, like the stress test, have proven effective when you look at the experience of the past couple of years.4 Second, when it comes to the mortgage market, there's no such thing as a simple change. The distribution of risks across the different players has many effects, including on the cost and availability of credit and the options and flexibility available to borrowers. And third, we need to resist the temptation to try to solve the housing affordability challenge by tinkering too much with the mortgage market. Housing affordability is a very real challenge to our economy. It's encouraging to see governments at all levels focused on this challenge and being creative with the range of solutions they are bringing forward. Ultimately, though, improved housing affordability requires a better balance between supply and demand, and achieving this balance will take time. In the meantime, leaning too much on measures that reduce the short-term cost of financing could have long-term impacts on the financial health of households, the mortgage market and the economy. This doesn't mean change is impossible, but it does mean change needs to be approached with care. It's always worth asking if there's room to improve, and the world offers plenty of examples to learn from. It's a question of finding the right balance. 7/8 BIS - Central bankers' speeches I would like to thank Brian Peterson and Yasuo Terajima for their help in preparing this speech. 1 Central Mortgage and Housing Corporation was created by an act of Parliament in 1945 to succeed Wartime Housing Limited. It was renamed Canada Mortgage and Housing Corporation in 1979. 2 Both NHA MBS and CMBs also benefit from a timely payment guarantee from CMHC (and ultimately the federal government). Furthermore, financial institutions also use mortgages as collateral in securitization for both covered bonds and asset-backed commercial paper. 3 F. van Hoenselaar, B. Cournède, F. De Pace and V. Zeimann, "Mortgage finance across OECD countries," OECD Economics Department Working Papers No. 1693 (December 2021). 4 J. S. Hartley and N. Paixão, "Mortgage stress tests and household financial resilience under monetary policy tightening," Bank of Canada Staff Analytical Note No. 2024-25 (November 2024). 8/8 BIS - Central bankers' speeches
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Remarks by Mr Rhys R Mendes, Deputy Governor of the Bank of Canada, at the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 26 November 2024.
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Remarks by Rhys Mendes Deputy Governor Greater Charlottetown Area Chamber of Commerce November 26, 2024 Charlottetown, PEI Sticking the landing: Keeping inflation at 2% Introduction Good morning, it’s wonderful to be here in Charlottetown today to give my first public speech as a deputy governor at the Bank of Canada. I’m delighted not only to visit Prince Edward Island but also to learn more about the local economy. To do our job well at the Bank, we need to understand how our policies affect people and businesses across this vast country. That’s why I’m meeting with business and community leaders from several sectors while I’m here. Our job at the Bank is to keep inflation low and stable, so we aim to keep it centred on a 2% target. This is how we ensure the economy works best for all Canadians. Inflation has now come down significantly and is back at 2%. We want it to stay there. For this reason, we decided last month to lower our policy interest rate by 50 basis points to 3.75%. Our focus now is on ensuring that inflation remains low, stable and predictable. We need to stick the landing. The past few years have been difficult for Canadians. The COVID-19 pandemic caused the sharpest economic downturn in a century, which was followed by an unexpectedly fast rebound. Inflation surged to a four-decade high, and the Bank responded by increasing interest rates to levels not seen since the early 2000s. We did what we believed was necessary to restore price stability. And it worked: inflation has returned to 2%, and interest rates have started to come down. But it hasn’t been painless. Higher interest rates were a burden for families and businesses. Inflation is back to normal, but it may not feel that way for many people. Especially if they are facing higher interest payments on their mortgages or other loans. With all of this in mind, the Bank owes it to Canadians to assess how effective our interest rate decisions were in countering high inflation. I’ll begin by discussing the factors that led to the run-up in inflation, and I’ll explain how monetary policy worked to address them. My aim is to shed some light on the question of whether higher interest I would like to thank Justin-Damien Guénette, Oleksiy Kryvtsov and Konrad Zmitrowicz for their help in preparing this speech. Not for publication until 08:05am Eastern Time -2rates were really needed to bring inflation down to 2% or whether it would have returned to target on its own. Then I’ll talk about what price stability means for us at the Bank of Canada. I’ll explain why we want inflation to stay around 2% and not fall below target. And why—even though it may seem counterintuitive—it would be painful for many Canadians if we were to try to bring about a period of price declines. How monetary policy helped tame high inflation Let’s begin with the sharp rise in inflation in 2021 and 2022. To better understand how monetary policy helped bring inflation down, we need to look at the factors behind inflation. We can break down these drivers of inflation in many ways. But for today, let’s think in terms of three broad categories. The first category is made up of mostly global factors, like food and energy prices, which aren’t directly influenced by our monetary policy. The second is inflation expectations. When businesses expect high inflation, they tend to raise prices more rapidly than normal in anticipation of future cost increases. And the third is the amount of demand relative to supply in the Canadian economy. If demand for goods and services goes up but businesses don’t have the capacity to keep pace, prices tend to rise. When this happens across many sectors at the same time, it leads to inflation. To keep inflation stable at 2%, we need the economy to be like the third bowl of porridge in the story of Goldilocks and the three bears—not too hot, not too cold, but just right. Monetary policy works primarily through the second and third categories. In the post-pandemic period, inflation initially picked up because of drivers in the first category.1 Strong global demand for goods—combined with pandemic- and weatherrelated disruptions—strained global supply chains and pushed inflation in goods prices sharply higher. As economies around the world reopened, global commodity prices began to rise. Then, in early 2022, Russia’s invasion of Ukraine disrupted the supply of many commodities, sending food and energy prices soaring. Admittedly, on its own, Canadian monetary policy would have had little effect on these global factors. This begs the question of why we bothered to raise interest rates at all. It’s a reasonable question, so I’ll try to answer it by explaining how our actions played a key role in reducing inflation here in Canada. The first thing to note is that we were not acting in isolation. Central banks around the world were also raising interest rates. Although these actions were not formally coordinated, the synchronized nature of this tightening contributed to reducing global 1 See, for example, F. Bounajm, J. G. J. Roc and Y. Zhang, “Sources of pandemic-era inflation in Canada: an application of the Bernanke and Blanchard model,” Bank of Canada Staff Analytical Note No. 2024-13 (June 2024). -3demand for goods. This, in turn, relieved some of the pressure on supply chains. Global tightening of monetary policy also eased commodity prices.2 Clearly, the collective impact of many central banks all acting at the same time helped lessen the global pressures behind the initial surge in inflation. But as these global developments were playing out, domestic pressures were building up here in Canada. Demand, in particular, started to play a more important role in keeping inflation elevated. So let’s now turn to how the Bank’s actions worked through the second and third categories of drivers I outlined: inflation expectations and demand in the Canadian economy. Anchored inflation expectations were a game changer To explain the role inflation expectations played, I need to take you back to the 1970s— another period when global forces sparked a run-up in food and energy prices.3 As inflation rose in the early 1970s, people quickly came to expect that it would remain high indefinitely. Starting in 1973, Canadians lived through a decade of fast-rising and volatile prices. Inflation averaged almost 10% and peaked just under 13%.4 Bringing inflation back down had huge economic and social costs. The Bank’s key interest rate reached 21%, and the unemployment rate rose above 13%. Canada’s recent experience in taming high inflation has been vastly different. Although inflation rose slightly above 8%, the policy rate peaked at 5%, and the unemployment rate has been around 6.5% since June. This dramatic difference in performance comes down to one key variable: inflation expectations. In the 1970s, inflation expectations were not anchored.5 In contrast, inflation expectations were well anchored before the 2021–22 price shocks happened.6 This was a game changer. 2 Tighter monetary policy can lower commodity prices in several ways, including by reducing current and future demand for storable commodities. See J. Miranda-Pinto, A. Pescatori, E. Prifti and G. VerduzcoBustos, “Monetary Policy Transmission through Commodity Prices,” International Monetary Fund Working Paper No. 2023/215. 3 See A. S. Blinder and J. B. Rudd, “The Supply-Shock Explanation of the Great Stagflation Revisited,” NBER Chapters, in: The Great Inflation: The Rebirth of Modern Central Banking, 119–175 (2013), National Bureau of Economic Research. 4 See T. Macklem, “Ending the pain of high inflation” (speech delivered to the Saint John Region Chamber of Commerce, Saint John, New Brunswick, November 22, 2023.) 5 While data on inflation expectations for the 1970s are limited, work done by the International Monetary Fund (IMF) based on proxies using past inflation volatility suggests that inflation expectations were more strongly anchored in the more recent episode. For more information, see IMF, World Economic Outlook: Policy Pivot, Rising Threats, Chapter 2, Washington, DC (October 2024). 6 See S. Kozicki, “Economic progress report: More transparency in uncertain times” (speech delivered to the Urban Development Institute of Quebec, Montréal, Quebec, December 8, 2022.) -4Inflation climbed to levels not seen in decades. But because the Bank had committed to an inflation target of 2% and had kept inflation close to that target for 30 years, Canadians continued to believe it would eventually come back down. We reinforced that belief by committing to act forcefully to get inflation back to 2% and then following through with decisive policy action. This kept long-term inflation expectations anchored and helped bring down short-term expectations, which had moved upward as inflation rose (Chart 1).7 7 Research supports the argument that monetary policy actions and communications in 2021–22 helped keep inflation expectations in check. See, for example, R. Reis, “The credibility revolution in inflation expectations” (John Kuszaczak Memorial Lecture at the Bank of Canada’s annual economic conference, Ottawa, Ontario, November 7, 2024) and R. Asghar and M. Jain “Perceived Monetary Policy Transmission,” Bank of Canada Staff Working Paper (forthcoming). -5Ultimately, anchored inflation expectations made it possible to get inflation back to target without causing a sharp economic downturn. The role of excess demand in the post-pandemic surge in inflation Now let’s turn to our final driver of inflation: the balance between supply and demand in the Canadian economy. Monetary policy affects the economy primarily through its influence on demand. Low interest rates encourage demand by making it less expensive to borrow and spend, while high interest rates encourage people to save, thus reducing demand. To ensure inflation stays sustainably at 2%, monetary policy needs to keep demand in line with supply. But as the economy rebounded from the pandemic, supply and demand fell out of balance. Restrictions had eased, and Canadians wanted to do all the things they had missed during the pandemic, like going out to restaurants or travelling. At the same time, many services businesses were struggling to fully reopen. They couldn’t hire enough workers or get all the equipment and materials they needed. By early 2022, demand was growing much faster than supply. There was too much—or excess—demand in the Canadian economy. There are various ways of assessing imbalances between supply and demand.8 But for the purposes of my speech today, I’ll focus on the ratio of job vacancies to unemployed workers. Like other measures, it was signalling significant excess demand during the post-pandemic period (Chart 2).9 8 The output gap is another commonly used way of measuring imbalances between supply and demand in the economy. It was also signalling significant excess demand. For a third example, see 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 No. 2023-13 (June 2023). 9 A key advantage of the vacancy-to-unemployment ratio is that vacancies are a direct measure of labour demand. However, the vacancy-to-unemployment ratio may have somewhat overstated the extent of excess demand during this period. See, for instance, H. Afrouzi, A. Blanco, A. Drenik and E. Hurst, “A Theory of How Workers Keep Up With Inflation,” University of Texas at Austin Working Paper (November 2024). Job vacancies—which measure the demand for labour—surged to a record high in 2022. At the same time, the unemployment rate fell to the lowest level on record, meaning that the supply of workers available to fill those job openings was limited. It’s clear that the Canadian economy was overheating—the porridge was too hot. We needed to raise interest rates to bring demand and supply back into balance and to cool inflation. But there’s more to the story. There’s reason to believe that, by eliminating excess demand, our actions ended up having more of an effect on inflation than is normal.10 This idea is complicated, so—bear with me here—I’m going to set it up with a potatorelated anecdote. Imagine you own a french fry factory. Suppose one day, consumers 10 See R. Asghar and M. Jain, “Perceived Monetary Policy Transmission,” Bank of Canada Staff Working Paper (forthcoming). -7decide they want to start eating more french fries, so orders increase. At first, your factory can meet that demand by being more efficient. But orders keep coming in, and you need to hire more workers to keep up. Labour markets are tight, which means you have to pay higher wages and charge a bit more for your fries. As time goes on, it gets more and more costly to expand your output to meet even small increases in orders. As a result, you raise your prices at a faster pace. This anecdote demonstrates that prices tend to become very responsive when the economy has a lot of excess demand. If this is happening in sectors across the economy, inflation begins to rise more rapidly. But a key feature of this responsiveness is that inflation acted in the same way on the way down as it did on the way up. The Bank raised interest rates, which eliminated excess demand. As that excess demand diminished, inflation declined relatively quickly.11 Now let me show you how this phenomenon played out during the pandemic using a Phillips curve. The Phillips curve is what economists call the relationship between inflation and economic activity. We can see that the Phillips curve was relatively flat until the middle of 2021 (Chart 3, blue dots).12 This means inflation never strayed too far from 2%, regardless of the level of economic activity. 11 In the post-pandemic episode, it took just over two years to bring inflation in Canada back to 2% from its peak of 8.1%. This is much shorter than the average duration of disinflation of 4.4 years in the international experience between 1990 and 2019. See A. Blanco, P. Ottonello and T. Ranosova, “The Dynamics of Large Inflation Surges,” National Bureau of Economic Research Working Paper No. 30555 (October 2022). 12 The Phillips curve is plotted using an average of our two preferred measures of core inflation, which are less affected by volatile price components, such as food and energy, than total inflation is. The link between excess demand in the economy and inflation is more evident using this measure. But as the economy moved further into excess demand—beyond anything we had seen in recent decades—inflation became more responsive. Prices began to rise more frequently, even with relatively small increases in demand (Chart 3, red dots).13, 14 13 A growing body of recent research points to nonlinearities in the Phillips curve. See for example M. C. Dao, P.-O. Gourinchas, D. Leigh and M. Prachi, “Understanding the international rise and fall of inflation since 2020,” Journal of Monetary Economics 148(S) (November 2024) and A. Blanco, C. Boar, C. J. Jones and V. Midrigan, “The Inflation Accelerator,” National Bureau of Economic Research Working Paper No. 32531 (May 2024). See also P. Benigno and G. B. Eggertsson, “It’s Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve,” National Bureau of Economic Research Working Paper No. 31197 (April 2023). 14 To some extent, the steep part of the empirical Phillips curve likely also reflects temporary shifts in the curve due to supply shocks and movements in short-run inflation expectations rather than a structural nonlinearity. For this view, see P. Beaudry, C. Hou and F. Portier, “The Dominant Role of Expectations and Broad-Based Supply Shocks in Driving Inflation,” National Bureau of Economic Research Working Paper No.32322 (April 2024). -9Then, as our successive interest rates increases chipped away at excess demand, we saw the same responsiveness on the way down. Inflation declined faster than normal. The idea that inflation could start to respond more dramatically to small changes in demand—what economists call a nonlinear Phillips curve—has been around for a long time.15 We just hadn’t had enough excess demand in recent decades to experience it. Before we move on, I want to tie excess demand back to those global supply challenges I spoke about earlier. The post-pandemic period was unique in that supply shocks coincided with excess demand. Because we had so much demand in Canada, the effects of those shocks—mainly increased prices for energy and agricultural products— impacted a broader set of consumer prices than normal. Businesses faced elevated input costs, and they were able to pass those costs on to consumers more easily than usual.16 Simply put, the presence of excess demand in the economy amplified the inflationary effects of supply shocks.17, 18 By eliminating excess demand, we were able to stop that amplification. The supply challenges were still there, but businesses were less likely to pass on any additional cost increases because there was less demand. I know I’ve covered a lot of complicated concepts so far. What I hope you’ll take away is that because there was significant excess demand in the Canadian economy, inflation went up faster than normal. But it also came down more quickly in response to higher interest rates. By eliminating excess demand, our actions played a central role in bringing down inflation. In addition, our three decades of successful inflation targeting ensured long-term inflation expectations did not become unanchored. This was crucial because it prevented a period of persistently high and volatile inflation like we saw in the 1970s. The bottom line is that monetary policy—both here and around the world—played a decisive role in getting inflation back to 2%. 15 See T. Macklem, “Capacity constraints, price adjustment, and monetary policy,” Bank of Canada Review (Spring 1997): 39–56. 16 See O. Bilyk, T. Grieder and M. Khan, “Markups and inflation during the COVID-19 pandemic,” Bank of Canada Staff Analytical Note No. 2023-8 (June 2023). The authors construct measures of price markups using the financial statements of publicly traded Canadian firms. They find that markups remained stable during the pandemic, suggesting that businesses fully passed through higher costs to consumer prices. 17 See T. Macklem, “The Bank of Canada’s response to post-COVID inflation, and some lessons learned,” in B. English, K. Forbes and A. Ubide (eds), Monetary Policy Responses to the Post-Pandemic Inflation, Centre for Economic Policy Research Press (February 2024) and N. Vincent, “Understanding the unusual: How firms set prices during periods of high inflation” (speech delivered to the Chamber of Commerce of Metropolitan Montreal, Montréal, Quebec, October 3, 2023.) 18 For a theoretical model that exhibits this effect, see S. Murchison, “Non-homothetic Preferences and the Demand Channel of Inflation,” Bank of Canada Staff Working Paper (forthcoming). In addition, M. Harding, J. Lindé and M. Trabandt, “Understanding post-COVID inflation dynamics," Journal of Monetary Economics, 140(S): 101–118 (November 2024), present a model in which the inflationary impact of cost-push shocks is greater when marginal cost and inflation are already elevated. - 10 - Why don’t we want inflation below 2%? Now that inflation is back around 2%, what should monetary policy aim to do going forward? Our inflation target is symmetric, which means we are equally concerned with inflation above or below 2%. We just lived through a period of high inflation. For many young Canadians, it was the first time in their lives that inflation was noticeable. And while the average wage has kept pace with prices, we also know that averages don’t tell the whole story.19 Income growth has not been even across households, and cost increases affect people differently, depending on their spending patterns. For instance, we know low-income families spend a relatively larger share of their household budgets on necessities like food and energy, which increased more than overall consumer prices. (Chart 4).20 19 Prices have increased by 19% since 2019, while wages have risen by 26%, according to data from Statistics Canada. Prices are measured by the consumer price index, while wages are average hourly wages of all employees from the Labour Force Survey. Alternative measures of compensation also indicate that wages have kept up with prices, although the magnitudes of the increases vary. 20 During the recent inflation surge in Canada and many other countries, the prices of cheaper brands of many food products grew faster than prices of the more expensive brands. See A. Cavallo and O. Kryvtsov, “Price discounts and cheapflation during the post-pandemic inflation surge,” Journal of Monetary Economics, 148(S) (November 2024). In addition, low-income households in Canada experienced more inflation than other households. See O. Kostyshyna and M. Ouellet, “Household Food Inflation in Canada,” Bank of Canada Staff Working Paper No. 2024-33 (September 2024). - 11 - It’s important to acknowledge these inequities, but monetary policy is not the best tool to address them. The best contribution monetary policy can make is to keep overall inflation low, stable and predictable. This begs another question. If low inflation is a good thing, why not let it fall below 2%? The idea of a period of no price gains—or even price declines—can sound tempting, particularly after three years of higher-than-normal price increases. But there are tradeoffs and risks involved in trying to push inflation below target, even temporarily. And it may not actually be that easy to accomplish. We know from the Phillips curve that I showed you earlier that inflation has tended to be fairly stable at around 2% when demand is weak. This means that the Bank would likely need to reduce demand by a lot to get to the point where prices were increasing by significantly less than 2%. To reduce demand, we would need to keep interest rates higher than otherwise. Put differently, we’d have to stop cutting interest rates and possibly even raise them again. This would affect mortgage rates and the cost of other loans. At the same time, lower - 12 demand would likely prompt businesses to lay off workers, which would lead to more unemployment and lower wages. In other words, it would take a pretty big hit to the economy to get a meaningfully lower level of prices. This trade-off would likely leave most people feeling worse off. In addition, there would be a risk that inflation expectations could drift lower. If this happened, it would limit the amount of stimulus that monetary policy can provide in response to a downturn and increase the risk of a severe recession.21 A shift down in inflation expectations would also make it difficult for us to eventually get inflation back up to 2%. For example, if consumers came to expect falling prices, they might put off purchases in anticipation of a better deal in the future. If lots of people put off buying things, businesses might drop prices to encourage buyers. But these price declines could instead incentivize consumers to continue delaying purchases in the hope of even lower prices. Escaping a deflationary cycle of this nature can be extremely difficult. Keeping inflation at the 2% target mitigates these risks. When inflation is stable at 2%, it fades into the background. Households and businesses can plan and invest with confidence, helping the economy to grow. Price stability is low, stable and predictable inflation. This is what we are aiming for—and what we achieved for most of the 30 years before the pandemic. We’ve restored low inflation; now we need to ensure it stabilizes near the 2% target. We need to stick the landing. Conclusion To wrap up, let’s go back to the question of whether inflation would have fallen back to target on its own. Clearly, global developments led the early surge in inflation, and they also played a leading role in its decline. However, if the Bank hadn’t raised interest rates, long-term inflation expectations may not have remained stable. Had long-term inflation expectations become less stable, it would have been far more costly to bring inflation back to 2%. Further, as I explained, global factors weren’t the only reason inflation rose so far above target. Demand was adding fuel to the fire, and the Canadian economy was overheating. If the Bank hadn’t acted, inflation wouldn’t have come all the way back to 2%—even after commodity prices declined and global supply chains began to normalize. Now that inflation is back at 2%, we want to keep it there. We know the increases in price levels over the past few years have been very difficult for many Canadians. But the trade-offs required to reverse those increases would be even more painful. Ultimately, the risks outweigh any potential benefits. 21 Because the policy rate is subject to an effective lower bound, lower inflation expectations reduce how low monetary policy can push the real (inflation adjusted) interest rate. - 13 Monetary policy worked to remove excess demand from the economy. We no longer need interest rates to be as restrictive as they were. This is why we took a bigger step at our last decision. Since then, data for October were released showing inflation at 2%, in line with our expectations. Our preferred measures of core inflation ticked up to about 2½%. We still have more information to come before our next rate decision in December, including third quarter gross domestic product data and the November employment numbers. We’ll be looking closely at those indicators and reviewing any other information we receive. If the economy evolves broadly in line with our forecast, then it’s reasonable to expect further cuts to our policy rate. That said, the timing and pace of further cuts will be guided by incoming information and our assessment of its implications for the inflation outlook. We will be taking our monetary policy decisions one at a time. The past few years were unlike anything we’d experienced before, and none of it was easy. But we believe inflation will once again fade into the background as it settles back at 2%. This will allow Canadian consumers and businesses to spend and invest with confidence and the economy to work better for everyone. Thank you.
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Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Greater Vancouver Board of Trade, Vancouver, British Columbia, 16 December 2024.
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Tiff Macklem: Delivering price stability - learning from the past, preparing for the future Remarks by Mr Tiff Macklem, Governor of the Bank of Canada, at the Greater Vancouver Board of Trade, Vancouver, British Columbia, 16 December 2024. *** Introduction Good afternoon. It's a great pleasure to be back in Vancouver for my final speech of 2024. I want to thank the Greater Vancouver Board of Trade for inviting me. I'm particularly looking forward to our discussion after my remarks. Hearing from you is always the best part. As some of you will recall, I was here in Vancouver two years ago in December 2022. Inflation was close to 7%. We'd just raised the policy rate by 50 basis points to 4¼%, our seventh straight rate hike in our fight against inflation, and we signalled we would be considering increasing rates further. Indeed, we ended up raising our policy rate three more times to 5%. Today, inflation is back at our 2% target. Last week we cut our policy rate by 50 basis points to 3¼%, the fifth consecutive decrease since June. We've come a long way in the past two years. Monetary policy has worked to restore low inflation. Interest rates have come down substantially, and household spending has begun to pick up. But I am not here to give a victory speech. Price stability is low, stable inflation. Inflation is low once again; now we need to stabilize it around the 2% target. That's price stability. That's giving Canadians the confidence that their cost of living will not change materially year to year. Today I want to talk about delivering price stability for Canadians. I'll start with the present-where the economy is today-and what we are focused on to keep inflation close to the 2% target. Then I will look back to learn from the past. We need to use the pandemic experience to prepare for future crises. Finally, I'll look ahead. The future looks more uncertain, and more prone to shocks than we would all like. We need to be prepared. And that work is underway. Monetary policy today Let's start by looking at current economic conditions. 1/7 BIS - Central bankers' speeches The economy grew by 1% in the third quarter, which was slower than we expected. Recent data offer a mixed picture. Consumer spending and housing activity both picked up in the third quarter, as lower interest rates started to boost household spending. Annual revisions also suggest the level of gross domestic product (GDP) is more than 1% higher than previously reported. However, weakness in business investment, inventories and exports point to less momentum headed into the fourth quarter, and the labour market is still softening. Looking ahead, a number of government measures will affect the dynamics of growth and inflation. Lower immigration targets suggest GDP growth next year will be lower than we forecast in October. Other federal and provincial government policies-including the GST break on some items, one-time payments to individuals, and changes to mortgage rules-will also affect household spending and inflation in the months ahead. As always, we will look through the effects that are temporary and focus on underlying trends to guide our policy decisions. Inflation has been close to target since the summer. It was exactly 2% in October and is expected to average close to the 2% target over the next couple of years. In the October CPI data, the upward pressure on inflation from shelter and the downward pressure from goods prices have both moderated as expected. In the next few months, the GST holiday will temporarily lower inflation but that will be unwound once the break ends. There are risks around our inflation outlook. Elevated wage increases combined with weak productivity could boost inflation as businesses look to pass on higher costs. Or the economy could continue to grow below its potential which would pull inflation down. With inflation back to 2%, we are equally concerned with inflation coming in higher or lower than expected. The economic outlook is also clouded by a major new uncertainty-the possibility the incoming US administration will impose new tariffs on Canadian exports. No one knows how this will play out in the months ahead. With inflation back to target, the economy in excess supply and the growth outlook softening, we cut the policy rate by 50 basis points at each of the last two decisions. Monetary policy no longer needs to be clearly in restrictive territory. We want to see growth and hiring pick up to absorb the unused capacity in the economy and keep inflation close to 2%. Learning from the past So that's the present. As we deal with the present, we also need to reflect on the past. And as much as we would all like to forget the dark days of the pandemic, we need to learn from this unprecedented crisis. To that end, the Bank of Canada has been conducting a review of the policy actions we took to restore financial stability and support the economy during the pandemic. This work is nearly done, and once it is completed, we will publish our review together with an assessment by an independent panel of experts. But some of the key takeaways are already clear. 2/7 BIS - Central bankers' speeches Our pandemic response was effective in restoring market functioning, preventing an even worse economic calamity, and supporting the recovery. The crisis was developing rapidly, and a quick and bold response was critical. But we can see in retrospect that when we use extraordinary tools, we need to be clear about what we're trying to achieve with those tools and under what conditions they'll no longer be needed. Perhaps most importantly, we need to remember that the actions we took were truly extraordinary. The bar to use exceptional tools has always been high in Canada-and it should remain high. These are not conventional monetary policy. We also need to take on board the lessons from the surge in inflation that followed. Why did inflation rise so rapidly? And how effectively did monetary policy respond? To be prepared for the future, we need to be clear-eyed about what surprised us. My colleagues and I have already written and spoken about some of the lessons, so I can be brief here.1 But I'll highlight three. First, economic supply matters every bit as much as demand, and we need to understand it better. Monetary policy typically focuses mostly on demand. That's because interest rates largely affect demand and because supply usually evolves more smoothly and predictably. The pandemic reminded us we cannot take that for granted. Supply disruptions can be sudden, severe and persistent, they can accumulate, and they are more inflationary when demand is strong. We also learned that what matters for inflation is not only the demand-supply balance for the economy as a whole but also across different sectors. The disinflation in weak sectors may be smaller than the inflationary impact of sectors that are overheated. In the future, we need better information and analysis about the supply side of the economy. Second, we learned that price-setting behaviour changes when inflation is high. Typically, businesses are hesitant to raise prices. They worry their price increases will stand out and they'll lose customers to their competitors. But as the economy came out of the pandemic, supply disruptions and higher commodity prices pushed up costs. And demand was very strong. Businesses had trouble keeping up with orders. With high demand, businesses felt they could pass on more of their cost increases than usual, and more rapidly. What we learned is that, in some contexts, businesses can dramatically change their pricing behaviour.2 Our economic models and forecasts need to reflect this reality. And finally, we learned-or perhaps relearned-just how much people hate inflation. All of a sudden, people couldn't afford the things they need to live. And while inflation is low once again, many prices are still a lot higher than they were before the pandemic. So people feel ripped off. And that erodes public trust in our economic system. The spike in inflation in 2022 was a reminder that even though inflation was relatively low and stable for 30 years leading up to the pandemic, central banks cannot take public trust for granted. We need to earn that trust, by being clear about our objectives, accountable for our actions, and humble in the face of uncertainty. Preparing for the future 3/7 BIS - Central bankers' speeches That brings us to the future. Unfortunately, it looks more uncertain than it did before the pandemic. Big structural changes are already underway. Deglobalization, demographic shifts, digitalization and decarbonization are all having significant effects on jobs, growth and inflation. Trade protectionism and economic fragmentation are rising, and the appetite for global cooperation is waning. Shifting international relationships are adding uncertainty and costs and altering investment plans. Aging populations and changes in immigration policies will also affect the supply and cost of labour. New technologies, including artificial intelligence (AI), will disrupt existing industries and create new ones. And the impacts of climate change and the transition to low-carbon economies are becoming more pervasive. Monetary policy cannot eliminate any of this uncertainty. But by keeping inflation low and stable, monetary policy can avoid making it worse. So how do we prepare? For 2025, we have set three priorities to help us deliver for Canadians in a more uncertain world. We need to work with our international partners to try and shape the future. Canada's G7 presidency next year is an opportunity to lead. We also need to improve our analysis, using richer information and better tools to respond to inevitable shocks. And finally, we need to ensure our monetary policy framework is fit for purpose. Let me take each of these in turn. Work with our international partners We often focus on negative international spillovers-the harm one country's actions can have on other countries. But we can create positive spillovers when we work together. The shared resolve of major central banks to fight post-pandemic inflation reduced the demand for global goods and took pressure off tangled supply chains. That helped us all get inflation back down without causing major recessions. In 2025, Canada hosts the G7 meetings. That gives us a chance to build on these positive spillovers. International cooperation is getting harder, but as shared global risks accumulate, it is more important than ever. At the top of the risk list is economic security. The combination of higher sovereign debt, higher long-term interest rates and lower economic growth is making the world more vulnerable. War, geopolitical tensions and the rising threat of protectionism are compounding these vulnerabilities. The democracies of the G7 will be stronger if we confront our shared economic security issues together. We must also confront other mutually important issues, including the risk and opportunity of AI, the potential vulnerabilities arising from non-bank financial institutions, and the need to improve cross-border payment systems. We can't do these things alone. Richer information and better tools 4/7 BIS - Central bankers' speeches Here at home, the volatility of the past several years highlights the need to sharpen our policy tools. That starts with richer information. We have invested in detailed sectoral data on global value chains. We have expanded our surveys to reach many more businesses and consumers in Canada. And we are using large micro-level datasets on prices, jobs and household credit to enrich our analysis. With richer information, we can build richer economic models. We've begun work on our next generation of economic models that incorporate the key lessons of recent years. This includes models that better capture the role of supply chains in production and the connectivity between sectors. This will help us understand and track how supply disruptions flow through our economy, and how they affect specific sectors and overall inflation. The new models will also distinguish between inflation that comes from higher demand and inflation that comes from higher input costs. And the new models will allow us to gauge the impact of changes in price-setting behaviour. This should all help us better understand inflation dynamics and develop monetary policy playbooks to better respond to shocks. Finally, our new models will also help us manage uncertainty using alternative scenarios. We'll be able to build scenarios with different assumptions about key inputs to the Canadian outlook, like the price of oil or the strength of the US economy. We'll also be able to examine scenarios with different views about how the economy works. Looking at the economy through different lenses and regularly challenging our assumptions are the best ways to manage the risk and uncertainty that surrounds the economic outlook. Review of monetary policy framework The final-and critically important-priority for the Bank is the review of our monetary policy framework. Every five years, the Government of Canada and the Bank of Canada review our flexible inflation-targeting framework to ensure it is the best way for us to promote the economic and financial well-being of Canadians. The joint nature of the agreement between the government and the Bank reinforces both the democratic legitimacy of the framework and our operational independence to pursue the agreedupon objectives. Right now, we're considering what issues to focus on in the upcoming review, reflecting on the big forces on the economy and what we're hearing from Canadians. This points to several questions. In a more volatile world, how do we identify and measure underlying inflation? Is 2% still the best target for the future? What's the interaction between housing affordability and monetary policy? I'll have more to say about the framework review in the new year, once the work truly begins. More than ever, Canadians are aware of economic issues and of the work we do at the Bank. And they are reaching out to share their views. We welcome this, and we will continue to seek out diverse perspectives as we undertake our framework review. 5/7 BIS - Central bankers' speeches We want the best monetary policy framework for the future-to fight the next battle, not the last one. Conclusion Let me conclude. As we look ahead, the world looks more shock-prone. We hope some of the major uncertainties hanging over the world will be resolved. We can't count on that-but we can prepare. With inflation back to 2%, we are in a better position to respond to whatever may come. We want to keep inflation close to the target-that's delivering price stability for Canadians. We have reduced the policy rate substantially since June, and those cuts are working their way through the economy. Going forward, we will be evaluating the need for further reductions in the policy rate one decision at a time. In other words, we anticipate a more gradual approach to monetary policy if the economy evolves broadly as expected. Our decisions will be guided by incoming information and our assessment of the implications for the inflation outlook. Even as we manage the present, we are preparing for the future. That means working with our international partners. It means making sure monetary policy is a source of stability, not further uncertainty. And it means taking on board the lessons from the pandemic and its aftermath: tapping new data sources and building our capacity to better manage uncertainty. Over the next year and half, we will also be reviewing our monetary policy framework. We are committed to being transparent and accountable in everything we do. That starts with listening. We're visiting more communities across the country. We are also doing more to explain our decisions. I now hold a press conference after every decision to answer the media's questions, and this is followed by a written summary of our monetary policy deliberations. The Bank has added an external Deputy Governor to provide a fresh perspective, and we are currently recruiting for a second one. We are also finding new ways to reach Canadians through new communication products and platforms. We will continue to look for ways to be more transparent and accountable. We want to earn the public's trust. And we are. Increasingly, households and businesses expect inflation will be low. And as that confidence in low inflation has come back, so has trust in the Bank of Canada. Our surveys show Canadians better understand our role and they see us as working to serve their best interests. That's encouraging. We are intent on rewarding that trust, by delivering low and stable inflation, by learning the lessons of the past, and by being the central bank that Canadians can rely on, now and in the future. Thank you. I would like to thank Don Coletti, Oleksiy Kryvtsov, Marie-France Paquet, Jonathan Witmer and Jing Yang for their help in preparing this speech. 6/7 BIS - Central bankers' speeches 1 See T. Macklem, "The path to price stability" (speech delivered to the Canadian Club Toronto, Toronto, Ontario, December 15, 2023); T. Macklem, "Putting the resolute in resolutions: Looking ahead to lower inflation" (speech delivered to the Business Council of British Columbia, Vancouver, British Columbia, December 12, 2022); R. Mendes, " Keeping inflation at 2%" (speech delivered to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, November 26, 2024); and T. Macklem, "The Bank of Canada's response to post-COVID inflation, and some lessons learned," in B. English, K. Forbes and A. Ubide (eds), Monetary Policy Responses to the Post-Pandemic Inflation, Centre for Economic Policy Research Press (February 2024). 2 See N. Vincent, "Understanding the unusual: How firms set prices during periods of high inflation" (speech delivered to the Chamber of Commerce of Metropolitan Montreal, Montréal, Quebec, October 3, 2023). 7/7 BIS - Central bankers' speeches
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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 11 December 2024.
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Tiff Macklem: Monetary Policy Decision Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 11 December 2024. *** Good morning. I'm pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss our policy decision. Today, we lowered the policy interest rates by 50 basis points. This is our fifth consecutive decrease since June and brings our policy rate to 3¼%. Monetary policy has worked to bring inflation back to the 2% target. Our policy focus now is to keep inflation close to target. Let me outline what we're seeing in the economy, and how that played into our decision. In the United States, the economy continues to show broad-based strength and inflation has been holding steady. The US dollar has appreciated against most other currencies, including the Canadian dollar. Canada's economy grew by 1% in the third quarter, which was slower than we expected. Recent data also suggest growth will be lower than projected in the final quarter of this year. Growth in the third quarter was pulled down by business investment, inventories and exports. But consumer spending and housing activity both picked up, as lower interest rates started to boost household spending. Canada's job market is still softening. Businesses have continued hiring, but the number of people looking for work has been increasing faster than the number of jobs. The unemployment rate rose to 6.8% in November. It has been especially hard for young people and newcomers to Canada to find work. A number of policy measures have been announced that will affect the outlook for growth and inflation in the months ahead. The most significant of these is reduced immigration targets, which suggest GDP growth next year will be lower than we forecast in October. The effects of lower population growth on the inflation outlook will likely be more muted because reduced immigration dampens both demand and supply in the economy. We'll have more to say on this when we release our next forecast in January. Other federal and provincial government policies-including a temporary GST break on some consumer products, one-time payments to individuals, and changes to mortgage rules-will likely affect the dynamics of household spending and inflation in the months ahead. Again, we will have more to say on this in January. As always, we will look through effects that are temporary and focus on underlying trends to guide our policy decisions. 1/2 BIS - Central bankers' speeches CPI inflation has been about 2% since the summer, and we expect it to be close to target, on average, over the next couple of years. We thought elevated shelter price inflation would continue to ease, and it has. And the downward pressure on inflation from goods prices has also moderated as predicted. We expect the GST holiday to temporarily lower inflation to around 1½% in January, but that effect will be unwound after the GST break ends in mid-February. We will be looking at measures of core inflation to help us assess the trend in CPI inflation. While the upward and downward pressures on prices have been moderating, risks to the inflation outlook remain. Elevated wage increases combined with weak productivity could push inflation up. Or the economy could keep growing below its potential, which would pull inflation down. In addition, the economic outlook is clouded by the possibility of new tariffs on Canadian exports to the United States. No one knows how this will play out in the months ahead-whether tariffs will be imposed, whether exemptions get agreed, or whether retaliatory measures will be put in place. This is a major new uncertainty. To summarize, inflation is back to the 2% target and lower interest rates are beginning to pass through to stronger spending by households. But the economy remains in excess supply and the growth outlook now appears softer than we projected in October. With inflation back to target, we have cut the policy rate by 50 basis points at each of the last two decisions because monetary policy no longer needs to be clearly in restrictive territory. We want to see growth pick up to absorb the unused capacity in the economy and keep inflation close to 2%. The Governing Council has reduced the policy rate substantially since June, and those cuts will be working their way through the economy. Going forward, we will be evaluating the need for further reductions in the policy rate one decision at a time. In other words, with the policy rate now substantially lower, we anticipate a more gradual approach to monetary policy if the economy evolves broadly as expected. Our decisions will be guided by incoming information and our assessment of the implications for the inflation outlook. The Bank is committed to maintaining price stability for Canadians by keeping inflation close to the 2% target. With that, the Senior Deputy Governor and I would be pleased to take your questions. 2/2 BIS - Central bankers' speeches
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Remarks by Mr Toni Gravelle, Deputy Governor of the Bank of Canada, at VersaFi (formerly Women in Capital Markets), Toronto, Ontario, 16 January 2025.
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Remarks by Toni Gravelle Deputy Governor of the Bank of Canada VersaFi (formerly Women in Capital Markets) January 16, 2025 Toronto, Ontario The end of quantitative tightening and what comes next Introduction Good afternoon. Thank you, Tanya, for the kind introduction. And thank you to VersaFi for hosting this event. The Bank of Canada’s balance sheet has been larger than normal for a few years now. That’s because of the role it played during the COVID-19 crisis, in making sure financial markets could work properly and in setting the economy on a path to recovery. As we began to emerge from the worst of the pandemic, we ended quantitative easing (QE) in October 2021. Six months later, in April 2022, we started shrinking the balance sheet through quantitative tightening (QT), a process that continues today. Under QT, we have been letting our bond holdings roll off the balance sheet as they mature, without replacing them. Last year, I said we thought that QT, also known as balance sheet normalization, would end sometime in 2025. Well, it’s 2025. And since I had also promised to deliver any news about QT ahead of time, that is why I am here today. When QT ends, we will be back to business as usual for how we manage the balance sheet. This will look a lot like how we managed it before the pandemic, which I outlined in a speech last March.1 Essentially, we’ll be purchasing assets mainly to offset the growth of currency in circulation—the cash in your wallets. But some things have changed in the five years since the start of the pandemic. In particular, the payment system has evolved, and so has our monetary policy implementation framework. As a result, some evolution in how we manage our balance sheet is needed. So, today I’ll give you an update on: 1 See T. Gravelle, “Going back to normal: The Bank of Canada’s balance sheet after quantitative tightening,” (speech to CFA Society Toronto, Toronto, Ontario, March 21, 2024). I would like to thank Kaetlynd McRae for her help in preparing this speech. Not for publication before January 16, 2025 12:30 p.m. Eastern Time -2• when, roughly, we expect QT to end • how we will manage the balance sheet after QT ends and we resume our business-as-usual asset purchases • what the likely drivers are of recent pressures in overnight funding markets Our estimate of demand for settlement balances Let me start with a bit of background about a crucial element of our balance sheet, one that is key to guiding our QT process. I’m talking about settlement balances—what most other jurisdictions call central bank reserves. These represent a liability on our balance sheet.2 They are interest-bearing deposits held at the Bank of Canada that belong to members of Lynx, Canada’s high-value wholesale payment system, who use them to settle large payments with each other. Lynx members include the biggest banks, which process the bulk of payments in Canada and, as a result, hold most of the settlement balances. The interest rate that we pay on settlement balances is called the deposit rate. Due to arbitrage in overnight funding markets, the rate for overnight repurchase—or repo—agreements in these markets tends to be at or close to our deposit rate. And since the deposit rate moves one-for-one with our target policy rate, this helps ensure that the one-day or “overnight” market rate used by financial institutions is also at, or close to, our target rate. When we change our policy rate, this implies an equivalent change in the deposit rate, leading to changes in the overnight rate and, in turn, influencing longer-term interest rates, such as on mortgages or business loans. This is how we implement our monetary policy and ensure that it is reflected in borrowing and lending rates throughout the economy. Now, as I discussed in my speech last March, because we now operate in a floor system, our aim in steady state is to supply just enough settlement balances to satisfy the demand for them from banks and other Lynx participants.3 Currently, though, the amount of settlement balances on our books is higher than our best estimate of that demand because of the balance sheet measures that we took during the pandemic. So, as we shrink our balance sheet through QT, we are lowering the supply of settlement balances toward our best estimate of demand. This lower level is really a range, because we use a few different approaches to estimate the demand for settlement balances. In estimating the overall demand for settlement balances in the financial system, we look at two types of demand. The first is payments-driven demand, which is the amount needed for Canada’s high-value payments system to operate 2 For more detail about how our balance sheet works and its role in the Canadian financial system and economy, see the dedicated page on the Bank’s website. 3 For a detailed discussion of why we switched to a floor system for implementation of our monetary policy, see my speech from March 2024. -3smoothly. In other words, the amount of settlement balances that Lynx members want to keep on hand so that they can settle daily payments with each other. The second type is precautionary demand. This is where risk-free and liquid assets, such as Government of Canada (GoC) bonds or settlement balances, are held as a buffer against unexpected funding or liquidity shocks. But measuring either payments- or precaution-driven demand for settlement balances is difficult. So, to come up with the best estimate that we can, we regularly survey and speak with banks and other Lynx participants to help us understand how much demand there is. And in the latter part of 2024, we determined from these discussions and our own subsequent analysis that precautionary demand had grown beyond the level we had previously estimated. Earlier last year, we thought QT would end when our settlement balances declined to a $20 billion to $60 billion range. This was based on our estimate of Lynx participant demand at the time. Due to our updated assessment of precautionary demand, we have revised the range upward to between $50 billion and $70 billion. Of this, we continue to see about $20 billion to $30 billion being needed to support the payments system. The rest of the range is what we now expect precautionary demand to be. Currently, we have about $130 billion in settlement balances, down from a peak of around $395 billion during the pandemic. As you can see from the chart (Chart 1), we expect settlement balances to reach our new estimated range around mid-year. So that brings me to when we will end QT and start buying assets again as part of our business-as-usual balance sheet management process. Based on the maturity profile of our assets, settlement balances are expected to fall well below the $50 billion to $70 billion range in the third quarter, due to a very large GoC bond maturity coming due on September 1, 2025 (Chart 2). To achieve a smoother glide path for settlement balances as they fall ahead of that large maturity, we will need a transition process where asset purchases help to offset the sharp and sudden drop. That means we will need to restart our normal-course asset purchases gradually, and well before September. As a result, we expect to announce the end of QT and the associated restart of our business-as-usual asset purchases in the first half of this year. When we make that announcement, we will also publish a market notice with more details about the asset acquisition process, including the timing of our initial purchases and expected amounts. Given this timeline, I expect we will be the first major central bank, or among the first, to finish unwinding its pandemic-related QE asset purchases. That reflects three considerations. First, going into the pandemic, our balance sheet was smaller as a proportion of gross domestic product relative to other central banks because we hadn’t used QE before. Second, we ended QE earlier than others. And third, the maturity profile of our asset holdings coming out of our COVID actions was shorter, so QT has gone faster in Canada than in most other jurisdictions. As you can see from this chart, in terms of assets as a share of the economy, our balance sheet is already smaller than those in other major jurisdictions (Chart 3). The estimated range for settlement balances will evolve over time Once we resume purchasing assets to offset the growth of currency in circulation, we will aim to manage our balance sheet in a way that keeps settlement balances in the range of $50 billion to $70 billion. But there may be brief periods when the amount falls below or rises above this range.4 I also want to stress that, over the long term, demand for settlement balances will continue to evolve as the financial system evolves. So the amount that the major banks and other Lynx participants want to hold will likely vary as well. This means we will probably adjust our estimated range from time to time, possibly both up and down, to reflect changes in settlement balance demand. This way, we can make sure that our framework for implementing monetary policy remains effective at keeping the overnight rate in markets close to our target for the policy rate. 4 In steady state, settlement balances will fluctuate in the new range due to autonomous variations in our other major liabilities. For example, fluctuations in the amount of funds the Government of Canada puts in its deposit account with us will cause offsetting fluctuations in the level of settlement balances, all other things being equal. Fluctuations can also occur due to differences in the timing and size of our asset purchases versus the relatively lumpy maturities of our legacy asset holdings. We will aim to minimize fluctuations in order to keep settlement balances in the range but, on rare occasions, we may not always be able to for a day or so. -7While our core objective is to supply enough settlement balances in the financial system for us to be able to implement our monetary policy effectively, that’s not our only consideration. Another important factor is market discipline, given that we are also responsible for promoting a stable and efficient financial system. What do I mean by this? Well, we don’t want to see major banks and other core financial institutions under-investing in their capacity to robustly manage their liquidity because they have developed an unhealthy over-reliance on settlement balances. In managing their liquidity needs, financial market participants should be able to respond to fluctuations in those needs in other ways—for example, through access to markets. Going forward, our assessment of the optimal range of settlement balances will account for the evolving nature of both payments and the financial system, as well as the need to maintain market discipline. The return to business-as-usual balance sheet management Okay, so what will business-as-usual look like after QT ends? Under our normal course of balance sheet management, we buy assets on a passive basis to reflect the autonomous rise in our liabilities. Traditionally, the biggest liability has been currency in circulation. Demand for cash usually grows at roughly the same speed as the nominal growth of the economy. I want to be clear, though, that while QT is almost finished, the composition of our asset holdings won’t be back to normal for quite some time. As I explained in my speech last March, we want to restore a more balanced mix of assets with a broader range of maturities—including more short-term assets—than we hold now. Currently, our asset portfolio is made up almost entirely of GoC bonds. And as a result, our asset holdings have a maturity profile that skews longer than it did before the pandemic. Going forward, we will hold not only GoC bonds but also GoC treasury bills (t-bills) and term repos, just as we did before the pandemic. In steady state, we will aim to have the amount of our floating-rate assets, mostly term repos and t-bills, match the amount of our floating-rate liabilities, which include settlement balances. And we will aim to have the size of our bond holdings roughly match currency in circulation, given that currency is assumed to be a permanent liability. Although our asset purchase plan will be designed to ramp up to this steady-state composition, our asset growth is limited by how quickly currency in circulation grows. So we may not reach that composition until around 2030. I want to emphasize that we will not be buying assets on an active basis to stimulate the economy like we did during the pandemic when we were doing QE. Our normal asset purchases before the pandemic were not QE. And our normal asset purchases after QT ends will not be QE either. Now let’s get into some of the specifics of our purchasing plans. When we start growing our assets again for business-as-usual balance sheet management, we will start with term repo operations. These will be 1- and 3month terms, and we will gradually ramp up the amounts through bi-weekly -8operations. T-bill purchases will take place in the primary market. We expect them to resume in the fourth quarter of this year, initially with relatively small amounts through each bi-weekly GoC debt auction. GoC bond purchases will likely not start until toward the end of 2026—at the earliest. But, as we get closer to purchasing bonds, we will announce the timing well in advance. When we start buying GoC bonds again in the normal course of business, we will do so in the secondary market, via reverse auctions. Secondary market purchases align with benchmark practices at other major central banks that buy their home jurisdiction’s government bonds as part of their normal-course balance sheet management. And there are advantages to doing it this way compared with buying bonds in the primary market—that is, at GoC auctions— which was our practice before the pandemic. One advantage is that secondary market purchases will give us the flexibility to buy any GoC bonds outstanding across the full spectrum of maturities, rather than being limited to what’s on offer at individual GoC bond auctions. This will allow us to replace maturing bonds with bonds from the maturity buckets that we want, which will help us rebalance the maturity structure of our balance sheet more quickly. Buying in the secondary market also helps enhance the GoC bond market’s functioning and liquidity. It gives participants more regular opportunities to trade and see pricing points for off-the-run securities that are less liquid than on-therun bonds. When we do become a regular buyer in these markets again, a couple of key principles will guide us to help ensure that our presence leans toward enhancing market functioning. First and foremost, we want to limit the market impact of our purchase operations. Our bond purchase operations, for example, will be pricesensitive, and we won’t necessarily buy everything that dealers offer to us. And second, we will always aim to be as transparent and predictable as possible. For example, we will publish calls for tender ahead of our operations, as well as quarterly purchase schedules. So now you know what comes next once we’ve finished QT. Where do recent repo market pressures fit? Before I conclude, let me also take this opportunity to say a few words about the recent pressures in repo markets and how they fit into all this. I want to be clear that we will not be ending QT out of any concern about the functioning of repo markets. Our assessment is that, for the most part, other factors are causing these pressures. I also want to be very clear that the pressures in repo markets are not a reflection or indication of broader financial system stress. Last year, our analysis determined that upward pressure in repo markets was being caused primarily by positioning in bond and futures markets, largely by -9hedge funds.5 Through our more recent monitoring and discussions, we can see that hedge fund activity and positioning continue to contribute to higher funding requirements sourced in the repo market. These have led to upward pressure on repo market rates—along with other factors, such as the transition to a one-day settlement period for trades, also known as T+1 settlement.6 We’ve also seen greater upward pressure on rates in overnight repo markets around regulatory reporting dates, such as at year-end or quarter-end for banks. This happens in many other major jurisdictions as well.7 Repo trading increases the size of a bank’s balance sheet and, in turn, its regulatory capital requirements. So as reporting dates approach, banks try to reduce their balance sheet to satisfy regulatory requirements. This tends to make them less willing to conduct repo transactions with clients and cash desks, due to the impact that repo deals have on their books. And that reluctance reduces the supply of repo funding to the market and can cause or amplify upward pressures on repo rates. Our analysis also finds that the Bank’s routine overnight repo operations, where we inject funds into the market to ease upward pressure on overnight repo rates, can at times be less effective in these periods. This is because sourcing liquidity around reporting dates in the inter-dealer broker (IDB) market can be a better deal for banks and other intermediaries than getting it through our repo operations. Repo trading via IDBs offers netting benefits provided by central clearing, which lowers the amount of equity capital required for trades done in the IDB segment of the repo market. That is especially useful for intermediaries around reporting periods. As always, we will continue to monitor all of these repo market dynamics. Conclusion It’s time to wrap up. It’s been a long road—almost three years since we began QT—but we are just about finished the QT process and the unwinding of our QE-related asset holdings. We will announce the end of QT in the first half of this year, and we will re-start business-as-usual asset purchases after it ends. When QT is done, we’ll go back to managing the balance sheet in a way that looks a lot like how we managed it before the pandemic. Crucially, when we start buying assets, these will be normal, passive purchases, reflecting the growth in 5 See B. Plong and N. Maru, “What has been putting upward pressure on CORRA?” Bank of Canada Staff Analytical Note No. 2024-4 (March 2024). CORRA (the Canadian Overnight Repo Rate Average) measures the cost of overnight general collateral funding in Canadian dollars using GoC treasury bills and bonds as collateral for repurchase transactions. Making sure overnight rates are at or close to the target for the overnight rate that we set for monetary policy is how we ensure that borrowing and lending conditions in the economy reflect our policy stance. 6 See B. Plong and N. Maru, “CORRA: Explaining the rise in volumes and resulting upward pressure,” Bank of Canada Staff Analytical Note No. 2024-21 (August 2024). 7 See, for example, R. Perli, “Facing Quarter-End Pressures: Understanding the Repo Market and Federal Reserve Tools” (speech to New York University’s Stern School of Business, New York, November 12, 2024). - 10 currency—not QE. However, because payments and the broader financial system have evolved, our approach to balance sheet management has also evolved. This is reflected in our shift to a floor system for implementing our monetary policy, which means we need to supply an amount of settlement balances that roughly matches the demand for them. And that demand is now estimated to be higher than where we thought it would be when I spoke about our QT process last year. Over the longer term, since the financial system will continue to evolve, demand for settlement balances can be expected to evolve too. Market participants can count on us to communicate our next steps clearly and ahead of time. And all Canadians can count on us to manage our balance sheet in a way that both lets us achieve our monetary policy mandate and promotes a stable and efficient financial system. Thank you.
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Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 29 January 2025.
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Tiff Macklem: Release of the Monetary Policy Report Opening statement by Mr Tiff Macklem, Governor of the Bank of Canada and Ms Carolyn Rogers, Senior Deputy Governor of the Bank of Canada, at the press conference following the monetary policy decision, Ottawa, Ontario, 29 January 2025. *** Good morning. I'm pleased to be here with Senior Deputy Governor Carolyn Rogers to discuss our policy decision and the Monetary Policy Report (MPR). Today, we lowered the policy interest rate by 25 basis points. This is our sixth consecutive decrease and brings our policy rate to 3%. We also announced our plan to complete the normalization of our balance sheet, ending quantitative tightening. The Bank will restart asset purchases in early March, beginning gradually so that its balance sheet stabilizes this year and then begins to grow modestly in line with economic growth. We have three main messages this morning. First, inflation has been close to the 2% target since last summer. Monetary policy has worked to restore price stability. Second, lower interest rates are boosting household spending, and economic activity is picking up. Third, the potential for a trade conflict triggered by new US tariffs on Canadian exports is a major uncertainty. This could be very disruptive to the Canadian economy and is clouding the economic outlook. Since the scope and duration of a possible trade conflict are impossible to predict, the MPR projection we published today provides a baseline forecast in the absence of tariffs. We also provide some discussion of the potential consequences of a major trade conflict. Let me expand on the first two messages before turning to the threat of tariffs. First, inflation. A year ago, inflation was 3%, short-term expectations were still elevated and inflationary pressures were broader than normal. In recent months, inflation has remained close to 2%, business and consumer expectations have largely normalized and there is no longer evidence of broad-based inflationary pressures. Shelter price inflation remains elevated, but it is gradually coming down. While we expect some volatility in CPI inflation due to temporary tax measures, our forecast is that inflation will remain close to the 2% target over the next two years. Second, growth. There are signs economic activity is gaining momentum as past interest rate cuts work their way through the economy. Lower borrowing costs are boosting activity in the housing market as well as consumer spending on big-ticket 1/3 BIS - Central bankers' speeches items like automobiles. The pickup in household spending is starting to broaden to other consumer items and is projected to strengthen further. Business investment has been weak, but is forecast to increase gradually. And the outlook for exports is being supported by new export capacity for oil and gas. Employment has strengthened in recent months. But with job creation having lagged labour force growth for more than a year, the labour market remains soft. The unemployment rate was 6.7% in December, and wage pressures, which have proven sticky, are showing some signs of easing. The Bank forecasts GDP growth will strengthen from 1.3% in 2024 to 1.8% in 2025 and 2026. Growth in GDP per person is projected to pick up as lower interest rates and rising incomes support spending. The projected increase in overall GDP growth is more modest than it was in October, largely due to lower population growth that reflects new federal immigration policies. There are risks around our outlook, and Governing Council is equally concerned with inflation rising above the 2% target or falling below it. Absent the threat of tariffs, the risks to the inflation outlook are roughly balanced. Let me turn now to the question of tariffs. US trade policy is a major source of uncertainty. There are many possible scenarios. We don't know what new tariffs will be imposed, when or how long they will last. We don't know the scope of retaliatory measures or what fiscal supports will be provided. And even when we know more about what is going to happen, it will still be difficult to be precise about the economic impacts because we have little experience with tariffs of the magnitude being proposed. Nevertheless, some things are clear. A long-lasting and broad-based trade conflict would badly hurt economic activity in Canada. At the same time, the higher cost of imported goods will put direct upward pressure on inflation. The magnitude and timing of the impacts on output and inflation will depend importantly on how businesses and households in the United States and Canada adjust to higher import prices. Unfortunately, tariffs mean economies simply work less efficiently-we produce and earn less than without tariffs. Monetary policy cannot offset this. What we can do is help the economy adjust. With inflation back around the 2% target, we are better positioned to be a source of economic stability. However, with a single instrument-our policy interest rate-we can't lean against weaker output and higher inflation at the same time. As we consider our monetary policy response, we will need to carefully assess the downward pressure on inflation from weakness in the economy, and weigh that against the upward pressure on inflation from higher input prices and supply chain disruptions. So let me tell you what we're doing in preparation. In recent years, we have invested in better information on supply chains, trade links and the connections between sectors. And this is helping us analyze the effects of supply disruptions including tariffs. We have begun assessing the possible consequences of different tariff scenarios, and present an example in this MPR. 2/3 BIS - Central bankers' speeches We are stepping up our outreach activities across the country to hear directly from those affected by trade uncertainty. This includes augmenting our surveys of businesses and consumers to better understand how trade uncertainty is affecting their decisions and how they would cope in the event of a trade conflict. We will update you on our analysis and assessments as developments unfold. Having restored low inflation and reduced interest rates substantially, monetary policy is better positioned to help the economy adjust to new developments. As always, the Bank will be guided by our monetary policy framework and our commitment to maintain price stability over time. With that, the Senior Deputy Governor and I would be pleased to take your questions. 3/3 BIS - Central bankers' speeches
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium and a member of the Governing Council of the European Central Bank, at a conference by the Belgian Banker's Association (ABB) in Brussels on 14 October 1999.
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Mr Quaden addresses the impact of the single currency on the financial markets and looks at the international role of the euro Speech by Mr Guy Quaden, Governor of the National Bank of Belgium and a member of the Governing Council of the European Central Bank, at a conference by the Belgian Banker’s Association (ABB) in Brussels on 14 October 1999. * * * I would like to leaf with you through the photo album of a baby, whose name is euro. He is now nine months old and he took years, not months, to conceive. Introduction On 1 January 1999, the final phase of Economic and Monetary Union (EMU) started with the successful launch of the euro. This followed a period of both intensive technical preparation and considerable progress in the economies of the participating countries. The changeover of all operations on 4 January went without upset and the major technical and logistical challenge which the preparation and success of the conversion weekend represented, has been fully met. Since the beginning of this year the Eurosystem, made up of the European Central Bank (ECB) and the 11 participating central banks, is responsible for the conduct of a single monetary policy for the whole of the euro area. Assessing the first nine months of EMU means first to focus on how the new System has been put in place and how it has been able to conduct the new single monetary policy efficiently. Monetary union also marks a significant milestone in the process of European integration, whose first beneficiaries are the financial markets. Their integration must indeed complement the integration of the goods, services and capital markets. I will successively address the impact of the single currency on the money markets, the bond markets and the equity markets. To conclude I will turn to the international role of the euro. Does the euro succeed a few months after its birth in becoming a genuine international currency? The single monetary policy On the macroeconomic level, the birth of the euro has not only meant the coming of a new international currency, but also the emergence of a new supranational body, which has as its task to implement the new single monetary policy in an independent way and with the participation of the national central banks. After a conversion weekend, during which the whole of the interbank payment systems and the various financial markets changed over to the euro in four days, the Governing Council of the ECB (formed by the six members of the Executive Board and the eleven governors of the National Central Banks) was able from its first meeting of the year to take its first decisions and to launch its first monetary policy operations. The objectives of the ECB’s monetary policy, which are laid down in the Maastricht Treaty, are ensuring price stability, and without prejudice to this primary objective, contributing to the general economic policy of the EU. Price stability has been defined by the Governing Council of the ECB as an increase of the Harmonised Index of Consumer Prices (HICP) of below 2% for the euro area as a whole from a medium-term perspective. To reach this objective a strategy has been established that rests on two pillars. As there is a large consensus about the fact that in the medium term inflation is a monetary phenomenon, the Governing Council has decided to adopt a reference value for the growth of a broad monetary aggregate, namely M3. The short-term relationship between money supply and prices being more complex to interpret, deviations of monetary growth from the reference value need to be addressed carefully. Beside this first pillar, the second is based on a large set of indicators, including inflation forecasts, wage developments and the exchange rate. The Governing Council has proven its capacity to think and act for the euro area as a whole by its decision in April to cut the ECB’s main refinancing rate from 3.0% to 2.5%, a historical floor. At that time production was slowing and inflationary expectations were going in a downward direction. The cut has served its purpose. It has contributed to the resumption of growth. The rate of increase of consumer prices (1,2% in August for the annual rate of change in the HICP) is still well below the ceiling of 2%. Recent monetary developments (the growth of M3 and especially of credits to the private sector) signal, however, a rather generous liquidity situation in the euro area while with the acceleration of the economic growth the balance of risks to price stability is at present on an upward trend. The Governing Council is monitoring the evolution closely and is now contemplating the appropriateness of modifying its interest rate. We don’t envisage adopting a restrictive monetary policy stance, but rather a less accommodating one which would be better adapted to the new context. The goal is in any case not to hinder growth but to preserve its sustainability by the mastering of inflationary risks. The euro area - and in particular Belgium - could perfectly enjoy, next year, a nice combination of strong economic growth and low inflation. The integration of the financial markets The integration of the European financial markets was one of the advantages expected from the introduction of the single currency. What can be said today? As far as money markets are concerned, a very strong convergence of short-term interest rates could be observed by the end of 1998. After the introduction of the euro, the implementation of the operational framework for the single monetary policy and the new TARGET system have accelerated the creation of a liquid and integrated money market for the whole of the euro area. The speed at which the eleven national money markets have integrated into one single large market is remarkable. The TARGET system has allowed for a swift and efficient transfer of funds within the monetary union, thus reducing interest rate differentials between countries. The elimination of short-term interest rate differences was in turn necessary to enable the Eurosystem to conduct its monetary policy in an efficient manner in the entire euro area. The success of TARGET cannot be denied, not only from a technical point of view, but also from a commercial one as it has for the moment captured about 70% of the total volume of large value cross-border payments in the euro area. Although it started earlier, the process of integrating bond markets will take longer. The impact of the single monetary policy is indeed slighter on these markets and national characteristics - in particular different tax regimes - still remain important. However, the disappearance of the exchange risk, the harmonisation of market practices, the redenomination of government debt into euro at the beginning of the third stage of EMU and important issues of government bonds in euro have contributed greatly to accelerate the process. Yet this has not led to the disappearance of interest rate spreads between countries. The European bond market is, as you know, largely dominated by the national Treasury departments which still place the major part of their issues on their domestic markets. While one has witnessed a decreasing spread between interest rates as a result both of the commitments made within the stability and growth pact and of the disappearance of the exchange risk, differences due to the size, liquidity and to the specific risk of each sovereign issue, however, still remain. Though the European market of government bonds still suffers from a certain segmentation, the corporate bond market has already at present exceeded all expectations. During the first six months of this year, European companies are said to have issued more than double the amount registered in 1998. Moreover, the average size of these issues has increased considerably. This evolution results from financing needs arising from Mergers and Acquisitions’ activities, but first and foremost from the enormous potential the private bond market represents. It indeed benefits from the decrease in the financing needs of governments, from the disappearance of exchange risk and from the advent of a large, more liquid and more homogeneous European bond market. European companies will therefore turn more and more directly to the financial markets. The increased demand of companies for new ratings is another example of the growing interest of the large European companies to issue securities rather than to make use of traditional bank credits (a development which, as you know, will have implications for the banking sector). Among the issued securities there are bonds, but also shares, and the introduction of the euro should foster the convergence and the progressive integration of the equity markets of the euro area. Things have evolved, but sometimes at a slower pace than had been hoped. Since the beginning of this year investors have indices at their disposal that are aggregated for the whole of the euro area. Several sometimes competing projects have emerged aiming to establish a common platform or to create links between stock exchanges to handle important European securities. These initiatives reflect the new perspectives monetary union offers. But a certain slowness and some hesitation also bear witness to the numerous obstacles that still check the stock markets’ harmonisation and integration. However, the evolution that has started is unavoidable and will gradually lead to the formation of European financial markets whose size and importance as for the reallocation of resources will become comparable to the markets of the US. In this way one will see the differences subside that characterise the respective roles of banks and financial markets on both sides of the Atlantic in the collection of savings and the financing of investments. We should mention that while bank deposits are higher in the euro area than in the US, stock market capitalisation is four times higher in the US than the capitalisation of the sum of all the stock exchanges of the euro area. This transformation of the financial markets in Europe will become even more pronounced in view of the demographic evolution and the increased importance of pension funds and insurance companies as institutional investors. The euro as an international currency In such a context, the euro has not taken long to establish itself as an international currency. At present the euro is the second most widely used currency, after the US dollar. The euro has of course inherited the weight of the former national currencies it replaces but its utilisation also stems from the economic importance of Europe in the world economy. With its 290 million consumers, the euro area is an economy similar in size to the US. GDP is lower than the one of the US, it contributes for a larger part to world exports. GDP of the euro area represents about 22% of world GDP, this is somewhat less than the US whose GDP reaches 29%, but considerably higher than Japan’s GDP that stands at 13%. On the other hand the euro area is the largest commercial partner, with some 20% of total exports, against 16% for the US and 8% for Japan. The emergence of a European international currency is one of the results that was expected from the introduction of the euro and it is an obvious advantage for European companies. However, the Eurosystem has adopted a neutral stance concerning the international status of the euro. Its importance as an international currency will be determined by the markets. To assess the international character of the euro after somewhat more than nine months, I will briefly go into the few functions usually attributed to an international currency. We can distinguish the official use of the currency and its use for private transactions. In the first instance, the euro can be used by public authorities as a reserve currency or as a pegging currency. Although no recent data are available on the relative share of the euro in the official reserves, one may suppose the euro to be the second reserve currency after the dollar, if one transposes the international weight of the currencies the euro has replaced. On the other hand the euro is used and will in all probability be even more used in the future as a pegging currency by some EU countries that have not joined the EMU, by countries of Central and Eastern Europe that are candidates for EU membership and by some other emerging countries. I would also like to mention countries such as Argentina, Brazil, Canada and South Africa which have issued international bonds denominated in euro in order to diversify their foreign debt to the benefit of the European single currency. The international use of the euro by private operators can primarily occur within the framework of transactions or for investment and financing operations. At the beginning of the 90s one estimated that about 50% of the exports of goods and services was invoiced in dollars, one third in one of the currencies that participate in the euro and only 5% in yen. Although the part of the euro area in world exports is greater than that of the US, the euro will only assert itself progressively as a payment currency in international transactions. Indeed, the evolution of invoicing practices will be slow and will depend among others on the usual practices in the field of price setting on the international markets and in particular on the commodities and on the oil markets. The almost exclusive use of the US dollar stems from both custom and ease as these products are quoted in dollars, a fact which will not be easy to change. The international transactions denominated in dollars are therefore four times higher than US exports. While the relative share of the euro as a payment currency is bound to increase, this evolution will in all probability be slow and progressive. As an investment and financing currency, the euro already plays an important part on international capital markets. During the first two quarters of this year, the share of euro denominated issues in the total of international issues has by far exceeded the aggregate part of its preceding currencies. In the first six months of this year, new euro denominated bond issues have surpassed by almost 50% the amount issued in the first six months of 1998 in the currencies that now participate in the euro. The international issues in euro now stand for more than 40% of the total amount issued on the international markets, which is a proportion that comes close to the one of US dollar denominated bond issues. Several factors which I have already referred to can explain this evolution: the financing of operations with regard to mergers and acquisitions, the bigger size and greater liquidity of euro markets and the euro issues undertaken by several major countries wishing to diversify the distribution of their foreign currency debt. Given the international importance of the new currency, it is not surprising that the development of the euro exchange rate has attracted considerable attention despite the fact that the level of the exchange rate is less important for the euro area as a whole than it was for each of the participating countries before the start of EMU, in particular for a small country like Belgium. For this reason the level of the euro exchange rate is not in itself a precise policy objective of the Eurosystem. Nevertheless it is an important indicator in its monetary policy strategy. In the first part of the year the relative weakness of economic activity in the euro area compared with the high growth in the US has affected the euro exchange rate. But now, with the good prospects for an economic upturn in the euro area, the firm commitment of the Eurosystem to internal price stability, which constitutes the best basis for the strength of the euro in the long run, is already better reflected in the external value of the currency. Conclusions The introduction of the euro stands for a profound and irreversible change in European integration. The euro did not only replace the participating currencies, it has given a new dimension to the single market by introducing changes in the structure of the European financial markets that now match the size of the single market. The euro has also made a promising start on the international capital markets and has contributed to a closer integration of European financial markets. Though these developments are certainly not complete they are impressive if one takes into consideration the short time covered. They show the confidence of European but also international investors in the soundness of the new European monetary policy based on the stability of the euro. I add that the euro is not only the financial sector’s concern. For the non-financial sectors, the remaining part of the transition period before the permanent disappearance of the different national currencies offers companies the opportunity not only to change over to the single currency gradually, but also to reposition themselves in the new economic and competitive environment the euro area from now on represents. Finally, for private persons new efforts should be made in the field of information and I wish that both on the European and on the national level the period to exchange banknotes and coins will prove a success and will reflect the European know-how as was the case during the changeover of the financial sector and the payment systems. The baby is in good health. He is even sturdy for his age. He looks older than he is. But he has still to grow. For him life is only starting.
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Speech delivered by Mr Guy Quaden, Governor of the National Bank of Belgium, on the occasion of the celebration of the National Bank of Belgium's 150th anniversary, Brussels, on 12 May 2000.
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Guy Quaden: Recent developments in the Belgian economy Speech delivered by Mr Guy Quaden, Governor of the National Bank of Belgium, on the occasion of the celebration of the National Bank of Belgium’s 150th anniversary, Brussels, on 12 May 2000. * * * Your Royal Highnesses, Ladies and Gentlemen, dear friends, I should like to begin by telling you how delighted and proud I am, as are the other members of the Board of Directors and the Council of Regency of our Bank. First, I am delighted to see so many friends of the National Bank of Belgium coming to Brussels this afternoon to celebrate the 150th anniversary of our institution with us. Friends who have come from Belgium, elsewhere in Europe, the rest of the world; from the world of public and private finance, but also from the political, economic, social and academic world. Allow me to express my special thanks to my colleagues and friends, the governors of the various groups to which the National Bank of Belgium belong: the European System of Central Banks, the G10, the Belgian Constituency at the International Monetary Fund. All are present or represented here. The world of central banks is exceptional because of its position at the boundary between the State and the markets, between action and deliberation, and between tradition and modernity, but it is also exceptional in the fellowship which prevails there. I am glad to be a part of that. Next I would like to tell you how proud I am, how proud we are, of two things. First, we are proud to be the guardians of a long and illustrious history, the history of an institution which, as the Prime Minister reminded us in his speech and as the video we have just seen also showed, has made a positive and substantial contribution not only to the economic and financial history of Belgium, but also to European unification and international monetary cooperation. In particular, I would like to pay tribute to the three people who have preceded me at the head of our institution, whom we are delighted to have here with us this afternoon: Cécil de Strycker, Jean Godeaux, Alfons Verplaetse. In the second place, we are proud that, right from the start, the National Bank of Belgium has become a member of the European System of Central Banks and more specifically the Eurosystem, which, in managing the new common European currency, links the European Central Bank and the eleven national central banks which are currently members. This represents the realisation of a great political and economic dream, and the National Bank of Belgium is proud to have contributed to it, both in planning the arrangements at European level and in ensuring that our country satisfied the conditions for membership. It was vital that Belgium should meet the convergence criteria: the fact that it succeeded is, of course, due primarily to the effort made by its people, but also to the pursuit of an appropriate economic, fiscal and monetary policy in which the central bank lent its assistance together with the political authorities. We have also been successful in preparing with the sectors concerned for the introducion of cashless transactions in euros. There has been a marked strengthening of economic growth in the euro area in general, and in Belgium in particular, over the past year. Business and consumer confidence has now reached record levels. Of course, the euro cannot take all the credit for this welcome change of climate. The international environment has also improved. But the introduction of the euro has contributed to this revival of growth by giving the area a stable internal environment, by irrevocably fixing the mutual parities of eleven currencies, damping down inflation and curbing budget deficits. And the fact that growth is strong, confidence buoyant and inflation low, also proves to my mind that the monetary policy of the new Eurosystem has not been inadapted. The appreciable gain in stability brought about by the euro was particularly evident in Belgium. You will recall that in the middle of last year our country was the victim of a localised or asymmetric economic shock: the dioxin crisis. As I have already said, it is thanks to the euro that the macroeconomic cost of that crisis was very small. Without the introduction of the single currency, it is highly probable that the exchange rate of the Belgian franc and the level of interest rates in our country would have come under pressure. The consequences of that crisis would have extended far beyond the boundaries of the sectors directly concerned. Here in Belgium, our motto is: strength in unity. At the National Bank of Belgium, we are certainly not nostalgic for a monetary sovereignty which in any case had become largely illusory for highly integrated small and medium-sized economies. The switch to a single monetary policy, decided by the Governing Council of the European Central Bank, did not mean any loss of monetary power for Belgium: on the contrary, since the Government and the Bank had decided ten years ago to peg the Belgian franc to the most stable European currency, Belgium was in reality already importing its monetary policy from Frankfurt. The difference is that, today, our monetary policy continues to be decided in that same city, but around a different table at which there is at least one Belgian. Moreover, the implementation of monetary policy is decentralised. And being closer to their respective national territories, the affiliated central banks retain an inimitable role in their contact with the financial players, and in communicating with the general public. In the Eurosystem, which is not modelled on any other existing central bank, the principle of subsidiarity prevails; that is a principle to which we, and I imagine our other partners, too, are deeply attached. It means that the European Central Bank has to be allocated all the resources which it needs for the proper performance of the tasks entrusted to it, but that the national authorities retain competence over the tasks not assigned to it. One would distort the character of the monetary union if one tried to force a move towards centralisation contrary to the provisions of the Treaty and one would thus deprive the monetary union of its democratic legitimacy. True, like any man-made edifice which aims to last, monetary union is bound to evolve. But if we want this edifice to remain legitimate, any proposed changes must be set out in totally clear terms, and on each occasion we shall need to check that the citizens approve of those changes. Studying the national and international economic environment, issuing banknotes and coins, including in our case printing banknotes, and controlling and sometimes actually developing reliable and efficient payment systems are three activities closely linked with monetary policy, activities which the National Bank of Belgium developed long ago and which we intend to continue to pursue in cooperation with our partners in the Eurosystem. Moreover, modern central banks are rarely just central banks. They are also enterprises providing services for public authorities, the financial world and the national economy as a whole. However, the National Bank of Belgium stands out from many of its colleagues in the diversity of the public service functions which the legislative body has entrusted to it for various reasons, notably the Bank’s acknowledged expertise. In passing, I would say that in view of this diverse range of activities, certain hastily drawn comparisons concerning the number of staff used by each central bank are inapt. The National Bank of Belgium acts as the State Cashier. In its Central Balance Sheet and Credit Offices it gathers and processes information on enterprises and individuals, and its statistical tasks expanded considerably in connection with the modernisation of the Belgian statistical system, launched in 1994; in particular, since that time the Bank has been responsible in particular for the foreign trade statistics and for compiling the national accounts. Two key features are characteristic of the recent evolution of many central banks including our own: the banks have to contend with increased pressure of competition and they enjoy greater independence. These changes require us to modify our behaviour. Most of our activities, be they connected with monetary policy or other functions in the public interest, are naturally affected nowadays by the establishment of monetary union, but also by the spread of new technologies and the concentration taking place in the financial sector. Having long been sheltered from competition, the central banks, too, are now inhabiting a more competitive environment. While they still hold a monopoly on the issue of banknotes, notes are less and less predominant as means of payment. Also, membership of the Eurosystem is naturally encouraging a process of benchmarking and emulation among the various member central banks. The ethos of an enterprise such as ours has centred on optimum quality of service. This is an aspect of excellence which we must, of course, preserve. But at the same time, greater attention is required to the cost effectiveness of our service. The concern about our production costs is nothing new, but it has increased. Under the Maastricht Treaty, the countries of Europe also opted for the model of a European central bank alongside national central banks with a large degree of independence. According to this idea, once the central bankers have been appointed by the political authority - because, fortunately, they do not coopt themselves - they act to the best of their knowledge and belief, without seeking or accepting any instructions, in taking the decisions which they consider most appropriate for attaining the objectives assigned to them by the Treaty on European Union and the national laws. Most people believe that such a system ensures the optimum credibility and effectiveness for monetary policy, in particular making it possible to keep interest rates relatively low. But this greater autonomy also entails greater obligations for us: we are aware of these and I shall pay particular attention to them. First, there is the obligation to be more conscientious than ever about ensuring objectivity and total impartiality in our analyses, decisions and recommendations. Then there is the obligation to render regular and clear account for our actions, to be unflagging in explaining our actions and, if possible, winning support, because the ultimate foundation of the independence of a central bank is not a law, nor even a treaty, but the acceptance by the people concerned of the policy being implemented. With this in mind, I think it was among others wise to keep the Bank’s Council of Regency in existence, even if it has finally lost all monetary power. It offers an irreplaceable opportunity for dialogue between the directors of the central bank and the experts representing the main spheres of Belgian society. The Bank’s board of directors have duties towards the population; they also have duties towards the staff of the Bank. The standards expected of the Bank and its staff are traditionally high and have been accentuated by the profound changes which I have already mentioned. We need to adapt our organisation without being over-hasty but also without dragging our feet, because anticipating probable developments is the best way of controlling them. Our staff, thanks to whom the switch to monetary union, in particular, was successfully accomplished, work hard and efficiently, and we still expect a great deal of them in meeting the challenges ahead and fulfilling our ambitions. But we must also be able to define for our staff - and this must be done in collaboration with our partners in the European Central Bank and the Eurosystem - clear prospects for the foreseeable future, without which, we know, enthusiasm could give way to bitterness. My colleagues on the Board of Directors and I myself have held a strategic reflection aimed at increasing the quality of the Bank’s response to today’s challenges, and especially the challenges of tomorrow. That reflection will shortly be extended, by degrees, to include all our staff. I have no doubt that they will enrich the discussion and that together we shall be able to realise the objective of a bank that is ever better equipped to meet the expectations of Belgian society, and to maintain its position in the concert of Europe and in international cooperation. We shall probably need to specialise more, perhaps giving up certain activities; we shall undoubtedly need to adjust the scale of others, but we shall also have to develop our action in fields whose importance is increasing. I will give two examples. The National Bank of Belgium like all central banks, has since long shown an interest in the security and stability of the financial system. But due to its integration in the European System of Central Banks, the Bank has been given an explicit responsibility in this field and the Belgian law has recently entrusted the Bank with the surveillance (or “oversight”) of payment systems and securities clearing systems. To prevent excessive debts the Government has also decided in principle to set up a “positive” credit centre, responsible for registering all credits taken out by households preventing default on payments. The competence which it demonstrated in managing the Negative Centre, responsible for registering cases of default only, and the commercial neutrality which typifies the National Bank it, seem to render her very well-suited for that function. Ladies and Gentlemen, the National Bank of Belgium is 150 years old. I cannot tell you what will have become of it in 50 years’ time, in 2050. But I will venture to tell you what it aims to be in 5 years’ time, in 2005. In 2005 the euro will have been in circulation for three years in Belgium and in ten other European countries in the form of coins and notes, some of which will have been printed by the National Bank of Belgium’s printing department. The National Bank will continue to ensure the quality of the notes and coins in circulation. There will be less branches but the Bank will maintain its presence in each Belgian province. The National Bank of Belgium will be a faithful, active and appreciated partner in the Eurosystem. The Bank will also have maintained the quality and relevance of its research and sometimes increased its originality. In its service activities, the Bank will endeavour to offer the best in terms of value for money; it may develop some of its activities with similarly reliable partners. External and internal communication will have been stepped up. The corporate ethos, centred on the pursuit of excellence, will encourage creativity and initiative more than it does today. In our various areas of activity, the National Bank will be able to recruit the best people. The entire population will regard it as an independent, competent and accessible public interest institution which provides real added value for Belgium’s economy and society. Ladies and Gentlemen, we are proud of the Bank’s history and ambitious for its future.
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at 'De Hanze' International Club of West-Flanders, held id Bruges on 11 January 2001
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Guy Quaden: The euro after two years Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at “De Hanze” International Club of West-Flanders, held id Bruges on 11 January 2001. * * * Since the changeover to monetary union on 1 January 1999, economic activity in the euro area has accelerated considerably. The year 2000 brought growth rates (of the order of 3.5 p.c. on average for the euro area and 4 p.c. for Belgium) which we had not seen since the end of the 1980s. Of course, this improvement was not due solely to monetary union. The international climate has become more favourable; following the 1998 crisis, Asia, in particular has seen a recovery and in the United States economic activity remained at a high level until the past few months. But the introduction of the euro has undeniably contributed to renewed growth in our countries by creating a far more stable economic framework. This was achieved by irrevocably fixing the parities between 11 and with the Greek dragma now 12 currencies, curbing inflation (a constitutional objective of the European Central Bank) and limiting budget deficits (required by the European Stability and Growth Pact). In 2000, the exchange rate of the euro against the dollar was much discussed. But there are some exchange rates which, fortunately, no one talks about at all any more: e.g. that of the Belgian franc against the German mark or the Italian lira, or the French franc. That kind of monetary instability has been totally eliminated for ever, since the introduction of the euro, but it was what caused our economy the most problems, since the bulk of our companies’ foreign trade is with other European countries. Our foreign trade with the other countries in the euro area has become domestic trade which is paid for in our common currency, the euro. The considerable extra stability created by the euro was particularly marked in Belgium’s case. You will remember that, a few months after the introduction of the single currency, our country suffered a specific economic shock: the dioxin crisis. If the macroeconomic consequences of that crisis were minimal, then that is thanks to the euro. Without the euro, the exchange rate of the Belgian franc would most likely have come under pressure, and the National Bank would have had to respond by increasing its interest rates. The crisis would then have had an impact extending far beyond the sectors directly affected. After a temporary slowdown in activity, the prospects for the coming year remain good. Most institutions agree in predicting a growth rate of the order of 3 p.c. for the euro area and for Belgium. Though this is not as high as in 2000, it is still very satisfactory in historical terms. Admittedly external uncertainty has recently increased with regard to the quality of the landing of the US economy. This might be somewhat abrupt. But a real recession remains improbable and the American authorities that are in charge of economic policy have already demonstrated their resolve to react without delay. Above all, internal demand in the euro area, which represents 85 p.c. of final expenditure remains robust. In Belgium, which is often regarded as indicative of future developments in the entire euro area, after the decline in both confidence of enterprises and consumers in September at the time of the oil crisis, confidence of enterprises has been rising again at the end of the year and consumer confidence has once more reached a historic peak. The latter is borne by a steady decline in unemployment and by job creation and also by the prospect of inflation coming down once more to a low level after the increase in the autumn. The oil price rise has not seriously disrupted growth prospects. We can call it a “mini oil crisis”. First, the rise, though rapid (recovering from a position where prices had fallen excessively low) was not comparable with the price increases of the 1970s. Also, our economies have become less dependent on oil (by the exploitation of new energy sources, the energy-saving measures which were implemented for a time and the shift in economic activity towards the service sector). Finally, the mistakes made in economic policy 25 years ago were fortunately not repeated. The suspension of index-linking of incomes –or in Belgium, the use of an adjusted price index– has made it possible to avoid a new inflationary spiral of prices and wages and governments have limited the compensatory budget measures. The European Central Bank, which is now in charge of monetary policy, has done what it should. Naturally, it could not prevent the oil price rise from causing inflation to worsen temporarily, but it had to prevent inflationary expectations from snowballing. That is why it raised interest rates several times last year. The aim of the European Central Bank is to maintain the confidence of the economic players in price stability in the medium term. And it is apparently succeeding because, despite the oil price rise, longterm interest rates –determined by the markets on the basis of the inflation outlook– did not increase in 2000. Monetary policy has kept inflation down but without destroying growth. Even now that they have been raised, the interest rates of the European Central Bank cannot currently be regarded as damaging economic growth, because real short-term interest rates (nominal interest rate minus inflation) are now no higher than when monetary union was launched at the beginning of 1999 (during the first quarter of 1999 the key benchmark rate was 3 p.c. and inflation in the euro area was 0.8 p.c.). The euro’s internal value (its purchasing power) has been safeguarded by the actions of the ECB, but we must admit that the trend in its external value has been less satisfactory. The relatively weak exchange rate of the euro has naturally favoured European exports, but that is a short-term advantage, because an economy’s competitiveness needs to be based on factors other than a weak currency. Furthermore, it has increased the cost of our imports. We have realised that as oil prices have risen, so that is a factor which can push up inflation. And if the exchange rate continues to weaken, that could in the long run impair savers’ confidence in this new currency, both in Europe and beyond. There was a time when one dollar cost over 3 marks and so the mark has been weaker against the dollar than the euro. And at that time no one ever viewed the mark as a bad currency. But it is true that the mark could boast of a long history and that no one in that instance doubted that the international currency fluctuations would change direction one day. The differences in economic growth and interest rates between the United States and the euro area could to some extent explain the depreciation of the euro against the US dollar. But last summer we, the members of the Governing council of the ECB, repeatedly said that the fall had become excessive and unjustified. We also said that intervention on the foreign exchange markets could not be ruled out. By actually intervening we gave the markets two signals: first, that even if the internal value of the euro is the only objective to which it puts a figure, the ECB is not indifferent to the euro’s exchange rate (and to demonstrate that, actions speak louder than words); also, it should be clear that this rate does not necessarily move in one direction only, that it is not a one-way trend. Recently, the markets do seem to have become more realistic once again; they are no longer considering only the good news about the dollar and the bad news about the euro, as was the case at one time. The euro exchange rate is beginning to recover; the extent of the recovery will depend mainly on the convergence of growth rates on either side of the Atlantic and continuing consolidation of the European economies. Of course, the improvement in the euro exchange rate should preferably be based not on thetransient- weakness of the American economy but on the lasting strengthening of the European economy. Fortunately, the structural reforms are gaining ground in Europe: new technologies are steadily making progress; competition on the markets has increased and labour markets are becoming more flexible, even if such a statement is taboo. Now that government finances are also being put in order, scope is gradually being created for reducing the fiscal and parafiscal burden in Europe. That is important because the burden is currently much higher in Europe than in the United States. It is time to conclude. Internationally, just as the notes and coins are about to be introduced, 2001 could become the year of the euro. The euro is only two years old, so it is still in its infancy and needs to grow up, but it is already sturdy and indeed looks older than it is. As we have seen, it has helped to boost growth and employment in Europe. It has proved itself on the financial markets, but many people still see it as a virtual currency because it does not yet exist in tangible form. Today the official interest rate stands at 4.75 p.c.; inflation ran at 2.7 p.c. during October 2000 and 2.9 p.c. in November for the euro area, and was probably lower in December. On its third birthday it will at last take on the form of notes and coins, which will circulate from Helsinki to Lisbon via Bruges. Europeans will then become fully aware of the fact that they have a common currency, which is already the second most widely used currency in the world.
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the 23rd SUERF Colloquium, Brussels, 27 October 2001.
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Guy Quaden: Central banking in an evolving environment Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the 23rd SUERF Colloquium, Brussels, 27 October 2001. * * * Ladies and gentlemen, I am particularly pleased to speak before this eminent forum and to have the opportunity of addressing the topic "Technology and Finance" from a central banker's point of view. Technology and the challenges it raises for financial markets is a most appropriate theme for this Colloquium. On the one hand, technology is closely intertwined with the evolution of many other factors affecting financial markets and, so, allows coverage of a wide range of issues. On the other hand, it has farreaching consequences for all market participants, and this certainly includes central banks. In a first part I propose to briefly recall how technology has impacted on our macroeconomic and regulatory environment. In the next two parts I would like to sketch the main consequences of these developments on what my colleagues at the Bank of England have described as the two wings of central banking, i.e. monetary and financial stability. * * * Technology is a powerful factor of change in our macroeconomic environment. So, a few years ago, our colleagues of the Federal Reserve had to recognize that something new was happening in the US economy: a persistent higher growth and lower unemployment without the emergence of inflationary strains. This was related, at least partly, to the revolution in the Information and Communication Technologies, which increased productivity growth and fostered efficiency in the labour market too. A third feature of the so-called New Economy, the reduction in the variability of output growth, obviously proved to be short-lived! But a wave of over-pessimism should not submerge the previous wave of over-optimism. The question whether the American economy is still on a higher trend productivity growth path remains open, as well as what the prospects for the European economy are in this respect. Europe will benefit from a specific driving force, the completion of the single market with the new single currency, which should trigger further structural reforms and hence foster innovative energies. Technology also radically transformed the financial sector, which by the way greatly contributed to the new technological wave by financing it. INew techniques in the treatment, the storage and the transfer of information exerted profound effects on a sector which is largely an information based industry. In a first stage, Information Technologies made it possible to develop more sophisticated products, to build up a better market infrastructure, to implement more accurate and reliable techniques for the control of risks, to reach more distant and diversified markets, and to multiply the value and the volume of operations. In short, new technology has radically transformed all three major functions performed by banks, i.e. access to liquidity, transformation of assets and monitoring of risks. A new phase is presently at work with the emergence of e-money, e-banking and e-finance. It is clearly this new development which will represent the great challenge of the coming years. The speed of adoption of these new products remains difficult to forecast. Contrary to the preceding phase, this new wave is not limited to professional operators but involves all customers, including the retail market. Many of the scenarios suggested by IT firms or consulting groups have proved to be overly optimistic. At the same time, it would be wrong to become complacent. Most new technology is spreading following an S-shaped curve. The base section of the S can be quite long and practically horizontal; however, it will sooner or later be succeeded by a steep section. The example of Nordic countries, and more specifically Finland, shows how quickly e-finance can develop, once circumstances are ripe. It is important to emphasize that the integration of new technology into the financial sector did not take place in isolation. Rather, it is the interaction of technology with another major development, deregulation, that contributed to reshaping the financial landscape. True, the pressure of the market to fully exploit the new technologies was strong, probably even irresistible. However a receptive environment had also been created by a lifting of the rather strict financial and banking regulations which were still prevalent at the end of the seventies. The increased awareness of the wide-ranging possibilities offered by new technologies illustrated that a lot could be gained through the removal of distortions in competition, directly linked to excessive regulation or intrusion from the Government. In combination, these two evolutions contributed to the emergence of a more open, competitive and globalised financial market, which obviously improves efficiency in the world economy. The transition, however, has not been a smooth one. It was not easy for the authorities who had to cope with the more frequent arbitrages operated by market participants between the various currencies and financial instruments or even between different legal, regulatory or tax regimes. Neither was it easy for financial intermediaries that had to work in a much more competitive environment where traditional protection and barriers to entry were progressively lifted. In short, the shift toward a more liberalised system together with the quick expansion of new products and markets has greatly increased uncertainties and risks for financial sectors. This was not immediately recognised by many market participants who had previously been sheltered by the existing regulation. As a result, individual bank failures and banking crises, quasi non-existent between the end of the forties and the early seventies, became all too frequent during the past two decades. In this context, the absence of significant problems within the Belgian banking sector during the recent period must be considered more an exception than a rule. Despite deregulation there is still a major role to be played by public authorities, among others in the field of competition rules, consumer protection, fight against money laundering... and, of course, central banking. Central banks indeed have to provide stability, which certainly does not mean "no change" but, on the contrary, building the best foundations for a sustainable dynamism. In doing so, central banks will cope with the evolving environment shaped by technical progress, by deregulation and globalisation and, last but not least in Europe, by the single currency. * * * As regards the first wing of central banking, monetary stability, central banks have to provide a durable anchor in order for the price system to appropriately guide economic decisions. A stable value of money is all the more necessary for preserving the information value of relative prices in a changing world, where decisions have to be taken rapidly. Maintaining price stability is the primary objective of monetary policy, not only for the Eurosystem - according to the Treaty of Maastricht- but also for every central bank. Nowadays the only regulations central banks rely on in designing the operational framework of monetary policy are the monopoly of banknote issuance and reserve requirements. The Eurosystem fully respects the principle of an open market economy with free competition, as enshrined in the Treaty. Its main instrument is the weekly allotment of credit by euro area-wide tenders. Minimum reserves, which are remunerated, have a stabilisation function, thanks to an averaging provision, and are enlarging the structural liquidity shortage of the money market. As the development of e-money is liable to weaken the leverage of the Eurosystem and in order to provide for a level playing field, e-money issuers should not escape reserve requirements. A European directive of last year rightly broadens the definition of credit institutions in order to include e-money institutions. Technological change and financial market developments do not only affect monetary policy instruments but also the whole transmission process and consequently the strategy of monetary policy. In this complex and changing world the Eurosystem was right in rejecting any simple rule and adopting an all-encompassing two-pillar strategy. Central bankers have to continuously reassess the information content of many economic indicators. Let me pick out some of them - output, money, stock prices and bond market indicators - not because other variables, like wage developments and the fiscal policy stance, are less important, but because the former are most affected by technological and financial market changes. Central bankers, even in the Governing Council of the ECB, are not insensitive to growth and employment prospects, as some critics argue. But they are well aware of two limitations: firstly, growth should not be stimulated to the detriment of price stability, because such a stimulus would be short-lived and would imply longer-term costs; secondly, as "Ã la plus belle fille du monde on ne peut demander que ce qu'elle a", monetary policy may exert some influence on the demand side of the economy but cannot solve structural problems, like persistent unemployment. Central banks may nevertheless contribute to output stabilisation, as far as the risks to price stability are linked to the business cycle. A central concept in this respect is the output gap, but its measurement, especially in real time, is surrounded with a large degree of uncertainty. Potential output growth, which is an ingredient of both pillars of the Eurosystem's strategy, is not known with precision. Should the New Economy materialise, higher rates of growth could become sustainable. In the absence of any firm evidence of a New Economy in the euro area - although some driving forces are to some extent in place - and since the emergence of a New Economy is not driven by monetary policy, the Eurosystem did not take the risk of pre-emptively accommodating it. Nevertheless it monitors a wide range of indicators in order to periodically reassess the "speed limit" of the euro area economy. Needless to say, in the present circumstances growth is unfortunately even below the Old Economy speed limit, and the associated decrease in inflationary pressures has already prompted a 100 basis points interest rate cut in three steps since the spring. The first pillar of the strategy of the ECB gives a prominent role to money. It is based on the conviction that inflation is a monetary phenomenon in the long run and underlines the medium-term orientation of monetary policy and the inheritance in this respect from the Deutsche Bundesbank. Recognising that the demand for money can be subject to short-term fluctuations which are harmless for price stability, the ECB has not announced an "intermediate objective" but rather a "reference value" for the growth of a broad monetary aggregate. The recent rise in M3 growth is up to now interpreted as being such a short-term fluctuation, caused by the relatively flat yield curve and the weakness in stock markets. Technology and financial market changes obviously affect the first pillar. They might increase the volatility of the income velocity of monetary aggregates and, as they are blurring the frontiers of "moneyness", they complicate the definition of key aggregates. To paraphrase a former Governor of the Bank of Canada speaking about M1 twenty years ago, I would say that while the ECB is not planning to abandon M3, I cannot rule out that, some day, M3 could abandon us, but you already noticed that the first pillar is much more than the reference value. It encompasses a broad monetary analysis which will duly take into account such developments. The first pillar also rests on the fact that credit institutions remain major players in the transmission process of monetary policy. The development of euro area capital markets could however increase the weight of financial market indicators in the second pillar. The stock market is still a much less important channel of transmission in the euro area than in the US, but the holding of shares is spreading, for example through mutual funds. I would not attempt to summarise the vast debate about the appropriate monetary policy reaction to asset price movements. I am inclined to say that central banks have not to put on these variables more emphasis than warranted by their effects on demand and should avoid asymmetric reactions - benign neglect in the case of irrational exuberance, intervention in the case of sharp downward correction - which could pose a moral hazard problem. The bond market provides indicators which are probably more important within the second pillar of the Eurosystem's monetary policy. Technical progress and European integration lead to more sophisticated and liquid markets which supply useful information about market expectations. Incidentally I notice that, while many central banks looked disapprovingly on indexed bonds prior to monetary union, the Eurosystem now welcomes the opportunity to extract information on inflation expectations from the comparison of yields on indexed and nominal bonds. Despite the upsurge in inflation in the euro area resulting from oil price and food price shocks, inflation expectations appear to remain very moderate, showing that the Eurosystem benefits from a high degree of credibility. Such a capital of credibility has to be preserved. * * * About the second wing of central banking, the safeguarding of financial stability, I would like to adopt a chronological approach. First, how are central banks currently adapting to the new environment by reconsidering the role they are playing in the financial market? Second, how could new technology affect the relations in the coming years between market participants, central banks and other supervisory and regulatory authorities? Financial market developments and the heightened risks associated with these rapid changes led central banks to reconsider the role they had to play to preserve financial stability. For those central banks that were in charge of the surveillance of individual credit institutions, the implications were straightforward. They had to adapt the modalities of their micro-prudential activities. However, the need to proceed to macro-prudential monitoring was also strongly felt by central banks, like the NBB, which were not vested with the micro supervision. First, at an analytical level, central banks were induced to enlarge the scope of their research. The use of new technologies has caused a spectacular expansion in the volume of financial operations, certainly in comparison to the growth of real activities. This has required reconsidering the direction of the links between these two fields. Central banks had traditionally focused on the consequences that changes in financial conditions could have on the real economy. If such analyses remain essential, central banks are also increasingly concerned by the vulnerability of the financial system to fluctuations in real activities. So, the causalities also have to be reversed and due attention must be given to the impact that evolution of the real economy could have on the stability of the financial system. It is no coincidence that an increasing number of central banks now complement their traditional annual reports centred on monetary policy and macro-economic developments by another report focused on the theme of financial stability. This is a development that the NBB will also actively embrace through the publication, possibly starting in 2002, of a new yearly Financial Stability Report. At a more operational level, central banks contribute directly to strengthening the stability of the financial system by the development of secure and efficient payment and settlement systems. Here also new technology is playing a crucial role. Real time gross settlement systems, delivery versus payment mechanisms, cross-border connections between various clearing or settlement institutions, instant world transmission of information would be in practice unmanageable without the possibilities offered by IT technologies. These multiple layers of networks are too often considered as mere plumbing. However, this so-called plumbing is in many respects as spectacular and sophisticated as the more glamorous Internet or mobile phone networks. The oversight of these modern payment and settlement systems has become a key function in modern central banking and this certainly applies to the NBB, as Belgium is hosting two major international institutions, SWIFT and Euroclear. The second step in our chronological approach is also the most uncertain as it implies speculating about the impact of new technology on the future organisation of financial markets. It must be recalled from the outset that the introduction of new technology in the banking sector is not a one shot phenomenon. On the contrary, it is proceeding by waves. As already said, the development of e-money, e-banking and e-finance will represent a great challenge. Whatever its speed, this new wave will strongly modify the nature of relations between market participants. Distant access to financial products is substituting for close individual contacts. Brand loyalty, while still a key asset in a business built on trust, is increasingly associated with cherry picking. Banks themselves tend to shift from an approach based on long term and stable relations to a strategy where each deal is individually appreciated on its own merits. The various financial institutions are also redefining what should be their core business. The technological wave of the eighties and early nineties allowed the unbundling of most financial products into their various components. To the unbundling of products is now associated, thanks to the second wave of innovation, an outsourcing of the production but also of the distribution process. Back office functions, distribution networks and IT infrastructures can now easily be subcontracted, creating a new web of connections between various categories of market participants. There are also important changes in the relations between monetary and prudential authorities, on the one hand, and financial institutions on the other. First the authorities will have to rely, much more than in the past, on the markets themselves for the surveillance of financial stability. One may legitimately feel concerned by such an evolution, which sounds like asking the fox to watch over the hens. However we must realise that financial markets are not only a major factor of change, they are also potentially a powerful factor of discipline. They are forcing credit institutions to be more transparent and to communicate more reliable information. The development of new, more sophisticated, risk management techniques, under the form of internal models, has been, at its roots, a private initiative from market participants. In order to integrate this modeling approach in the monitoring of banks solvency, the Basle Committee on Banking Supervision is not designing a new system from scratch. On the contrary, it is referring to the best practices of the market itself as a benchmark against which to calibrate its own proposals. Now, the authorities should not delude themselves. Best practices are what they are, easier to respect by strong institutions and in favourable circumstances, but much harder to maintain when the situation deteriorates. Far from being lightened, the burden of prudential authorities is becoming heavier. The necessarily limited human and financial resources of these authorities will be called upon all the more by the new Basle proposals which will require a more individualised and detailed surveillance of these new internal risk management systems. The resource constraint will finally also strongly determine the relations that the various monetary and supervisory authorities will have to maintain among themselves. A more globalised financial market calls for a more globalised approach to supervision. At the international level, several co-operative bodies and mechanisms have been established, either in the form of multilateral forums bringing together the competent authorities in the fields of prudential control and financial stability, or by means of bilateral protocols concluded between the supervisory bodies of different countries or sectors. At each national level, the authorities also have to carry out an in-depth examination of their supervisory structure and procedures. I will not dwell here on the subject of the devolution of prudential tasks. Different models exist across the world bearing witness to the trade-offs which have to be made to adapt to market trends while also taking account of the specific national context. Finally, this existing national and international framework needs to be periodically reviewed and adjusted. Whatever its form, the prevailing structure will have to fulfil two major conditions. On one hand, it must be efficient in preventing either loopholes or redundancy in supervision. On the other hand, it must be all encompassing by combining the microprudential control of individual institutions with macroprudential monitoring of the systemic risks faced by the global financial market. * * * To conclude, let me stress that central banks are fully aware of the close connection and the large convergence existing between the two goals of financial stability and monetary stability. Keeping inflation under control, which is the ultimate goal of every central bank, has proved to be the best way to reduce uncertainties on the market, to alleviate distortions and, so, to eliminate one of the fundamental sources of financial instability. Conversely, central banks need sound and efficient banking systems for ensuring rapid transmission, to the whole economy, of the impulses of their monetary policy. This is all the more important given that the assets at the disposal of central banks - the monetary base in our jargon- is becoming increasingly tiny compared to the total assets managed by credit institutions and, beyond that, by financial market operators. In this context, the monitoring of financial stability may certainly not be considered as a by-product or a mere extension of the traditional monetary stability objective of central banks. The two functions are closely related but distinct. In other words, the monetary stability and financial stability wings belong to the same bird.
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium and Member of the Governing Council of the European Central Bank, at a conference in Ottawa, 30 November 2001.
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Guy Quaden: The monetary policy of the European Central Bank and the economic outlook in the euro area Speech by Mr Guy Quaden, Governor of the National Bank of Belgium and Member of the Governing Council of the European Central Bank, at a conference in Ottawa, 30 November 2001. * * * For economists and financial markets, the euro has been reality since January 1st, 1999. The decisive steps were taken at that moment by irrevocably fixing parities between the different national currencies that continued to exist momentarily and the start of the single monetary policy conducted by the new European Central Bank. For the general public, however, in Europe and elsewhere, the euro will only be real when it will at last be tangible in the form of notes and coins. In little over one month, on January 1st 2002, the euro banknotes and coins will become part of the every day life of more than 300 million European citizens in 12 countries. And, after an unprecedented logistical operation, at the end of February at the latest, 12 national currencies will have disappeared for good. At that moment, monetary union will have been achieved completely. * * * To my mind, the implementation of monetary union in Europe can be explained by a series of long term structural factors. First of all European integration is to a large extent a political process, having its roots in the two world wars that have devastated our continent in the first half of the 20th century. The Schuman Declaration of May 1950, which provided the basis for the European Coal and Steel Community, stated clearly that “solidarity in production will make it plain that any war between France and Germany becomes not merely unthinkable, but materially impossible”. Then came the deepening of economic and financial integration with the common market which has logically culminated into monetary union. Finally, during the 1990s, a large consensus was reached regarding the objectives of a stability oriented macroeconomic policy which has contributed to a remarkable convergence towards low inflation and limited public deficits, without which monetary union would not have been possible. * * * In the new monetary constitution of Europe, what we call the Eurosystem plays an essential role. It consists of the European Central Bank as such, that is situated in Frankfurt, and of the twelve national central banks of the countries that have introduced the euro. The Eurosystem is not to be confounded with the structure of any other central bank in the world, be they even of a federal nature. In the euro area, monetary policy decisions are centralised from now on, but their implementation remains to a large extent decentralised. The Governing Council of the European Central Bank is the supreme decision-making body. It meets every fortnight and consists of the six permanent members of the Board of the ECB and of the governors of every national central bank. It is the Governing council which more in particular determines the level of official interest rates. In practice, decisions are taken on a consensus basis, but according to the legal provisions they require a simple majority of votes. Each member has one vote: the vote of the governor of the National Bank of Belgium carries the same weight as the one of the president of the Bundesbank, the governor of the Central Bank of Luxembourg or the Governor of the National Bank of Belgium. The principle ‘one person, one vote’ thus reflects the fact that even though they are originally from different countries of the euro area, the members of the Governing Council act completely independently and not as representatives of their country. The Treaty specifically stipulates that they can neither ask for or receive instructions from their government or from anybody else and that they must take their decisions solely on the basis of the interests of the euro area as a whole. * * * In granting the decision makers of the European Central Bank a high degree of independence, the Treaty of Maastricht- and I think these two things go together- has also assigned them a specific task: i.e. to guarantee price stability. Indeed, the Treaty clearly states that this is the primary objective of European monetary policy and that, without prejudice to this stability, monetary policy contributes to the other objectives of economic policy. In every country in the world the population is, I think, of the opinion that the first duty of the central bank consists in maintaining the purchasing power of the currency it issues. But this mandate is particularly stringent for the euro area, as was the case previously for the Bundesbank in Germany. The people in Europe, and moreover not only in Germany, seem to be particularly attached to price stability. Moreover, no central banker, and in any case not the members of the Governing Council of the ECB, is insensitive to growth and employment. But we think that growth should not be stimulated to the detriment of price stability, as such an action is short-lived and costly in the long term and monetary policy cannot resolve structural problems, in particular structural unemployment, which is important in Europe. Furthermore, price stability contributes to economic growth by sustaining consumer confidence, an essential element of growth, and by favouring low long term interest rates, these rates being even more important for the financing of growth than short term rates in many European countries. (It must be observed that while for the moment short term rates are higher in the euro area than in the United States, long term rates are slightly lower). The European Central Bank has given a precise definition of what she understands by price stability : price stability is defined as “an annual rise in the harmonised index of consumer prices for the euro area of less than 2 p.c. It must be maintained in the medium-term.” Such a definition offers a stable anchoring point for the expectations of economic agents in an uncertain environment. It also offers the public a means to evaluate monetary policy, thus enhancing the transparency of the European Central Bank and enabling it to be called to account for its performance. The expression “of less than 2 p.c.” specifies the maximum limit for the pace of inflation that is considered compatible with price stability. At the same time, the word “rise” clearly indicates that deflation must be avoided in the same way as inflation. By defining price stability at the level of the euro area, one clearly specifies that monetary policy is based on an assessment of developments at this level. Finally, when one speaks about maintaining price stability “in the medium term”, this means that one acknowledges the existence of short term price volatility, due to non-monetary influences and that monetary policy must be oriented towards the future (“forward looking”). * * * To reach its target and to assess the risks weighing on price stability in a founded manner, the ECB carries out its analyses according to two separate, but complementary, analytical approaches. These are called the two pillars of the strategy. In the first pillar, the emphasis is on the monetary origins of inflation, as inflation indeed remains ultimately a monetary phenomenon and the important role of money supply in the strategy also emphasises the responsibility of the Eurosystem for inflationary monetary pressures, which a central bank can more easily keep under control than inflation itself. For the assessment within the framework of the second pillar, use is made of a wide range of other economic indicators, especially variables which have qualities as leading indicators of future price developments. These consist of, among other things, wages, exchange rates, bond prices, the term structure of interest rates, indicators for budgetary policy, various standards for measuring real economic activity, and the results of surveys among producers and consumers. * * * If I make a short comparison between the monetary policy in the United States, Canada and the euro area, I observe a great similarity between the Bank of Canada and the ECB : price stability is clearly the primary objective of their policy, whereas the mandate of the Federal reserve is both wider and less specific. In your country quantifying the objective(“inflation target”) is subject to an agreement between the Minister of Finance and the central bank, whereas in the euro area, the central bank determines this autonomously. It is true that in the euro area we have twelve Finance Ministers! However the discretionary power of the Fed is greater still. But apart from these few differences, our three central banks share the characteristics of the major modern central banks : price stability is considered as a necessary condition for sustainable growth; they enjoy a high degree of independence in the conduct of monetary policy and simultaneously have a strong concern for transparency and accountability. * * * During the first three years of the euro’s existence, the European Central Bank has already been confronted with important and different challenges. At the start of the single monetary policy, in the beginning of 1999, its principal leading interest rate stood at a low level of 3 p.c. During the spring of that same year the ECB then has had to address a deflationary threat and lowered its rate to 2.5 p.c. Later on, primarily due to the steep rise in oil prices, but also of meat prices in Europe inflationary risks appeared which the ECB has sought to contain by gradually raising its interest rate from 2.5% to 4.75% between November 1999 and October 2000. No central bank can avoid that a shock beyond its control, such as an oil shock, momentarily increases inflation. But the central bank has to prevent the increase of certain prices from transforming into an upward spiral of all prices and costs. The European Central Bank has succeeded in doing so. Euro area inflation reached a maximum of 3.4 p.c. at the beginning of the summer of this year; since then it has been declining and should according to all expectations drop below 2 p.c. in the coming months. The reduction of inflationary pressures has allowed the European Central Bank to reduce its interest rates since the spring by 150 basis points in four moves (coming from 4.75 p.c., a level lower than in North America). These moves had moreover become desirable given the weakening economic activity in the euro area. * * * The economy of the euro area has been affected, more than originally thought, by the slowdown in the United States, (which itself has been more important and long lasting than initially foreseen). Admittedly, since trade between European countries has become internal trade, from a monetary point of view, paid for in euro, our countries have become less dependent of their foreign trade as such. But other transmission channels have developed: European financial markets have grown, but Wall Street still sets the tone; as European companies have invested on a large scale in the United States during the last years, the height of their profits and investments is more influenced by their results on the other side of the Atlantic than was previously the case. Finally, different shocks, such as the increase in oil prices or the crisis of the new technologies have hit all industrialised countries and more recently the tragic events of September 11th have significantly increased uncertainty all over the world. It is true that the economy of the euro area is running for the moment at a very slow pace. However economic activity should return to a much more satisfactory path in the course of next year. Normally the high level of uncertainty currently affecting the world economy should diminish. And, with the exception of the confidence of consumers and entrepreneurs, the conditions for a recovery are already present in Europe. I think of the gradual effects of the measures favourable to growth that have already been taken (interest rate cuts and in many countries also tax cuts); of the fact that inflation is low and is still declining and that financing conditions (both short term and long term interest rates) have become very favourable. Moreover consumers in the euro area are hardly indebted and there has been less excess in investments, which should make it easier for consumption and investment to take off again if non-economic uncertainty progressively recedes. * * * Europe is not an island as we have seen in 2001. However, the full introduction of the euro should, without immunising us against external influences, allow the euro area in the coming years to register supplementary growth owing to supplementary stability, efficiency and visibility. More stability: since the birth of the euro in 1999, much has already been achieved in this field. Within the euro area exchange rate fluctuations have disappeared. A framework has been set up for a macroeconomic policy aiming at stability, where monetary policy is oriented towards price stability and fiscal policy, within the framework of the so called Pact for Stability and Growth, towards sound public finances. These objectives are crucial for the confidence of economic agents and sustainable economic growth. The single currency is also a major step forward in terms of more efficiency, by lowering transaction costs and increasing price transparency and competition, which will be even more evident once the notes and coins will have been introduced. Monetary union also intensifies the integration of European financial markets, which improves financing possibilities for companies. The single currency should also help speed up other necessary structural reforms in Europe. Finally, the introduction of euro banknotes and coins will provide not only the new currency but Europe itself with more visibility all over the world. And within Europe, the use of the same notes and coins from Helsinki to Lisbon and Athens via Brussels will give the European citizens, much more than is now the case, the feeling of belonging to a community sharing the same destiny.
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Keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the OECD Forum, Paris, 14 May 2002.
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Guy Quaden: The Euro - a milestone on the path of European integration and a contribution to world economy stability Keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the OECD Forum, Paris, 14 May 2002. * * * It is a great honour and pleasure for me to address this important Forum of the OCDE on the theme of the euro. On 1 January 2002, the euro was physically introduced in the form of banknotes and coins. This event marked the conclusion of the changeover to the single currency, which had been initiated three years earlier, on 1 January 1999, when the non cash euro was successfully introduced in the money and financial markets. With effect from 1 March 2002, the euro has become the sole legal tender in the 12 countries of the euro area. The success of the euro cash changeover has surpassed all expectations. That such an unparalleled logistical operation took place almost without a hitch bears witness to Euroland’s operational capability. Such a massive and complex project could in fact only be successfully completed thanks to meticulous preparation and the all-out efforts of innumerable people, authorities, enterprises and associations working together in a constructive and co-operative spirit, in the public and private sector alike. European citizens have accepted their new money rapidly and enthusiastically and have chosen to be actors and not merely spectators in the changeover. They have helped to write a decisive page in the history of modern Europe whose significance far transcends the purely monetary field. In my presentation today I first would like to analyse the implications of the introduction of the euro, both as a completion of the single market and for the creation of a new framework for economic policy. Thereafter, I would like to explore three important challenges for the euro area: firstly to increase the growth potential and growth performance of Europe’s economies, secondly to reinforce policy co-ordination and political cohesion between the countries of the zone, and thirdly to prepare for and to succeed its enlargement and the accession of new members. I would conclude with some comments on the international aspects of the euro. *** European monetary union pursues two, interrelated economic objectives: more efficiency and more stability. Let me start off with more efficiency. The euro is, in the first instance, a completion of the single market. The introduction of the euro has created one of the world’s major economic areas. The young euro area is an important economic power, with a population of around 300 million people, having a considerable purchasing power, which is only exceeded by the United States. Thus, the Member States of the euro area together represent some 15% of world GDP, which is less than the United States - with about 20% - but twice as much as Japan. By way of comparison, the biggest country of the euro area by itself is estimated to represent only 4.5% of world GDP. Monetary union also implies that some exchange rates do no longer exist, as for instance the rate of the Belgian franc against the German mark or the Italian lira. In the past, the volatility of these exchange rates has been most harmful to the closely interdependent national economies of the European common market. Let’s think back for instance to the ERM-crises in 1992 and 1993. The single currency has completely removed exchange rate risks for exporters and importers, debtors and creditors across the 12 countries of the euro area and has thus eliminated the costs of hedging exchange rate risks vis-à-vis other euro area countries. I notice in passing that this “internal exchange rate” stability has often been overshadowed by a disproportional interest in the floating of the US dollar-euro exchange rate. The dollar/euro exchange rate movements have, in fact, been comparable with the dollar’s historical fluctuations vis-à-vis the European currencies (in particular the German mark) prior to the introduction of the euro. The euro is leading to an increased transparency of prices and greater competition and a thorough integration process has taken place in the area. The integration of the money market and the disappearance of the exchange rate risk have provided a boost to the integration of other financial markets, such as the bond market and the equity markets, be it to a lesser extent. The stability effects which the euro’s arrival has brought about and which have improved growth potential in the zone, cover other types of stability: price stability and fiscal stability. 1. There can be no doubt that both deflation and inflation are harmful for both output and welfare in the medium term: they distort the information contained in the price system, imperceptibly change the real value of contracts and savings and heighten uncertainty. They consequently disturb the allocation of resources, the investment process and the income distribution. In the case of Europe, this consensus on the contribution of price stability to promoting long-term growth is explicitly enshrined in the Treaty of Maastricht which states unambiguously that the primary objective of monetary policy is to maintain price stability. The Eurosystem, which associates the European Central Bank and the national central banks of the 12 euro countries, is convinced that by fulfilling this mandate, monetary policy is making its most effective contribution to the realisation of strong output growth as well as to sustainable employment prospects. As part of its monetary policy strategy, the European Central Bank has published a quantitative definition of price stability. It aims to create a stable anchoring point for price expectations, making it also easier for the public to judge its actions. Price stability is defined as an annual rise in the harmonised index of consumer prices for the euro area of less than 2%. It must be maintained in the medium term. Central bankers cannot avoid that external shocks, such as a rise of commodity prices on the international markets, lead to a temporary increase in inflation. However they do have to prevent second-round effects and must ensure that the internal value of the currency will be maintained in the medium term. That the policy of the Eurosystem has been convincing in this respect can be seen from the moderate inflation expectations as evidenced, among other things, by the level of long-term interest rates. Together with the present easy monetary conditions, the continuance of low risk premiums in euro long-term interest rates is one of the factors from which the economic recovery in 2002 can draw strength. 2. Another stability-related aspect in the new European economic policy framework is the discipline of fiscal policies. The convergence criteria leading to the last stage of Economic and Monetary Union have played an important part to ensure a stable environment. In addition, the institutional set-up and different permanent procedures within the European Union aim to promote the stabilityoriented policies further. The Stability and Growth Pact, multilateral surveillance and peer pressure are important tools to this end. Monetary policy decisions are centralised but fiscal policy is still conducted at the level of the Member States, in accordance with the subsidiarity principle. This leaves room for manoeuvre regarding the composition of public spending and revenues, in line with national preferences and with possible differences in the cyclical positions. However decentralised fiscal policies had, within the eurozone, to take into account the potential for spillover effects. The present framework has been designed to minimise the risk of negative spillovers (across countries and across policies) from inappropriate fiscal policies. Crucially, the Treaty contains an obligation to avoid “excessive deficits”. This constraint, together with procedures for a multilateral review of national fiscal policies, has been further specified by the Stability and Growth Pact. The Pact stipulates quantifiable deficit rules, which provide a clear policy orientation for the budgetary authorities in the Member States. It is not correct to describe the Pact as a fiscal straitjacket. In a monetary union a more prominent role is generally assigned to fiscal policy in dealing with cyclical movements. If correctly applied, the Stability and Growth Pact certainly offers the necessary scope for this. Indeed, the obligation for the EU Member States to aim for a budget which is “close to balance or in surplus” “over the medium term” does make it possible to allow the nominal budget balances to fluctuate according to the changing cyclical circumstances. The so-called economic stabilisers can operate freely in a period of economic slowdown in the countries having structurally balanced their budget at the top of the cycle. *** The changeover to the physical euro has concluded a chapter in the history of the European integration but not the book. After the introduction of the new currency, the countries of the euro-zone are facing three main challenges. 1. The economic outlook remains subject to uncertainties but after a disappointing year 2001 globally business confidence has markedly improved in the euro area over the last few months and the conditions for a sustained upswing are in place, including favourable financing conditions. While the recovery is expected to initially proceed at a gradual pace, real GDP growth rates should gravitate towards potential growth later this year. The growth problem has however two dimensions: short term and long term. Potential growth in the euro-area is estimated at between 2¼ and 2½%, still noticeably less than in the US. This growth potential needs to be increased. Yet the solution is not necessarily, I think, to duplicate the American “model”. The experience of some countries in Northern Europe (Scandinavia) indicates that it is possible to combine a level of social protection conform to the European preferences with high rates of participation to the workforce, technological innovation and economic growth comparable to those of the US. Monetary unification is in itself a major structural reform, which has already stimulated other reforms. Yet further strides are necessary in order to increase overall productivity and to include in working life those who are still unemployed. The euro area countries must raise the “speed limit” of their economies by continuing to improve the efficiency of labour and products markets, to encourage the entrepreneurship and to foster a knowledge-based economy. 2. A question often asked is whether it was appropriate to introduce monetary union between different European countries before political union. It is true that in the case of the US for instance, political unification preceded monetary unification. There is however no precedent or pre-set scheme for the construction of Europe. The single currency was the desirable complement to the single market and European leaders took advantage of an exceptional political momentum in the late 1980s to proceed with monetary union. This monetary union can operate - and it has been proven for more than three years - in the current institutional framework with monetary policy determined centrally by the Governing Council of the European Central Bank, with a high degree of independence and a clear mandate, and national fiscal policies which, though autonomous, are bounded by the rules of the Stability and Growth Pact. The soundness of the euro is essentially based on the strength of the area’s economy (the largest trading bloc in the world) and on price stability which safeguards the euro’s internal value, given that its external value inevitably fluctuates on account of differentials in growth and interest rates, particularly vis-à-vis the US. Having said that, I add, speaking in a personal capacity that new progress in the economic policies co-ordination among the Member States of the euro-area and more political cohesion among them inside and outside Europe would be welcome to consolidate monetary union and deepen European integration. 3. The prospect of enlargement is another reason to adapt the EU’s institutions and procedures. The EU is indeed facing another major challenge: many countries in the rest of Europe are knocking on its door. The accession criteria to the European Union were defined at the European Summit in Copenhagen in 1993. The political criteria concern the existence of stable institutions guaranteeing democracy, the rule of law, respect for human rights and protection of minorities. According to the economic criteria these countries must be viable market economies. In this connection it is necessary to verify whether prices and trade have been liberalised and whether a binding legal system, including property rights, is in place. These countries must also be competitive, i.e. capable of withstanding competitive pressure and market forces within the Union. Finally, an institutional criterion concerns the adoption of the “acquis communautaire”. Moreover the accession criteria to the monetary union are well known: there are the famous Maastricht criteria relative to the moderation of inflation, the avoidance of excessive public finance deficits and the stability of the exchange rate. In many accession countries substantial progress has already been achieved in different fields and one can expect the participation of over ten new Member States to the European Union in the coming years and later on to the monetary union. However a lot remains to be done. *** I shall now move on to the last topic of my speech: the international role of the euro. In the past, for economic and political reasons, some countries have adopted an active stance with regard to the internationalisation of their own currency, by either fostering or hindering its external use. For its part, the Eurosystem has adopted a neutral stance. This means that it neither pursues the internationalisation of the euro as a policy goal, nor does it attempt to hamper its use by non residents. The international role of the euro is and will be determined by the choices of market participants in the context of increasing market liberalisation and integration. There is place for at least two international currencies: in that field too competition is beneficial. Given the weight of the euro area in the world economy and the legacy of the former national currencies of the area in financial markets, the euro has already become the second most widely used international currency behind the US dollar. As an anchor currency, the euro has largely inherited the role played by some of its legacy currencies (e.g. the German mark and the French franc). The euro plays a role as a peg in 55 countries outside the euro area, mainly in countries in the rest of Europe, Africa and the Middle East having close trade and historical links with the euro area countries. Arrangements adopted range from very close links to the euro to looser forms of anchoring. With regard to other functions, the euro’s international role has remained more limited. The US dollar remains the main reserve currency and the dominant pricing and quotation currency. The predominance of the dollar is attributable mainly to the combined and reinforcing effects of network externalities and economies of scale in the use of the leading international currency. Future developments in the international use of the euro are likely to be influenced by two main factors - size and risk. With regard to the size factor, a broad and liquid euro area capital market may lead to greater use of the euro through lower transaction costs. This may, in turn, facilitate the development of the euro as a vehicle currency for trade and commodity pricing. In addition, if international investors and issuers consider the euro to be a stable currency, they will hold more euro assets to minimise risks in their internationally diversified portfolios. Two processes of great significance for the world economic and political order have unfolded in the last decades: economic globalisation and European integration. They are partially linked. Yet they have different roots. One is the fruit of technological process and the free forces of the markets. The other has been motivated by political will and vision. Regional integration and international co-operation are surely appropriate means to promote more stability and economic growth in the different parts of the world and to contribute to humanise the process of globalisation. *** The euro banknotes show windows, gateways and bridges. These symbols of openness and communication will help both to promote a feeling of shared identity and to further strengthen exchanges among the nations of Europe. At the same time, these symbols are a reflection of the European attitude towards the rest of the world.
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Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, for the National Bank of Belgium Conference, Brussels, 27-28 May 2002.
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Guy Quaden: New views on firms’ investment and finance decisions Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, for the National Bank of Belgium Conference, Brussels, 27-28 May 2002. * * * Ladies and Gentlemen, I am really pleased to welcome you here at the National Bank of Belgium 2002 Conference. My wish, one of my wishes, since I have become Governor, and it is shared by the members of our Board, is to stimulate the scientific co-operation between the Bank and the academic community and more in particular the Belgian academic community in a modus operandi of mutual respect and independence. Two years ago, the National Bank of Belgium organised a conference on “How to promote economic growth in the euro area” to celebrate its 150th anniversary. On that occasion, I announced that the Bank would call an international conference every two years to encourage the debate between academics and professional economists working in central banks and in other policy making institutions. At that time, the Bank also decided that a joint research project between its own economists and Belgian academic researchers would precede the conference. The project started in March 2001 and ends with the current conference where the results of the research are presented. The Bank requested the Belgian academic community to express its interest in participating in the joint research project by submitting a proposal concerning the content of an analysis on one or several sub-items of the general project, preferably with an empirical content making use of available panel data from firms’ balance sheets and other sources. All in all we received nineteen proposals from the academic community. Since at this conference also foreign speakers are invited, we were forced to select a limited number among the proposals we received. This selection was based on a number of criteria but, especially, on their compliance and coherence with the overall research project. Allow me to explain the reasons that have led to the particular choice of the topic of the conference. Everybody will acknowledge that investment is a key variable in economics. Capital accumulation not only plays a pivotal role in determining the process of long-run economic growth, as was clearly evidenced by our previous international conference two years ago, but it is also an important driving force of business cycles. Although investment represents a relatively minor fraction of GDP, a major part of output fluctuations is driven by firms’ investment behaviour. For the conduct of monetary policy, it is, therefore, crucial to understand the mechanisms that drive an essential component of the interest sensitive expenditures, and more in particular, how monetary policy affects investment spending by firms. Given that investment is an important element in the complex transmission mechanism of monetary policy, and given the continuous change of economic behaviour and institutional structures, a continuous interest of the central bank in this kind of research can easily be motivated. Despite the best efforts of economists working in various research institutes and in central banks, it remains, however, imperfectly understood. This is, of course, to a large extent due to the volatility of investment itself, which is many times higher than that of GDP. By choosing it as the theme for its second international conference the Bank wants to encourage further research in this field of economics. In that respect, after the pioneering work of Dale Jorgenson, analysing the investment decision in a neo-classical framework, and who will speak about taxation issues today, two major strands in the literature have been developed, which examine the implications of capital market imperfections and uncertainty for investment behaviour. Our distinguished invited speakers, Lenos Trigeorgis, Jean-Bernard Chatelain, Charles Himmelberg and Julian Franks, will give an overview of these subjects in their contributions. The first strand shows that in the presence of information asymmetries firms with weak balance sheets may become financially constrained in the sense that their cost of external funds substantially increases or that they are unable to attract external funds. In these circumstances, the effects of a change in the monetary policy-controlled interest rate will not only be transmitted through an increase in the user cost of capital but also through their impact on the financial structure of the firm. Indeed, an increase in policy rates will result in larger interest payments, hence a worsening of the firm’s cash flow and its ability to self finance, and in a decrease in the value of assets that could be used as collateral for new loans. As a consequence, firms that are likely to be more exposed to problems of asymmetric information, will react more to a monetary tightening. Variations in the availability of credit as a result of changes in monetary policy may act as an important channel of transmission, since these financial frictions amplify the effect of changes in the policy-controlled interest rates. In order to assess the monetary policy stance it is important for the policy maker to know whether these frictions are present or not. A second recent strand in the theory of business investment addresses the impact of uncertainty on investment. The main insight from this literature is that a firm, being uncertain about the future and knowing that investment is a sunk cost, may choose to postpone investment in order to obtain further information about future market conditions. One can show that, in this case, the required rate of return to undertake the investment project increases. It is clear that, hereby, uncertainty introduces additional frictions in the investment decision process, which are likely to temper the effect of a change in the policy-controlled interest rates. Therefore, also in this respect, the monetary authorities need to evaluate the precise timing and magnitude of these frictions, which are caused by uncertainty. As to the requirement to use micro data, it is known that aggregation can blur identification of important parts of the behaviour of economic agents. So, studies at the aggregate level often fail to find an economically significant relation between investment and the user cost of capital, a relation of the utmost importance for the transmission of monetary policy. This failure is attributed in literature to the so-called simultaneity bias. Using micro data allows alleviating these problems. Moreover, micro data allow analysing important economic questions that cannot be addressed using aggregate data sets. This is precisely the case if one wants to identify the existence of financial frictions, because here the individual balance sheet position of the particular firm matters. Next, I want to review the importance of the launch of the euro and of the ECB’s price stability policy for investment behaviour. The introduction of the single currency three years ago provoked fundamental changes in the environment in which the public and the private sector operate. First, the most apparent change has been the elimination of exchange rate risks. Together with the lower transaction costs and more transparent markets, this has created new opportunities for companies within the euro area. Second, the euro has given impetus to the process of financial integration by enhancing the widening and deepening of the euro area financial markets. This evolution may appear to be beneficial for firms, which were or still are financially constrained and unable to execute all their investment plans. Especially young and risky firms often suffer from insufficient tangible assets, that might serve as collateral for external funds, and/or develop activities that are highly risky in terms of future returns. Since these are typically the enterprises which tend to bring new technologies to the market, financial market deepening, as triggered by the euro, may contribute to boost investment and economic growth. Although with the launch of the euro, the exchange rates of the currencies of the euro area countries became irrevocably fixed and the national currencies were only expressions of the same currency, for most residents of the euro area the euro only arrived with the introduction of the new euro banknotes and coins at the beginning of this year. Since the first of January, more than 300 million citizens in Europe share the same tangible currency. This event will further foster transparency and efficiency. Not only the mere launch of the euro, but especially the rigorous and credible pursuit of the ECB of its objective of price stability as assigned by the Treaty of Maastricht, can stimulate investment and contribute to sustained long-run economic growth. First, price stability allows changes in relative prices to be more easily observed, since they are not obscured by fluctuations in the overall price level. This enhanced transparency allows economic agents to make better-informed decisions, which result in a more efficient allocation of resources. Second, monetary stability also eliminates some of the uncertainties about the future which private decision-makers face in managing their businesses. If providers of funds are convinced that price stability will be maintained in the future, they will not require a “risk premium” to cover themselves against future inflation. By reducing such risk premia the real interest rate may fall, and monetary policy can give an incentive to invest. Finally, a credible policy of price stability also makes it less likely that firms will divert resources from productive uses to stockbuilding in order to hedge against inflation. In a high inflation environment there is, indeed, an incentive to accumulate real goods since they are expected to become more expensive in the near future. To sum up, the ECB’s monetary policy of maintaining price stability can affect expectations of market participants about future price developments when it succeeds in achieving a necessary degree of credibility. The continuous low inflation expectations reflect that the ECB has been successful in its task, and has created the basis for low long-term interest rates. These have had significant positive effects on the government budget in many countries and have stimulated investment. Stabilising expectations has also shown to be beneficial for the ECB itself, since it enhances the predictability of the conditional relationships between major macroeconomic variables and diminishes the uncertainties involved in the conduct of monetary policy. Before leaving the floor to our first speaker, Professor Dale Jorgenson I would like to thank all the invited speakers and discussants for accepting the invitation and for actively taking part in this event. I am also very grateful to the Belgian teams for their research effort in exploring the factors that drive business investment in Belgium. Finally, I want to thank all the participants whose large attendance today will certainly contribute to the success of the conference too. I hope that this conference will help us all to better understand the mechanisms underlying investment behaviour and to discover the policies needed to foster it. I wish you all a very productive conference.
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Introductory speech by Guy Quaden, Governor of the National Bank of Belgium, at the IRR?NBB?colloquium in Brussels on 28 January 2003.
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Guy Quaden: Models of co-operation in an enlarged EU Introductory speech by Guy Quaden, Governor of the National Bank of Belgium, at the IRR-NBB-colloquium in Brussels on 28 January 2003. * * * Ladies and Gentlemen, I am very pleased and proud to welcome you all at the National Bank of Belgium. I would like to bring you back in time for a while, to the summer of 1993. Most Belgian people surely remember the decease of King Baudouin on Saturday, 31st of July. However, in my memories the same weekend is also connected to some other, also rather dramatic, events that took place in Brussels. At the time, I was a member of the Monetary Committee of the European Community and I remember very well that the European Monetary System got into severe problems in July 1993. Friday 30th of July has been recorded as "black Friday" in the history of the Banque de France because of the huge interventions needed to support the French franc on the exchange markets that day. The situation made it necessary to call an urgent meeting of the EU finance ministers and the central bank governors and their closest collaborators. We met on Sunday afternoon the 1st of August here in Brussels in Centre Borchette while thousands of Belgians queued before the Royal Palace to pay their last respects to the King. We all were convinced that we had to find a solution to the crisis before the opening of the exchange markets on Monday morning. The negotiations -under the newly started Belgian presidency- were very tough. France wanted the German mark to leave the EMS but that was of course unacceptable, not only for Germany. Only after midnight, a couple of hours before the opening of the Tokyo market, we could reach an agreement. It was decided to open up the fluctuation margins of the exchange rate mechanism to 15 percent above and under the central parities. In less than one year, we had lived 6 realignments plus the opening up of the margins! Today recalling these events may seem like telling heroic stories from ancient times. We can only imagine what kind of currency tensions the bursting of the ICT bubble, the terrorist attacks of IX-XI ["nine-eleven"] and the current geopolitical and economic stance in general would have brought to the Western European countries, if we hadn't got the euro. It will be obvious to you now why the National Bank of Belgium is in favour of European Integration. We are rather convinced that integration and stability are highly correlated and we believe that this applies not only to monetary policy but also to for instance foreign policy. Our trust in European integration is one of the reasons why we at the National Bank of Belgium are very happy that we got the opportunity to organise the colloquium of today in close co-operation with the Royal Institute for International Relations. A second reason is that we feel like naturally related to the European construction. Belgium is indeed one of the six founding fathers of the European Union and Brussels hosts the main headquarters of the European institutions. At several occasions the National Bank of Belgium provided the link between the European central banks and the European institutions, for instance on the 31st of December 1998, when the ECOFIN-ministers met in the Consilium building in order to fix the irrevocable conversion rates of the euro. It can't be surprising that we are - maybe more than our colleagues are - keen on the institutional aspects of the European integration. Today's colloquium is set against the background of the European Convention and the imminent enlargement of the Union. The topic we would like to discuss today is the controversial idea of flexibility. Is it right that we need more flexibility than provided for by the Nice Treaty, if we want the larger and more heterogeneous Union to function effectively? In the very near future we will indeed be confronted with two challenges when it comes to European integration. One is that the EU is going to expand to an important extent. Next year the number of citizens in the EU will increase by 20 %. Second challenge is that part of the Member States want to deepen the integration, but probably only part of them ! I am surely not against the establishment of a larger free trade zone in Europe, in particular as a Central bank governor. But, as a citizen, my ambition for Europe is higher. What instruments do we need to be able to reconcile expansion and deepening ? Can I recall to you that the former Belgian Prime-Minister Leo Tindemans argued already in 1975 - more than a quarter of a century ago - in his "report on the European Union" in favour of flexibility as a means of deepening the integration process, particularly for monetary policy. It seems that there is nothing new under the sun. And indeed, models of flexible co-operation have already been used in European integration in the past. We can think of the Schengen Accords agreed in 1985 but originally kept outside the Treaty because only 5 Member States were ready to implement them at the time. Second example is the Social Charter, that was negotiated together with the Maastricht Treaty, but that was not acceptable at the time for the British Government. A third example of flexibility brings me back to my own business. As you surely know only 12 out of the 15 current Member States have until now adopted the single currency. According to the Treaty, Member States that have not yet adopted the euro are called "Member States with a derogation". Two categories can be distinguished. The UK and Denmark make up one category : these Member States got respectively an opt-in and an opt-out. The second category consists of the Member States that can't adopt the euro because they do not yet comply with the well-known convergence criteria. Only Sweden is currently in this position, but very soon a number of new Member States will join Sweden, having the vocation - and even the legal obligation - to adopt the euro at the right moment. It is very obvious that the Member States of the euro area are more advanced in economic integration than the others are. So, this is clearly a case of "closer co-operation", which has taken shape in the creation of a forum where the ECOFIN-ministers of the euro area can discuss the economic situation in the world, in the European Community and in the euro area, and its consequences for economic policy making. This forum is, as you know, called the "Eurogroup" and I'm sure that Minister Reynders will tell you everything about it after lunch. So to us, central bankers, closer co-operation or models of flexible integration is not some kind of theoretical exercise, we live with it constantly. Ladies and gentlemen, My feeling is that the Royal Institute and the National Bank have chosen for the colloquium of today a topic that is very much alive in the ongoing debate about the future institutional framework of European integration. The fact that we could find a series of utmost distinguished speakers ready to discuss this topic today with you, is a further demonstration of its importance.
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Introductory speech by Guy Quaden, Governor of the National Bank of Belgium, at a conference organised by CEPS in the framework of The European Network of Economic Policy Research Institutes (ENEPRI), in Brussels on 24-25 January 2003.
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Guy Quaden: Ageing and welfare systems: what have we learned? Introductory speech by Guy Quaden, Governor of the National Bank of Belgium, at a conference organised by CEPS in the framework of The European Network of Economic Policy Research Institutes (ENEPRI), in Brussels on 24-25 January 2003. * * * Ladies and gentlemen, I am very pleased to welcome you all at the National Bank of Belgium and to open this ambitious twoday conference on population ageing. The steadily increasing life expectancy in our countries is very good news but, as you know, combined with the dramatic decline of birth rates after the baby boom in the 1950s and the 1960s it implies that populations in a large number of countries are ageing rapidly. Ultimately, the elderly dependency ratio will rise gradually but substantially. To put it more clearly: our children will have to cater for a growing number of pensioners. Even if ageing pressures will in most cases only culminate from the second decade of the current century onwards - when the baby boom generation starts to retire from the labour market - the economics profession has a long-standing interest in population ageing. As early as the 1980s, individual authors or international bodies singled out ageing as one of the biggest economic challenges of the future. The first task at hand for economic researchers was obviously to estimate the size of the problem: what is it that we are facing? How bad will it be? Most studies initially focused on the pensions problem and the budgetary impact of ageing. Two remarks in that respect. – Subsequent studies revealed that, contrary to what is still often thought, pension expenditure is not the only budgetary item that will soar because of population ageing. The ageing problem is as much a health care problem, for instance, as it is a pension problem. On the other hand, one should not forget that ageing will have a beneficial effect on other spending categories like child allowances and education expenditure. Hence, the net budgetary cost of ageing can be somewhat lower than the projected increase in pension and health care spending. All in all, even taking into account the large degree of uncertainty inherent in this kind of exercise, ageing will undoubtedly weigh substantially on future governments' budgets. – One should refrain, however, from simplifying a problem as complex as population ageing into a kind of bill for the governments to pay. Ageing will have a substantial impact on a wide range of economic variables -without speaking of other serious aspects of the social life-, from activity growth to unemployment, from national saving to the composition of private consumption and -yes, I am a central banker- from asset prices to inflation. Hence, it goes without saying that ageing requires a holistic approach on our behalf. From the very beginning central bankers have always been keen observers of, if not active contributors to the research on ageing. Any shock that has a sizeable impact on the macroeconomic environment should be taken into account when setting monetary policy and, as we have seen, the potential consequences of population ageing, for the government accounts, for instance, can hardly be underestimated. Considering the impact that the combination, in a number of European countries, of sizeable tax cuts and an, altogether, limited slump in activity growth currently has on public finances, it is quite unsettling to imagine what kind of havoc can be wreaked in government budgets by inappropriate policy responses to population ageing. If what we are currently witnessing is the budgetary fall out of a mild economic storm, then, surely, the ageing problem should be compared to a genuine earthquake. All in all, it is a problem that can only be countered by a well-balanced and consistent strategy that should be put into action as soon and as determinedly as possible. The lines along which action should be taken have been clearly identified. First, governments should get their fiscal houses in order before ageing really starts to kick in; excessive deficits should be avoided and countries that still face a high public debt ought to continue and, if necessary, intensify debt reduction. Second, economic policy has to be geared towards increasing productivity growth and the employment rate - especially of older workers - so as to broaden the tax base as much as possible. Third, the buoyant growth of health care spending needs to be analysed and the individual pension entitlements, both in the private and in the public sector, need to be thoroughly assessed taking into account also the development of secondand third-pillar schemes. In addition, governments of some countries should consider in what way the latter schemes can be encouraged further, either by tax abatement or by regulation. Considering present market returns, it's probably needless to add, however, that second and third pillars based on capitalisation in the stock market, can not by themselves provide a miracle solution, contrary to what some people advocated previously. Any viable solution to the ageing crisis is bound to be a blend of those three ingredients: it would be very easy, for instance, to offset the upward pressure on government spending coming from the rising number of elderly by simply reducing the average pension to a basic-needs level and to turn the health care system into a two-tier one, where public insurance is very limited and only the richest part of the population has access to new technologies via private schemes, but that would simply amount to a hollowing out of the welfare state, which our fellow citizens and myself do not wish. Taking stock of the policy response to the ongoing research on ageing, I guess it is fair to say that the results so far have been mixed. * * * On the plus side, one can not deny that ageing features prominently on the political agenda and, in many countries, significant steps are being taken. Several countries are reforming or are set to reform their pension systems with a view to improving the sustainability of public finances. Considerable progress towards sound fiscal positions is also made in some countries. In a high-debt country like Belgium - and you will hopefully forgive me that I take this example - a special pension fund, the socalled Silver Fund, has been created within the government sector in order to clearly visualise the link between debt reduction and the impending costs of ageing and to enhance public support for further fiscal consolidation. However, there are also some worrying trends. First, fiscal consolidation has not been commendable everywhere with some countries in the euro area clearly showing signs of post-Maastricht fiscal fatigue. Even worse is the fact that, following the problems that those countries are experiencing now, the credibility of the Stability and Growth Pact and the whole institutional framework is constantly undermined either by calling into question sensible rules or by resorting to creative accounting. The ECB Governing Council has recently confirmed in the strongest possible terms its support for both the Pact, which, if applied correctly, offers enough leeway to reconcile short-term flexibility and long-term sustainability of public finances, and the 3 p.c. of GDP deficit ceiling. Second, policies geared towards market liberalisation, increased research and development and human capital formation, which could spur long-run productivity growth, have been hesitant at most in many cases. Third, even if some initiatives have aimed at increasing the employment rate of older workers, progress has generally been slow, partly due to popular resistance. Still too often, negative temporary demand shocks, both at the macro and the micro level, crystallise into permanent institutional arrangements that put downward pressure on the effective retirement age and, hence, undermine future governments' capacity, if not to ward off the ageing crisis, then at least to soften its impact. If we do not want the famous Lisbon objectives to become just a slightly offbeat alternative scenario in our projections, rather than realistic targets, then, clearly, more action is needed in these areas. All in all, it is essential that policy makers fully understand that the window of opportunity that we have now, will not last forever. We should be aware of the fact that we still have a lot of convincing to do. Earlier on I have likened the ageing problem to an earthquake. Contrary to a regular earthquake, however, we can predict almost exactly when and where it will hit us. In addition, the quake will not take the form of a big bang but will reach its full impact only very gradually: its disrupting ripples will be felt throughout the following decades. And although it is hard to give precise estimates of the amount of damage that it will do, this is the kind of earthquake that is certain to shake the very foundations of our modern welfare states. It is our task, as economic researchers, policy advisors and, ultimately, policy makers, to make sure that, by the time ageing really starts to kick in, these foundations can withstand the blow. I firmly believe that conferences like this one bringing together a host of distinguished researchers from both sides of the Atlantic are a crucial step in reaching this objective.
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Introductory talk by Mr Guy Quaden, Governor of the National Bank of Belgium and Chairman of the Financial Stability Committee, at the installation of the Financial Stability Committee, Brussels, 30 July 2003.
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Guy Quaden: Installation of the Financial Stability Committee Introductory talk by Mr Guy Quaden, Governor of the National Bank of Belgium and Chairman of the Financial Stability Committee, at the installation of the Financial Stability Committee, Brussels, 30 July 2003. * * * The installation of the Financial Stability Committee, the committee which the Ministers Reynders and Moerman are doing us the honour of inaugurating today, is one of the very last stages in the implementation of the law of 2 August 2002, designed by the Ministers Reynders and Picque and adopted by Parliament by a very large majority, a law which has modernised our financial markets and reformed their supervision. I would like to take advantage of the opportunity to welcome this reform, and especially its institutional aspects. Thus, I am delighted that the supervision of the rules on market operation has been transferred to the public authorities - more precisely the BFC (Banking and Finance Commission) - in cases where those rules are of public interest. It was doubtless also necessary to review the governance - to use a fashionable word - of the institutions responsible for supervising the financial markets and intermediaries, and I include insurance companies here. By equipping the supervisory institutions with proper management boards whose members carry full responsibility for managing the institution, we are undoubtedly providing a better guarantee that decisions are genuinely taken on a collegiate basis. In my view, it was also wise to decide that the microprudential supervisory authorities, the BFC and the ISO(Insurance Supervision Office), which tomorrow become the BFIC (Banking, Finance and Insurance Commission), should remain separate from the central bank while strengthening their links with the Bank. Finally, in a country where “bancassurance” groups are particularly well developed, the reform was complemented, I believe logically, by the planned merger of the BFC and the ISO. Where financial supervision is concerned, we must admit that there is no obvious model to follow. Thus, the arrangements still vary from one country to another, depending on the national institutional history. Broadly speaking, however, we can identify two main models for organising these powers in the European Union: a model like that used in Britain and also in Sweden, in which a single agency, almost entirely separate from the central bank, is responsible for all micro-prudential supervision, and a model - which is the most common type in the euro area - in which the central bank itself takes charge of part of the prudential supervision, usually the supervision of credit institutions, while one or more separate agencies supervise the other financial intermediaries and the markets. I consider that what we might call the intermediate model resulting from the law of 2 August 2002 is a fairly good combination of these two main models, and it is fair to say that this Belgian design could be a source of inspiration once it is considered necessary to set up prudential supervision arrangements at European level. In any case, the reform has attracted favourable comments both from the European Central Bank and from the International Monetary Fund. The new set-up is headed by the Financial Stability Committee, which now combines the management boards of the BFC, the ISO and the NBB, alongside the Financial Services Authority Supervisory Board, which will combine the supervisory boards and council of regency of the various institutions. As regards the Financial Stability Committee which is being installed today, in accordance with the intentions of the legislature I see it as: • the pilot for the collection and development of expertise relevant to the professions of both supervisor and central banker; • a place for dialogue and consultation, certainly for providing warning of financial instability but also, if necessary, for managing such situations; • a body in charge of organising certain synergies between the three institutions (tomorrow it will be two: the BFIC and the NBB), in order to achieve economies of scale in their operation, all without affecting the specific responsibilities of each institution. To quote an expression used by my colleague at the European Central Bank, T. Padoa-Schioppa, macro- and micro-prudential supervision are nowadays two sides of the same coin: distinct but inseparable. The central bank, traditionally in charge of macro-financial stability, as well as being the bankers’ bank, must not be cut off from information about the conduct of the few major players who dominate the financial scene and whose failure - should it occur - could have systemic consequences. Similarly, the body or bodies in charge of micro-prudential supervision have the advantage of being able to suit their action to the relevant macro-economic context. The many shocks which the world financial markets have suffered in recent years are sufficient demonstration that financial stability cannot be regarded as an established fact. Even though, very fortunately, no major problems have ensued for individual players or for the systems as a whole, these events have confirmed the need to reinforce the resources devoted to the preservation of financial stability at macro and micro level. In Belgium, the legislature considered that, in a small country like ours, whose human and material resources are bound to be limited, the way to achieve significant reinforcement of the resources allocated to financial stability is to develop substantial synergy between the various institutions concerned, in order to achieve the maximum economies of scale and to take the resources thus released and reallocate them to the basic functions of each institution. The law of 2 August 2002 provides that the rules governing the arrangements for pooling resources must be set out in a protocol concluded between the institutions concerned and approved by the King. Without waiting for the official inauguration of the FSC, its members have agreed on a framework for exploiting synergy and have submitted proposals to the Minister for achieving greater cooperation in regard to prudential policy and various support activities. The FSC has also set up a number of priority projects for the coming months, in particular the launch of a national coordination initiative on the subject of business continuity, which will take account, in particular, of the lessons which can be drawn from the events of 11 September 2001. In conclusion, I would simply say that this new Committee and the far more historic institutions from which it emanates are firmly resolved that they will actively seek the solutions best suited to the general interest in the field entrusted to them, namely the field of financial stability.
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national bank of belgium
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Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the National Bank of Belgium Conference on Efficiency and Stability in an Evolving Financial System, Brussels, 17 and 18 May 2004.
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Guy Quaden: Efficiency and stability in an evolving financial system Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the National Bank of Belgium Conference on Efficiency and Stability in an Evolving Financial System, Brussels, 17 and 18 May 2004. * * * Ladies and Gentlemen, I am pleased to welcome you at the third biannual international conference organised by the National Bank of Belgium. This year's subject is “Efficiency and Stability in an Evolving Financial System”. The topic is of the utmost importance not only to central banks but also to all economic agents. Indeed, the efficiency and stability of the financial system is a prerequisite for the optimal allocation of capital over different sectors, for adequate risk-sharing across agents and ultimately for economic growth and stability. Central banks have a particular interest in the maintenance of an efficient and resilient financial system, because it ensures the effective implementation of monetary policy and thus contributes to meeting the final objective of price stability, and to promoting high sustainable growth. Over the past decade our financial systems have been going through major changes. Those developments raise new questions and face central banks and other bodies having supervisory and regulatory powers with new challenges. In order to provide an appropriate response to these new and changing circumstances, policymakers should have a detailed knowledge of the ongoing processes and apply adequate theoretical models and insights to support their decisions. This conference combines keynote lectures by internationally distinguished researchers with the research effort of 6 Belgian teams, 4 academic teams and 2 teams from within the Bank. A selected group of international experts, with a broad research experience in financial issues, will act as discussants of these research papers. Their comments will be the start of a discussion I would like all of you to participate in. We hope that this conference, offering central bankers, academic researchers and financial experts the opportunity to exchange ideas, will contribute to our understanding of the ongoing changes. Major changes having taken place in our financial environment over the last five to ten years have been the introduction of the euro and European financial integration, the global financial liberalisation and the rapid development of new financial products, the consolidation in the banking industry and new technologies for producing financial services. The introduction of the euro has removed one of the main factors of financial segmentation across eurozone countries, namely the multiplicity of currencies. Thereby, it has reduced the vulnerability of the financial and real sectors to exchange rate shocks. The resulting financial integration has proved to be impressive in the securities markets. For example, the differential between interest rates in interbank markets and bond markets has narrowed drastically, cross-border bond and mutual funds holdings have been increasing very rapidly, a market for private bond issuance has developed within Europe and equity price fluctuations have been converging. These factors have induced a rapid growth of the financial markets and have facilitated the direct access of borrowers and savers to the markets. Our traditional bank-oriented financial systems are gradually turning into a mixed organisation with substitution possibilities between bank and market-based financial products. The co-existence of and the competition between the two systems for allocating financial flows and risks in the economy should enhance economic efficiency, provided appropriate regulations, monitoring and supervision create the conditions for fair competition. Against this background, the banking sector has experienced major changes. Consolidation in the banking industry has been substantial. At the same time, banks have diversified their activities through mergers or by creating bank insurance groups. They have also been trading parts of their balance sheet assets and risks through financial markets. In addition, they have expanded their activities abroad, although further developments towards cross-border mergers and the creation of larger Europe-wide banks can be expected. So the banking sector is now characterised by higher concentration, stronger competition from foreign banks and direct competition with financial markets. But what precisely will be the future role for banks in this new financial environment? Theory and empirical evidence support the view that, as providers of finance, banks have the advantage of being in a position to acquire information on the borrowers and to monitor them thanks to long-lasting bank-lending relationships. This mitigates the effect of asymmetric information and moral hazard problems on the provision of funds. It is especially relevant to newly set up, small and medium-sized enterprises. This debate is not only important for banks, but for corporations themselves. Indeed, it is regularly asserted “,-in various countries, not the least in Belgium, that SME face increasing difficulties to get bank financing and that this problem could be compounded by the revised capital requirements imposed by the new Basel II agreement. I would like to emphasise two points. First, the new Basel rules take expressly into account the specificities of SME. Second, recent figures for Belgium clearly indicate that, while large corporations have recently shifted to market financing, bank loans to SME keep increasing, and, moreover, are priced to rates which compare rather favourably to the ones applied in the rest of the eurozone. In this context, it seems quite difficult to speak of a credit crunch or of a comparative hardening of credit conditions in Belgium. Nevertheless, given the recent trend towards bank consolidation, a clear understanding of how banks succeed in combining the benefits of large-scale operations without losing the close relationships with their clients is required. These questions as to the future equilibrium between banks and financial markets will be tackled during our first session today. These recent financial developments will have an impact on all financial tra nsactions and on the whole spectrum of financial firms. But the benefits gained from increased financial integration and efficiency will extend well beyond the financial sector. Actually, the real economy may be expected to benefit most, because a more efficient financial system implies higher expected returns for sectors with a financial surplus and lower borrowing costs for investing in new projects that need external finance. This should facilitate the re-allocation of capital towards new developing sectors and firms that have a high growth potential. The real effects of financial market liberalisation will be envisaged during the second session of our conference. Increasing financial efficiency while maintaining financial stability is not only a major objective but also a challenging task. In order to meet this goal we should carefully design and monitor market organisation and set up appropriate regulatory and supervisory arrangements. Recent research has shown the important role market organisation or market micro-structure plays as to the efficiency and the stability of financial markets, and more in particular as to market liquidity. Insufficient market liquidity during periods of tension may exaggerate price volatility and increase risks of contagion over markets and institutions. The availability of broad market liquidity under all circumstances is therefore crucial to reap the rewards from the expansion and the integration of financial markets. The third session in the conference will deal with these issues. Financial services and bank management in general have become increasingly sophisticated and complex. Information technology has fostered the use of quantitative management tools to evaluate credit and market risks as well as other risks, such as liquidity and operational risks. Current banking regulations should be adjusted to take into account the specificity of bank risks. They should provide the proper incentives for financial firms to strengthen their internal control and risk management systems. The new Basel II solvency requirements for instance develop a more comprehensive and risk-sensitive approach to banks’ capital requirements and a strengthened role of market discipline. As a member of the Basel Committee on Banking Supervision, the Bank has been deeply involved in the design of these requirements. As the new requirements will have to be endorsed by the G 10 Governors and Heads of Supervision before their publication at the end of June, I will be involved as well. Last week the Basel Committee published a press release to announce that it had achieved consensus on the remaining issues so that I don’t expect that this endorsement could still prove problematic. The introduction of this new set of rules represents a milestone in the design of a more dynamic prudential environment, combining rules and discretion, supervisory monitoring and market discipline. This does however not mean that the work is now finished. The implementation of the new requirements will necessitate considerable efforts by the financial firms, the supervisory authorities and central banks. In order to facilitate that process the Basel Committee created an Accord Implementation Group and European supervisors decided to cooperate more closely in order to achieve a greater convergence of supervisory practices. The legal work of implementing the new requirements in EU and national legislation will also be a huge task. It is therefore important that the closer interaction between the academic and regulator’s worlds which is one of the new features in the design of Basel II be maintained during the implementation phase. I hope that this conference will also contribute to this. Other developments of our financial system I have mentioned before, such as the concentration process in the banking sector, the creation of financial conglomerates or bank-insurance companies and the development of cross-border activities, also call for a reassessment of our regulation mechanisms. However difficult it has proved to achieve a convergence between the national supervisory authorities in the banking sector, the next daunting challenge will most probably be, in my opinion, to enlarge that convergence to other segments of the financial system. I would like to thank all speakers and discussants taking part in this conference. I am also grateful to the Belgian academic researchers and our own staff who have contributed to the research projects prior to this conference and, like all of you, I am looking forward to the presentations of their research results. Finally, I would like to thank all of you for your attendance here today and I trust your participation in the discussions and question time will be very active. I hope this conference will help all of us to better understand the mechanisms underlying the recent financial developments as well as the policy responses which should accompany them.
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national bank of belgium
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Foreign Bankers' Association in the Netherlands, Amsterdam, 27 May 2004.
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Guy Quaden: Challenges for the European economy Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Foreign Bankers’ Association in the Netherlands, Amsterdam, 27 May 2004. * * * Ladies and Gentlemen, Members of the Foreign Bankers’ Association in the Netherlands, I am very pleased and indeed I think it is a great honour for me to have been asked to be the keynote speaker at the 2004 Annual General Meeting of your Association. As you have noticed I have decided to talk about “Challenges for the European Economy” but of course I fully realize that I myself am facing a great challenge this evening, as I am aware that I am following in the footsteps of a large number of distinguished speakers you have invited for your previous lectures. I would only like to refer to Jean-Claude Trichet, Otmar Issing, Eddy George or David Dodge, colleagues or former colleagues within the Eurosystem or the G10 Governors’ Group. I hope my presentation will be as interesting as that of my colleagues I have the greatest admiration for. The European economy is facing many challenges: consolidating the current recovery, redressing public finances which have deteriorated in many countries, reducing unemployment which is still too high and preserving the social cohesion, preparing for the ageing process and in particular its financial consequences, but I think one of them is now the most important: improving Europe’s growth potential. Its realisation is a prerequisite for meeting the other challenges mentioned. From the outset I want to make it absolutely clear that I am neither a eurosceptic nor a europessimist. So, I fully acknowledge and admire the resounding success European integration has achieved in two fields over the past few years. As a central banker I would of course first like to refer to the introduction of the euro which, as you all know, was brought about in two stages. On 1 January 1999 financial markets started using the euro while the single monetary policy of the Eurosystem was implemented. Three years later the introduction of euro notes and coins led to the general use of the single currency by all economic agents, thereby doing away with national currencies. This changeover to the single currency was the final touch of European monetary integration and had a profound effect on the deepening of the single market through the elimination of the exchange risk, the reduction in transaction costs and the increase in price transparency. This improvement of the single market will enhance the overall efficiency of the European economy and, other things being equal, also its growth performance. However, it is doubtful whether the population of our countries correctly perceived the latter advantage. Indeed, the introduction of the euro unfortunately coincided with a severe slump in economic activity: while in 2000 real GDP growth in the euro area reached 3.5 p.c. it declined during the following years to reach a mere 0.4 p.c. in 2003. Earlier this month European integration achieved another major success. Ten new member states joined the European Union, which now makes European reunification almost complete. However, this historic event occurred immediately after a period of sluggish economic growth which left the European economy somewhat weakened. Therefore, the enlargement, instead of generating enthusiasm, has in many instances given rise to misgivings among the population and even among the enterprises. The concern regards the possible delocalisation of enterprises and significant job losses. At microeconomic and sectoral level, the integration of the ten new Member States will undoubtedly entail some adjustments and shifts but overall it should result in a win-win situation. The past decade has already brought a strong expansion of trading links between the old and new EU Member States. As purchasing power in those countries catches up and their markets become more accessible, European firms are set to expand their potential outlets while the continuing dismantling of trade barriers and harmonisation of the regulatory framework will gradually create a level playing field. The expansion of trade leading to increasing specialisation, and hence greater productivity, as well as consumers having a wider choice will produce benefits that are much larger than the costs of integration. These two recent major events show that insufficient growth is a real cause for concern for the population in our countries which feels insecure about their employment. This factor obscures the achievements European integration has reached and so prevents people from believing in the dynamism of European unification. Therefore weak growth could be a factor entailing growing euroscepticism, especially in Western Europe. For the coming months a reasonable optimism is justified. While the latest positive signals need to be confirmed by future developments, they underpin the expectation that the gradual recovery in the euro area will continue and will strengthen over time. The conditions are in place. First, the global economic upturn continues to be robust and broadly based, both geographically and across sectors, and world trade has also strengthened. In this context of a favourable external environment, euro area exports are expected to grow significantly this year and the next. Second, favourable financing conditions, improvements in corporate efficiency and earnings and the strength of global demand help investment. Over time, consumer spending should also be supported by growth in real disposable income and better labour market conditions. The latest data point to a stronger than expected recovery of real economic activity in the euro area at the beginning of 2004. According to Eurostat’s flash estimate, euro area real GDP increased by 0.6 p.c. quarter on quarter in the first quarter of 2004, after rising by 0.4 p.c. in the fourth quarter of 2003 (revised upwards from 0.3 p.c.). Concerning the prospects, the slight decline in May in the two business confidence indexes which are the most closely watched in the euro area - the German IFO and the National Bank of Belgium index does not question the strong improvement recorded since the end of last year. Obviously the consolidation of the recovery is, as often, subject to some risks and uncertainties. Consumer confidence is still relatively weak in many countries and the strong rise of oil prices is of course not good news for the European economy. There is no free lunch. The strong growth in the United States and Asia has sustained economic activity in the rest of the world, but has also caused a rise in commodity prices. As regards oil, it is clear geopolitical uncertainties also contribute to rising prices. However one should not overdramatise either.The solidity of the euro exchange rate has limited rising oilbills for us. Moreover, owing to energy saving measures and the use of other types of fuel the relative weight of oil in the production of goods and services has declined markedly over the past thirty years. On an annual basis, the latest public and private sector forecasts point to growth in the euro area of 1.6 p.c. to 1.7 p.c. in 2004 and more than 2 p.c. next year. This is however not a reason to be satisfied and complacent. In the EU or in the eurozone we speak of a recovery when growth is approaching 2 p.c. while in the US they speak of a recession when growth is falling to 2 p.c. ! And, on the other hand, while most of the rest of the world is already enjoying robust growth, the recovery in Europe remains gradual and overly dependent on booming international trade. What is also needed are efforts to make the European economy more resistant to external shocks as those which have reduced its growth in the latest years and to increase its long term growth potential. Europe has to cope with a structural problem of low economic growth. The growth performance of the euro area is weak from an international point of view, in particular vis-à-vis the United States: over the past 10 years the American economy has shown an average GDP growth of 3.3 p.c., while the euro area could only reach an economic growth of 2 p.c. The euro area only succeeded in achieving a higher growth rate in 2001 when the United States were hit by a severe but short slowdown. The following years the American economy however showed a much stronger recovery than the euro area and now again acts as the main growth engine for the world economy. Yet it is important to note that data for the eurozone are averages for twelve countries and that a country like Finland in the euro area (and more generally the Nordic countries) has booked in the most recent decade performances in the field of growth and employment rates which are comparable to those of the US and are much better than those of countries like Germany and Italy. Given an unequal population growth - it is higher in the US - a further analysis shows that the gap in real GDP growth between the US and the euro area that opened up in the mid-1990s is half the size if measured in per capita terms. The remainder is due to differences in productivity growth (the increase in overall labour productivity in the US, measured by real GDP per person employed, reached on average 1.9 p.c. in the last 10 years, almost twice as much as the 1 p.c. recorded in the euro area) and to a much lower level of labour utilisation in the euro area. In the euro area unemployment rates are currently around 3 percentage points higher, labour force participation rates more than 10 percentage points lower and annual hours worked per employed person lower by more than 300 hours. Europe is of course not the US. It has its own specificities which should be taken into account. So at least part of the gap in average hours worked between the US and the euro area should be attributed to structural preferences rather than to structural rigidites. However, when discussing this issue it has to be borne in mind that households also take into account the institutional environment, including tax, social security and pension systems when deciding on their labour supply. Moreover, the problem to what extent the present European system is sustainable cannot be ignored. The so-called European model has come under increasing pressure from demographic factors. Further policy changes towards stimulating labour supply are inevitable if living standards and social cohesion are to be preserved. Unlike social preferences and rigidities, macroeconomic policies m ust not be seen as an explanation of the weaker growth in the euro area. First of all this holds true for monetary policy. As you know, the Treaty of Maastricht unambiguously provides that maintaining price stability constitutes the primary objective of the European Central Bank. According to the definition of the ECB which was clarified about a year ago and which aims to create a stable anchor for price expectations, price stability implies an annual rise in the harmonised index of consumer price for the euro area below but close to 2 p.c. This objective must be maintained in the medium term. Central bankers can not prevent external shocks, such as a rise of commodity prices on the international markets, from resulting in a temporary rise of inflation. But, they have to preclude second-round effects. In its conduct of monetary policy, the ECB has already gained a high degree of credibility with market participants as is shown by moderate inflation expectations. These expectations remaining in line with its target the ECB was able to cut its key interest rate to historically very low levels (2 p.c. in nominal terms and actually zero in real terms). Monetary policy thus made its own contribution towards stabilising economic activity in the euro area. Ensuring price stability, as well as confidence in the euro, is the best contribution to higher and sustainable growth the ECB can make because it also allows for the advantage of low medium and long term market rates which in many European countries are still more important for the financing of investments by enterprises, households and government. In the fiscal sphere, almost all the governments in the euro zone allowed the automatic stabilisers to take full effect during the recent slowdown, and that effect was often reinforced by discretionary measures. Between 2000 and 2003, the budgetary deficit of general government in the euro area has grown from 0.9 p.c. of GDP to 2.7 p.c. The deficits of some countries have even exceeded the threshold of 3 p.c. Fiscal policy has thus not been an impediment to recovery. One might however wonder whether the stimulation of the economy intended by the fiscal easing in many countries was not eroded by the adverse impact which such a relaxation of discipline can have on the climate of confidence. It seems that people in Europe more and more have a “Ricardian perception” of fiscal deficits. They are more aware of the enormous challenges and costs our ageing society entails. People in the different European countries are really worried about the long-term sustainability of public finances. High fiscal deficits will only worsen their anxiety and so incite them to increase their precautionary savings. In this context, the rules of the Stability and Growth Pact are appropriate. It is not correct to describe it as a fiscal straitjacket. Starting from a budget in balance or in surplus at the peak of the cycle, a country can let the automatic stabilisers fully operate when the activity is slowing down. The main problem with the Pact is, I think, that better incentives are needed to respect fiscal discipline during good economic times. So I hope that the forthcoming recovery will be the right moment for the European governments now facing budgetary difficulties, to put their finances again on the right track, so that in that field it will be possible to reconcile short time flexibility with long term sustainability. In that case fiscal policy may again become an element of the required lasting macroeconomic stability. It is by paying more attention to the quality of public finances and by rendering the structure of taxes and that of expenses more growth oriented that Governments can contribute to stimulating Europe’s growth potential. I refer to expenditures such as education and improvement of human capital, public investment in infrastructure and research and development. R & D could become a comparative advantage of Europe. At the moment Europe invests 1.9 p.c. of GDP in R & D and is thus lagging behind the US figures and the Lisbon target (3 p.c.). Over the past years, European policymakers have become more aware of this growth problem Europe is facing. So, in March 2000, during the Lisbon summit, an ambitious strategy was adopted aiming to increase the rate of sustainable economic growth and even to enable Europe to become the most competitive and dynamic knowledge-based economy in the world in 2010. In order to achieve such a strategic goal the Lisbon agenda has brought together the different strands of reform policies on product, labour and capital markets aiming at promoting a more efficient allocation of resources and at higher growth potential. Moreover, in order to facilitate monitoring of progress with reforms, quantitative targets have been fixed to measure progress in particular on the labour market in achieving for instance higher participation and employment rates. The Lisbon agenda was excellent in terms of diagnosis. Until now it has however not been given a sufficiently powerful implementation. One cannot say that there was no progress in the last years in the field of structural reforms, but much remains to be done. The pace of reform needs to be significantly stepped up if the Lisbon targets are to be achieved. The review carried out by the high level group chaired by former Prime Minister Wim Kok provides an excellent opportunity to accelerate the process. Progress has been most tangible in deregulating and integrating product and financial markets. Since the introduction of the euro, the pace of financial markets’ reform has been impressive. This includes policy-induced reform, such as the Financial Services Action Plan initiated by the European Commission in the spring of 1999. Reform also covers market-led initiatives, as for instance the development of electronic trading platforms. As you know, the different financial markets have reached different levels of integration. So integration in euro money markets was achieved very quickly after the introduction of the new currency while for instance the euro area equity market, despite advances such as the setting up of Euronext, remains among the least integrated. Thus there is still need for continuation and completion. New progress should result from the cohesive and effective interplay of free competition, coordinated action by all market participants and policy enforcement by public authorities. Much progress has also been made regarding the integration and level of competition in productmarkets. However substantial barriers to free competition continue to exist, particularly preventing the integration of services’ markets and effective competition in network industries. Fostering competition in these fields should also contribute to a downward effect on prices. Further regulatory reforms should be accompanied by a sustained reduction in state aid - particularly if it constitutes economically questionable and sector-specific measures. In the end, this will promote the entry of new players, enhance innovation and reduce the tax burden. High unemployment and insufficient employment rates are still preoccupying. The labour market participation rates of women and the youngest and oldest age groups remain too weak in many countries. Thus far, progress with the implementation of labour market reforms has been uneven in the euro area. In some countries, significant achievements in terms of lower unemployment are already visible. Others are lagging behind. It is important to enhance the flexibility of labour markets to make the whole European economy better able to absorb economic shocks. Reforms are also needed not only to reduce non-wage labour costs and increase incentives for job creation but also to ensure the sustainability of the social security systems. The challenges are known and the analyses are completed. Now the implementation should be focused on. As I have said at the beginning of my speech, I am neither a eurosceptic nor a europessimist. So I believe Europe can implement the Lisbon agenda. The introduction of the euro was a splendid example of a not easy but successful structural reform. It can be and it should be followed by others. The framework through which the Lisbon agenda is implemented relies largely on a peer pressure mechanism, mainly depending on goodwill of governments in individual EU countries. The pressure must be reinforced, including by clearly identifying and publicising successful and lagging country cases accross the EU and possibly industrialised countries more generally. Communication must also be improved. The transition from the pre-reform to the post-reform equilibrium conditions normally takes time and we must recognise that within this period some uncertainty may occur. For this reason the implementation of social reforms requires a strong leadership and a continuous explanation effort. We have to convince our public opinion that our countries would be better off - with more growth and more jobs - if we could deliver the reforms of the Lisbon agenda. I shall conclude with a last remark: the current recovery of economic activity, as welcome as it is, must surely not constitute a pretext for postponing a program of reforms, as its implementation is essential to achieve stronger and more sustainable growth in the long term.
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national bank of belgium
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Swiss Chamber of Commerce, Brussels, 27 October 2004.
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Guy Quaden: Prospects and challenges of the European economy Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Swiss Chamber of Commerce, Brussels, 27 October 2004. * * * Ladies and Gentlemen, I thank you very much for your invitation to speak this evening on the topic: “Prospects and Challenges of the European Economy”. The European economy is facing many challenges: consolidating the current recovery, redressing the public finances which have deteriorated in many countries, reducing unemployment which is still too high and preserving social cohesion, preparing for the ageing process and in particular its financial consequences, but I think one of them is now the most important: improving Europe’s growth potential. Its realisation is a prerequisite for meeting the other challenges mentioned. From the outset I want to make it absolutely clear that I am neither a eurosceptic nor a europessimist. So, I fully acknowledge and admire the resounding success European integration has achieved in two fields over the past few years. As a central banker I would of course first like to refer to the introduction of the euro which, as you all know, was brought about in two stages (1999 and 2002). It was a huge political, economic and technological challenge and it was an impressive achievement. The finalisation of European monetary integration had a profound effect on the deepening of the single market through the elimination of the exchange risk, the reduction in transaction costs and the increase in price transparency. This improvement of the single market will enhance the overall efficiency of the European economy and, other things being equal, also its growth performance. However, it is doubtful whether the population of our countries correctly perceived the latter advantage. Indeed, the introduction of the euro unfortunately coincided with a severe slump in economic activity: while in 2000 real GDP growth in the euro area reached 3.5 p.c. it declined the following years to reach a mere 0.5 p.c. in 2003. Earlier this year European integration achieved another major success. Ten new member states joined the European Union, which now makes European reunification almost complete. With its 25 member countries, the EU now has a population of 455 million people. With the participation of Switzerland we would be still closer to half a billion people. But even without Switzerland the EU as a whole has the third largest population in the world (only after China and India) making it larger than the US and Japan combined. However, this historic event occurred immediately after a period of sluggish economic growth which left the European economy somewhat weakened. Therefore, the enlargement, instead of generating enthusiasm, has in many instances given rise to misgivings among the population and even among the enterprises. The concern regards the possible delocalisation of enterprises and significant job losses. At the microeconomic and sectorial level, the integration of the new Member States will undoubtedly entail some adjustments and shifts - it would be naive to claim otherwise -but overall it should result in a win-win situation. The past decade has already brought a strong expansion of trading links between the old and new EU Member States. As purchasing power in those countries catches up and their markets become more accessible, Western European firms are set to expand their potential outlets while the continuing dismantling of trade barriers and harmonisation of the regulatory framework will gradually create a level playing field. The expansion of trade leading to increasing specialisation, and hence greater productivity, as well as consumers having a wider choice will produce benefits that are much larger than the cost of integration. These two recent major events show that insufficient growth is a real cause for concern for the people in our countries who feel insecure about their employment. This factor obscures the achievements European integration has reached and so prevents people from believing in the dynamism of the European unification. For the coming months a cautious optimism is justified. Mainly driven by the strong growth in the US and Asia, economic activity has been higher than expected in the euro zone in the first half of this year. The conditions for a continuation of the recovery remain in place. Economic growth outside the euro zone should continue to support euro area exports. On the domestic side, strong foreign demand and firm activity growth should sooner or later revive investment and employment. At this stage, the signs pointing to a broader-based recovery are mixed, with non negligible variations across countries, e.g. the recovery has been stronger and broader-based in Belgium than in Germany as was confirmed again today by the publication of preliminary figures for the third quarter. The scenario of an ongoing recovery is, as is frequently the case, subject to some risks. The main risk relates to oil prices. The recent rise in oil prices has been proportionally smaller than in previous episodes, particularly when expressed in euro, and since the 1970’s, the oil intensity of production in the euro zone has fallen significantly. Nevertheless, persistently high and even further increasing oil prices would probably dampen both foreign and domestic demand. Finally, the effects of oil prices on growth and inflation will not depend only on the amplitude and duration of the oil price rise, but also on the appropriateness of the responses of our authorities and economic agents. Lessons learned from the bad experience of the 1970’s, when there were desperate attempts to compensate the consequences of the oil shock by lax budgetary and wage policies, must not be forgotten. Most forecasting institutes expect for the euro zone this year and next year growth rates between 2 and 2.25 p.c. close to the growth potential of the zone. That would be good to have but that should not be a reason to be satisfied. What is needed are efforts to make the European economy more resistant to external shocks as those which have reduced its growth in the latest years and to increase its long term growth potential. Europe has to cope with a structural problem of low economic growth. The growth performance of the euro area is weak from an international point of view, in particular compared to the United States: over the past 10 years the American economy has shown an average GDP growth of 3.3 p.c., while the euro area could only reach an economic growth of 2 p.c. It is necessary to specify that given unequal population growth further analysis shows that the difference in real GDP growth is half the size if calculated in per capita terms (per head). The fact remains however that since the mid 90’s the gap in product or income per head between the US and the euro zone has significantly widened. Macroeconomic policies are not the explanation of the weaker growth in the euro zone. First of all this is true for monetary policy. In less than six years the new ECB has gained a high degree of credibility. The euro zone has witnessed a period of low rates of inflation and low levels of short term and long term interest rates. For months the ECB’s nominal central rate has been maintained at 2 p.c., that means zero in real terms, and the level of market long term interest rates (the most important rates in the euro zone for the financing of investments by enterprises, households and government), which has fluctuated around 4 p.c., is lower than in the US. In the fiscal sphere, almost all the governments in the euro zone allowed the automatic stabilisers to take full effect during the recent slowdown, and that effect was often reinforced by discretionary measures. Between 2000 and 2003, the budgetary deficit of general government in the euro area has risen from 1.0 p.c. of GDP to 2.7 p.c. The deficits of some countries have even exceeded the ceiling of 3 p.c. Fiscal policy has thus not been an impediment to recovery. One might in fact wonder whether the stimulation of the economy intended by the fiscal easing in many countries was not eroded by the adverse impact which such a relaxation of discipline can have on the climate of confidence. It seems that people in Europe more and more have a so called “Ricardian perception” of fiscal deficits. They are more aware of the enormous challenges and costs our ageing society will entail. People in the different European countries are really worried about the long-term sustainability of public finances. High fiscal deficits will only worsen their anxiety and so incite them to increase their precautionary savings. The differences in GDP growth per capita between the US and Europe are due to differences in labor utilisation and in productivity growth.The level of labor utilisation is much lower in the euro zone. Three elements stand out. First, labor force participation rates, especially of women and the youngest and oldest age groups, are substantially lower in continental Europe: more than 10 percentage points. Second, unemployment rates are much higher: currently around 3 percentage points. Third: annual hours worked per employee are lower by more than 300 hours. Europe is of course not the US. It has its own specificities which should be taken into account. So at least part of the gap in average hours worked between the US and the euro area should be attributed to structural preferences rather than to structural rigidities. And in democratic societies people’s preferences have to be respected. However, when discussing this issue it has to be borne in mind that households also take into account the institutional environment and the system of incentives and disincentives in place, including tax, social security and pension systems when deciding on their labour supply. Moreover, the problem to what extent the present European system is sustainable cannot be ignored. The so-called European model will come under increasing pressure from demographic factors. Further policy changes towards stimulating labour supply are inevitable if living standards and social cohesion are to be preserved. Last remark on the unequal growth between Europe and the US. At a certain time Europe was able to compensate a lower utilisation of labor through a higher labor productivity - a higher production per hour - but in the last decade its lead in that field has dwindled. Since the mid-90’s there was a marked and surprising acceleration in US productivity growth. The bulk of this acceleration reflects the production and use of information technology. The take-up of new technologies has been slower in most European countries which meant that Europe did not benefit to the same degree from the productivity boost that came from the technology revolution. Over the past years, European policymakers have become more aware of this growth problem Europe is facing. So, in March 2000, during the Lisbon summit, an ambitious strategy was adopted aiming to increase the rate of sustainable economic growth and even to enable Europe to become the most competitive and dynamic knowledge-based economy in the world in 2010 (I prefer to say modestly: one of the most...). In order to achieve such a strategic goal the Lisbon agenda has brought together the different strands of reform policies on product, labour and capital markets aiming at promoting innovation and employment. Moreover, in order to facilitate monitoring of progress with reforms, quantitative targets have been set to evaluate progress in achieving for instance higher labor market participation and employment rates. The Lisbon agenda was excellent in terms of diagnosis. Until now it has however not been given a sufficiently powerful implementation. One cannot say that there was no progress in the last years in the field of structural reforms. In particular progress has been tangible in deregulating and integrating some segments of product and financial markets. But the pace of reform needs to be significantly stepped up if the Lisbon targets are to be achieved. Insufficient participation rates and high unemployment are still preoccupying and ongoing reforms on the labour market are needed not only to increase incentives for job creation but also to ensure the sustainability of the social security systems. The challenges are known and the analyses are completed. Now the implementation should be focused on. As I have said at the beginning of my speech, I am neither a eurosceptic nor a europessimist. So I believe Europe can implement the Lisbon agenda. The introduction of the euro was a splendid example of a not easy but successful structural reform. It can be and it should be followed by others. The framework through which the Lisbon agenda is implemented relies largely on a peer pressure mechanism, mainly depending on goodwill of governments in individual EU countries. The pressure must be reinforced, including by clearly identifying and publicising successful and lagging country cases. I have generally referred to average data for the twelve countries of the euro zone but we must not ignore that a country like Finland (and more generally the Nordic countries in the EU) has booked in the most recent decade performances in the field of growth and employment rates which are absolutely comparable to those of the US and are much better than those of countries like, for instance, Germany and Italy. Finally, communication must also be improved. The transition from the pre-reform to the post-reform equilibrium conditions normally takes time and we must recognise that within this period some uncertainty may occur. For this reason the implementation of social reforms requires strong leadership and a timeless explanation effort. We have to convince our public opinion that our countries would be better off - with more growth and more jobs - if we could deliver the reforms of the Lisbon agenda.
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Introductory statement by Mr Guy Quaden, Governor of the National Bank of Belgium, at a symposium on the history of the National Bank of Belgium, Brussels, 22 November 2005.
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Guy Quaden: The National Bank of Belgium - a century and a half of Belgian and European history Introductory statement by Mr Guy Quaden, Governor of the National Bank of Belgium, at a symposium on the history of the National Bank of Belgium, Brussels, 22 November 2005. * * * Ladies and Gentlemen, When Belgium celebrated its 175th anniversary, the National Bank naturally joined in. Thus, we sponsored an exhibition on “La Belgique visionnaire”, and today we are publishing a book on the history of the Bank, together with a set of detailed articles on the period 1940–1971. The history of the Bank is closely intertwined with that of the Belgian State. However, while the Kingdom of Belgium is celebrating its 175th anniversary this year, the Bank is only –might I say – celebrating its 155th birthday. During the first twenty years of Belgium’s existence, banknotes were issued by several private banks, mainly the Société Générale, founded in 1822 under the Orangist regime, and its principal rival, the Banque de Belgique, established in 1835. The financial crisis of 1848 led to the imposition of the ‘compulsory rate’ – i.e. the suspension of the right to exchange banknotes for precious metals – and paralysis of the discount credit system. At this time, a young, dynamic politician, Walthère Frère-Orban, was appointed as Minister of Finance. Drawing radical conclusions from the situation, he took action against the two big mixed banks which were monopolising financial power in the country. He forced them to amend their statutes, renouncing their right of issue together with certain discount activities in favour of a new institution, the National Bank. By way of consolation, when the National Bank was launched, the two big banks became the sole shareholders in the new company, established in the form of a private limited liability company. All the same, at the time of its establishment the National Bank was not the mere puppet of the big private banks. Thus, the Governor, the linchpin of the system, was appointed by the King and the Government also nominated a Commissioner, making the institution different from its counterparts in neighbouring countries. In return for the right of issue, the State also received a substantial part of the Bank’s revenue. The National Bank has never been quite like other financial institutions or limited companies. Minister Frère-Orban, addressing parliament in 1850, made the following statement which I have sometimes had occasion to repeat in recent years: “Que voulons-nous en instituant une Banque ? Nous voulons, non pas donner des bénéfices à des particuliers, non pas enrichir des actionnaires, mais nous instituons une banque dans l'intérêt public, dans l'intérêt général”.(What is our intention in setting up a Bank? We do not want to give profits to individuals, nor do we want to enrich shareholders; we are establishing a Bank in the public interest, in the general interest). Like the other central banks of the day, however, the Bank did combine functions in the public interest with commercial activities. The book being published today describes the long and sometimes bumpy road, leading from the issuing and discount institution created in the mid 19th century to the modern central bank which the National Bank of Belgium gradually became in the course of the 20th century. Over the years, the Bank underwent a metamorphosis, shaped by developments in the monetary and financial system, changing attitudes towards the role of government in economic life, and changes in the international context. It gradually phased out its commercial activities, becoming increasingly public in character, especially just before and just after World War II. And the Bank’s activities became international in scope. Nowadays, the National Bank of Belgium performs its functions as a modern central bank within a European context: issuing banknotes, defining and implementing monetary policy, managing the official foreign exchange reserves, overseeing the payment systems and contributing to the stability of the financial sector. The Bank has been a member of the Eurosystem ever since it was launched in 1999. The National Bank of Belgium has always been pro-European. In accordance with our country’s motto, we believe that in union there is strength. At the National Bank of Belgium we are not at all nostalgic for a monetary sovereignty which has in any case become illusory in highly integrated small and medium-sized economies. The switch to a single monetary policy, decided on by the Governing Council of the European Central Bank, has not meant any loss of monetary power for Belgium. Quite the reverse. In reality, since the day when the Government and the Bank decided, fifteen years ago, to peg the Belgian franc to the most stable European currency, Belgium was in reality already importing its monetary policy from Frankfurt. The difference is that, while our monetary policy is still decided in Frankfurt, the decisions are now taken around a table where at least one Belgian has a say. Furthermore, the Eurosystem - comprising the European Central Bank and the national central banks of the twelve countries which have so far adopted the euro - is an unprecedented structure governed by the principle of subsidiarity and having no equivalent in the world of central banks. The implementation of the monetary policy is decentralised. And, in the analysis of each country’s situation, in dealings with the financial players, and in communication with the general public, the member central banks, being closer to their own particular country, retain a supreme role. Finally, it is unusual for modern central banks to be purely central banks. They are also businesses providing services for the government, the financial world and the population in general. However, the National Bank of Belgium differs from many of its colleagues in the diversity of the public service tasks entrusted to it by the legislature. For example, in Belgium the Bank is the main centre for the collection, processing and analysis of economic data, covering both the national accounts and the financial and social balance sheets of businesses, as well as consumer credit. In view of its acknowledged expertise, its commercial neutrality, its sense of the public interest and its autonomy, further reinforced recently by the Maastricht Treaty, the Bank is regularly called upon to cater for new needs of Belgian society. In the Maastricht Treaty, the European States in fact opted for the model of a European central bank and national central banks with a high degree of independence. Under this arrangement, once the central bankers have been appointed and recognised by the political authority, they act in accordance with their own instincts and conscience, without seeking or receiving instructions, taking the decisions which they consider best suited to the attainment of the objectives assigned to them by the European treaty and by national law. Most people believe that such a system is the best way of ensuring the credibility and effectiveness of monetary policy; in particular, it makes it possible to keep risk premiums to a minimum and to maintain relatively low interest rates. But this increased autonomy also implies that we are under greater obligations, of which I am particularly well aware. First, there is the obligation to keep a closer watch than ever on the objectivity and impartiality of our analyses, decisions and recommendations. And there is the obligation to render account for our actions, to be tireless in our efforts to explain and where possible persuade, because the ultimate foundation of the independence of the central banks is not a law, nor even a treaty, but the support of the people concerned for the objectives pursued and the measures which they devise. Similarly, I am also glad that the Bank’s Council of Regency has been retained, even if it has finally lost all monetary power. It provides an irreplaceable opportunity for dialogue between the officials of the central bank and the experts representing Belgian society in general. The Bank gave responsibility for the publications being presented today not only to some of its own staff, but also to teams of experienced economists and historians: that is, in its own way, a further illustration of our desire for objectivity and neutrality. I would like to express our thanks to the various authors. I would also like to express my gratitude and that of my colleagues to our predecessors at the head of the National Bank of Belgium. Like any human endeavour, the history of the Bank is certainly not without its imperfections. But overall, that history has been distinguished and fruitful. The Bank has made a significant contribution to the economic development and financial stability of Belgium. It has also always been a steadfast supporter of international monetary cooperation, and particularly of European monetary unification. In the new context created not only by the changeover to the euro, but also by the spread of the new technologies and the concentration taking place in the commercial financial sector, we are striving to fulfil our aim of being a modern central bank, increasingly capable of meeting the expectations of Belgian society and taking our place on the European and international stage. Ladies and gentlemen, As I said on the occasion of the celebrations marking the Bank’s 150th anniversary in 2000: we are proud of the Bank’s past and we are ambitious for its future.
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Introductory speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Ordinary General Meeting of the National Bank of Belgium, Brussels, 27 March 2006.
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Guy Quaden: Review of significant events in 2005 Introductory speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Ordinary General Meeting of the National Bank of Belgium, Brussels, 27 March 2006. * * * Ladies and Gentlemen, I would like to welcome you, both personally and on behalf of my colleagues on the Board of Directors, on the occasion of this ordinary general meeting of the shareholders of the National Bank of Belgium. I also hope that this meeting can proceed smoothly and enable us to answer, in a calmer atmosphere than last year, the questions which you have submitted to us and any others that you raise. We want to answer as many questions as possible, but reasonably quickly and in an orderly way. In particular, this meeting is not the place to answer questions concerning the legal actions which are still pending before the courts, nor questions which do not concern the past financial year. As last year, I would like to give you a brief account of the most significant events in the year under review, before handing over to the Vice-Governor who will present and comment on the annual accounts for 2005. Various new projects entrusted to the Bank by the public authorities and the economic agents in general bear witness to the confidence which Belgian society as a whole continues to place in our institution. The principal project concerns the future of the means of payment. In 2004, the Ministers of Finance, Economic Affairs and Consumer Protection commissioned the Bank to organise a national dialogue on the efficiency of the payment systems in Belgium. To that end, the Bank set up a Steering Committee on the future of the means of payment, with representatives from all the parties concerned. In 2005, that Steering Committee published two reports: the first concerns the costs, advantages and disadvantages of the various means of payment, and the second deals with the modernisation of the payment channels used by the public authorities. This Steering Committee has yet to address the question of the transition to the Single Euro Payments Area, in which the payment systems of various countries will be integrated, augmenting the efficiency of cross-border payments. The establishment of synergies between the Bank and the CBFA, provided for by the law of 2 August 2002 on the supervision of the financial sector and on financial services, has continued, particularly in regard to financial stability, IT systems and crisis management. However, the only way of fulfilling the ultimate goal of the reform is by fostering still closer links and the spirit of cooperation, with due respect for the powers of each institution and the specific character of their respective areas of activity. For our institution, the year 2004 had featured a new strategic review of the future of its activities. In 2005, that review led to the adoption of master plans which define the future pattern of activities and employment at the Bank. Those plans provide a stable medium-term framework up to the year 2009. For the Bank, it is a question of working within the Eurosystem, adopting a more selective approach with increasing specialisation, maintaining cost control and continuing to improve the quality of the services provided for the community. *** The progress of the various activities in 2005 is set out in the annual report which has been sent to you and which is also available on our website. In addition, that document contains the annual accounts for the year and describes the governance of our enterprise. A number of questions have been sent to us by shareholders, particularly by the Deminor company, on the subject of the Bank’s corporate governance statement. Why does it not conform to the Lippens code when the Bank is a listed company, and why does it not explain, for each of the code’s provisions, the reasons for not conforming to it? First, it must be remembered that the special legal framework governing our institution and its specific position as a central bank mean that we cannot systematically compare its governance with the “Lippens Code” recommendations. The Belgian corporate governance code, which supplements the ordinary legislation on listed companies, itself affirms the code’s character as a recommendation. It cannot replace the existing laws and treaties, particularly those applicable to the Bank. The Bank is in fact governed first by the provisions of the Maastricht Treaty, and then by its Organic Law and its own Statutes, and finally – on a purely additional basis – by the companies code. The Bank is therefore not subject to the same legal rules as other public limited liability companies. Furthermore, the Lippens code is inappropriate to the special characteristics of the Bank, a company which – unlike other listed companies - does not aim primarily to maximise its profit, but which, in accordance with the Treaty and the law, promotes monetary and financial stability in the public interest. It is the dominance of the public interest that caused the legislature to determine the composition and powers of the Bank’s organs. These are different from those of the companies addressed by the Belgian governance code. While the organs of conventional companies are the administrative board, the general meeting and, perhaps the management board or chief executive, the organs of the Bank are the Governor, the Board of Directors, the Council of Regency and the Board of Censors. The special arrangements for the appointment of the members of these organs, the specific composition and role of the Council of Regency, and the provisions for the exercise of supervision are all examples of the way in which the dominance of the public interest is reflected in the Bank’s special governance structure. This is also the explanation for the quite specific role of the Belgian State, which is involved both as a shareholder and as a sovereign State. It is because it acts primarily as a sovereign State that it granted the Bank the right of issue and has a priority right to the resulting profits. However, the National Bank has always been scrupulous in ensuring compliance with the ethical principles and values underlying the Belgian corporate governance code. It can be said that the system of governance and control imposed on us is just as exacting as that recommended by the Belgian corporate governance code, and in some respects even more so. In fact, as a member of the European System of Central Banks, the Bank is subject to special rules and obligations which do not apply to any other Belgian companies. Moreover, I feel that there are few companies which publish such detailed information as that contained in Part 2 of the Bank’s annual report, which you have all received and which is available on the Bank’s website. That demonstrates our desire to act correctly in providing all possible information for the public, and more particularly for our shareholders, on the operation of our institution. *** As in 2003 and 2004, the judgments handed down in 2005 and early 2006 following the legal actions brought by certain shareholders found in favour of the Bank. Thus, on 27 October 2005, the Brussels Commercial Court confirmed, as the Court of Arbitration had already done in 2003, that the Bank has not lost its right of issue and that it therefore does not have to liquidate its reserve fund. Since the start of monetary union, the Bank has in fact shared the right to issue euro banknotes with the European Central Bank and the eleven other national central banks of the Eurosystem. A second judgment passed on 2 February 2006, again by the Brussels Commercial Court, concerned a write-back from the provision for future foreign exchange losses, effected at the end of the 2003 financial year and intended to adjust the amount of the provision in line with the change in the currency risk. The amount of that write-back was included in the Bank’s financial income shared between the Bank and the State. The Brussels Commercial Court rejected the demand made by certain shareholders to cancel that decision, and confirmed that the annual accounts for 2003 were perfectly legal. In helping to clarify the status of our institution and shed light on its special characteristics, these court decisions should put an end to certain arguments and reduce the fluctuations in the Bank’s share price. In the foreword to the Annual Report, when I mention unjustified speculation concerning these shares, I mean that these fluctuations originated because of legal arguments which we consider to be incorrect, and which the judgments so far have also refuted. *** In 2005, the Bank’s profits improved, mainly as a result of the increase in the amount of euro banknotes in circulation (+15 p.c.), and hence the increase in the Bank’s share of that issue. This expanded the volume of interest-earning assets held as the counterpart to the banknotes, and therefore increased the income which these assets generate. Moreover, the Bank earned a higher rate of interest on its dollar investments and did not have to constitute provisions, as it did in 2004, to cover losses incurred by the ECB. The improvement in the return on the assets meant that the State was once again able to receive seigniorage income. It is in return for the right of issue which the State has granted the Bank that the State is entitled to the part of the income from the net interest-earning assets which exceeds 3 p.c. of those assets. The dividend paid to shareholders is, as usual, increasing in line with inflation. Thank you for your attention. I will now hand you over to the Vice-Governor for the detailed presentation of the annual accounts for 2005; it is the accounts that constitute the most important information for the general meeting and which have, as in previous years, given rise to the largest number of questions from shareholders.
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Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the fourth biennial colloquium of the National Bank of Belgium, Brussels, 12 October 2006.
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Guy Quaden: Price and wage rigidities in an open economy Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the fourth biennial colloquium of the National Bank of Belgium, Brussels, 12 October 2006. * * * It is a great pleasure for me to open the fourth biennial colloquium of the National Bank of Belgium and to welcome you all at this conference. The topic of this year's conference is "Price and Wage Rigidities in an Open Economy". Understanding how prices and wages are determined and how they fluctuate over the business cycle is of course a crucial issue for central banks. Nominal and real rigidities in price and wage setting have a strong impact on how the economy, and inflation in particular, reacts to all kinds of shocks. As far as these rigidities result in deviations of prices from their efficient levels, they will lead to an inefficient allocation of resources and unnecessary volatility in output and employment. Especially in a global context, with a rapidly changing external environment, flexible prices and wages can protect the economy against costly real adjustments and improve its resilience. That is the very reason why we are interested in measuring these rigidities, in understanding their nature and in assessing their welfare implications. This knowledge may eventually result in formulating deliberate policy recommendations for structural reforms in view of reducing rigidities in price and wage setting, to the extent that this is desirable from a welfare perspective. However, as far as these rigidities are deeply rooted, monetary policymakers are faced with them as part of the environment in which they operate. Price and wage rigidities have indeed a strong impact on the monetary transmission mechanism. They also affect the way central banks will combine their pursuit of price stability with a more general concern about real economic developments and the policy trade-offs involved. The importance of these issues induced the National Bank of Belgium to devote its 4th biennial colloquium to "Price and Wage Rigidities in an Open Economy". The aim of this conference is to promote theoretical and empirical research, both at the micro and the macro level, on the measurement, the rationale and the consequences of price and wage rigidities in an open economy. By way of an introduction to the conference, I would like to underline the policy relevance of many of the topics that will be discussed in the presentations today and tomorrow. In order to evaluate the relevance of the different types of rigidities, it is first of all important to document the stylised facts of price and wage setting at the micro, the sectoral and the macro level. Recently, there has been an increased research interest in studying price and wage setting at the very micro level, for instance within the scope of the Eurosystem Inflation Persistence Network and the International Wage Flexibility Project. The studies produced in these research networks constitute important contributions to our understanding of price and wage rigidities and I myself was impressed when Frank Smets presented the findings of the Inflation Persistence Network in a seminar for the Governing Council of the ECB. Frank Smets will give a similar presentation here. I am also pleased that tomorrow morning Bill Dickens from The Brookings Institute will present the results of the International Wage Flexibility Project. In addition, some other papers will provide us with new material based on micro-economic datasets of prices and wages. Besides measuring the degree of price and wage rigidities, it is also important to understand their economic rationale. Nominal adjustment costs constitute the simplest argument to explain price and wage rigidities. However, constraints on price and wage changes may also assume a much more complicated form. Pricing decisions can be influenced by arguments that are derived from strategic interactions with competitors or with customers. Wage flexibility can be restricted by the existence of collective agreements, that avoid costly individual and frequent wage negotiations, by the existence of search costs or by the impact of wages on the employee-employer relation in terms of motivation or perception of fairness. Price and wage arrangements might also reflect distributive motives to guarantee a stable income flow to firms or households, as capital market imperfections may constrain their ability to smooth their revenue. Therefore, understanding the rationale behind the different forms of rigidities is of particular importance for analysing their welfare implications, for assessing the scope to address them with structural reforms and, finally, to derive their implications for monetary policy. Understanding how prices and wages are set at the firm level is also a prerequisite for understanding the behaviour of the aggregate price and wage level over the business cycle and to see how they react to different types of shocks. Nominal rigidities in price and wage setting also imply that monetary policy, and nominal demand fluctuations in general, have an impact on economic activity. Knowledge about price and wage setting is therefore fundamental to understand both the monetary policy transmission process and the potential trade-offs monetary policy may be faced with. These trade-offs come up in the debate on the optimal rate of steady state inflation, in which it is emphasised that inflation has both so-called "grease" effects, essentially because it makes the economy more flexible - particularly in the presence of specific downward rigidities -, and so-called "sand" effects, which are mainly due to the fact that inflation leads to more adjustment costs and to excess relative price and wage variability which distorts allocative decisions. The "sand" argument stresses that the existence of nominal rigidities is an important element explaining why inflation is costly and why central banks should maintain price stability. However, central banks also acknowledge the "grease" argument as they typically define price stability as a moderately positive inflation rate. Weighing both arguments was one of the reasons why the Governing Council of the ECB in May 2003 specified that, in the euro area, price stability is to be seen as an annual increase in the area-wide HICP below, but close to 2 % in the medium term. Moreover, monetary policy may be faced with a short-run trade-off between inflation stabilisation around the target value and output stabilisation. Some contributions during the conference, for instance the keynote presentation which Jordi Galà will give this afternoon, address these issues in theoretical models. It is however obvious that this topic is also relevant for the actual conduct of monetary policy. Indeed, as in recent years we have been faced with a rather unusual clustering of shocks of the cost-push type with an upward impact on inflation in the euro area, the medium-term orientation of the monetary policy framework of the Eurosystem induced us to accommodate their first round effects on inflation and to focus on avoiding their having second-round effects in price and wage setting. Thus, the flexibility explicitly embedded in the medium term orientation of our monetary policy framework allowed us to take care, insofar as possible, of stabilising output developments, while the mere fact of having a well-specified strategy with a quantified definition of price stability helped us to anchor inflation expectations. Another relevant question being raised is how price and wage rigidities are affected by the ongoing process of globalisation. The keynote presentation of Andrew Scott in tomorrow afternoon's session for instance focuses on how relative prices and mark-ups are influenced by trade integration. Ongoing globalisation is indeed expected to strengthen competition and to reduce mark-ups in goods and labour markets. In conjunction with other structural changes resulting from reform efforts, this should lead to a higher steady state output and employment level, and to the extent that these structural changes actually take place, monetary policy can and should accommodate this increase in potential output. This globalisation process had also an impact on inflation, and if it is a gradual and ongoing phenomenon, inflation may be affected over a fairly long period of time by a succession of impulses which, taken individually, are generally short-lived. Coping with these developments is another important challenge for monetary policy. Many of these topics are discussed in detail in the twelve papers that will be presented during this conference. The papers are grouped in four sessions. Each session starts with a keynote lecture by an internationally distinguished researcher. Seven papers are the result of the research effort of Belgian academic teams, some of which were carried out in collaboration with our own researchers or with international experts. A selected group of outstanding economists will act as discussants of these research papers. Their comments will be the start of a discussion I would like all of you to participate in. I hope that this conference, by offering central bankers and academic researchers the opportunity to exchange ideas, will contribute to our understanding of price and wage dynamics, and improve further economic analysis on which our policy decisions are finally based. I should like to thank all researchers who contributed a paper to this conference, the discussants for their efforts to stimulate the discussion, as well as all participants in the conference. I hope you will spend two rewarding and pleasant days at the National Bank of Belgium and I am looking forward to learn at some point in time about the outcome of your research efforts and the discussions held in the course of this conference.
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Exposé by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Central Bank of Luxembourg, Luxembourg, 12 January 2007.
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Guy Quaden: Structural reforms in Europe – harmonisation or decentralisation? Exposé by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Central Bank of Luxembourg, Luxembourg, 12 January 2007. * * * I would like to thank my colleague Governor Mersch for giving me the opportunity to address this assembly, where I recognise a good many Luxembourg, Belgian and fellow European friends. They immediately bring to mind the close relations between our two countries, including close links on the monetary front for more than 80 years. I am pleased to see that these links have not been broken down within the wider European monetary union, which Luxembourg and Belgium have belonged to since 1999 and which expanded to 13 countries just a few days ago. The theme of our discussion is obviously something that is at the heart of my preoccupations, and for several reasons. Firstly, as an economist, understanding how the economy works and proposing ways of improving it, through structural reform, is almost a raison d'être. Then, as a central banker, along with my colleagues in the ECB Governing Council, I put out a reminder of the need for structural reform each month, in the explanation of our monetary policy decisions. What might sound like the monetary authorities singing the same old song to politicians at little cost does in fact reflect the importance of the two-way interaction between monetary policy and structural reform. On the one hand, by ensuring price stability in the medium term and making sure that inflation expectations are well anchored, monetary policy helps foster a macroeconomic environment that is more stable and therefore conducive to more growth and employment. The current low level of longterm interest rates is without a doubt largely attributable to the credibility earned through monetary policy. This achievement needs to be preserved; not least because it helps make structural reforms easier to implement. On the other side of the coin, by improving the economy’s capacity to adapt and raising the growth potential, structural reforms facilitate monetary policy-making. Therefore, my colleagues and I welcome the efforts that have already been made in areas where the benefits are only reaped in the long term, while political considerations tend to be rather short-term. And lastly, as both a Belgian and European citizen, it seems quite legitimate to aspire to a society organised in such a way that everyone can put their talents to good use, be rewarded for their efforts, but also give and take a sufficient dose of solidarity, and live in a quality environment. Indeed, the overall objective of structural reform must be to raise the standard of living in a sustainable way for each of us today, and for generations to come. I believe that the diagnosis for the European economy is already well known. Labour force mobilisation is relatively weak in Europe - and this has certainly proved to be the case in Belgium - while productivity gains have slowed down, despite remarkable scientific and technological progress. In the light of these observations, there has been a consensus for several years now - under the influence of work carried out notably by the IMF, the OECD and the European Commission - on the need to stimulate labour market participation, reinforce the quality of the labour force, improve the functioning of markets in goods and services, including financial services, and step up the innovation effort. This strategy was endorsed by the governments of the European Union Member States at the March 2000 European Council in Lisbon. I think we have to acknowledge that progress has been made, albeit at varying speeds from one country to another, but that there is also still a long way to go. European economies today are faced with many challenges. I am of course thinking of globalisation of the economy, demographic shifts and climate change. The current improvement in the economic climate must not be used as an excuse for postponing reforms; on the contrary, it should be seen as an opportunity to put them into practice with even greater resolve. My exposé will obviously not cover the whole issue of structural reform. Owing to time constraints, I will not go into nonetheless important topics like education and innovation. In line with what has been suggested, I would like to illustrate the subject of reform with some concrete examples drawn from my country’s experience and pointing up encouraging progress, even though it is often still not enough. *** First and foremost, in Belgium’s case, reforms were carried out in areas where they were deemed most urgent. Significant progress has been made towards improving the country’s public finance situation, which had become unsustainable in the 1980s, and with wage-setting, taking account of the need to remain sufficiently competitive, because Belgium has such an open economy. Apart from these characteristics that are peculiar to the Belgian economy, reforms have also been started in the field of pensions and employment of the older age bands of the population. 1. On the public finance front, the results so far are quite satisfactory. Belgium brought down its budget deficit from 8 p.c. of GDP in 1992 to less than 3 p.c. in 1997, which was one of the conditions for joining the monetary union. With the exception of 2005, a year for which Eurostat considers that the government’s takeover of a public enterprise’s debt should be accounted for as non-recurring expenditure, public sector accounts have been in balance since the year 2000. Of course, a central banker must never let complacency creep in. So I make no secret of the fact that these results have been helped along a little by low interest rates, one-off revenues and, more recently, a favourable economic situation. On the other hand, I urge even greater ambition. For, in order to meet the cost to the budget of population ageing in the coming decades (healthcare, pensions, etc.), it is structural surpluses we should be showing as soon as possible. Even if it is advisable to further speed up the trend, the debt ratio, which reached a peak of 133.5 p.c. of GDP in 1993, has nonetheless been on a continual downward path since then and dropped below the 90 p.c. mark in 2006. The return to a sustainable long-term budgetary policy has been made possible thanks to credible commitments, based on the opinions of independent institutions. EU constraints and peer pressure have certainly served as an incentive, especially in the form of the multilateral surveillance system laid down by the Maastricht Treaty and then by the Stability and Growth Pact. European budgetary standards have been a powerful disciplinary tool in preparing for Economic and Monetary Union membership. They remain effective in that respect. They have also played a big part in persuading the public to accept the need for the adjustment process. To prepare the ground for its work on the budget, the Belgian government draws widely on the expertise and advice of independent national bodies. On the one hand, it has entrusted the National Accounts Institute with the task of preparing the macroeconomic forecasts which, in principle, serve as the basis for drawing up public budgets. On some occasions, the government has chosen to add a safety margin to these forecasts. Conversely, credibility factors effectively prevent it from taking into consideration a more favourable macroeconomic scenario than that published by the National Accounts Institute. In addition, and again acting independently, the High Council of Finance, in whose work the National Bank is involved, draws up recommendations for the course of the public sector borrowing requirement. These targets – certainly ambitious, but realistic all the same - have formed the basis for successive governments’ budget plans. These recommendations go even further than strict respect for EU rules, since they take into account future requirements stemming from the ageing population. Moreover, the High Council of Finance, which also comprises experts appointed by the Communities and Regions, contributes to ensuring the necessary coordination between the various levels of power that make up the country’s system of government. It effectively transposes the general objectives for all the public authorities into specific recommendations for each entity. These are given a formal setting in cooperation agreements between the federal government and the communities and regions, a sort of internal stability pact. We could look at it as an example of good practice. Besides, the beneficial role of the NAI and the High Council of Finance in preparing the ground for consolidation of public finances is acknowledged in recent IMF and EC publications. 2. Unlike the budgetary procedures, the automatic wage-indexation mechanism used in Belgium meets with almost unanimous disapproval by the international institutions, because of the nominal rigidities it risks causing. Along with Luxembourg, Belgium is certainly in good company here, but we are quite isolated among the European countries, even if several of them have partial indexation systems. Are Belgium and Luxembourg right to go it alone or not ? In my view, in the Belgian case the question calls for a carefully weighed-up response. The wage-indexation mechanism has been around for a long time in Belgium. The first collective agreements on the subject were concluded as early as 1920, notably in the mining industry, and, after a wage freeze during the second world war, they were widely reinstated at the end of it. The wage-indexation mechanism has become an essential element of a wide social consensus, but at one time, it also risked undermining business competitiveness. Index-linking was also temporarily suspended following the devaluation of the Belgian franc in 1982. The need to keep a competitive edge led to a thorough reform in 1994. The government laid down a new requirement for the so-called health index to be used as a reference for indexation rather than the general consumer price index. A number of products like tobacco, alcoholic drinks, petrol and diesel are not taken into account in calculating the health index. In this way, any increase in taxes and excise duties on these products, especially tobacco and petrol, is no longer passed onto wages and prices and, on the other hand, second-round effects on wages from a sharp rise in oil prices are limited. This goes a long way towards explaining why, unlike what happened during the 1973 and 1979 oil crises, nominal wages have not been caught up in an inflationary spiral in recent years. No doubt driven on by the same desire for competitiveness, but also by the need to rein in public finances and inflation, I understand that the Luxembourg government also decided in spring 2006, after negotiating with the social partners in the tripartite coordination committee, to adjust the automatic indexation mechanism until 2009, by delaying the point in time when wages are indexed. And it decided to neutralise certain taxes, excise duties, fees and other contributions in the reference index for index-linking. While the indexation system, after being thoroughly reformed, remains an acquired right for both employees and for recipients of social benefits, the total development in private-sector wages has also been controlled since 1996 by the wage norm-another distinctive feature of the Belgian system. This indicative norm is set every two years by the social partners (employers and trade unions) in line with the expected evolution of hourly labour costs in the three main neighbouring countries (Germany, France and the Netherlands). It builds into the wage-formation process an explicit reference to the external situation and thus the competitiveness of the economy. It is a strong coordinating tool for negotiations at sectoral level. Among these sectors, the so-called "all-in" agreements, introducing a corrective mechanism in the event of higher indexation than anticipated during the negotiations, have mushroomed. All in all, I would say that if we didn’t have wage indexation, we wouldn’t have to invent it. But, taking account of the built-in control features, now keeping it within limits, indexation in Belgium is not - or to be more precise, is no longer - the bugbear still decried by so many international institutions. 3. On the other hand, I wholeheartedly share these same international institutions’ opinion on the need to raise the rate of employment in Belgium. At just 61 p.c. of the population aged between 15 and 64, Belgium’s employment rate is still noticeably lower than the average in Europe, not to mention other parts of the world. The boost it needs concerns, in particular, those groups that are under-represented on the labour market – young people, women, people of foreign origin and especially the relatively older groups of the potentially-working population. Raising the rate of employment among the over-55s is essential both to guarantee the financial viability of the legal pension system and to reinforce the economy’s medium- and long-term growth potential. Quite paradoxically, the low rate of employment can be regarded as a pool of unused potential. However, tapping this potential is proving particularly difficult because the reforms we need to implement in this field frequently come up against strong resistance, from workers and employers alike. Action along these lines has already been taken in Belgium. As early as 1996, the federal government got down to tackling a major reform of the pensions regime for employees and the self-employed, by gradually raising the statutory retirement age for women, from 60 years at the beginning of 1997 to 65 on 1 January 2009. By then, it will be the same as the legal retirement age for men, which is helping to bring down the cost of population ageing. More women staying on in the labour force has also helped push up the employment rate among 55 to 64 year-olds, a rate which rose from 26 p.c. in 2000 to 32 p.c. in 2005, even though this is still very low. The exemption from seeking work granted to older unemployed people provided an important opening for early retirement from the labour market. The age limit for this exemption, which was set at 50 years until 2002, has been raised gradually to reach 58 in mid-2004. In 2005, the government launched another big reform whose main objective is to raise the employment rate among older people, above all by boosting the labour supply. It is known as the Solidarity Pact between the generations. The most significant measures concerned early retirement. This scheme has been used a lot from the end of the 1970s onwards, initially along with business restructuring efforts, but it quickly became widespread. At one time, the early retirement age was brought down to 55, and even to 50 in companies in difficulty or undergoing restructuring. These conditions have become unsustainable now that people are living longer and the population is ageing. The Pact brings the statutory early retirement age up to 60 years from 2008 onwards, with a seniority condition which will be gradually raised to 35 years. Various measures have also been taken to limit the use of early retirement schemes in the event of mass redundancies, notably by giving priority to active employment policies through outplacement and training. An employment cell must now be systematically set up in such cases. Moreover, the Pact has also established a framework to encourage people reaching the end of their career to keep their job or return to work. Financial incentives have therefore been introduced, including a new bonus system granting a pension supplement for people continuing to work after the age of 62. This should push up the actual retirement age itself. The Pact bears witness to an awareness and brings in an indispensable change of trend. According to the work done by the Study Group on Ageing set up within the High Council of Finance, it is a significant stage in the process, but still not enough in itself to bring the employment rate in Belgium up to a satisfactory level. *** Before summing up, I just have to say a few words about the question posed by the organisers of this debate to each of the contributors, namely, which is the best method: harmonisation or decentralisation? Do these few selected examples of measures taken in Belgium enable us to draw some lessons about the best strategy for continuing and speeding up implementation of the structural reform so badly needed by European economies ? First of all, I would point out that this reform applies to existing situations which differ radically from one country to another, even from one region to another. These specific characteristics, which can range from the institutional set-up to the labour relations and social security system, the structure of the economy or even the preferences of the various parties involved, must be taken into account when drawing up appropriate measures, likely to get sufficient backing from society at large. Faced with these arguments in favour of decentralisation, we should not overlook the importance of the common approach developed at European level, in the context of the Lisbon strategy. Its contribution has been primordial in making structural reform a subject of national debate. The use of benchmarking and promoting "best practice" also come into this awareness-raising effort at national level. Furthermore, the European dimension helps reap the benefits of positive externalites factors stemming from close coordination of reform measures between countries, and helps keep the risk of possible "beggar-my-neighbour” policies to a minimum. In the updated Lisbon strategy that they endorsed in 2005, the Member States and the EU authorities have put together a useful combination of a common and decentralised approach. The broad lines are drawn up at European level while the Member States are now given more responsibility in implementing reform measures. Individual Member States mainly have their say by adopting National Reform Programmes, setting out government action in the fields of public finance, employment, the functioning of product and labour markets and promoting innovation. This joint process enables the European Union to take advantage of the positive interaction between structural policies. In the EU countries, notably in Belgium, drawing up these National Reform Programmes and implementing the reforms effectively requires close cooperation between the different levels of government (regional, national, European), as well as between public authorities and other stakeholders, and here I’m thinking particularly of the social partners, the academic world and society at large. Within this framework, the national central banks also have a key role to play. One the one hand, they must back up the political decision-makers and the social partners by providing their macroeconomic and financial expertise. On the other hand, they have to keep the public informed of the grounds for and the need for the structural reforms. Ladies and gentlemen, The structural economic reform train in Europe is certainly on track. It now just needs a strong push, so that every citizen can enjoy a higher level of employment and well-being tomorrow.
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Exposé by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Eurosystem seminar with the central banks of West and Central Africa, jointly organised by the Bank of France and the European Central Bank, Paris, 1 February 2007.
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Guy Quaden: Regional economic integration and monetary cooperation (in Europe and Africa) Exposé by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Eurosystem seminar with the central banks of West and Central Africa, jointly organised by the Bank of France and the European Central Bank, Paris, 1 February 2007. * * * Dear colleagues, Chairman Trichet and Governor Noyer have asked me to introduce the session of our seminar devoted to "Regional economic integration and monetary cooperation". It is both an honour and a pleasure for me. In my presentation, I would like to talk to you about the subject that I know best, one in which I obviously have a comparative advantage, and that is Economic and Monetary Union in Europe (EMU). So, I will recap on why and how the euro was introduced and what are the main problems with European monetary union in practice. Drawing on this European experience, I will then broaden the perspective to Africa, under the supervision of our friends and colleagues from over there. I. EMU: a single and stable currency EMU comprises two separate, but complementary, elements: a single currency and a stable currency. These correspond to the two, interrelated, objectives of EMU: efficiency and stability. EMU is, in the first instance, a culmination of the Single Market. Monetary union implies that some exchange rates no longer exist, as for instance the rate of the Belgian franc against the German mark or the Italian lira. In the past, the volatility of these exchange rates has been most harmful to our economies and the functioning of a Single Market. With the introduction of the euro, this form of intraEuropean monetary instability has been entirely wiped out once and for all. The single currency is a major step forward in terms of efficiency, resulting in lower transaction costs, more price transparency and a financial market operating in a more integrated way. All those elements favour a more efficient allocation of resources, thereby allowing a better functioning and a deepening of the European Single Market and more dynamic economic growth. The introduction of the euro and the new monetary policy have had important consequences for the financial markets in particular. A thorough integration process has taken place in the whole euro area. This integration is most evident on the money markets, especially on the interbank market. On that level, one may really refer to a single European market, the direct outcome of the common monetary policy. The integration of the money market and the disappearance of exchange rate risks have also provided a great boost to integration of the other financial markets. The Maastricht Treaty also ushered in a new framework for macroeconomic policy in Europe, aiming at stability through both a single monetary policy and coordination of other economic policies. Significantly, the Maastricht Treaty also laid down guiding principles for the conduct of economic policies, thereby elevating the goals of “stable prices and sound public finances”, as well as the “principle of an open market economy with free competition” to constitutional status. Monetary policy plays a crucial role. The institutional foundations on which the ECB has been built are very sound. The Maastricht Treaty has made it one of the most independent central banks in the world. In this way, political pressures can be avoided and European citizens can be assured the central bank's mandate of price stability will be pursued from a long-term euro-area-wide perspective. The Maastricht Treaty leaves, in principle, the other elements of economic policy in the hands of the Member States as a matter of national responsibility. This has led to an "asymmetric" economic policy framework. This asymmetry reflects the limits of the Member States’ willingness to hand over their national sovereignty in the area of economic policy-making. However, it is also a reflection of the subsidiarity principle, a fundamental constitutional principle of the European Union. But the subsidiarity principle also has an economic rationale, namely that the delegation of policy responsibilities to a higher level is only justified if the Community is better placed to carry them out. Applied to economic policy-making in the euro area, the subsidiarity principle therefore implies that monetary policy, by its very nature an indivisible whole, is not suitable to be left decentralised. The same logic of centralisation also holds true for the Single Market’s regulatory framework. By contrast, fiscal, structural and employment policies have remained largely national prerogatives. II. Why was Europe’s attempt at EMU successful? European integration is to a large degree a political process, which has its roots in the two world wars and the devastation they caused. The Second World War proved to be a real trauma for Europe's political leaders. The Schuman Declaration of May 1950, which laid the foundations for the European Coal and Steel Community, stated clearly that "solidarity in production will make it plain that any war between France and Germany becomes not merely unthinkable, but materially impossible". So, the memory of the two wars made for a very strong political will to further European integration. At its heart was a process of Franco-German reconciliation and cooperation. So, although the start of the European integration process dates back to the years after World War II, the first official attempt to set up an economic and monetary union was not made until 1970, when the so-called Werner Report (commissioned by the European Council) outlined the main features of EMU and the road to its achievement. However, due to strong turmoil in the international economy (the collapse of the Bretton Woods system and the oil crisis) and the absence of both policy coordination and political will, this first attempt at monetary union proved unsuccessful. It was not until the end of the 1970s that the monetary integration process resumed, more specifically with the establishment of the European Monetary System. Despite considerable difficulties, especially during the first years, the EMS contributed to a broadening of the "acquis communautaire", on the basis of which a genuine project for monetary union could be set in motion. This new initiative was based on the "Delors Report", again commissioned by the European Council, which came up with a blueprint for an economic and monetary union in Europe and specified the successive stages through which it would have to go. Further negotiations resulted in the Treaty of Maastricht, which, despite the serious problems in the EMS during the years 1992-93, finally led to the launch of EMU in 1999. The EMS crises in 1992 and 1993 could have been fatal for the EMU project and served to show that EMU was not inevitable. However, the crises also underlined the political will of Europe's leaders and showed that they were ready to adopt difficult measures in order to move on to Economic and Monetary Union. Apart from an ever-stronger underlying political will, two long-term structural factors which prepared the way for the key decisions on EMU can be singled out, namely, an increasing degree of economic integration and a growing consensus on macroeconomic policy objectives. Economic integration in Europe has advanced enormously over the last few decades. Trade interdependence has increased. With growing financial integration in Europe and more foreign direct investment flows, income from wealth has also become more internationally diversified. Economic linkages between the European countries have therefore grown much stronger. This interdependence has pushed up the costs linked to the use of national currencies in a Single Market in terms of conversion costs as well as costs of hedging against risks of appreciation or depreciation. Economic thinking also developed profoundly between the 1970s and the 1990s. At the beginning of the 1970s, what we called Keynesianism was still very influential among economic policy-makers in the European Community. The "Monetarist counter-revolution" shook it up completely. The Phillips curve and the economic policy trade-offs it appeared to allow were called into question. Above all, it was the stagflation of the 1970s that further indicated the limits of activist policies. The monetary and fiscal expansionary policy adopted in several countries led to an upsurge in inflation and in public debt with no sizeable effect on the level of employment. Gradually, a new consensus developed which moved away from active demand-management policies towards a more medium-term orientation, emphasising structural, supply-side-oriented policies. A core ingredient of the new strategy was that monetary policy should be conducted by an independent central bank and geared towards price stability. III. Does EMU need a political union? I would now like to turn to two questions which, for some outside observers, constitute just as many objections to European monetary union: - is a monetary union conceivable and can it be stable without a political union between the countries concerned? - can a single monetary policy be appropriate for a group of countries whose individual economic performance, especially on the growth front, remains heterogeneous. Today, there are still some States in the world that don’t have their own currency (because they use a currency – like the US dollar or the euro for instance – issued by other countries), but there is only one currency (and by no means an insignificant one because it is the world’s second most important) that is not linked to any specific state structure – and that is the euro. In Europe, it all started with economic integration. Monetary integration followed later, at least for 13 countries. Political integration is still lagging behind. Neither the European Commission nor the Council of Ministers constitute a genuine government for the EU or the euro area. Back in the 1980s, the most widely-held view was that monetary union should go hand in hand with political union. But, at the beginning of the 1990s, a number of European leaders cashed in on the exceptional momentum triggered by the fall of the Berlin Wall to push ahead with this monetary unification plan without waiting for similar progress to be made on the political unification front. Nevertheless, launching monetary union was in itself a political decision of the utmost importance since it meant transferring an essential part of national sovereignty – the monetary policy – to a supranational authority. After that, and despite the lack of a European State, the euro rapidly gained recognition as a credible currency for what I think are two basic reasons. On the one hand, the ECB and the Eurosystem, in charge of euro-zone monetary policy, have a clear mandate: price stability. On the other hand, their leaders are totally independent. They can neither receive nor ask for instructions from any outside interests, especially national governments. They must protect the sole collective interest of the zone as a whole. The monetary policy decision-making process has not only been centralised but also depoliticised. That said, there is no denying a certain lack of symmetry in the current structure of EMU, the relative weakness of the politico-economic pillar vis-à-vis the monetary pillar. Unlike monetary policy, fiscal policy remains in the hands of national States. Up to a certain point – which I have already mentioned – this situation corresponds to the principle of subsidiarity. However, we have to prevent inadequate national policies from causing any damage for the other partners and, in particular, for the common good that the euro enshrines. This is why the budgetary rules or constraints that make up the Stability and Growth Pact were defined. As we all know, the provisions of the Pact have not been fully respected. But they have constantly exerted a certain amount of pressure on States that have flouted the rules and it is to be hoped that the revised version of the Pact will be applied more rigorously. We also know that the Finance Ministers of the euro-area member countries meet regularly within the Eurogroup. Some politicians talk about wanting to transform this group into Europe’s economic government. From a personal point of view, I don’t see any objection to this, quite the contrary. But, if the objective – stated or not – of such a rise in power were to reduce the independence of the central bank, then it would be a really bad thing. However, the risk is very slight as this principle of independence is set in stone in the Treaty. I would add that the lack of visibility and substance of the political axis and the European Central Bank’s “institutional loneliness” all too often, and quite unfairly, make the ECB an escape goat for everything that is going wrong in Europe. After all, the examples of Germany yesterday or the United States today just go to show that you can have a strong political power and a strong central bank at one and the same time. IV. Is heterogeneity a cause for concern? In reality, the question of heterogeneity comes up in the case of any monetary policy, even national policy, applying to a more or less disparate set of regions, and all the more so, of course, in big monetary unions. “Can one size fit all?” According to theory, an optimal currency area needs free movement of the factors of production as well as flexible markets and a limited impact of asymmetric shocks on the various partners of the monetary union. The euro area is not an optimal currency area. But does that really exist? In Europe, however, factor mobility, financial integration and fiscal transfers between Member States are less than in the United States. In this case, can monetary union function properly? There is only one single monetary policy and the ECB can only focus it on price stability at the level of the euro area as a whole. In this kind of framework, the burden of adjustment, to asymmetric shocks for instance, rests on other mechanisms such as wages and relative prices or fiscal policy. What are the hard facts? As far as inflation is concerned, as I said before, both inflation rates and the divergences between them dropped sharply before the move over to monetary union. Since then, inflation differentials have not been any higher than the gaps that can be observed between the main American regions. As for the dispersion of growth rates within the euro area, this has not got any wider since exchange rates were irrevocably fixed and is also comparable to the American situation. In both cases – inflation and growth – the difference with the United States lies in the persistence of the differentials: it is nearly always the same countries that have the highest or the lowest inflation or growth rates. Growth differentials may be linked to catching-up processes (and here they are to be welcomed), to specific shocks or to inappropriate national policies. They may be the result of differences in trends or cyclical situations, too. Business cycles have become more closely aligned over the years under the impact of deeper product and financial market integration and convergence of macroeconomic policies. Differences in trend growth are now the main reason for most differentials, something which also explains why the dispersion of growth rates shows a considerable degree of persistence. What conclusions can be drawn from these observations? Firstly, that, since it turns out that there is more heterogeneity across countries in trend output developments than in cyclical movements, monetary policy is confronted with a relatively symmetric environment in those fields where it has an impact. Secondly, for the competitiveness mechanism to work properly, wage and price rigidities have to be tackled by national structural reforms. Moreover, decentralised fiscal policies based on automatic stabilisers are also an important instrument in reducing growth differentials. But sound public finances are a necessary condition for automatic stabilisers to work fully. Member States should draw lessons from their maladjusted fiscal policy in the previous upswing and get their budgets into surplus during good times. V. Lessons from EU integration and challenges for Africa As previously mentioned, the road to EU economic and monetary integration has been paved by three long-term structural factors. First and foremost, there has been a strong underlying political will which has its roots in the reconciliation and cooperation process initiated in Europe after the Second World War. Secondly, economic integration advanced considerably over the following decades, fostered not only by trade interdependence, but also by the web of social linkages created through business, tourism or educational exchanges. And, thirdly, there is a growing economic consensus moving away from active demand management policies towards a more medium-term orientation, based on structural, supply-side-oriented policies with a monetary policy strongly geared towards price stability. Those three factors have reinforced each other in a long process of gradual building on prior achievements. Although that process was repeatedly interrupted owing to a diversity of economic and political difficulties, it comes to the credit of Europe's political leaders that they were able to appreciate those difficulties correctly and to respond to them with a visionary and forward-looking project, sometimes in the face of strong opposition. An important ingredient in the success of EMU is also that the project was flexible enough to address specific concerns and overcome various sources of resistance while keeping a high degree of consistency as regards its aims and conditions of access. In launching its own economic and monetary integration process, Africa is starting out from quite a different position, in all three above-mentioned fields. Countries on the African continent are mostly young states, so they do not share a long history of common experience. They are also very heterogeneous. Compared with the EU, the degree of economic integration is also much more limited, especially when it comes to trade flows. Heavy reliance on commodities and the general lack of complementarity in production and/or exports of goods and services automatically reduce the scope for intensive intra-regional trade, even within the same monetary zone. Last but not least, the building of a consensus on policy objectives is complicated by the multiplicity of different integration initiatives in Africa. Those initiatives often overlap in terms of membership. African countries can rely on various assets to strengthen their economic integration. The important initiatives that have been set up all over the continent over the past four decades show a strong willingness to pursue regional economic and monetary integration. Notable achievements have been realised on which to build further progress. Real integration between African countries is also stronger than it may appear from official statistics due to the large size of the informal economy. Indeed, official data largely underestimate inter- and intra-regional flows, a lot of transactions being unrecorded. These informal trade flows can be expected to be substantial, if not larger in some instances than official trade flows. Bringing those informal trade flows into the formal economy would, at the same time, represent a strong and enticing objective for further integration and, in turn, cement a wide community of interest between countries on which to build a large consensus to push the integration process further ahead. Given the various regional integration initiatives already in place, there seems to be little need for any more formal initiatives. Taking capacity and budgetary constraints into account, the main challenge is to implement the agreements that already exist in order to bridge the gap between formal agreements and de facto (informal) trade integration which can be observed all over the African continent on a daily basis. This requires removing existing impediments to formal trade, improving the general business climate and enhancing transparency and good governance. It also requires giving oversight institutions the necessary resources to do their surveillance job and a forceful mandate to intervene when problems arise. Other challenges are to address supply-side constraints, by enhancing complementarities, investing in labour-force skills, fostering a supportive business climate which allows the private sector to develop and expand its activities, and by addressing infrastructure constraints in transport and power supply. Africa has 15 landlocked countries, for which transport corridors are extremely important. The lack of adequate transport infrastructure remains a problem in some parts of Africa, and without these, economic integration is bound to remain limited. This leaves the question of the potential role to play by monetary integration, especially since the functioning of the CFA Zone has been an undeniable success in the global process of African integration. This currency union has certainly yielded positive results, in terms of stability, for instance. Yet this stability has largely been achieved by importing credibility from a supranational central bank and thanks to the backing of the French Treasury. This is further evidenced by the respective role played by convergence criteria in the EMU and in the CFA Zone. The observance of those criteria was, from the outset, considered as a necessary condition to ensure the credibility of the single European currency and as a prerequisite for individual countries to join the EMU. On the contrary, in the CFA Zone, those criteria were introduced afterwards. This does not mean that they are superfluous, far from it. The imported credibility of the CFA Zone would be greatly fostered by meeting those criteria and this would in turn help to make further progress with economic integration. However, monetary issues do not seem at present to be the main impediment to regional economic integration and this integration does not seem to be much more advanced in the CFA Zone than in other parts of Africa. For African countries which do not belong to a monetary union, monetary cooperation is not the most urgent issue that needs to be addressed to improve regional economic integration. Pursuing monetary integration may even deflect much-needed political energy and focus away from the main priorities with regard to regional integration. Those priorities should quite clearly be trade, infrastructure and good governance. As I mentioned at the beginning of my exposé, I have spoken only briefly and more cautiously about Africa as I do not know the region as well as my own continent. I am counting on the other participants who will now take the floor to certainly expand upon and perhaps even correct my remarks. Thank you for your attention.
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Remarks by Mr Guy Quaden, Governor of the National Bank of Belgium, on signing the Cash Single Shared Platform contract between Bank of Finland and the central banks of Belgium, Luxembourg and the Netherlands, Bank of Finland, Helsinki, 16 March 2007.
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Guy Quaden: CashSSP – the cash single shared platform Remarks by Mr Guy Quaden, Governor of the National Bank of Belgium, on the occasion of signing the Cash Single Shared Platform contract between Bank of Finland and the central banks of Belgium, Luxembourg and the Netherlands, Bank of Finland, Helsinki, 16 March 2007. * * * Dear Governor, dear Erkki, Dear colleagues, First of all, let me thank you for your kind invitation and for organising this event. The Eurosystem is an entity which has no equivalent anywhere in the world. For me, the creation of the ECB did not raise any doubts on the usefulness of the NCBs. In fact, the reverse is true. Luxembourg, the only country which did not have its own central bank, had to create one just before the transition to the single monetary policy. Nevertheless, our integration into the Eurosystem has obviously influenced the life of our institutions. I think on two changes which are not necessarily apparent to the outside world. The first is due to the fundamental change in the actual role of our NCBs, which now participate in the management of the world's second most important currency. The decisions taken in Frankfurt are taken on a collegiate basis by the Governing Council. This means that every governor of an NCB must be properly prepared to deal with all the issues considered at that level. They concern not only the single monetary policy but also the Eurosystem's other spheres of activity, such as financial stability and payment systems. In recent years, our NCBs have therefore extended and strengthened their analysis capacity. A large proportion of our staff is nowadays involved at various levels in the preparation of these decisions "taken in Frankfurt". The investment in resources is substantial, and so is the resulting enrichment of the job content of our employees. The second change concerns operational aspects. One of the Eurosystem's basic operating principles is a high degree of decentralisation. Our NCBs remain the contact points between financial institutions or economic agents of our countries and the Eurosystem. However, the concept of decentralisation has evolved since the Eurosystem was first formed. To quote the words of the Eurosystem's mission statement: "We are committed to good governance and to performing our tasks effectively and efficiently, in a spirit of cooperation and team work". This is further elaborated in the Organisational Principles, which state "that potential synergies and economies of scale shall be identified and exploited to the extent feasible". Furthermore the Council Task Force of which Erkki is a member has been mandated by the Governing Council "to prepare proposals for discussion and decision on issues related to the role, objectives, functions and operational modalities of the Eurosystem". In my view, it has a crucial role to play as an independent think thank. Having said that I believe that if the time is not ripe for a top-down decision, there should be room for NCBs – and in particular for medium-sized NCBs – to initiate voluntary collaboration in the development of joint projects and the exploitation of synergies following a bottom up approach. I think also that the long term vision for the Eurosystem calls for a shift from the pure centralisation and decentralisation models that have been applied in the past towards models of pooling and consolidation. In my view, the CASH SSP partnership fits perfectly into this framework. The introduction of euro banknotes provided an excellent opportunity for the NBB to modernise and reengineer its IT-application for cash handling. The goal was twofold: first of all, to manage cash flows more efficiently, both within the central bank and between the central bank and its main customers, financial institutions and cash transport firms; and secondly, to improve the security of these cash transactions. The successful implementation of this new cash application inspired the Bank's cash department to start thinking about the possibility of promoting it to international scale, starting with the neighbouring central banks. So in 2006 CASH SSP was formally born and the first agreements were signed between the Dutch central bank, the Banque centrale du Luxembourg and the NBB. Today the partnership is extended to a fourth partner, which shows that the scope of the business case is larger. Also on behalf of the Dutch central bank and the Banque centrale du Luxembourg let me warmly welcome you as a full and equal partner in the group. We find it very important that standards are being developed, because this shows to the commercial banks active in several countries, that we exploit a number of synergies of the single currency for cash handling and maybe, dear friends, could you use your privileged relationship with the Baltic countries to see whether other central banks would be interested in such type of collaboration. From our side, we will continue at the NBB to try to play a pro-active role in promoting collaboration between central banks within the Eurosystem also in other fields like collateral management and statistics. This also implies that the NBB is open to support or participate in initiatives launched by other NCBs in other fields of activity. A last remark. It is often said that "IT should follow the business". I agree, but both sides should be in permanent contact with each other and look for efficiency gains on the IT side and on the business side, too. Open communication between business and IT is the cornerstone of the CASH SSP partnership as it results in transparency and mutual trust between all partners. In the move towards closer collaboration between Eurosystem central banks, transparency and mutual trust are of utmost importance in promoting a genuine Eurosystem team spirit. This is something that should be supported and it calls for an improved governance framework in order to fully realise efficiency gains for the whole Eurosystem. Dear colleagues, The Eurosystem has established itself as a sound system capable of taking well-founded monetary policy decisions. On the operational level, it is now moving towards more specialisation. Tomorrow, our central banks will probably not be performing all the same tasks anymore. Some decisions will be taken following a top-down approach, others will grow from the bottom up. I am convinced that within the Eurosystem, there is, and there should continue to be, an important role for each and every member. Erkki, let me conclude by once again thanking the Bank of Finland for the warm welcome I have been given here in Helsinki, and that is not just because of the warm winter weather we are having these days. Let me also thank you once more for sharing the vision that the CASH SSP partnership can boost collaboration between Eurosystem central banks, building on the expertise and know-how available across the whole system, something that is fully in line with the team spirit promoted by the ECB Governing Council.
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Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the 2007 International Arab Banking Summit, Brussels, 28 June 2007.
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Guy Quaden: Financial sector development and the role of central banks in securing financial stability in a globalised economy Opening address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the 2007 International Arab Banking Summit, Brussels, 28 June 2007. * * * Chairmen, ladies and gentlemen, I am very pleased to address the 2007 International Arab Banking summit. I would like to thank the Union of Arab Banks and the World Union of Arab Bankers for their invitation and congratulate them for their excellent organisation of this important event. As the issue of Euro-Arab banking dialogue takes centre stage, it is fitting that, after having met in Rome in 2006, you have chosen to meet this year in Brussels, capital of the Kingdom of Belgium and also of the European Union (EU). I welcome you in this city on behalf of the Belgian authorities and more in particular of the National Bank of Belgium, the central bank of our country. You come here at a good moment: incoming data have confirmed that economic activity in the EU and the eurozone has continued to expand at a strong pace and the outlook for the second part of this year and next year remains very encouraging. Having regained more dynamism, the EU and the eurozone significantly contribute to the needed rebalancing in world economic growth. The Arab region is a key partner for the European countries and both sides attach great importance to building strong, meaningful relationships. As you all know, the EU and its Mediterranean partners have in 1995 created the European-Mediterranean partnership, also known as the Barcelona Process, to lay the foundations of a new regional relationship. Also, the European Commission has entered into co-operation agreements with the countries of the Gulf Cooperation Council, in 1989, and with Yemen, in 1997, thus comprising the whole of the Arabian Peninsula. The Eurosystem – namely the European Central Bank and the national central banks of the thirteen countries which have adopted the euro – has established a working relationship through central bank co-operation, notably with the members of the Gulf Co-operation Council and Egypt, as well as through the organisation of an annual seminar with Mediterranean central banks at the level of Governors. Experience during the last few decades has learned that financial sector development is crucial for sustaining economic growth. A modern financial system promotes investment, mobilises savings and allows risks to be diversified, resulting in a more efficient allocation of resources. In this speech, I would like to briefly touch on two related subjects. Firstly, what reforms seem necessary to stimulate financial sector development and, secondly, how can central banks secure financial stability in a globalised economy? These questions are all the more relevant, given the emergence of international financial centres in Beirut, Dubai, Qatar and Bahrain, among others. The increasing importance of cross-border financial flows means shocks originating in one financial market can quickly be propagated to other markets. To avoid contagion when financial instability occurs, national financial systems need to be adapted so as to be able to contain shocks originating in their own jurisdictions, while also being capable to weather external shocks. The IMF-supported conference on Financial Sector Reforms and Prospects for Financial Integration in the Maghreb countries in Morocco in December 2006 concluded that over the last decade, all countries concerned have implemented reforms to modernise their financial sectors, allowing financial systems to develop and grow more resilient and sophisticated. However, according to the conclusions of that meeting, reform efforts should continue in the following areas: • Firstly Strengthening banking system soundness by reducing banks’ nonperforming loan portfolios, ensuring adequate loan classification and provisioning, and adhering fully to internationally accepted prudential rules. • Secondly Enhancing competition in the banking systems by ensuring a level playing field for all banks, including through the restructuring of public banks and privatization, if warranted. • Thirdly Deepening financial markets through strengthening the regulation and supervision of securities markets, broadening the investor base, and improving transparency. • Fourthly Strengthening financial sector oversight by allowing greater autonomy to supervisory agencies and providing them with more resources to hire, train, and retain qualified staff. • Fifthly Bringing financial infrastructure in line with international best practice by establishing commercial courts, strengthening corporate governance, and fostering a sound credit culture. Regional integration can reinforce the progress made in financial sector reform. Useful lessons on regional financial integration can be learned from similar endeavours in other parts of the world. These experiences, particularly those of the European Union, suggest adopting a gradual approach and underscore the importance of sound macroeconomic frameworks and healthy domestic financial systems for successful financial integration. I now turn to the second issue: the role of central banks in securing financial stability in a globalised economy. The objective of financial stability requires action on three fronts: prevention, surveillance and crisis management. Concerning prevention, national and international authorities have concentrated on defining and working-out rules and standards aimed at improving the functioning of institutions, markets and infrastructures that are essential for the good functioning of the financial system. This includes not only hard laws, but also codes of conduct, standards and best practice, mostly designed at the transnational level. One of the key objectives of the IMF financial sector assessment programmes (FSAP), in which a number of countries present here have already participated, is to assess the observance of those standards and codes by member countries. Prevention needs to be accompanied by a surveillance structure aimed at detecting leading signs of vulnerability at both the micro and macro level. Supervision at the micro level seeks to avoid the collapse of individual financial institutions in order to assure a high level of consumer protection. Central banks complement surveillance of individual institutions through a wide-ranging surveillance of the whole financial system, in order to avoid systemic, global crises that could slow down or disrupt economic activity. Such crises can be the result of the breakdown of infrastructure that assures essential linkages between financial institutions. They could spread through a succession of defaults or because a large number of financial market participants all want to liquidate certain positions simultaneously. Even preventative measures coupled to an efficient surveillance system cannot guard against all eventualities, throwing up the question of what role central banks have to play when a financial crisis erupts, especially in their capacity as lender of last resort. Priority must be given to private sector solutions in order to avoid moral hazard, i.e. market participants should not be led to expect a rapid, even automatic, intervention by the authorities to solve problems before they grow any larger. Intervention by authorities cannot be excluded altogether, but it must be viewed as a last resort aimed at limiting systemic risks. In any case, such intervention must be guided by the principle that the financial implications of any crisis resolution package must be borne, to the fullest degree possible, by the institutions in trouble, their management, stockholders and, the case being, their creditors. Ladies and gentlemen, the challenges facing financial sector decision makers posed by globalisation are significant and manifold. However, they are not insurmountable. If handled skilfully, globalisation offers the prospect of increased prosperity for our economies. Co-operation and co-ordination among national authorities in the EU, the Mediterranean and the Middle East, as well as continued reforms to make financial systems more resilient to internal and external shocks seem to be two key elements of our response to these challenges. I wish you all very fruitful discussions over the coming days. Thank you for your attention.
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Remarks by Mr Guy Quaden, Governor of the National Bank of Belgium, at a business dinner, Dubai, 31 October 2007.
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Guy Quaden: The outlook for the European economy, the turmoil in financial markets and monetary policy Remarks by Mr Guy Quaden, Governor of the National Bank of Belgium, at a business dinner, Dubai, 31 October 2007. * * * I thank you very much for your invitation to this business dinner. I am very pleased to have the opportunity to spend a few days in the United Arab Emirates, one of the most quickly developing regions in the world and in my eyes one of the most fascinating places to be. I will present some remarks about the outlook for the European (eurozone) economy, the consequences of the turmoil in financial markets (but not about the causes of the turbulence and the first lessons to be drawn: it will be the subject of another speech) and the stance of the monetary policy. The latest news from Europe is not bad. 2006 was an excellent year and prospects for this year and next year remain positive. However the uncertainty surrounding these prospects has increased. The world has been experiencing a fairly long period of economic good times. For a few years the strong activity has been driven only by the United States and the emerging markets whereas Europe seemed to stand back. However the pace of global economic activity has become more balanced across the main economic regions. After having gone through a protracted period of subdued growth and short-lived recoveries, Europe was in the upswing of a cycle since early 2005, backed in particular by the longawaited recovery in the largest economy of the zone, Germany. In 2006, real GDP expanded by 2.9 % in the eurozone, twice the rate recorded in the previous year. Investment increased by 5.2 % and private consumption also picked-up. Gross exports rose by an impressive 8.2 %. However the contribution of net exports to GDP growth was relatively moderate (0.3 %) because imports also rose significantly. Therefore last year GDP growth in the eurozone was mainly driven by the faster increase in domestic demand, sustained in particular by a steady improvement in the labour market. The number of employed people rose by around 2 million (1.4 %) and the unemployment rate dropped in 2007 to the lowest level since 1993. Moderate wage developments have also contributed to stronger employment growth. That said, the level of unemployment in the eurozone (close to 7 %) is still high in comparison with other regions and there remain inefficiencies and rigidities in labour markets to be tackled through further structural reforms. Until this summer, the diagnosis of the economic situation in the eurozone was bright. The outlook was seen as favourable, supported by both the external and internal pillars of demand. According to the June 2007 Eurosystem staff projections, GDP growth in the euro area was projected to be close to 2.6 % in 2007 and 2.3 % in 2008. Obviously the turbulence in financial markets has clouded the prospects to some extent. The potential impact of this turmoil on the real economy is still difficult to assess. So far the effects have been limited. While euro area consumer and business confidence indicators declined in September, and most of the early indicators available fell slightly in October too, they were still above their historical averages and continued to point to ongoing sustained growth during the second half of 2007. Very recently, the IMF staff forecasted real GDP growth in the euro area at 2.5 % in 2007 and 2.1 % in 2008 and most private sector forecasts are close to these numbers. As regards the short – and medium – term outlook, I would make a distinction between the main scenario, which is the most likely outcome, and the risk assessment. The most likely scenario remains favourable with growth still close to our potential but it is now surrounded by much more uncertainty than usual. And that applies to other regions of the world. World economic growth is expected to remain robust over the medium term, despite the slowdown of the US economy, because the emerging market economies should continue to expand at a rapid pace. As the recent IMF World Economic Outlook points out, China, India and Russia have together accounted for half of global growth over the past year, and further strong expansion is also expected in other emerging markets and developing countries. This trend should improve living conditions and income for a large part of the world's population. It is also a source of continued support for euro area exports and investment. However the slowdown in the US economy could be more pronounced and the US dollar exchange rate could come under renewed downward pressure. In these conditions, it remains to be seen whether the recent signs of emerging economies de-coupling from US developments will usher in a sustainable process. Another crucial question is whether the euro will continue to bear more than its share in the resorption of global imbalances. Here I refer to the continuous strengthening of the exchange rate of the euro not only vis-à-vis the US dollar but also vis-à-vis the currencies of countries recording year after year large current account surpluses. Domestic demand for its part is expected to be supported by strong corporate sector earnings, healthy balance sheets, still moderate interest rates (lower than in the US) and better labour market conditions. The central scenario assumes financial markets gradually returning to normal, which does not mean that we should expect risks to be underpriced again, but simply that the current liquidity crunch will not turn into a fully-fledged credit crunch. This view is supported inter alia by the resilience of major financial institutions and more generally of the global financial system. True, profits have recently been deteriorating. Nevertheless this downturn in profitability starts out from a very high position. So far, potential credit losses appear to be manageable and banks' capital bases being largely in excess of regulatory requirements seem to be sufficiently solid to face additional stress. Nonetheless, the uncertainty about the exact magnitude and distribution of these losses remains and is a major cause of the persistent liquidity squeeze. Therefore less benign scenarios cannot be ruled out altogether and the financial turmoil might affect bank lending conditions for households and non-financial corporations, through higher costs of financing or more restrictive credit standards, as well as corporate bond spreads. To a certain extent this seems to be happening already, although the levels reached so far do not seem really worrying. All in all, credit standards and bond spreads are still well below the situation seen in 2001-2003. Furthermore, the tightening of credit conditions is expected to affect mainly M & A activities, more than fixed investments. Finally, greater uncertainty could curb both entrepreneurs' and consumers' confidence. It is up to policy-makers to ensure sound economic conditions and thus contribute to the preservation of economic agents' confidence. For its part, the Eurosystem – the European Central Bank and the national central banks associated in the single European monetary policy – has faced up to its responsibilities in this respect. As the other central banks, the Eurosystem has to conduct the European monetary policy with a clear medium-term orientation. It therefore sets interest rates with the aim of preserving price stability. This action hinges on a macroeconomic assessment of the risks to price stability. On the other hand, the Eurosystem conducts money market operations that provide liquidity to ensure the orderly functioning of the money market. Monetary policy decisions are about the level of official interest rates. Once the level of interest rates is decided, the Eurosystem has the responsibility of ensuring the smooth functioning of the segment of the money market that it is able to influence. It should be very clear that these two responsibilities should not be confused. However in fulfilling these two responsibilities, they reinforce each other, to the benefit of both macroeconomic and financial stability. In order to restore orderly conditions on the money markets, the Eurosystem injected liquidity over and above what is needed by the banking system under normal circumstances, through regular MRO allotments, ad hoc fine-tuning operations and supplementary longer-term refinancing operations (LTROs). These injections allowed banks to front-load the fulfilment of their reserve requirements and eased the tensions on the overnight interbank market. The Eurosystem also absorbed excess reserves when needed to avoid downward pressure on overnight rates. While the Eurosystem's liquidity-providing and absorbing operations had a stabilising effect on euro money markets at the shortest end, market liquidity remains thin and activity limited in the unsecured interbank market. Recently, the ECB clearly communicated to the markets that it will reinforce its policy of allocating sufficient liquidity to accommodate the demand of counterparties to meet reserve requirements early within the maintenance period. This policy will be followed as long as necessary. However, the restoration of normal conditions over the whole maturity spectrum depends mainly on the return of confidence and trust by market participants, both in the other participants and in their own ability to access funding in sufficient amounts. It must be emphasised that the Eurosystem conducted these operations through standard market-compliant procedures and without changing the overall stance of monetary policy. Let me now turn to an assessment of the monetary policy stance at the current juncture. The primary mandate of the Eurosystem is to deliver price stability in the medium term. On the basis of a thorough economic and monetary analysis and by acting in a firm and timely manner, the Governing Council of the ECB has to ensure that medium- and long-term inflation expectations remain firmly anchored in line with price stability, thereby favouring an environment conducive to sustained economic growth and well-functioning markets. The rise of many commodities prices – in particular oil –, the dynamism of monetary developments and the emergence of capacity constraints, implied upside risks to price stability over the medium term. This led us to issue in the summer a new message of "strong vigilance". However, since then, the ECB Governing Council, which is never pre-commited, has not changed policy rates. What happened ? The incoming macroeconomic data remained in line with our baseline scenario and confirmed that risks to price stability are mainly on the upside over the medium term, as identified by both our economic and monetary analysis. However, the continued financial market volatility and ongoing reappraisal of risk has undoubtedly led to an increase in uncertainty surrounding the economic outlook, due to the possible effects of these financial developments on the real economy. Therefore, it was appropriate to gather additional information before drawing further conclusions for monetary policy. This (very attentive) "wait and see" attitude did not jeopardise the maintenance of price stability over the medium term. Indeed, a market-driven tightening of monetary conditions could be observed, as money market rates have risen, lending standards have somewhat tightened and the euro exchange rate has again appreciated. By the way, let me remind you that the Eurosystem has no target for the euro exchange rate, as the primary objective concerns internal stability. However, the exchange rate is an important indicator in the economic analysis, in particular to the extent that it influences the overall outlook for price stability. At its last meeting on 4 October, the ECB Governing Council still considered this outlook for price stability over the medium term to be subject to upside risks. It gave itself a period of time to analyse incoming information in order to refine and update its risk assessment. In particular, should financial market tensions persist or intensify, they would affect financing conditions more significantly and eventually economic activity too. These downside risks are, I think, relevant both for the growth and the inflation outlook, as they have the potential to alleviate some of the expected upward pressure on prices of a cyclical nature embedded in the baseline scenario. Conversely, should the financial turbulence fade away and the main scenario be confirmed, our monetary policy should be and would be ready to counter possible upside risks to price stability. Uncertainty having increased, times have once again become more challenging for central bankers. More than ever they require from us to make appropriate, overall and forwardlooking judgments.
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Welcome address by Mr Guy Quaden, Governor of the National Bank of Belgium, at a 3L3 Meeting of the European Financial Regulators, Brussels, 26 November 2007.
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Guy Quaden: Assessment of the Lamfalussy architecture Welcome address by Mr Guy Quaden, Governor of the National Bank of Belgium, at a 3L3 Meeting of the European Financial Regulators, Brussels, 26 November 2007. * * * Ladies and Gentlemen, Colleagues and Friends, It is both an honour and a great pleasure for me to welcome you to Brussels for the third meeting of the 3 level 3 Committees. Belgium is well suited to host a meeting on the selected topic, not so much because its capital inspired a fantastic architectural revolution, as it is a cradle of Art Nouveau, but rather because, besides being one of the countries hosting the European Parliament, the Council of the European Union and the European Commission, Belgium is also the country of Baron Alexandre Lamfalussy, who lent his name to the now famous Lamfalussy architecture. The theme of today's meeting is a very good choice and is also highly topical. As key stakeholders in the ever-increasing cross-border integration of financial systems, market participants quite legitimately demand an institutional framework that can sustain integration on this scale. Therefore, as authorities, it is essential to constantly ensure that our institutional architecture remains adapted to a world in which financial institutions operate across different countries, across different sectors, and integrate and centralise some of their key functions. This institutional framework should lay the foundations for a competitive and dynamic financial sector, make sure it is secure and efficient, while at the same time limiting the cost of integration that comes with potential duplication of controls, divergent laws or inconsistent application of rules and regulations. The whole Lamfalussy architecture has been specifically devised to meet market participants' demand for more consistency. At each level, considerable and commendable progress has been made towards faster, more efficient and more consistent rule-making as well as closer convergence of supervisory practices. In addition, the Lamfalussy architecture has nurtured a culture of cooperation, fostering greater transparency and strengthening dialogue between rule-makers and with the private sector. Participation of all stakeholders in the review of the Lamfalussy architecture It is precisely because the Lamfalussy architecture is a key component of the rule-making process in Europe that it is crucial to assess it regularly. Although most of the benefits associated with the Lamfalussy architecture and the contribution of each level are obvious to many of us, it is still essential to evaluate whether and how its functioning could be facilitated and how its high-quality output could be improved or delivered more rapidly, if need be. Since any such assessment requires the cooperation of all stakeholders involved, I am particularly glad that each level of the Lamfalussy architecture could be represented here today. Indeed, the European Parliament, the Council and the European Commission have agreed to share their assessment, in what seems to be a very promising programme for this 3 level 3 meeting. In addition, the simultaneous presence of members of CEBS, CEIOPS and CESR gives some leverage to our discussions by enabling us to share experience that is specific to each committee but nevertheless of common interest. This exchange between committees is all the more beneficial because they have worked at a different pace in the past so there is real potential for what I could call cross-fertilisation. A full review of the Lamfalussy architecture should also necessarily involve market participants. Therefore, they, too, will get a chance today to voice their concerns on the architecture and share their own assessment of the process. The report of the Inter- institutional Monitoring Group, composed of 6 independent experts, has already unveiled part of this assessment. The recently-issued report is a major contribution that provides much food for thought. Today's 3 level 3 meeting will give us a chance to launch a fruitful discussion on its recommendations and will constitute a unique opportunity for each of the stakeholders to respond to it and to exchange opinions about the challenges facing the current financial supervisory architecture. Link between supervision and crisis management To be complete, the assessment of the Lamfalussy architecture should also take into account the special link between the supervisory framework and the crisis management framework. This link is especially important in the banking industry but it is also crucial for the insurance and securities sectors for at least two reasons. Firstly, a banking crisis can potentially destabilise the whole financial sector. Secondly, banking, securities and insurance businesses are in some cases combined within financial conglomerates, creating potential channels for intra-group contagion. In the present period of turbulence and uncertainty, it is very important to look closely at this link. Although we may have to wait until the dust settles before we can identify all the causes and consequences of the crisis, I think we can already pinpoint some areas where level 3 committees have succeeded and where potential shortcomings have been observed. I personally believe that the trust and mutual knowledge built up over the years through regular contacts in each committee have helped foster multilateral exchanges of information and smooth cooperation between supervisory authorities during the crisis. However, we may want to examine today if there is a need to further intensify this multilateral cooperation, both in normal circumstances and in times of crisis. First, several ways to strengthen the links between authorities in normal times have already been explored and sometimes tried out in practice. Future priorities for further developing financial supervision in the European Union have been set out and several instruments to reinforce cooperation between authorities have been identified. At present, we need to further work on the implementation of these measures and to monitor their efficiency. Secondly, with regard to potential improvements in the crisis management framework, let me first note that several observers had predicted that the shortcomings in our system would be striking in a crisis situation. Similarly, the functioning of our crisis management framework has been tested in crisis simulation exercises on several occasions over the last years and many suggestions have been made to improve it. The crisis that we have been dealing with over the last few months, together with the generally satisfactory functioning of our crisis management framework up to now, obviously force us to take a fresh look at the various suggestions that were made to improve the framework before the crisis arose. However, they do not excuse us from keeping a critical eye on our framework. All suggestions relating to improvements in the supervisory and crisis management framework may at the end of the day call for consideration to be given to making some legal changes and re-distributing responsibilities. Whatever changes might be needed, they should always ensure that we have a flexible enough crisis management framework to deal with any kind of crisis, especially as each one is different and has elements that can never be anticipated. And it is essential for authorities to keep the right balance between the allocation of responsibilities in the supervisory and the crisis management frameworks. These two key concerns should obviously remain in the back of our minds when we review the Lamfalussy process today. Concluding remarks To conclude, and before we start assessing the Lamfalussy architecture, I would like to remind you what architecture is all about. In an early essay in the first century AD, the Roman architect Vitruvius defined the essence of his art as being the design of buildings meeting three different criteria. They first need to be durable and so should be strong, solid and based on sound foundations. Secondly, buildings need to be functional and convenient for the people using them. Thirdly, buildings need to be beautiful, and should raise the spirits of those who are living or working in them. So, as you can see, architects need a mix of different abilities, a magic combination of art and science. Thanks to this combination, architectural works of art have become a cultural symbol of Europe over the years, as demonstrated for instance by the illustrations on our bank notes. Similarly, a complex, but nonetheless useful, institutional architecture has characterised European integration. Assessing this institutional architecture will require the same architectural skills as those originally needed to set it up. Therefore, I would like to wish you today an open and constructive discussion combining both scientific method and the visionary perception that characterised some of the most influential European artists.
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Introductory speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Biennial NBB Conference "Towards an integrated macro-finance framework for monetary policy analysis", Brussels, 16 October 2008.
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Guy Quaden: Towards an integrated macro-finance framework for monetary policy analysis Introductory speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Biennial NBB Conference "Towards an integrated macro-finance framework for monetary policy analysis", Brussels, 16 October 2008. * * * It is my great pleasure to welcome you to this biennial NBB Conference. At a time when we are experiencing the biggest financial crisis since the 1930's, it doesn't take much motivation to explain why it is extremely important for central banks to have at their disposal a coherent framework that can explain and analyse the interaction between financial markets and the real economy. The theme of this conference – "Towards an integrated macro-finance framework for monetary policy analysis" – is now even more up to date than we could have anticipated at the time it was chosen. Although I would have preferred a different course of events, even if that would have meant a less topical conference today, it is quite clear that the current crisis poses important challenges for monetary policy. Central banks around the world have at least two immediate concerns in this respect: providing sufficient liquidity to keep the financial system functioning, and adopting the appropriate monetary policy stance in a highly uncertain and rapidly changing environment. Let me summarise briefly the approach that has been taken by the ECB over the last 15 months. Our first challenge was (and still is) to make sure that solvent financial institutions obtain the liquidity they need. As the liabilities of financial intermediaries are more liquid than their assets, they are by nature subject to liquidity shocks. If the effects of such shocks are not properly managed, illiquidity problems can lead to bankruptcy, even when the intermediary is fundamentally sound. Therefore, it is important to make sure that solvent financial institutions can obtain liquidity with the central bank. So far, we have coped with this challenge. One stabilising factor has certainly been the fact that, well before the start of all this financial turmoil, the Eurosystem already accepted a broad range of assets as collateral in its refinancing operations. Another element was that we were able to flexibly adapt the existing framework to new challenges. We did so by adopting an ample allotment policy in our main refinancing operations, particularly at the beginning of each reserve maintenance period, by having wider recourse to fine-tuning operations when market conditions were rapidly changing, and by increasing the share of long-term refinancing operations. Last week, for our main refinancing operations, we decided to switch from a variable-rate tender with a minimum bid rate to a fixed-rate tender at the policy rate with full allotment, implying that financial intermediaries no longer face uncertainty about the share they will be allocated. Together with our decision to narrow the interest rate corridor for the standing facilities, this should also improve our ability to stabilise the overnight money market rate close to the policy rate and to adequately signal our monetary policy stance. Since December of last year, we have also provided liquidity in US dollars against ECBeligible collateral, as part of a coordinated action by the central banks of several major advanced economies, including notably the United States' Federal Reserve. The amount of US dollar liquidity provision has in the meantime been increased, in view of the growing tension. Yesterday, the Governing Council decided to further enhance the provision of longer term financing operations through fixed rate tenders with full allotment. Taking into account the substantial extension of the liquidity, as well in euro as in dollars, provided by the Eurosystem and as there were signs that some counterparties were getting constrained by collateral, it was further decided to expand the list of Eurosystem collateral. In a climate of generalised distrust, some financial institutions have come under particularly strong pressure. When they are systemically relevant, public authorities had to intervene in order to avoid contagion effects. In the euro area, it is up to national central banks to provide emergency liquidity assistance and to governments to reinforce the solvency of such institutions in order to restore confidence. Governments have recapitalised some institutions and have provided public guarantees to restore confidence in the interbank market. Smooth cooperation among all players involved is crucial. In particular, when the central bank does not directly supervise credit institutions, it is essential for it to receive without delay all relevant information. Our second concern is that, at the same time, we need to think about and choose the appropriate monetary policy stance. In doing so, we have to take a somewhat longer perspective and weigh up the implications of the financial turbulence for the consumption and investment decisions of the various sectors in the economy, as these will in turn determine future outcomes for economic growth, employment and inflation. Eventually, the policy stance is set to optimise macro-economic outcomes, given all ongoing shocks (and that includes other shocks like rising oil and commodity prices which have also been buffeting the economy) and taking into account the underlying structure of the euro area economy. One question that could arise here is whether the massive injections of liquidity into the banking system come at the price of either an inappropriate monetary policy stance or a less than optimal signalling of it. In practice, this is very unlikely to be the case. Indeed, since the beginning of the financial turmoil in August 2007, the ECB has repeatedly emphasised that the policy stance is defined in terms of the interest rate at which financial intermediaries can obtain liquidity, rather than by fixing the quantity of liquidity which is provided. As early as 1970, William Poole's classical analysis of the instrument-choice problem taught us that using the interest rate as policy instrument is desirable when short-term uncertainty stemming from instability in the money multiplier or from money demand shocks is high relative to the uncertainty stemming from aggregate demand shocks. The provision of liquidity then becomes an endogenous variable as it is steered in order to stabilise the money market rate at its desired level. In this framework, the sometimes substantial liquidity injections by the Eurosystem should be seen as simply offsetting the sudden and sharp declines in the money multiplier induced by the financial crisis. As far as our monetary policy decisions are concerned, they depend on our medium-term assessment of the risks to price stability and are based on our two-pillar strategy, which enables us to cross-check developments in the money, credit and financial markets with the signals provided by economic analysis. Given existing upward inflationary pressures from oil and other commodity prices and the associated likelihood of second-round effects, euro area monetary policy was until recently faced with predominantly upward risks to price stability. However, as the financial crisis intensified further, financial conditions for the private nonfinancial sector have tightened – independently of monetary policy – and the supply of credit from financial institutions might be reduced. As a result, expectations regarding economic activity have rapidly deteriorated over the last two months and the upward inflationary pressures have eased, partly as a result of lower commodity prices but also because of the change in the outlook for domestic economic activity. Therefore, the coordinated interest rate cut of 50bp last week was also the appropriate response for the euro area to the materialisation of previously identified downside risks to growth and the associated decline in the upward risks to price stability. For the near future, we will continue to closely monitor all relevant economic, financial and monetary developments and act firmly whenever necessary. Particularly at the current juncture, we expect monetary analysis to provide us with relevant information about how banks’ balance sheets are adjusting to the financial crisis and what this implies for credit and money and, eventually, for economic activity and inflation. The present situation is indeed exceptional in this regard, as financial frictions or constraints, which might seem only marginal in normal times, may now suddenly become predominant for understanding and forecasting economic developments. This comes on top of regular empirical analysis and reduced-form models which show systematic and quite robust relationships between monetary and financial developments and future economic activity and inflation. Money and credit developments tend to precede long-run inflation developments. Current asset prices influence future investment decisions, and measured risk premiums predict future cyclical developments. These aspects are poorly developed in our standard econometric macro-models, as well as in the benchmark new-Keynesian model which is so prominent in the academic literature. For the time being, it is difficult to reproduce these statistical relationships and their time-varying nature in state-of-the-art structural models. That is the main reason why the Eurosystem's monetary policy strategy now deals with these aspects in a separate pillar. But it would obviously be extremely useful to have models that can integrate these relationships in a structural way. This is clearly the way forward for research on these issues. I firmly believe that this kind of conference helps to encourage research work on such integrated models and that policymakers will eventually benefit from these research efforts. Let me conclude by stressing that the financial developments unfolding before us also reveal that we face important challenges beyond the business cycle horizon. Indeed, we have to rethink the role of asset prices, risk premiums and money and credit developments for the systematic conduct of monetary policy, for ensuring financial stability and for re-designing the regulation of the financial sector. Here again, we could clearly benefit from models which integrate real, monetary and financial developments. If there are actually common cycles in monetary, financial and real economic activity and inflation, it would be appropriate to adopt a longer-term perspective that concentrates on avoiding boom-bust cycles. Structural models that incorporate these interactions should be helpful to answer a crucial question: to what extent can monetary policy contribute to preventing excessive liquidity and financial bubbles from building up in prosperous times? They should also help clarify the role of financial regulation and the extent to which it should be designed to avoid any excessive accumulation of risk during good times and prevent binding capital constraints from adding to deflationary pressures during bad times. It is important to better outline the relative role of monetary policy and financial regulation for price and financial stability, both in terms of strategies and institutional design. In today's integrated financial world, international coordination at appropriate level seems desirable for policies to be effective in this respect. In Europe, the organisation of banking supervision at quasi purely national level contrasts with financial market integration and the existence of cross-border financial institutions. The current crisis raises all these challenges much more strongly than before. I am convinced that academic research in these domains will be boosted in the near future and that new and clarifying insights will result from this work. I sincerely hope our conference can help stimulate research in these directions.
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Keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Third Annual European Government Bond Summit, Brussels, 24 October 2008.
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Guy Quaden: The integration of the euro government bond market – standstill or restart? Keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Third Annual European Government Bond Summit, Brussels, 24 October 2008. * * * Ladies and Gentlemen, It is a great pleasure for me to be the guest speaker at this third annual European Government Bond Summit. Even in these turbulent times, I hope that you still enjoy your dinner and will have time to attend the conference tomorrow. Its programme looks very interesting indeed, and closely reflects the current difficulties in the financial markets. The primary dealers community is now, maybe more than ever before, of great interest for central bankers. Indeed, one of your main missions is to make sure there is enough liquidity in the government bonds secondary market. Proper functioning of this market is crucial to ensure liquidity for financial institutions, via the collateralised interbank market among others. And this market has become increasingly important since liquidity in the unsecured interbank market has been drying up. Owing to the high distrust among market participants, banks are still facing acute borrowing restrictions. This lack of market liquidity is one of the main problems with which central bankers are confronted at the moment. The Eurosystem has adjusted its distribution of liquidity – and will continue to adjust it for as long as necessary – to ensure that solvent banks have continued access to liquidity and to keep the very-shortterm rates, in particular the overnight rate, as close as possible to the policy rate. The Eurosystem has assumed an increasing intermediation role during this period of turbulence. With its actions and the guarantees offered by individual governments, conditions are in place for a pickup in confidence and a gradual reduction in tensions on the money market. Since the beginning of the financial turmoil in the summer of last year, the ECB Governing Council has made a clear distinction between liquidity management and its monetary policy stance, which is signalled by the interest rate on the main refinancing operations. The dramatic worsening of the financial crisis since the collapse of Lehman Brothers radically modified the outlook for growth and, as a consequence of lower commodity prices and faltering domestic activity, our assessment of risks to price stability as well. Therefore, the coordinated interest rate cut of 50 bp on 8 October was appropriate for the euro area. The Governing Council has thus shown that, without prejudice to its main objective of guaranteeing price stability in the medium term. it can also use its interest rate policy to help alleviate financial tensions and sustain confidence and economic activity. Also from a monetary policy viewpoint, a properly-functioning secondary government bond market is very important. Allowing for the existence of a "risk-free" yield curve, it plays a crucial role in the transmission of monetary policy. Indeed, while the Eurosystem has only a direct influence on very-short-term money market rates, households and firms look mainly at medium- and longer-term rates when taking consumption and investment decisions. Consequently, when the Governing Council of the ECB reacts to disturbing shocks in order to maintain price stability in a medium-term perspective, it is interested in seeing monetary policy impulses effectively transmitted along the yield curve. Moreover, the Eurosystem's monetary policy strategy aims at firmly anchoring inflation expectations and minimising the inflation risk component of long-term interest rates. In this respect, government bond markets provide useful information on inflation expectations. Through their pricing of long-term government bonds, primary dealers thus contribute to the efficiency of monetary policy. Of course, we are well aware that the whole transmission process is now impaired by the banking crisis and we have to counteract these disturbances. Last but not least, I am very pleased that the organiser of this summit, the European Primary Dealers Association, sees promoting integration of the EU government bond markets as its mission. Your association is therefore an active agent of financial integration. I would like to devote the rest of my speech to this issue. Firstly, I will remind you that the Eurosystem, too, has a strong interest in promoting such integration. Secondly, I will give a short overview of the current state of financial integration in the euro area, focusing on the government bond market. Thirdly, I will discuss several initiatives recently taken by the Eurosystem to foster financial integration, with special emphasis on the second generation of the Eurosystem's collateral management system, the so called CCBM2. Apart from its particular importance for the conduct of monetary policy, financial integration is highly relevant to other Eurosystem tasks. It is fundamental to the Eurosystem's job of promoting the smooth operation of payment systems, which in turn relates to its great interest in the safe and effective functioning of securities clearing and settlement systems. Furthermore, by permitting risk-sharing and diversification, by enhancing depth and liquidity of financial markets, integration also contributes to safeguarding financial stability. We are nevertheless aware that spill-over effects and contagion increase with financial integration. So, it will probably be a major challenge in the coming years to accurately gauge this dimension, as borne out by the growing importance of cross-border financial institutions. In recent weeks, when the financial turbulence was at its fiercest, it became clear that a revamp of prudential supervision in Europe will be an essential element of the reforms necessary to avoid a repetition of such a dramatic turmoil. Finally, by encouraging more efficient allocation of resources, financial integration acts as a prerequisite for realising Europe's full economic potential, that is raising the potential for stronger non-inflationary economic growth, as highlighted in the Lisbon Strategy. For all these reasons, the Eurosystem has always been a strong supporter of the European financial integration process and we have monitored developments in the different segments very closely. The tenth anniversary of the ECB, a few months ago, gave us the opportunity to take stock of the achievements in European financial integration over the last decade. We were proud to conclude that significant progress has been made and that the single currency has acted as a major driving force. The progress that has been achieved nevertheless differs across market segments. The money market, in particular the interbank market for unsecured deposits, can be considered as a single area-wide market – also its current difficulties ignore national borders! But the segment for short-term debt securities (commercial paper and certificates of deposit) is still fragmented. I would like to remind you that, in order to try and close this gap, the Eurosystem is supporting the private STEP initiative which aims to develop a pan-European short-term paper market. A considerable degree of integration has also been achieved in corporate bond and equity markets. By contrast, while the euro-area banking markets for wholesale and capital-marketrelated activities also show clear signs of integration, retail banking markets have so far remained fragmented. Undoubtedly, the euro-area government bond market is the segment – apart from the unsecured money market – that has reached the highest degree of integration. The removal of exchange rate risks, the drop in transaction costs and the disappearance of currency restrictions for investors and intermediaries have pushed up cross-border bond holdings. Let me mention the case of my own country. At the end of June this year, the proportion of Belgian linear bonds held by foreigners reached 55 p.c. In the case of Treasury certificates, foreign holdership came to 73 p.c. at the same moment in time, which reflects the strong foreign demand generated by the relative scarcity of short-term euro-denominated public securities which were accorded a good rating by the credit rating agencies. The primary dealer community, which has become more and more diversified, has been highly supportive of these developments. Looking for instance at the situation in this country, only 3 of the 16 primary dealers active on the Belgian government securities market, are actually Belgian! Financial institutions active in the main financial centres of the world (New York, London, Paris, Frankfurt) are now contributing to a successful widening of the investor base for securities issued by the Belgian Treasury. Besides growing market integration, the long-term tendency towards more sustainable public finances, across all member states, has also helped achieve close convergence of government bond yields among EMU countries. For many euro-area nations, government bond yield spreads vis-à-vis the German Bund declined from the introduction of the euro until mid-2007, when they were just a few basis points. While government bond yields are increasingly driven by a common factor, local factors continue to play a role, however. The financial crisis we are going through has shed some light on the remaining gaps in the euro-area bond markets. Strong flight-to-quality flows have been accompanied by a sharp widening of intra-euro-area government bond yield spreads. In the euro area, the ten-year sovereign spreads vis-à-vis the German benchmark have reached levels not seen since the start of EMU (this morning: Italy 88 bp, Spain 56 bp, Belgium 53 bp, France 26 bp). A common shock – namely, the sharp increase in risk aversion in global markets – thus led to different responses in the government bond market. The underlying factors behind this increase in bond yield spreads are multiple. The German Bund certainly benefited from its high liquidity – favoured by a highly-performing futures market – a strong plus in these turbulent times. Credit risks were also a factor – although not the main one – behind the increase in bond yield spreads, as corresponding credit default swap spreads also widened. Here in Belgium, the long drawn out discussions about the country's institutional future have long hampered the formation of a stable government. All this uncertainty has taken its toll on the financial markets; the credit default swap rate for Belgium increased somewhat, compared with Germany's rate. These increases have been quite modest, though, which seems to indicate that the markets believe – as I do – that these difficulties could be solved without far-reaching financial consequences. More recently, the problems confronting some of our main financial institutions have also had some influence. The Belgian government – like several other European governments – had to recapitalise those institutions, which pushed up the outstanding public debt, and thus also the credit default swap rate for Belgium, which is now some 26 basis points higher than for Germany. Anyway, as I said before, the increase in spreads vis-à-vis the German Bund is a general phenomenon. One may fear that the recent financial turbulence will lead to a standstill or even a setback for European government bond market integration. So it might be useful to consider some initiatives to relaunch this integration process. Here, we can refer to several reports written by the Giovannini Group. In a report presented in 2000, this Group addressed the issue of "Co-ordinated public debt issuance in the euro area", arguing that the decentralised approach to public debt issuance was an obstacle to full market integration. Different options for greater co-ordination were discussed, including the creation of a single euro-area debt instrument backed by joint guarantees, an option that could be beneficial for smaller member states, currently paying liquidity premiums. Unfortunately, the Group did not start any concrete specification of such options. I nevertheless notice that tomorrow you will be bringing up the subject of common issuance again. Maybe your summit will give new impetus to this idea. In two later reports (2001 and 2003), the Giovannini Group focused on clearing and settlement infrastructures in the EU. It described clearing and settlement as an essential feature of a smoothly functioning securities market, providing for the efficient and safe transfer of ownership from the seller to the buyer. It identified a number of barriers to efficient cross-border clearing and settlement. Since the start of EMU, the ECB has taken a good many initiatives to provide payment and settlement facilities that foster market infrastructure integration and ensure the highest standards of efficiency and safety. First of all, I would like to mention TARGET, the real-time gross settlement system for the euro, which, since its launch in January 1999, has contributed to the integration of euro-area financial markets, by providing its users with an area-wide payment infrastructure. In response to the growing demand from financial institutions for more advanced and harmonised payment and settlement services across Europe, the Eurosystem decided to migrate from TARGET as a system of systems, to a single shared platform, TARGET2, where the rules of the different legal systems are harmonised to the greatest possible extent. Let me now say a few words on the second of these ECB initiatives: the so-called CCBM (Correspondent Central Banking Model). As you know, all Eurosystem credit operations have to be adequately collateralised by eligible assets. Moreover, the Eurosystem's operational framework stipulates that counterparties can only obtain credit from the national central bank in the country in which they are located, and that any Eurosystem counterparty should be able to use any eligible asset as collateral. Thus, a specific mechanism had to be established to enable the cross-border use of collateral, regardless of the location of the asset or the counterparty. Against this background, the Eurosystem introduced the CCBM in 1999 in parallel with TARGET. Through the CCBM, counterparties obtain credit from their "home central bank" based on collateral provided to another Eurosystem central bank and this "correspondent central bank" holds the collateral on behalf of the home central bank. In the current framework for the delivery of collateral, the CCBM provides for a common cross-border procedure, while national collateral delivery procedures are still not harmonised. The CCBM has proved to be a success, as the cross-border use of collateral has increased significantly. However, market participants have found some drawbacks in this system which mainly relate to the lack of standardisation of existing procedures, both domestically and at cross-border level. Against this background, the Governing Council decided in March 2007 to review the current Eurosystem collateral handling procedures. In July 2008, it has decided to launch a single technical platform – called CCBM2 – and assigned the development and operation of CCBM2 to the National Bank of Belgium and De Nederlandsche Bank. CCBM2 will first and foremost provide a harmonised level of service, thus facilitating interaction between the Eurosystem central banks and their counterparties. While the CCBM was built for the cross-border use of collateral only, CCBM2 will provide a single set of uniform procedures both on a domestic and a cross-border basis. CCBM2 will handle all eligible collateral, marketable as well non marketable. It will consequently allow to manage securities but also incorporate functions for the use of credit claims as collateral. Furthermore, CCBM2 will support the two currently used collateralisation techniques (pledge/pooling and repo/earmarking) and will be able to accept collateral through all eligible Securities Settlement Systems. While CCBM2 is first and foremost a collateral management facility for the Eurosystem (a "Eurosystem back office"), it will at the same time bring new opportunities for Eurosystem counterparties to reduce back-office complexity and cost and optimise their collateral and liquidity management with the Eurosystem. By harmonising procedures related to the Eurosystem credit and collateral management, it will also create a level playing field. In order to ensure that CCBM2 is fully in line with counterparties' needs, the Eurosystem is developing this new facility in close cooperation with market participants themselves. If we look to the future, CCBM2 will also be implemented in a way that changes in the collateral framework, such as the acceptance of new asset types or the introduction of risk control measures, can easily be taken up. As you know, the acceptance of a wide range of assets eligible as collateral is a structural feature of the Eurosystem's operational framework. Nevertheless, last week, the ECB Governing Council decided to extend it further until the end of 2009, to make sure that solvent banks can get the liquidity they need. This temporary measure is liable to increase the risks taken by the Eurosystem in its refinancing operations. Adequate risk control measures will be applied in order to limit those risks. Finally, as a third initiative aimed at better market infrastructure integration, the Governing Council decided, back in July, to launch the TARGET2 Securities (T2S) project. T2S will be a technical platform for central securities depositories for the settlement of euro securities in central bank money, thereby bringing together securities and cash settlements within Europe on one efficient single platform. On a more technical level, T2S will remove the differences between conducting domestic and cross-border settlements within Europe and will act as a catalyst for the integration of the European post-trading financial sector. It will also foster competition and harmonisation in post-trading by providing equal and less costly access to a common settlement service. Through the single platform, economies of scale can be fully exploited, while at the same time the safe and smooth settlement of securities transactions in central bank money is ensured. Subject to certain conditions, almost all euro-area central securities depositories, accounting for a very large share of settlement activity in the euro zone, have reacted very positively to the initiative. For the further development of T2S, the Eurosystem will continue to cooperate closely and transparently with these depositories, their users and other relevant stakeholders. Once implemented, the three so called "second-generation" services, TARGET2, CCBM2 and T2S, will represent a quantum leap forward in the integration and quality of the euro area's core infrastructure. These initiatives enhance the harmonisation efforts through the removal of Giovannini barriers, thus reinforcing the Lisbon Strategy. I am sure that market participants – and especially the primary dealers – will recognise the opportunities these Eurosystem initiatives present so that we can work together for truly integrated euro financial markets, capable of withstanding turbulence in future. Ladies and Gentlemen, thank you for your attention and I wish you a pleasant and very interesting meeting tomorrow.
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Annual Meetings of the IMF and the World Bank, Istanbul, 6 October 2009.
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Guy Quaden: A changing IMF and World Bank Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Annual Meetings of the IMF and the World Bank, Istanbul, 6 October 2009. * * * I would like to warmly thank the Turkish authorities for their hospitality shown during these annual meetings. The past 12 months have demonstrated the importance of a strong and effective IMF. The Fund reacted appropriately to the unfolding financial and economic crisis, by giving substantial financial support and advice. In this regard, I welcome that important modifications to the Fund’s instruments were implemented, improving its capacity to help its members. Moreover, I welcome the major initiatives that are being taken to improve the Fund’s surveillance capacity. All members’ full cooperation is needed to ensure surveillance traction. The Fund must retain the central surveillance role and should not be subordinated to any outside process. The financial resources of the IMF were significantly enhanced, reassuring its members that the Fund has enough ammunition to fight any crisis. I expect that the money raised under the bilateral loan agreements and the IMF notes programme will be folded into the new and expanded NAB. The Fund’s legitimacy follows from its almost universal membership combined with adequate governance arrangements. As the world changes, the Fund must adapt to those changes. The governance reform being discussed is therefore important to improve the Fund’s legitimacy, as well as its effectiveness. I fully support the general quota review to be concluded by January 2011. This review should be based on objective economic and financial parameters, relevant for the Fund’s mandate and applied in a uniform manner. It should be guided by the long term resource needs of the Fund, ensuring the Fund remains a quota-based institution and should at the same time realign quotas with countries’ economic position and their responsibilities in the world. This also implies that there cannot be a disconnect between representation and financial contributions. The oversight role of the Executive Board should be strengthened and the Board should focus more on the Fund’s strategy. But there is no reason to fundamentally change the responsibilities of Board and management. The current number of seats on the Board, 24, is appropriate for an institution the size of the IMF. A reduction by a few seats will not significantly improve its effectiveness. Moreover, the freedom of the members to form constituencies should be respected. The strategic guidance provided by the IMFC could be improved. But more political involvement should not lead to politicized decisions. Also, the composition of the Board and the IMFC should remain aligned. The mandate of the Fund should be updated. I favour the formal extension of the Fund’s jurisdiction over capital account transactions. The World Bank Group has shown its commitment to assist developing and transition countries in dealing with the aftermath of the multiple crises they face in a more flexible fashion, by stepping up its lending capacity and by speeding up the delivery of its assistance. However, the World Bank Group’s capacity to respond to crisis situations should be further enhanced. Responding to a rapidly changing environment requires some important institutional and organizational changes. The Bank needs to evaluate and reshape its lending toolkit and its decentralization policy in order to be able to respond more efficiently and effectively to these challenges. Work is ongoing, but it needs to be accelerated. During the past year, the Bank has been stretching the use of its capital in order to increase its lending capacity in response to the crisis. The question is whether a capital increase at this stage is necessary. Therefore, the Bank should analyze and assess in more detail postcrisis demand for World Bank lending and explore other options before resorting to a general capital increase. As a result of the crises, the number of people living in extreme poverty has increased significantly. The Bank Group should not lose focus on this vulnerable group. In this respect we call upon all donors to secure a sufficient replenishment of IDA-16, for which negotiations will start soon. The second phase of voice and participation reform should be concluded within the agreed timeframe. This reform should be based on a widely accepted measure for countries’ relative economic weight, but should also take into account members’ contributions to IDA. Other ongoing institutional reforms related to decentralization, workforce diversity and country ownership, should receive proper attention in the debate. To conclude, a successful reform of the Bretton Woods Institutions is important to keep the institutions in the vanguard of the effort for a more prosperous and equitable world. Decisions on the reform of the institutions must be taken by their members. No other international institution is better placed to execute their mandate.
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Closing speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the joint SUERF, CEPS and Belgian Financial Forum Conference, Brussels, 16 November 2009.
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Guy Quaden: Crisis management at cross-roads Closing speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the joint Société Universitaire Européenne de Recherches Financières (SUERF), Centre for European Policy Studies (CEPS) and Belgian Financial Forum Conference, Brussels, 16 November 2009. * * * Ladies and Gentlemen, More than two years after the US subprime crisis triggered world-wide financial turbulence and one year after the collapse of Lehman Brothers exacerbated the crisis dramatically, the title of this conference rightly suggests that crisis management is at a crossroads. Indeed, the exceptional measures taken by central banks and governments do appear to be achieving their objectives. It seems now that the most severe financial crisis since the 1930s, which provoked a free fall in world trade and industrial production over two quarters, will not develop into another Great Depression, even if its toll in terms of subdued economic activity and higher unemployment is not yet over. Crisis prevention will soon have to take over from crisis management. This will require both a timely exit from the exceptional measures taken to stabilise the financial system and the economy, and the implementation of fundamental reforms to remedy the structural defects exposed by the crisis. 1. Timely exit Let me turn firstly to the issue of a timely exit. The policy reaction to the financial crisis was very decisive. Central banks were the first to react in August 2007, by providing ample liquidity. After the sudden aggravation of the crisis in September 2008, they reduced interest rates to unprecedentedly low levels and took some non-conventional measures to support bank lending and the financial markets. Governments rescued systemically important financial institutions, through capital injections and asset purchases, and supported bank funding, through guarantees. They also launched fiscal stimulus packages. In order to consolidate the recovery, to avoid nurturing the seeds of future crises and to promote sustainable development, these short-term measures have to be unwound at the right time and pace. The effectiveness of fiscal policy depends on the confidence in its sustainability, and it is important to avoid the private debt crisis being followed by a public debt crisis. The burden of fiscal consolidation should not be passed on to the next generations. Credible fiscal consolidation programmes have to be set up, and the current outlook should allow the first steps to be taken next year. But let me focus on the Eurosystem’s monetary policy. Too early an exit from the current very accommodative monetary policy stance would entail the risk of a relapse: renewed negative interactions between financial sector problems and the real economy, along with a possible threat of deflation. Too late an exit would sow the seeds for new financial excesses, with a risk of inflation. Obviously, the assessment of risks to medium-term price stability must remain the fundamental criterion. Moreover, I expect gradualism to be a key feature of the exit. Certainly, our toolkit would allow us to react swiftly to any abrupt change in inflation expectations. However, economic and financial conditions are likely to gradually return to normal and, consequently, the upward shift in the balance of risks to price stability will probably be gradual. In fact, gradualism is most appropriate in uncertain times as it dampens the risk of disruptions in financial markets. The sequencing of the exit is not pre-defined, nor is its end point, and will depend on developments in financial markets and in the real economy. For example, the Governing Council of the ECB could change interest rates while keeping some non-standard measures in place, if required by a dysfunctioning of the money market – and you may remember that this kind of separation of monetary policy and liquidity management measures was quite common in the first phase of the crisis, from August 2007 to September 2008. Conversely, and this is may be more obvious, some non-standard monetary policy measures are likely to be withdrawn before raising interest rates. So, where do we stand now? Even though they are not yet back up to their pre-crisis levels, most financial market indicators have improved considerably. Since the spring of this year, there have been signs of a nascent recovery, the “green shoots”, mainly thanks to the policy reactions around the world and especially to a rebound in Asia. However, the economic recovery is still fragile and reliant, in no small measures, on expansionary monetary and fiscal policies. Moreover, commercial banks still have to repair their balance sheets and reinforce their capital base. The current slack in the economy is dampening price developments, an assessment which is confirmed by the monetary analysis. Consequently, the Governing Council believes that current interest rates remain appropriate. At the same time, the situation is not quite as dire as it was a few months ago, especially in terms of financial market functioning. Therefore, the first steps of a gradual phasing-out of non-standard measures can be envisaged, like a discontinuation of 1-year refinancing operations or a lower frequency for 3-month and 6-month refinancing operations. They should not be seen as the start of a tightening cycle, but rather as an incentive for banks to restructure their portfolios and to resume their market-based funding activities, as a long period of cocooning in the banking sector has microeconomic drawbacks too. Looking further ahead, the Governing Council will continue to set the monetary policy stance by assessing the appropriateness of monetary and financial conditions in view of the risks to price stability. One of the lessons of this crisis is that central bankers should not be guided by excessively narrow inflation targeting but should pay attention to the build-up of financial imbalances, which may not immediately exert pressure on prices, but an abrupt correction of which may put price stability at risk. The Governing Council can claim that the medium-term orientation of its strategy and its monetary analysis are assets in this respect. A few years ago, at a previous SUERF conference, I announced that M3 might abandon us. And indeed, the long-run relationship between M3 and prices proved to show signs of instability. At the same time, I pointed out that monetary analysis was much richer than monitoring M3 only. We now monitor credit developments closely. Research at the BIS, the IMF and within the Eurosystem is exploring the leading indicator properties of money and credit aggregates which may be useful in the identification of detrimental asset price bubbles. Further research is still needed in order to reach definite conclusions. While monetary policy should play a role in “leaning against the wind” of over-optimism in financial markets, it should however not be over-burdened. Interest rate policy on its own cannot guarantee both price stability and financial stability, and should therefore be backed up by prudential policies. 2. Fundamental reforms This leads me to the second issue, the fundamental reforms which are badly needed. There is a long list of work in the pipeline of international fora. The Financial Stability Board at G20 level as well as Ecofin at EU level have drawn up detailed roadmaps to pave the way for extensive reforms. The authorities must be determined in their drive for better regulation and supervision. As explicitly noted by the Basel Committee, “the banking sector entered the crisis with an insufficient level and quality of capital, inadequate provisions, imprudent valuations, insufficient liquidity buffers, compensation polices that encouraged excessive leverage and risk taking and excessive concentration of exposures among major financial institutions”. The insistence on the words “insufficient”, “inadequate” and “excessive” shows that, in particular, more and better buffers are expected. The crisis has given rise to a unique momentum for profound reform of the financial sector. We should not let this momentum slip away. I know full well that the return to more simplicity will be anything but simple. Of course, I realise that a lot of technical issues have still to be resolved. And I admit that it will be important to introduce the new regulations in a timely manner so as not to repress the smooth flow of credit which will be required to support the nascent recovery. In fact, while there is much discussion at the moment on the design of the exit strategy from the public support measures, we should be equally aware of the need for an entry strategy for moving over to more comprehensive regulatory requirements. But all these considerations should not be an excuse for prevarication and delaying the essential decisions to take for the design of a more comprehensive framework. The crisis has seriously dented belief in the ability of the markets to regulate themselves. While it would be illusory to dispense with the assistance of the market in designing new supervisory and regulatory arrangements, these market consultations have more often that not been used by many financial institutions as a channel to lobby for softer regulation, certainly in the past and probably still today. The rapid spread of the financial crisis has also served as a lesson for supervisors. It has shown that the root of the problems was not linked to any specific difficulties faced by individual institutions but, rather, to the gradual build-up of common risks within the system. It is now widely acknowledged that such crystallisation of risk, linked to major shifts in the correlation between financial products and markets, requires more systemically-focused oversight and regulation. To use the professional jargon, micro-prudential control, the preserve of the supervisory authorities, must be complemented by macro-prudential oversight, resorting to the expertise of central banks. To improve the symbiosis between these two approaches, a growing number of countries are adopting the so-called “twin peaks model” where the central bank is in charge of the full range of prudential supervision, in both its micro- and macro dimension, leaving the oversight of market integrity and investor protection to a separate institution. Just a few weeks ago, the Belgian authorities, too, decided to introduce this “twin peaks model” here as quickly and smoothly as possible. Needless to say, I am well aware that the macrodimension does not stop at our country’s frontiers, while the micro-supervision of cross-border groups also requires close multinational coordination. So, I strongly support the recent proposal to set up, at EU level, a European Systemic Risk Board (ESRB) and European System of Financial Supervisors (ESFS), which are called on to cooperate closely in order to bring more comprehensiveness and consistency to national and international supervision. Macro-prudential analysis must rely on rapid, direct and comprehensive access to data on individual developments liable to affect global financial stability while, in turn, this analysis must feed the micro-prudential control. It would be a pity if our efforts to improve this flow of information in our respective countries were to be impeded by hurdles at the international level. Ladies and Gentlemen, Crisis management has been effective: many banks have been rescued, the abrupt rise in risk aversion has been countered and it seems that financial markets are returning to normal and that the fall in trade and output has come to an end. For the emergency measures not to nurture renewed financial excesses, they have to be withdrawn in a timely and gradual way and, above all, backed up by structural reforms. Better regulation and supervision are needed. Great haste in regulating complex matters would probably not be wise, but the political resolve for reforms should not lose momentum. Thank you for your attention.
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Intervention by Mr Guy Quaden, Governor of the National Bank of Belgium, at the International Monetary Fund-Monetary Authority of Singapore IMF-MAS Conference "The IMF and the international financial system: the post crisis agenda", Singapore, 24 September 2010.
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Guy Quaden: Modernising IMF surveillance Intervention by Mr Guy Quaden, Governor of the National Bank of Belgium, at the International Monetary Fund–Monetary Authority of Singapore (IMF–MAS) Conference “The IMF and the international financial system: the post crisis agenda”, Singapore, 24 September 2010. * * * First of all, I would like to thank the Monetary Authority of Singapore and the IMF for inviting me to contribute to this high-level conference. The world economy has changed in important ways. Capital flows now dwarf trade flows. Many economies are now integrated into world capital markets. Financial sectors have become more interconnected and a channel for rapid transmission of crises across regions and at a global level. This requires Fund surveillance (in other words its crisis prevention role) to adapt both in substance (what surveillance should do) and modalities (how to do it). I would like to focus on three major topics: 1. the analysis of financial sector stability must be strengthened both at global and country level; 2. bilateral surveillance must be complemented with multilateral surveillance; 3. the so-called traction of Fund surveillance – the ability and willingness of countries to heed Fund advise – must be improved. Let me elaborate. Financial sector stability issues The international community has drawn many important lessons from the recent financial crisis. Implementing the needed changes has only just begun. The Basel III Agreement, reached only recently, is a major step to make the banking sector more stable and better equipped to absorb losses. It is only a first step. Improving capital adequacy primarily focuses on the stability of individual banks. It is foremost an instrument of micro-prudential regulation. Compliance of individual banks with prudential regulations does not assure the stability of the system as a whole. Macro-financial stability concerns must be kept under constant review and addressed by national institutions – the central banks – with a clear mandate. In the European Union, the European Systemic Risk Board will be established next year and assume an important role at EU-wide-level. However, the implementation of its recommendations will remain largely the responsibility of national authorities. I see an evident parallelism and potential for synergy between the surveillance mandate of the ESRB and IMF surveillance, the latter remaining broader in scope. After a series of national and regional crises (Mexico, Asia, Russia, ...) the IMF Board adopted in 2000 a Financial Sector Assessment Program. The Fund would at regular intervals (of 3 to 5 years) conduct an in depth evaluation of the vulnerabilities of a country’s financial sector and the adequacy of prudential regulation and surveillance. However, the membership could not agree, in a straightforward manner, that financial sector stability was an integral part of Fund surveillance, and therefore mandatory. The technical assistance nature of FSAPs was used by some countries to argue that the Fund should prioritise its resources to countries less equipped to conduct sound financial sector policies. As a consequence, some major systemically important financial sectors that proved very vulnerable did not undergo a timely and sufficiently in-depth scrutiny. Last Tuesday, the IMF Board decided that the 25 countries with a systemically important financial sector will undergo at least every 5 years an in-depth assessment of their financial sector. Moreover, the Board has stressed that financial sector policies are important in all cases of bilateral surveillance. This is a significant progress. Multilateral surveillance Bilateral surveillance, understandably, focuses on how national policies must be conducted in the country’s best interest. The premise is simple: if each country achieves internal stability and a sustainable external position without manipulating exchange rates, the system as a whole will function satisfactorily. While this remains largely valid, trade and financial integration and economic interdependence are now so far advanced that national economic interests must be pursued in a shared framework of collective stability. National policies pursued in the country’s own best (short term) interest might not be collectively consistent. The problem of the persistent global imbalances is an important example. To complement bilateral surveillance, the Fund must formulate policy-oriented advice on how to improve the coherence of national policies toward improved collective stability and sustainable global growth. A promising proposal that has been floated recently is the production of spillover reports. It is to be welcomed that the Fund plans to prepare, on a trial basis over the next year, at least three spillover reports for the US, the euro area and China. These reports will focus on outward spillovers of domestic policies of these economies and would involve not only the authorities of these economies (akin to the contact for the regular Article IV consultations) but also the authorities of the economies affected by the policies. The launch of the first Mutual Assessment Process (MAP) by the G20, in collaboration with the IMF, is a new attempt at multilateral cooperation and coordination. Given the potential benefits, this objective should be pursued with determination. However, the effectiveness of the G20 process still needs to be demonstrated going forward. Moreover, many special topics affecting groups of countries that may include non-G20 members or only a few of the G20 members will remain uncovered in that G20 process. The IMFC could provide a forum for addressing these issues. Prioritization and collaboration The improvement of surveillance will require adequate resources and Fund members should not withhold them. But it is obvious that choices will have to be made among a very wide range of ideas; and priorities will have to be set. This should happen taking into account in particular the effectiveness and cost of each proposal and the work done by other international institutions. When considering the creation of IMF surveillance products, sufficient attention should be devoted to the integration of these products in the overall IMF surveillance framework in order to maximise the effectiveness of and the synergy among all these products. The Fund has indeed already a large array of surveillance instruments (at bilateral, regional and multilateral level: Article IV, FSAPs, WEO, GFSR, REO, EWE, Vulnerability Exercises in EMs, Multilateral Consultations ...) which are the result of its efforts to keep its relevance in a changing world. At the same time, close cooperation with other international institutions and fora is essential, taking due account of comparative advantages and expertise, and avoiding duplication of efforts. Regarding, for instance, financial stability surveillance, the IMF and the FSB work together on the Early Warning Exercise and on systemically important financial institutions. Nevertheless, there remains probably room to improve further the coordination of their activities. In retrospect, we have to admit that the record of both the FSF and the IMF was less than perfect. The Fund has also to collaborate efficiently with the Basel institutions: with the BIS, that produces high-quality macrofinancial research, and with the Basel Committee on Banking Supervision, given that it has much responsibility for micro-financial issues. Another proposal which is gaining attention is to tailor further the content and frequency of the surveillance process according to the specific circumstances of each member country, and thus also according to the systemic importance of the country concerned. While I can certainly see merit in this proposal, it should be kept in mind that surveillance is important for all countries and that all members have the right to receive adequate policy advice during regular Article IV consultations. Tailoring consultations to specific circumstances should not lead to diverging surveillance quality for different categories of members. Traction of Fund surveillance I come to my last topic: the so-called traction of Fund surveillance. With highly competent economic analysts in central banks and governments in most countries, some have questioned the usefulness of Fund surveillance. Such is not my view. The added value of Fund surveillance rests on the political independence of the Fund opinion. Like independent central banks, Fund experts put longer term considerations above short term political calculus. In doing so, the Fund steers policy makers toward more honesty and boosts the government’s ability to implement often politically difficult reforms. There is a debate about how transparency can help improve traction of Fund surveillance. Prior to the Mexican crisis in 1994, IMF surveillance reports were highly confidential. Today, all Article IV reports, with a few exceptions, are available on the Fund’s website. For the Fund, the challenge in this context, is to be perceived as an impartial advisor and monitor, not too tied by its structure to the official view in which problems are downplayed 1. Let’s be frank. The IMF must indeed avoid public clashes about short term emergencies. On this, candid analysis is only acceptable if treated with the needed degree of confidentiality. Full and unfettered transparency could on the contrary induce complacency and a loss of credibility for the Fund. However, at the same time, the IMF must become more pro-active in persuading public opinion, social partners, and NGOs of the long-term costs of unadjusted policies and of the long-term gains that will outweigh short-term pain. Explanation by a credible international institution that promotes a global common good, might find more support from the public for long-term objectives than politicians believe there is. 2 Much has been said and written on improving the governance of the IMF and enhance ministerial involvement. Many observers conclude that nothing really happens at the international meetings of the IMF and the World Bank. This perception is not entirely unfounded. As I see it, the central task of ministers and governors meeting in the IMF is to seriously discuss policy-oriented multilateral surveillance reports. This is a task that the IMF Executive Board can only prepare. In the end, it is up to the policymakers at the highest level to agree on how consistency among their policies can be promoted, and policy coordination improved. Pursuing these objectives will elevate the level of ambition of Fund surveillance and the cooperation of its members to a higher level than that exists now. Today’s conference should advance our ambition. Cfr. for instance the interview of Professor Reinhart published for the attention of the IMF staff in November 2009. Cfr. for instance Raghuram Rajan, Fault lines, page 215.
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Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Eurofi Financial Forum, Brussels, 28 September 2010.
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Guy Quaden: Basel III and beyond Speech by Mr Guy Quaden, Governor of the National Bank of Belgium, at the Eurofi Financial Forum, Brussels, 28 September 2010. * * * Ladies and Gentlemen, I am very pleased to have the opportunity to participate in the Brussels Eurofi conference and to share some thoughts with you at this opening session. It is now just about 3 years after the US subprime crisis triggered world-wide financial turbulence and 2 years after the collapse of Lehman Brothers dramatically escalated the crisis. The crisis has seriously dented belief in the ability of the markets to regulate themselves. There are currently a lot of items on the agenda of international fora waiting to be dealt with. The Financial Stability Board at the G20 level as well as Ecofin at the EU level have drawn up detailed roadmaps to pave the way for extensive reforms. The crisis has indeed given rise to a unique momentum for profound reforms of the financial system. We should not let this momentum slip away. Unfortunately the general public sometimes gets that impression. Of course many complicated technical issues have had to be resolved. And I admit that it will be important to introduce the new regulations in a timely manner so as not to hamper the smooth flow of credit which will be required to support the nascent recovery. In fact, while there is much discussion as to the design of the exit strategy from the public support measures, in the monetary and financial fields, we should be equally aware of the need for an entry strategy for moving over to more comprehensive regulatory requirements. From this point of view the recent proposal coming from Basel represents a very important contribution. Two weeks ago, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, endorsed a broad proposal to strengthen the quality and quantity of regulatory capital held by banks and to institute a global liquidity standard. This proposal, the heart of the new Basel III framework, will be submitted to the approval of the leaders of the G20 countries at their November summit in Seoul. The proposal represents a major reform of banking regulations, which should substantially improve the resilience of banks to stress conditions, thus reinforcing financial stability and reducing the occurrence of a new crisis with injection of public money. Key elements include not only an increase in the minimum regulatory capital requirement but also an increase in the amount of capital that must be held in the form of common equity, which offers the greatest capacity for loss absorption. I will not discuss the various proposed ratios in detail, as by now I am sure you know them quite well. Many in the banking industry complained and argued that these reforms will make lending more expensive and imply a decline in the quantity of credit and, therefore, of GDP. We in the regulatory community believe that the length of the transition periods provided for the implementation of the new rules will significantly diminish the costs, to banks and the economy alike. Consequently, the economic cost of the transition towards the new requirements should be very small in relation to the magnitude of the long-term benefits, derived from reducing the probability of financial crises and the severe loss in GDP and growth that would ensue. Moreover the banks can use different avenues to reach, if needed, higher capital ratios: raising new funds, retaining a larger part of their profit, reducing some activities that are more risky. While the current proposal addresses a large part of the G20 global financial reform agenda, work on some crucial, additional elements will have to be completed in the coming months, in particular concerning the modalities of the introduction of a countercyclical buffer and new liquidity ratios. But I would like to insist in this short statement on a very critical macroprudential issue not yet really addressed: the potential impact of failure of systemically important financial institutions, or SIFIs, and the moral hazard associated with the belief that these institutions are too big to fail, a curiosity and, if I may say so, an extravagance in a market economy. The Basel Committee is currently working together with the Financial Stability Board to develop a comprehensive, global approach to SIFIs that could involve a potential mix of policies such as capital or liquidity surcharges, large exposure limits, contingent capital, and bail-in debt. The goal is for each jurisdiction to have in place a SIFI policy. Effective resolution regimes, will constitute the basis of the approach, upon which other policies would build. A cornerstone of this foundation should, I think, consist of recovery and resolution plans, or “living wills”, formulated by the largest financial institutions. These plans will require institutions to specify the measures they will take in the event of severe stress and will also allow authorities to assess the potential orderly resolvability of these institutions without having recourse to public funds. The rapid spread of the financial crisis has been a lesson not only to market participants but also to supervisors. It has shown that the root of the problems was the gradual build-up of common risks within the system. It is now widely acknowledged that such crystallisation of risk, linked to major shifts in the correlation between financial products and markets, requires more systemically-focused oversight and regulation. To use the professional jargon, microprudential control, the preserve of the supervisory authorities, must be complemented by macroprudential oversight, resorting to the expertise of central banks. In order to improve the symbiosis between these two approaches, a growing number of countries are adopting the so-called “twin peaks model” where the central bank is in charge of the full range of prudential supervision, in both its micro and macro-dimension, leaving the oversight of market integrity and investor protection to a separate institution. This “twin peaks model” will also be introduced in Belgium next year. Needless to say, I am well aware that the macro-dimension does not stop at our country’s frontiers, while the micro-supervision of cross-border groups also requires close multinational coordination. So, I strongly support the recent decision to set up, at the EU level, a European Systemic Risk Board (ESRB) and a European System of Financial Supervisors (ESFS), which are called on to cooperate closely in order to bring more comprehensiveness and consistency to national and international supervision. Macroprudential analysis must rely on rapid, direct and comprehensive access to data on individual developments liable to affect global financial stability while, in turn, this analysis must feed into the microprudential supervision. It would be a pity if our efforts to improve this flow of information in our respective countries were to be impeded by hurdles at the international level. In conclusion, the global nature of the crisis has highlighted the necessity of a holistic, internationally coordinated approach to achieve fundamental reforms in financial regulation. These reforms are under way. It is important that this approach result in consistent, international adherence to measures aimed to raise the capacity of individual institutions to absorb losses, reduce the impact of systemically important institutions on the financial system and the whole economy, limit the buildup of systemic risk, and foster international cooperation in macro-prudential supervision. Ladies and gentlemen, this week the Eurofi conference will provide ample opportunity to discuss and reflect on the topics and challenges the financial sector and the authorities are facing. I hope you will all have a very successful and rewarding conference and a very pleasant stay in Brussels. Thank you for your attention.
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Introduction by Mr Guy Quaden, Governor of the National Bank of Belgium, at the International Conference 2010, Brussels, 14 October 2010.
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Guy Quaden: International trade – threats and opportunities in a globalised world Introduction by Mr Guy Quaden, Governor of the National Bank of Belgium, at the International Conference 2010, Brussels, 14 October 2010. * * * Ladies and Gentlemen, On behalf of Governor Quaden and also on my behalf, as member of the Board of Directors in charge of the Research Department, I am pleased and I indeed feel it an honour to have the opportunity to welcome you to the sixth National Bank of Belgium Conference. As you will have seen in the programme, Governor Quaden was initially scheduled to open the Conference. Unfortunately, in view of unforeseen circumstances, he cannot be here with us this morning. He kindly asked me to offer his apologies in that respect. Instead, he will address you tomorrow at the closure of Conference, drawing the conclusions from the discussions, and will outline his views on a topic he thinks is of the utmost importance. At present, I would like to bid you once more a hearty welcome to our Conference. Held once every two years since the year 2000, this regular event is one of the initiatives taken by the Bank to promote scientific research in fields that lie at the heart of the concerns of all those involved in economic life, and also to expand its own understanding of the functioning of the economy. The theme that has been chosen for this sixth edition, namely international trade and capital flows, is of particular importance for our institution, just as it is for other observers of the Belgian economy. Indeed, our country owes a good part of its prosperity to its particularly high level of openness to trade. One consequence of being so open to the rest of the world is of course the fact that our economy’s growth depends heavily on world demand and on the capacity of our domestic firms to tap new opportunities on foreign markets. The close relationship linking economic growth to firms’ performance on external markets obviously does not only concern Belgium. Against a backdrop of the increased globalisation that has rapidly taken hold over the last twenty years, it is a topic followed very closely by economic stakeholders in all the industrialised nations. That can be mainly explained by the rise in power of emerging countries, notably the central and eastern European states, India, Brazil and, above all, China. Having benefited from both a strong trade liberalisation and large foreign investment inflows, while taking advantage of low production costs and raising their level of technological know-how, these economies now seem like fearsome competitors for European and North American companies. These firms must therefore take up many challenges in order to safeguard their competitive edge, both on their domestic markets and their foreign outlets. At the same time, the emerging countries are large in size and exhibit strong economic growth, too. Therefore, they also offer many opportunities for firms that are able to seize them. All these developments linked to the increasing globalisation of the economy obviously raise a good many questions. These include the determinants of trade flows, strategies enabling companies to gain a foothold in external markets, or the employment consequences of importing goods from low-cost countries. These issues have been extensively discussed in both the theoretical and empirical economic literature. Since the mid-nineties, a growing segment of this literature has been paying particular attention to the microeconomic determinants of international trade and foreign investment. Researchers have made intensive use of firm-level databases specific to different countries that have gradually become available for them. This microeconomic approach has brought an important contribution to our understanding of the causes and consequences of the globalisation, mainly because firm-level data make it possible to point up things that do not show up in aggregate statistics. If only one example had to be given, it would of course be the fact that trade is concentrated among a few firms, which are in a better position than the others to bear the high costs associated with entering foreign markets. Indeed, within each industry, firms of different sizes, with different performances, and with different behaviour in terms of innovation and international involvement, operate alongside each other. It is important to take this heterogeneity into consideration to understand the dynamics of foreign trade. This heterogeneity also has very important implications for economic policy, in the sense that it helps to identify two levers that are likely to be activated as a means of boosting firms’ international involvement. The first consists of encouraging their expansion – and especially that of SMEs – so as to give them the best preparation to go international, including policies designed to foster their research and development efforts. The second lever concerns measures aimed at cutting the costs of entering foreign markets, for instance by helping firms to find potential new customers there or by removing administrative and regulatory barriers. Another undeniable advantage of the microeconomic approach is that it helps bring out the scale of reallocation of production factors from the weakest-performing firms towards those whose business is more flourishing. Among other things, this enables economists to gain a better understanding of the impact of globalisation on the labour market. Issues related to this subject are naturally of paramount interest for policy-makers. Although resource reallocation has always been a key determinant of economic growth, it also involves costs that need to be taken into account. These costs are mainly related to updating workers’ skills and to innovation efforts that firms have to undertake to adapt to changes in comparative advantages. By organising this conference, the National Bank of Belgium is hoping to contribute to the enrichment of this growing area of economics. To this end, we have invited several top economists to present the findings of part of their research work here today. Four of them, who will be keynote speakers, have already made a very significant contribution to the literature on international trade over the last fifteen years. It is a great privilege for us to welcome here today Andrew Bernard, Jonathan Eaton, Marc Melitz and Gianmarco Ottaviano, who will give their perspective on the various questions dealt with during this conference, and I would like to thank them warmly for accepting our invitation. These two days will also be largely devoted to the presentation of eight original contributions by research teams from different Belgian universities and the National Bank. The papers to be presented are the outcome of research work started about a year and a half ago, under the supervision of the Research Department, with the help of the Statistics Department and the Microeconomic Analysis Service. All these projects use microeconomic data on Belgian firms that we have made available for the different research teams. Moreover, these teams have been meeting regularly to discuss the progress made with their work. These exchanges of views also give the Bank a way of encouraging the sharing of knowledge and scientific research. I hope that they have been beneficial for the participants and enabled them to optimise the quality of their work. Four of the contributions look in particular at the strategies put into place by internationally active firms. In so doing, they tackle some very relevant questions on the factors that enable firms to maintain their international competitiveness. For instance, do firms that go into many different markets at once perform differently from those that only start exporting to a very small number of destinations? What determines the supply of products that are sold on these markets? What conditions make it more efficient for a firm to resort to foreign direct investment rather than supplying markets through exports? How can firms keep their place on the export markets in the face of competition from the emerging economies? These are just some of the questions that will be dealt with in four of the presentations featured at this conference. Two other contributions should help to further deepen our understanding of the interaction between firms’ characteristics and the costs of entering foreign markets. One of them looks more specifically at the influence of technological change on trade in services. The other one deals with spillover effects, that is, the influence exporters are likely to have on the productivity of other firms, as well as on their propensity to export in their turn. And two last contributions focus on the impact of globalisation on the labour market. The first of these endeavours to study its influence on demand for labour. The second one addresses the question whether the costs related to employment adjustments vary significantly between local firms and multinational enterprises. In my opinion, the issues that will be debated today and tomorrow, during the four sessions of the conference, are extremely interesting, not just for academic circles but also for those involved either closely or indirectly in economic policy decision-making processes. And I strongly urge members of the audience to join in with the discussants, who will be commenting on each paper, and voice their own remarks and ideas. May I take this early opportunity to thank the keynote speakers, the university researchers and those from the Bank who have contributed to this conference, as well as the discussants for stimulating the exchange of ideas over the next two days. All that’s left for me to do is to hand the floor to Peter Praet, who will be chairing the first session of this 2010 Conference, and to wish you all two very pleasant and instructive days. Thank you for your attention.
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Keynote speech by Mr Luc Coene, Governor of the National Bank of Belgium, at the 29th SUERF Colloquium, Brussels, 10 May 2011.
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Luc Coene: Challenges for euro area monetary policy going forward Keynote speech by Mr Luc Coene, Governor of the National Bank of Belgium, at the 29th SUERF Colloquium, Brussels, 10 May 2011. * * * Ladies and Gentlemen This week marks the first “anniversary” – if I may say so – of the sovereign debt crisis. Indeed, the first week of May last year was characterised by extreme turmoil on financial markets and on the markets for public debt of some European countries in particular. That forced the Eurosystem to announce a set of measures on Monday 10th of May 2010, including a programme to intervene on markets for debt instruments. One year after that very turbulent period, I think it is a good time to take a look at what challenges are ahead of us. I will focus my remarks on monetary policy in the euro area, and in particular on the challenges posed by the current macroeconomic outlook and how the sovereign debt turmoil has an impact on euro area monetary policy decisions. Let’s first go back to the early days of May 2010. What we witnessed those days, was a fullblown panic on financial markets after tensions on some government debt markets had been mounting since the fall of 2009 as investors increasingly cast doubts on the capacity of Greece to repay its public debts. The turmoil in May not only led to very high spreads on Greek paper, but also affected other countries’ sovereign debt markets, led to extremely volatile equity and foreign exchange markets and brought about a new freeze in interbank trading as banks again became reluctant to lend each other in a context of uncertainties regarding exposure to the countries concerned. Therefore, the Governing Council of the Eurosystem decided on a package of measures. First, a programme to intervene on the secondary markets for private and public debt securities was set up in order to restore the smooth functioning of securities markets, a key link in the monetary transmission chain. Second, it was decided to organise again all Eurosystem liquidity providing operations as fixed-rate full allotment tenders, which allows banks to obtain all liquidity they need at a fixed rate, of course against the pledge of appropriate collateral. Finally, banks could again obtain US dollar liquidity through a swap line with the US Federal Reserve. Since these early May days one year ago, the economic outlook has improved, both on the global level and at the euro area level. Yet, in my view, the economic environment is characterised by some divergences. I see two types of divergences. At the global level, we currently experience what the IMF in its latest World Economic Outlook calls a two-speed recovery. Indeed, the recovery is led in particular by the emerging market economies while the advanced economies are still characterised by rather low growth and excess capacity. The resource-intensive growth of the emerging economies does put severe upward pressure on commodity prices, which are now standing at levels close to those seen before the financial crisis erupted in 2008. Of course, not only the fast economic growth in emerging economies pushed up commodity prices, also tensions in the Middle East and North Africa and the Japanese disaster led to higher prices. At the euro area level too, we see divergences. The rather solid recovery for the euro area as a whole does, indeed, hide significant heterogeneity as the so-called “core countries” are posting nice growth numbers while the countries most affected by the sovereign and banking crisis are lagging behind. This all means that, when doing our job – which is to maintain price stability –, the Governing Council faces a number of challenges. First and foremost, the Governing Council identifies clear upside risks to price stability which do require close monitoring. At the same time, I must admit that the sovereign debt crisis and – in some cases mutually related to that – the still fragile euro area banking sector do complicate the Governing BIS central bankers’ speeches Council’s task as it threatens the good functioning of the monetary transmission mechanism. I will look at each challenge in turn. Risks to the inflation outlook have shifted to the upside: the euro area recovery is now gaining a good footing and commodity prices have posted large gains. These higher prices push up inflation: according to Eurostat’s flash estimate, headline inflation stood at 2.8% in April, clearly above the ECB’s quantitative definition of price stability. On top, we see a lot of price pressures in the pipeline which implies that the risk of second-round effects is non-negligible today, in the context of a continuing recovery and given the likely persistent nature of the raw materials price increases. Therefore, the Governing Council decided to raise the key ECB interest rate in April to 1.25%, up from the 1%-level at which it stood since May 2009. That interest rate rise – which was widely anticipated by financial markets – indeed aims at avoiding that the first-round effects of higher commodity prices which we see in today’s inflation figures translate into second-round effects and would hence entail a prolonged period of high inflation. The higher commodity prices – which, as I said earlier, mainly reflect the good performance of emerging economies and are therefore, at least in that sense, a blessing – are a real impoverishment for the euro area economy which cannot be avoided. Higher wage claims or price increases seeking compensation for such a deterioration in the terms of trade only postpone necessary adjustments and only lead to a longer period of higher inflation without any longer-run real benefits. Therefore, a solid anchoring of inflation expectations is essential and the Governing Council will do whatever is necessary to maintain price stability over the medium term. The Governing Council acknowledged that the current monetary policy stance does remain accommodative. “Is this increase the first in a series of interest rate rises?”, is therefore a question which observers have often raised over the past month. As you all know, the Governing Council never pre-commits but at the same time, I think our strategy is very clear and markets and observers alike do realise that we will do whatever is necessary to ensure price stability will be maintained. Markets currently anticipate a gradual withdrawal of monetary accommodation and I personally think that is no unreasonable assumption, given the clear upside risks to price stability I mentioned earlier. Needless to say, it is incoming data and our assessment of the economic outlook that will ultimately determine our course of action and the pace at which monetary accommodation will be withdrawn. Another question people often raise is how such an increase in interest rates squares to the ongoing sovereign debt turmoil, which brings me the second challenge I want to discuss. I see two ways in which the sovereign debt turmoil enters our discussion. First, the turmoil does have important bearings on the transmission of monetary policy. Indeed, that was the very motivation for setting-up the Securities Market Programme in May 2010 and for re-introducing the regime of fixed-rate full allotment for longer-term operations, which is still in place at the current juncture. It will be maintained for as long as necessary, and at least until July 2011. That should avoid that banks in need of short-term funds are being cut-off from liquidity in case banks with excess funds are no longer willing to lend to them because of uncertainty on counterparties’ exposure to sovereign debt. At the current juncture, we deem these non-standard measures an essential part of our monetary policy toolkit as they help to maintain financial stability and hence a good functioning of the monetary transmission mechanism, an essential condition for being able to deliver price stability. At the same time, I would like to stress that these measures are temporary in nature. Indeed, they are not without drawbacks. The regime of fixed-rate full allotment discourages interbank trading because the Eurosystem in fact puts itself between banks with excess liquidity and those in need of liquidity. That is not a sustainable situation and it does not fit in the ECB’s view of a market-oriented implementation of monetary policy. Moreover, the non-standard measures may lessen the incentive for banks to regain access to market funding, for instance through recapitalisation – possibly with the help of public funds –, balance sheet restructuring or a change in their business model. These are the only structural and long-run solutions for the banks concerned. The current non-standard BIS central bankers’ speeches measures – which will be phased-out when appropriate – help to make the transition as smooth as possible but are no substitute for concrete actions on the part of the banks. Another way through which the sovereign debt problems enter our discussion is through their impact on the economic outlook and the outlook for price stability in particular. The considerable fiscal consolidation efforts already undertaken and those still to come, are of course indispensable to secure sustainable public finances over the longer term, but they do weigh on domestic demand in the short-run. Moreover, we continue to see the sovereign debt turmoil and its possible fall-out to the financial sector and the real economy as a downside risk to the economic outlook. These developments are therefore duly taken into account when deciding on monetary policy in the months ahead. To conclude, I would like to touch upon two issues which often raise questions with observers. The first concerns the role of heterogeneity in the euro area and the second concerns today’s policy constellation in which we raise interest rates but maintain very flexible liquidity provision policies. As regards heterogeneity across euro area countries, I do not consider this as such a phenomenon which greatly complicates our task. It is the outlook for the euro area as a whole that determines the course of our actions: there simply is no other option with a single monetary policy. Moreover, I tend to see the current heterogeneity as being part of a necessary – but, admittedly, painful – process of adjustment through which some countries have to go in order to regain competitiveness and to repair their balance sheets. Besides, being part of a monetary union will help them – rather than make it more difficult – to do so, because the greater trade links they have, allow them to benefit from faster growth in well performing member countries. Although monetary policy cannot be tailored towards the needs of specific countries or regions, national developments are to some extent taken into account when deciding on monetary policy measures. That is, for instance, the case when the Governing Council decides on its non-standard measures. Indeed, the monetary transmission impairments we observe are located mostly in those countries most affected by the sovereign and banking crisis. It is therefore no coincidence that we kept these measures in place, although we raised interest rates. In that respect, some people ask me whether I see any conflict between raising interest rates and maintaining such flexibility in liquidity allotment modes. The answer is “No”: both conceptually and technically, I see no problems in raising rates while at the same continuing to provide banks with unlimited liquidity. From a conceptual point of view I want to underscore that these two types of measures are geared towards different, but complementary, goals. The monetary policy stance is signaled by our key interest rates and is set as a function of the outlook for price stability. The non-standard measures, in contrast, are designed to ensure that the transmission of the monetary policy stance to the rest of the economy happens as smooth as possible, which should in turn allow the Governing Council to deliver price stability over the medium term. Hence, these measures are complementary to each other, rather than conflicting. Let me conclude. The Governing Council has shown it will do whatever is necessary to deliver price stability, which means taking the necessary measures to avoid a “Great Depression”-scenario as we did in 2008, but also to raise interest rates if upside risks to price stability threaten to materialise. We do have the will and the tools – including non-standard ones – to cope with the challenges in front of us. The flexibility of our framework should, however, be no excuse to postpone necessary adjustments, both in the financial and nonfinancial sector. And although we see encouraging signs – for instance in terms of competitive adjustment in some countries –, I think there is still a lot of work to do. Thank you for your attention. BIS central bankers’ speeches
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Speech by Mr Luc Coene, Governor of the National Bank of Belgium, at the colloquium "The Belgian Banking Sector in 2020" in celebration of the 75th anniversary of the Belgian Financial Forum publications "Revue bancaire et financière/Bank- en Financiewezen" and "Droit bancaire et financier/Bank- en Financieel Recht", Brussels, 22 November 2011.
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Luc Coene: The Belgian banking sector in 2020 Speech by Mr Luc Coene, Governor of the National Bank of Belgium, at the colloquium “The Belgian Banking Sector in 2020” in celebration of the 75th anniversary of the Belgian Financial Forum publications “Revue bancaire et financière/Bank- en Financiewezen” and “Droit bancaire et financier/Bank- en Financieel Recht”, Brussels, 22 November 2011. * * * The many lessons learned from the crisis that began in 2007–2008 have given rise to an ambitious, internationally coordinated, and broad-based set of regulatory reforms. The new regulatory framework not only strengthens requirements and supervision at the microprudential level, but it also incorporates new macroprudential requirements. Changes to the regulatory architecture have also led to the creation of new regulatory authorities, at both the European and Belgian levels. All of these developments will have significant impacts on the Belgian banking sector over the next decade. 1. Microprudential supervision – Basel III Key elements, which are designed to increase banks’ resiliency to shocks, include: An increase in minimum regulatory capital requirements: the range of risks for which regulatory capital must be held has also expanded. Higher quality of capital: an increase in the amount of capital that must be held in the form of common equity, which offers the greatest capacity for loss absorption. A leverage ratio, which is a non-risk-weighted capital requirement that should serve as a backstop to protect against situations where risk-weighted capital requirements are too low (through underestimation of risks or regulatory arbitrage) Liquidity ratios: the liquidity coverage ratio will ensure that banks can withstand a liquidity shock of 30 days in duration; the net stable funding ratio will ensure that banks have a sufficient amount of longer-term stable funding. 2. Macroprudential supervision One of the striking outcomes of the crisis has been a change in the focus of prudential regulation, from a narrow concern with the resiliency of individual institutions to a broader preoccupation with the entire financial system. This concern has translated into the inclusion in the Basel III of new macroprudential capital requirements. It has also led to the establishment of a macroprudential authority in the new European regulatory framework. New macroprudential capital requirements: Countercyclical capital buffers (CCBs) have been introduced into the Basel III framework, to address the time dimension of systemic risk. The level of countercyclical capital buffers, which will vary between 0 and 2.5% of risk-weighted assets, will be determined at national level for all credit exposures to counterparts in that country. When credit growth is judged excessive, national authorities will require banks to build buffers, which can then be drawn down in the ensuing downturn. The countercyclical buffer policy is reciprocal, meaning that all banks, even foreign ones, with exposures in a country must hold the buffer that has been set by that country’s authorities. SIFIs. Systemic risk also has a cross-sectional dimension, as illustrated in the crisis by the multiple instances where governments felt compelled to intervene with public BIS central bankers’ speeches money to rescue large financial institutions whose failure could have transmitted distress to the entire financial system. On the one hand, failure of systemically important financial institutions (or SIFIs) would generate large costs that the institutions themselves do not internalize. On the other hand, belief that these institutions are too big to fail creates a moral hazard problem, weakening market discipline and providing the institutions with an incentive to take excessive risk. Both of these observations point to the need to find ways to allow such institutions to fail without injections of public money. At the global level, the Basel Committee is working together with the Financial Stability Board to develop a comprehensive approach to address the systemic risk created by global SIFIs. A methodology has been developed to 2.5%, dependingidentify global SIFIs, which will face capital surcharges of 1 upon their degree of systemic importance. These institutions will be subject to enhanced supervision, as well as to the requirement to formulate recovery and resolution plans (or living wills). At the Belgian level, the NBB has developed a methodology for identifying institutions whose failure could have a significant impact on the domestic financial system i.e., domestic SIFIs. The methodology, in line with the international practice, focuses on the institution’s size, its interconnectedness with other domestic financial institutions, and the ease of substitutability of the critical functions performed by the institution to gauge its degree of systemic importance. Domestic SIFIs will be required to submit plans for all strategic decisions to the NBB, which has the power to veto these decisions if they are judged to have a negative impact on the institution’s risk profile or on the financial system. D-SIFIs will also have to comply with special reporting requirements and will need to develop recovery and resolution plans. The recovery plan – which is developed by the bank – outlines the different options that can be taken in response to a major shock to its liquidity or solvency. The resolution plan, developed by authorities, outlines options for cases where the recovery plan of an institution has not succeeded. 3. Resolution frameworks The focus on recovery and resolution plans highlights another critical area of regulatory reform: the improvement of crisis management and bank resolution frameworks. The crisis has revealed many obstacles to the resolution of crossborder financial institutions, and here is now a clearly acknowledged need to improve resolution regimes. Importantly, the effectiveness of crisis resolution framework also affects the behavior of financial institutions and their stakeholders, even in non-crisis times. If the crisis resolution mechanism is weak, leading to a high probability of government bailout of SIFIs that encounter distress, then stakeholders of these institutions will have little incentive to exert discipline on management, who may engage in excessive risk taking. In Europe, a legislative proposal soon to be published by the Commission should help to lay the foundations for a new crisis management framework. Key elements of the framework will involve the formulation of recovery and resolution plans (at least for large, cross-border institutions), enhanced resolution powers for authorities, and provisions linked to bail-in debt, which protects taxpayers by converting certain types of debt to equity at the point of non-viability of an institution. BIS central bankers’ speeches Authorities in several G20 countries are currently working with their credit institutions to develop recovery and resolution plans (RRPs). These efforts are being coordinated by the Financial Stability Board. Along similar lines, the European Council conclusions of May 10, 2010, relating to crisis prevention, management and resolution contain a requirement that Cross-Border Stability Groups (CBSG) coordinate the drafting of RRPs. 4. The new institutional architecture In response to the crisis, a new supervisory architecture has been established in Europe. This framework includes three new European supervisory authorities (ESAs) – for banking, insurance and securities markets – and the European Systemic Risk Board (ESRB), which is responsible for macroprudential oversight and based at the ECB. Each of the new supervisory authorities is responsible for creating a single rulebook, designed to establish harmonized regulatory technical standards and ensure a level playing field across the Union. The ESAs must also, in cooperation with the ESRB, initiate and coordinate Union-wide stress tests to assess the resilience of financial institutions to adverse market developments. The ESRB monitors and assess systemic risk with the objective of lowering the probability of a build-up of systemic risk or mitigating the impact of any materialization of systemic risk. The ESRB’s principal tasks include identifying and assessing systemic risks, issuing early warnings as risks emerge, and formulating policy recommendations in response to the observed risks. Warnings and recommendations can be addressed to the European Union as a whole, to one or more Member States, to one or more of the ESAs, or to one or more national supervisory authorities. The move in Belgium to the twin peaks model is in line with these developments. This adaptation of the domestic institutional framework allows for a regular flow of information between microprudential and macroprudential supervisors and for the coordination of micro and macro-prudential policies. It also permits application of the “four-eyes principle”, which incorporates a transversal approach to risk analysis, across risks, institutions, and time. 5. Impacts of these developments on the Belgian banking sector As indicated by the previous speaker, the financial sector will face a very competitive environment in the search of stable financing. This will result in a number of consequences: More costly credit. It is difficult to deny that the stricter capital requirements, combined with the new liquidity rules and new taxes, will increase the cost of credit. We do not yet know the extent to which this higher cost will impact aggregate lending or the real economy. However, the experience of the past three years has clearly demonstrated that banking crises are extremely costly and have significant negative, long-term impacts on the economy. The deleveraging process will reinforce this development. This is likely to affect more SME’s than larger corporations, that can still access the financial markets. This last development may lead to some disintermediation. Fewer cross-border institutions or activity, or less centralized liquidity management. The failures of resolution frameworks revealed by the crisis and the difficulty of establishing an effective resolution framework for cross-border institutions suggest that cross-border activity will be reduced in the future. BIS central bankers’ speeches Contributing to this development may be the new liquidity requirements, which could result in less centralized liquidity management by cross-border groups. At the same time, while some degree of explicit or implicit ring-fencing is an understandable outcome of the crisis, we must be aware of the fact that Belgium is a country with excess savings. We would not be doing Belgian banks a favor by forcing them to employ all of Belgian savings within Belgium. We will need to ensure that the new regulatory framework allows for an appropriate balance between limiting the risks associated with cross-border activities and allowing savings to flow to their most profitable uses. Industrial organization and SIFIs. Another dimension through which the future structure of the banking system may be affected is related to the treatment of SIFIs. The identification of SIFIs involves gauging, among other things, size, market shares, and the degree of interconnectedness between banks. Limiting their size and interconnectedness, which SIFIs should have the incentive to do, will potentially lower concentration in the banking system and reduce the potential contagion that could result from a shock. Risk management for systemically important banks will also likely differ from the past, as SIFIs will be required to formulate recovery plans and regularly update them. Developing a recovery plan requires envisaging a series of scenarios involving severe shocks and the bank’s possible responses to those the potential in consultation with authorities shocks, as well as assessing effectiveness of these responses. The recovery plan process must be ongoing and integrated into the bank’s risk management procedures. This process should require banks to undertake more advanced planning for distress situations than in the past and should encourage a fundamental reflection regarding the rationale underlying the bank’s activities, complexity, and organizational structure. Greater focus on traditional banking. Several elements of the regulatory reforms (e.g., liquidity requirements and increases in capital requirements for the trading book) provide the incentive for banks to move more toward the “traditional” model of banking. While a requirement such as the ring-fencing of retail banking from investment banking proposed in the UK probably goes too far, a toughening of capital requirements for the trading book and greater alignment of capital requirements for exposures in the trading and banking book should give banks less incentive to take excessive risk through proprietary trading, thereby relying more on traditional banking activity. In smaller countries like Belgium ring fencing retail banks would be rather counterproductive. the main victims of such a reform could be the SME’s. They need more sophisticated instruments than those retails banks can offer and they would be too small for investment banks. We have in Belgium a strong model of universal banking. We should preserve that. Less discretion by banks in the determination of risk-weighted assets. Recent events, including the European stress tests and the sovereign debt crisis, have highlighted significant differences across banks and across jurisdictions in the calculation of risk weights and capital requirements for certain assets. This raises the question as to whether such outcomes are consistent with what was intended by the designers of the Basel framework. In coming months work will be initiated by both the Basel Committee and EBA to monitor the implementation of the new regulatory framework and to ensure that risk-weighted assets are appropriately and consistently calculated for exposures in both the banking and the trading book. This will likely result in more harmonization, at least among European banks, of IRB models for determining PDs and LGDs. Significant differences across banks in riskweighted assets must arise as a result of true differences in risk and not from the underestimation of certain risks by some banks. BIS central bankers’ speeches 6. Challenges While it is possible to make some predictions about the changes in the Belgian banking sector in the coming years, several open questions remain, linked in part to the challenges associated with implementation of the regulatory reforms. One issue that we are all now acutely aware of as a result of the crisis is the fact that sovereign debt can no longer be considered to be a risk-free asset. It now becomes crucial for regulators to ensure that the credit risk of sovereign debt exposures is adequately recognized by banks. A reflection needs to be undertaken concerning the role of sovereign debt in regulation. Questions that will need to be addressed include the allowance of a zero risk weight for certain sovereign exposures (standardized approach allows zero risk weight for AAA and AA-rated sovereigns; IRB approach has no floor on sovereign PDs), the reliance of liquidity requirements on sovereign debt holdings, and exemptions of sovereign debt from large exposure rules. How these issues are resolved will obviously have an impact on the future composition of many banks’ balance sheets. E.g. we see now that the liquidity cover ratio (LCR) as it is designed, discourages interbank lending. Other open questions relate to potential unintended consequences of the regulatory framework. To what extent will the tougher requirements on regulated institutions cause risks and activities to flow into the shadow banking sector and what will be the implications for banks and for systemic risk? Work is currently ongoing at the international level, under the leadership of the FSB, to strengthen the oversight and regulation of the shadow banking sector, and European authorities are also working on this issue. Yet, authorities will still need to remain extremely vigilant over the coming years in tracking the ultimate distribution of risks. Finally, many reforms are being introduced simultaneously. We do not yet understand fully the extent to which different reforms are complements or substitutes and, hence, what their cumulative impacts will be. The interactions between the various regulations must be carefully monitored, in order to understand the impact of the reforms on the financial landscape and to ensure that the goal of increasing the resilience of banks and the financial system are achieved at least cost. BIS central bankers’ speeches
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Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the EACB Regulatory Debate, Brussels, 20 March 2018.
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Jan Smets: The impact of monetary policy on the macroeconomy and European banks Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the EACB Regulatory Debate, Brussels, 20 March 2018. * * * Accompanying slides of this speech. Ladies and gentlemen, I would like to thank you for inviting me to participate in this interesting event. My talk will somewhat deviate from the main topic of regulation that you are debating today. Instead, I will focus on the ECB’s monetary policy and its impact on the banking sector and the macroeconomy. A recovery with low inflation I am well aware that the last years have been challenging for the banking sector. Banks have navigated the troubled waters of a financial and economic crisis. They have had to adapt to a new regulatory and supervisory setting. Believe me, also for central banks the last few years have not really been a walk in the park. Over the past decade, the ECB, like other central banks, has taken unprecedented measures to limit the impact of the financial crisis on the economy of the euro area. Supported by these measures, economic conditions improved. Unemployment has gone down and confidence, up. Economic indicators are solid and the most oft-used measures of slack are closing; and yet – inflation has remained subdued. Since 2014, euro area inflation has averaged 0.6% in annual terms. Currently, both headline and underlying inflation remain well below 2%. Looking ahead, we expect a slow recovery of inflation towards our inflation aim. Why this disconnect between growth and inflation? Despite stronger growth, slack might be larger than presumed One important factor that may be weighing on inflation is the presence of idle resources in the economy. Indeed, we suspect that, despite the recovery, there remains slack on the labour market, although its exact magnitude is uncertain. For instance, it is useful to look at the ‘broad’ unemployment rate, which includes discouraged work seekers, or employees working part-time but who would want to work full-time. During the crisis, the rise in this measure was considerably stronger than that of the ‘normal’ unemployment rate. The gap between the two remains wider than before the crisis. This shows that the untapped supply of labour remains more significant than suggested by the simple unemployment rate. The latest estimates for the equilibrium rate of unemployment also make us suspect that slack is bigger than we thought. This measure is the unemployment rate which is consistent with stable wage inflation, the NAWRU (non-accelerating wage rate of unemployment): if unemployment is higher than this equilibrium rate, increases in wages will be slower; if lower, wages will go up faster. Since 2014, the NAWRU –here I present European Commission estimates— has been systematically revised downwards. This means that the economy could converge towards an even lower level of unemployment without creating undue inflationary pressures. 1/5 BIS central bankers' speeches Structural factors (for instance labour market reforms) may be boosting the economy’s potential. This is good news, for it means that we have more margin to grow. However, in the short term it implies a slower convergence of inflation towards our aim. Furthermore, more flexible price and wage setting can imply that idle resources weigh more on inflation. Besides, a long period of low inflation could lead firms and unions to become more backward-looking when setting prices and wages, making inflation more persistent. If low inflation stems from such factors, one can be confident that it will recover, albeit perhaps only slowly. To support it, as President Draghi stressed, monetary policy needs to remain patient, persistent and prudent. The importance of getting inflation back towards 2% Absent such support, the economy would be prevented from tapping its full potential. Furthermore, the too long period of low inflation would lead economic agents to reassess their long term inflation expectations. Were this to happen, the trend inflation rate could fall below precrisis levels and hence below our price stability definition. Inflation would thus settle permanently at a level below our inflation aim. This lower trend inflation, through its impact on nominal incomes, would complicate the still necessary deleveraging efforts. There is yet another, and perhaps even more worrying and longlasting, effect: because inflation is a determinant of nominal interest rates, low trend inflation implies low nominal interest rates in steady state. This means that, faced to negative shocks, the central bank would have a smaller margin to reduce rates, so recessions might last longer and inflation would recover more slowly. Of course, faced with the lower bound, the central bank could use non-standard measures more often. Yet, such unconventional measures – asset purchases and negative interest rates, for instance – are typically seen to have more side effects, including on financial stability. In sum, I believe such “low inflation-low interest rate” environment would not be a friendly one for banks – either because it means less macroeconomic stabilisation or because it means more nonstandard measures. You may think it paradoxical that a member of the ECB Governing Council – the first big central bank to lower rates below zero – is warning you about the risks of low interest rates. And yet, this is precisely what I want to address today, with an important nuance: these adverse effects are larger the longer the period over which rates remain at such low levels. With our measures, we intend to provide strong enough a stimulus to get inflation up again, creating the conditions that allow us to again raise nominal interest rates. On the contrary, surrendering to the low inflation would cause lower inflation expectations and an even longer period of low nominal interest rates. The experience of the Fed, where the US macroeconomic situation has allowed it to raise rates, is encouraging in that respect. At the same time, I acknowledge that our current measures may have a temporary negative impact on financial stability or bank profitability. This is particularly true of the negative rate policy, particularly when combined with a flatter yield curve. Monetary policy makers are not directly concerned about bank profitability. However, banks are the main source of funding for the non-financial private sector in the euro area and, thus, the main channel of transmission of our measures. If the adverse impact of our measures on bank profitability becomes – or is expected to become – too large, banks’ capacity to lend may decline, and we would not achieve the more favourable financial conditions we seek. Thus, a profitable and well-functioning banking sector is essential to ensure a good transmission of our monetary policy measures. 2/5 BIS central bankers' speeches Negative rates affect bank profits in different ways The potentially most adverse effect of negative rates on banks’ profits works through the net interest income. This is the essential source of revenue for the traditional banking model, based on maturity transformation and financed by deposits. Thus, banks focused on retail business, among them many cooperative banks, could be especially hurt by the negative interest rate policy. How so? The crux of the matter lies in the coincidence of two circumstances: the reluctance of households to pay to banks for depositing their money, and the importance of this type of funding for banks. Retail customers are strongly averse to negative nominal rates, even if negative real rates are generally accepted. Because the cost of holding cash is relatively low when amounts are not too large, withdrawing part of their negative-yielding deposits could even be a rational reaction for many households. In the euro area, household deposits account for one fifth of banks’ liabilities on average. Thus, a large withdrawal of retail deposits could be very problematic for banks, as they could become underfunded and more dependent on less stable financing. Hence, banks have a strong interest in keeping retail deposit rates positive, even when other funding costs drop: in practice there is a zero lower bound for retail rates, so when policy rates become negative, the cost of part of the bank’s funding does not go down. However, after the drop in policy rates, interest revenues on assets do decrease: variable rate loans adjust to market rates, and the maturing portfolio will be replaced with assets yielding less. Thus, banks’ net interest income starts to fall. Of course, banks can try to limit the impact on profitability, by taking on more risk, or getting cheaper, but less stable, funding. However, this could make them more fragile. To limit the fall in their interest income, banks could reduce lending rates to a lesser degree than with a “normal” interest rate reduction. Of course, this would hamper the monetary transmission to the real economy. That is the opposite of what we want. Fortunately, this is not the whole story, as other channels can offset this adverse impact of negative rates. When policy rates are lowered, fixed-rate marketable assets held by banks gain in value. This boosts banks’ economic capital at the moment of the rate cut. Banks also benefit from the improvement in the economy that follows the rate cut: the quality of the lending book improves, borrower risk goes down, and the demand for loans increases. In addition, variable rate loans become more affordable after a rate cut. While this reduces banks’ interest income, it also makes repayments cheaper and should lower default rates. Banks’ characteristics matter Thus, the ultimate impact of negative rates on bank profits and credit supply is difficult to estimate. Not all banks would be affected to the same extent by the negative rates. The impact of negative rates on banks’ profits will depend on the composition of their balance sheets and, more generally, on their business model. The channels through which profitability is affected – the share of retail deposits, scope for valuation gains and maturity of the loan book– can provide an indication of the direction and the extent of the effect on each bank. 3/5 BIS central bankers' speeches The lower bound in the remuneration of retail deposits is the core factor behind the specialness of negative policy rates for banks. Therefore, the share of retail deposits in a bank’s funding is the first relevant variable to assess. Indeed, some analyses show that, when rates are at zero or below, new rate cuts will weigh more on banks’ stock prices[1] and on their lending volumes[2] if banks are more funded through retail deposits. To be clear: this does not mean that our negative rate has had a general tightening effect. Rather, we have all indication of the opposite: bank lending rates have decreased and lending has accelerated over the last three years. But it indicates that the rigidity of the cost of deposits can make cuts in negative territory less expansionary than when rates stay above zero. On the asset side, interest risk exposure works in the opposite direction: the smaller or slower the adjustment of interest income to the new rate cut, the more positive the impact on bank profitability. A longer average maturity of marketable assets implies bigger capital gains for banks. Long-term fixed-rate loans allow the bank to benefit from higher net interest income until the full repayment, although loan renegotiations may limit the additional benefits. In contrast, more variable-rate or short-term loans entail a faster fall in interest income. Thus, the net impact of negative rates on profitability will be different for different banks. Those most reliant on deposits, providing short-term lending and holding fewer marketable assets might be the most affected. Many cooperative banks may fit in this description. Yet, the final impact on aggregate credit supply will depend on still other characteristics: banks with higher initial capital or margin to lower costs will be able to weather the temporary compression on profits and to better transmit the easier financial conditions to the economy. Other measures implemented by the ECB over the last few years may have also offset the potential hampering impact of negative rates. The Targeted LTROs, for instance, have contributed to lowering the cost of funding for banks. Our forward guidance on policy rates and our asset purchase programmes have increased the value of assets held by banks and to accelerate the recovery. In sum, they help to create the conditions which will allow us to normalise interest rates again. [1] Ampudia and Van den Heuvel, 2017. [2] Heider, Saidi and Schepens, 2017; de Sola Perea and Kasongo Kashama, 2017. Final thoughts I will briefly summarize. Low rates, and most particularly negative rates, can have an adverse impact on bank profitability and, in consequence, on financial stability. Such an impact will be stronger the longer the period of low or negative rates. However, today’s very low – even negative – rates have been and are still absolutely necessary to avoid that inflation settles at too low levels, which would mean permanently low rates and even larger challenges for the economy, including the banking sector. Let me share three final thoughts. First, the experience of the past years highlights the importance of banks’ resilience, so they can withstand a transitory period of very low rates. This underlines the necessity of prudential – including macroprudential– policies to strengthen the banking sector. There has been progress on this: the prudential framework has been revised and extended significantly since the crisis. While adapting to it has been a challenging task for banks, its completion should kick-start a period of regulatory stability. Second, even when we deliver on our mandate and bring inflation back towards 2%, the real 4/5 BIS central bankers' speeches component in nominal interest rates might not recover to pre-crisis levels. Beyond cyclical factors, the low level of real rates is also due to structural drivers, such as demographic developments or slower potential growth. These factors are beyond the reach of monetary policy. That might mean that interest rates could settle at lower levels than before the crisis, and that episodes of very low rates – for instance during recessions – may become more frequent. That makes my previous recommendation even more important. In order to increase real returns again, other policymakers should do their job by pursuing structural reforms to boost economic growth. Finally, while the current period of low rates can put pressure on banks’ profits, other, more structural factors, may also play a role. Banks, especially in Europe, are still facing a number of considerable challenges going forward, which will remain after the ‘normalisation’ of monetary policy. These challenges include still elevated cost structures, the emergence and growing role of Fintech competitors, IT and cybersecurity risks, and evidence of overcapacity in the European banking sector, to name but a few examples. To continue playing their important role in our economy, banks must still continue to adapt to the new environment. Thank you for your attention. 5/5 BIS central bankers' speeches
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Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the 7th Annual Research Conference "Around a Decade After the Crisis: Heading to the New Global Cycle and Monetary Policy Normalization", National Bank of the Republic of Macedonia, Ohrid, 13 April 2018.
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Jan Smets: Monetary policy normalization – where do we stand? Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the 7th Annual Research Conference "Around a Decade After the Crisis: Heading to the New Global Cycle and Monetary Policy Normalization", National Bank of the Republic of Macedonia, Ohrid, 13 April 2018. * * * Accompanying slides of this speech. Dear ladies and gentlemen, It’s a pleasure and honour to be here with you today. Many thanks to the National Bank of the Republic of Macedonia for the invitation. The last decade has been a challenging one for policymakers, not the least for central bankers. Confronted with a severe economic downturn but determined to deliver on our mandates, we were forced to expand our monetary policy toolkit with negative interest rates, asset purchases and forward guidance. Overall, these measures have been very effective and helped set in motion the current synchronized global upturn. Notwithstanding the economic recovery, central bankers cannot (yet) rest at ease. First, weak inflationary pressures remain a lingering concern. Second, monetary policy normalization itself poses a new challenge which requires our attention. My talk today will focus on these topics – low inflation and its implications for monetary policy normalisation –, primarily viewed from a euro area perspective. But let me first take a broader view, as also central banks from other advanced economies are confronted with the same challenges. Indeed, for some time, advanced economies have been characterized by robust economic growth but puzzlingly weak or inexistent inflationary pressures. The United States economy recovered relatively quickly from the 2008 financial crisis with real GDP catching up again with its pre-crisis peak level in 2011. The economic expansion has been ongoing since then and may be on its way to register as the longest on record. The improvement in the labour market has been impressive with the unemployment rate falling from its peak at 10 % in October 2009 to 4.1 % currently, a level below most estimates of the natural unemployment rate. Tightness in the labour market has, however, not translated into strong wage and price pressures. From a historical perspective, wage increases have been muted and core PCE inflation has overall remained below the central bank’s 2 % target. Looking forward, the inflation outlook is more upbeat, though: wages have accelerated a little of late and temporary factors that have held down core inflation are disappearing. Consequently, US monetary policy makers project core inflation to pick up, running slightly above 2 % in 2019 and 2020. This suggests that the growth-inflation disconnect in the US is temporary. For the euro area, available data call for more caution. The sovereign debt crisis meant that the cyclical recovery took much longer to manifest itself: real GDP only returned to its pre-crisis peak level in 2015 but the economic expansion has been robust and broad-based since and looks set to continue. The unemployment rate is on a downward path, although it has not yet reached its pre-crisis level. Despite these favourable developments, inflationary pressures remain weak. Underlying inflation has been basically flat at 1 % over the last 5 years – far from our objective of below but close to 2 % - and wage growth does not yet show convincing upward momentum. Looking forward, underlying inflation is projected to only gradually rise to 1.8 % in 2020. In contrast to the euro area and the Unites States, nominal weakness has been a permanent 1/5 BIS central bankers' speeches feature of the Japanese economy over the last 2 decades. While recently, economic growth has strengthened a bit and the unemployment rate fell to record lows, wage growth has remained weak and inflation stubbornly low. The Bank of Japan appears confident in reaching its inflation target, however, projecting CPI inflation excluding fresh food to accelerate to above 2 % in 2019. As the three economies find themselves at different points in the business cycle and confidence in inflation getting back to target varies, the respective monetary policy stances differ as well. On the one hand, the Federal Reserve is well underway with normalization. It ended its net asset purchases in October 2014, started raising the federal funds rate in December 2015 and has recently started to gradually reduce its balance sheet. Consequently, the federal funds rate has again become the primary tool for signalling the monetary policy stance. In March the rate’s target range was hiked to 1.5 % to 1.75 %; currently markets expect 3 more rate hikes this year while Fed officials pencil in 2 more. On the other hand, the Eurosystem and the Bank of Japan remain more cautious, keeping their monetary policy stimulus in place. In 2016, the Bank of Japan even revamped its monetary policy framework introducing negative rates, yield curve control and an inflation-overshooting commitment. In the euro area, the strengthening recovery and improved confidence in inflation converging to our aim have allowed us to gradually start recalibrating our monetary policy package over the past months. We reduced the pace of our monthly net asset purchases and removed some so-called “easing biases” in our communication. This notwithstanding, our overall stance continues to be very accommodative. The cautious approach taken by the Eurosystem is inspired by the multitude of uncertainties that remain present in the economy and that are complicating our understanding of how the economy exactly works. I already mentioned one such uncertainty: the link between inflation and economic growth. Recent research has come up with a number of possible explanations accounting for the slower reaction of underlying inflation to a strengthening economy. One entails that despite the robust recovery, labour market slack might be larger than presumed. For instance, in the euro area the “broad” unemployment rate – which includes discouraged work-seekers and employees working part-time but who would want to work full-time – rose considerably more strongly during the crisis than the conventional unemployment rate. And the gap between the two remains wider than before the crisis. This suggests that the untapped supply of labour remains possibly more significant than suggested by the simple unemployment rate. The recent downward revisions in the natural rate of unemployment – here the European Commission’s NAWRU (non-accelerating wage rate of unemployment) estimates are shown – also make us suspect that slack in the euro area is bigger than we thought. They imply that the economy could converge towards a lower level of unemployment without creating inflationary pressures. Past and ongoing structural reforms, for one, could account for the boost to labour supply, and therefore to the economy’s potential as a whole. On the one hand, this entails good news as we have more margin to grow. How much precisely remains, however, an open question as the exact magnitude of slack and the pace at which it is eroding remain uncertain. On the other hand, higher slack implies a slower convergence of inflation towards our aim and such a long period of too low inflation can also pose specific challenges, even beyond its underlying cause – the excess capacity. Let me now try to shed some light on how important this slack story is in explaining the low 2/5 BIS central bankers' speeches inflation or whether also other factors play a role here. A Phillips curve analysis – allowing for time-variation in the parameters – can give us an idea. It caters for many potential sources of low inflation, including idle resources but also lower trend inflation and external price pressures. In house NBB estimates1 find that since 2013 the negative output gap and weaker import prices have been the most important factors in lowering headline inflation in the euro area. While import prices are now pulling up inflation – reflecting the impact of the recent recovery in oil prices – slack still remains a bit of a drag. Nominal factors – related to how firms and households set prices and wages – seem to have played a more limited role. As of 2013, trend inflation seems to have fallen a bit below 2 %, but only slightly so. In addition, inflation persistence – which is captured by the ρ in the Phillips curve equation – appears to have increased somewhat. This implies that shocks have a longer-lasting impact on inflation as a result of which inflation converges more slowly to its trend. In this regard, the long period of low inflation could have led firms and unions to become more backwardlooking when setting prices and wages, making inflation more persistent. Or it could also reflect that the lower bound has somewhat affected monetary policy’s effectiveness in dealing with the shocks hitting the euro area economy. As the euro area expansion proceeds, most of these disinflationary forces should disappear. As a result, inflation should recover to our target of close to but below 2 %, albeit perhaps a little more slowly given the higher inflation persistence. Another uncertainty that warrants a cautious monetary policy approach concerns the level of the natural rate of interest. Of course, our estimates about its level are always a bit of a guess as the natural rate is unobservable. What several studies suggest, however, is that it has fallen in several advanced economies since the crisis. That puts an even higher premium on bringing inflation back towards our inflation aim – even if the absorption of slack that accompanies it is of course already a very good reason to do so. In a low real rate world, the frequency of lower bound periods is likely higher. In such an environment, avoiding inflation to settle at too low levels is of utmost importance as it helps preserve the macroeconomic stabilization capacity of the central bank’s nominal policy rate instrument. Were we to allow trend inflation to settle below pre-crisis levels and hence below our price stability definition, it would imply even lower nominal interest rates in steady state. This means that, faced with negative shocks, the central bank would have a smaller margin to reduce rates, so recessions might last longer and inflation would recover more slowly. True, faced with the lower bound, the central bank could use non-standard measures more often. Yet, such unconventional measures – asset purchases and negative interest rates, for instance –, while effective, are typically seen to have more side effects, including on financial stability, and they also have limits. Because of the firm commitment to bring inflation back in line with our inflation aim, I thus believe that the prudent, persistent and patient monetary policy approach followed by the Governing Council so far is fully justified. The different environment that we are operating in since the crisis should make us more wary of past relationships guiding our decisions today and tomorrow. These will continue to be supported by a cautious monitoring of actual data, in particular wage growth and underlying inflation. The conditionality is embedded in our reaction function in the form of the concept of “Sustained Adjustment in the Path of Inflation” (SAPI). It entails that inflation has to move in line with our aim of below but close to 2 % in a sustainable way. This requires that three criteria, namely 3/5 BIS central bankers' speeches convergence, confidence and resilience, have to be fulfilled. At present, we are increasingly confident that inflation is on a rising path and converging to our objective in the medium term. But it lacks some resilience, though, as it still relies on our monetary policy support. Therefore our monetary policy package remains in place for now. This is fully consistent with our primary objective of realizing price stability. In doing so, we give the economy the time to tap its full potential. This steady-hand approach of monetary policy should also pay off in the future. For one, it helps ensure that when we start normalizing we will be able to do so in a durable way, meaning in an economy where the nominal and real side are sufficiently strong. Again having mandateconsistent inflation readings will allow the central bank to perform its stabilising role at all times, including during future recessions. This brings me to my next topic, namely: what would the ECB’s monetary policy normalization look like? Even if it is early days to talk in detail about this, our forward guidance gives already some guiding principles that I would like to share with you. The first decision we will make concerns our asset purchase programme. Its horizon is conditional on SAPI, so once we decide that sufficient progress on this front has been made, net asset purchases will gradually come to an end. By reinvesting maturing assets for as long as necessary, we ensure that the stock of assets on our balance sheet will remain stable for a good while, and that the downward pressure on longterm interest rates will persist. In other speeches, Peter Praet has already shown that the reinvestment policy indeed has a very persistent impact on term premia2. Likewise, our continued pledge to keep key policy rates at their current levels well past the end of net purchases has assured in the past and will assure in the future that the short-end of the curve remains firmly anchored at low levels. As we move further in time, the main instrument for shaping the stance will again become the key policy rates, including forward guidance about their likely evolution. As such, our communication will likely be further specified and calibrated to ensure that inflation continues to evolve in line with our objective. We will continue to inform markets to the best of our ability about the state of our thinking about the way forward, making adjustments to our policy as predictable as possible. Predictability and gradualism should also limit the spillovers to Central, Eastern and Southeastern European (CESEE) countries when we decide on normalizing our monetary policy. Indeed, the Federal Reserve “taper tantrum” of May 2013 did lead to sizeable capital outflows from catching-up economies, including in the CESEE region. However, the monetary policy tightening alluded to in Ben Bernanke’s tapering speech came as a surprise to financial markets; as said before, the ECB’s monetary policy normalization aims to be gradual and predictable. Moreover, since then, CESEE countries have taken steps to reduce their vulnerabilities: most of them now have deeper local currency debt markets, smaller macro imbalances, and stronger macroeconomic frameworks. Nevertheless, CESEE countries are still exposed to a tightening in global financial conditions, due to their generally elevated external liabilities; at 56 % of GDP on average (in 2017), most CESEE countries have a relatively high external debt ratio. Vulnerability to a rise in global rates varies greatly across the region, however, reflecting not only differences in debt levels but also in the structure of countries’ external liabilities, including the role of FDI versus more volatile capital inflows in those liabilities and the shares of foreign currency and short-term debt. Hence, CESEE countries should take advantage of the current stronger global economy to 4/5 BIS central bankers' speeches continue to build resilience to changes in external financial conditions. Structural policies to foster higher productivity and sound fiscal and financial policies remain key. Ensuring efficient corporate insolvency and restructuring frameworks would also help achieve faster and less costly resolution of repayment difficulties should they arise when global financing conditions gradually become less accommodative. Summing up, the robust non-inflationary growth that we are experiencing now in the euro area should make us, central bankers, neither satisfied nor anxious but rather patient. Uncertainty, for instance about the underlying strength of real variables, calls for a steady-hand monetary policy, finding first confirmation from the nominal side of the economy that price pressures are sufficiently strengthening. But I am confident that inflation will sustainably converge to our aim. I thank you for your attention. 1 See Cordemans N. and J. Wauters (2018) “What explains the disconnect between real and nominal developments?” forthcoming in the June issue of the NBB Economic Review. See for instance the speech “Assessment of quantitative easing and challenges of policy normalization” given by P. Praet at The ECB and Its Watchers XIX Conference in Frankfurt am Main on 14 March 2018. 5/5 BIS central bankers' speeches
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Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the ninth European Central Bank Conference on Statistics, Session 1: New data needs for monetary policy, Frankfurt am Main, 11 July 2018.
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Jan Smets: New data needs for monetary policy Speech by Mr Jan Smets, Governor of the National Bank of Belgium, at the ninth European Central Bank Conference on Statistics, Session 1: New data needs for monetary policy, Frankfurt am Main, 11 July 2018. * * * Reflections on the future of monetary policy may require new data needs I would like to thank the organisers for inviting me to this most interesting conference, and especially this particular session as it really is about the interactions between statistics and the future of monetary policy, a hotly debated topic. Some important (and interrelated) things have been happening over the last decade or so in the monetary policy landscape. Not only have central banks broadened their toolkit to tackle the financial crisis but also the economic world has been faced with structural changes. Besides, both the use of new instruments and the availability of new data have spurred advances in monetary policy research. The interplay of these phenomena could potentially have serious implications for the way we think about monetary policy going forward, be it in terms of objectives, instruments, transmission channels or data monitoring. But – and that is the message I want to convey here –to avoid drawing overly hasty conclusions, this requires careful reflection and, in some cases, implies new data needs. Only after careful investigation of the issues at stake, can lessons for the future of monetary policy be drawn. In my remarks today, I will focus more specifically on three phenomena that challenge our traditional thinking about monetary policy: First, the role played by heterogeneity – which has been clearly demonstrated by the use of new monetary policy tools (typically more targeted) and something which is increasingly documented in economic research and data. Second, digitalisation – probably one of the most notable structural economic changes over the last few years – which also opens the door to a new world of data. Third, the changing role of the financial sector. I intend to raise a number of questions to foster the debate and hopefully help to structure our thinking. “How exactly have these challenges called into question the consensus on which monetary policy has been based? How can new data help to identify whether – and to what extent – the practice of monetary policy has changed? More speculatively, can new data help shape a possible "new normal" for monetary policy?” Needless to say, I do not want to provide any definite answers to these key questions; they have far-reaching implications making it unrealistic to settle all these issues on this panel. Taking a step back: data and the New-Keynesian consensus Before looking ahead, let's first look back a bit. Data that central banks traditionally look at are broadly tailored to the New-Keynesian model paradigm. In this view of the world – and I am grossly oversimplifying here, not doing justice to macro-modellers, nor to policy-makers – the central bank operates in a framework where representative agents interact, production is labour-intensive and where the role for financial factors is limited. Building on rational expectations and sticky prices, inflation is driven by 1/4 BIS central bankers' speeches expected inflation and the anticipated change in real marginal costs – the so-called NewKeynesian Phillips curve which links economic activity and inflation. In this set-up, monetary policy should aim for price stability. Doing so requires bringing aggregate demand into line with the potential output path. The prime way to do so in these models is by steering individuals’ intertemporal choice between consuming today versus tomorrow. This gives a key role to interest rates, where the working assumption is that the central bank steers perfectly the interest rate that is relevant for the representative agent. The careful monitoring of macro-economic aggregates and their projections successfully supported monetary policy decisions in this view of the world which seemed fairly appropriate up to about ten years ago. Like I hinted at in my introduction, several developments might have called into question this fairly simple framework. So, I will focus on three key challenges to the standard practice of monetary policy and their data dimension that I just mentioned. These are: heterogeneous agents, digitalisation and, finally, the changing role of the financial sector. Let’s look at each in turn. First challenge: heterogeneous agents The appropriateness of representative agent models has been challenged quite strongly since the crisis. For instance, some people have claimed that monetary policy tools aimed at stabilising macro aggregates have harmful side effects on specific sectors or types of economic agents. The allegation that asset purchases increase wealth inequality, that the low rate environment “punishes” savers or that easy monetary policy facilitates the survival of zombie firms are just a few examples. But, are we only talking about possible side effects of some measures here? I think these reflections are a broader indication of how heterogeneity can also be a transmission channel for monetary policy. Going one step further, it could appear that monetary policy works more via the cross-section than via the time dimension which is the traditional New-Keynesian intertemporal story. To put it bluntly, could it be that an interest rate cut has a bigger impact on aggregate demand because it shifts income from creditors to debtors – who stand ready to spend –, rather than via intertemporal substitution? Micro heterogeneity and distributional aspects already appear on the monetary policy stage. They are backed up by advances in theoretical research. Brunnermeier and Sannikov, for instance, argue that targeted monetary policy leads to redistributive effects that help mitigate financial frictions. I think credit-easing policies are an explicit example of that since specific types of lending are being supported. Newly developed Heterogeneous Agent New Keynesian models (HANK models) also help to get essential insight on monetary policy transmission channels when the assumption of representative agents is abandoned. Such models suggest that forward guidance could be less powerful than conventional rate cuts because of liquidity-constrained households1. This strand of research would benefit from additional data to help rigorously test these theories, at the euro area level too. For sure, extra data at a fairly granular level, with a panel dimension to capture effects over time as well, are of interest here. Micro data from the Household Finance and Consumption Survey (HFCS) are already a step forward and that effort should be continued. For example, these data have allowed researchers at the ECB to mitigate concerns that the APP benefits the wealthy at the expense of the poor2. Other Eurosystem data initiatives like Anacredit can also be useful, for instance to study the extent of zombie lending and how it interacts with the monetary policy stance. Second challenge: digitalisation 2/4 BIS central bankers' speeches As we all know, digitalisation of society dramatically changes our lives – how we produce, work, trade or consume3. So what are the consequences for monetary policy? I shall mention two interlinked dimensions here. First, digital products and services raise issues with measuring the genuine level of macro aggregates that central banks typically look at. How to adequately capture quantities when, for instance, Netflix or Spotify memberships allow unlimited consumption of content? How do we determine potential output in such economies? And what about measuring consumer prices for digital service providers such as social network platforms? Second, technology challenges our understanding of price dynamics. Is price stickiness still relevant for digital transactions? How do prices behave when the marginal cost of producing more is very small, even close to zero? Addressing all these questions is no easy task. Overall, digitalisation complicates our understanding of the transmission process from extra output to inflation. This has implications not only for the way we model the economy – and here I am thinking about possible adjustments to the New-Keynesian Phillips curve – but also for the role we devote to monetary policy. Should monetary policy set different objectives if prices are highly flexible and the costs of inefficient price dispersion are much smaller than presumed? Too early to tell, of course, but definitely worth an in-depth investigation. Meanwhile, I welcome advances made in measuring macroeconomic aggregates in the digital economy, in particular consumer prices. Across the Atlantic, the Billion prices project and Adobe Analytics data are promising examples of that. They provide tentative evidence that US inflation could be overestimated, although this result seems to depend on the dataset used. At the euro area level, national statistical offices’ initiatives on integration of online and scanner prices into HICP measures, as well as the Eurosystem's choice of investing heavily in research on pricesetting using micro data will certainly help too. While digitalisation challenges our thinking about macro-economic accounting, it can also provide a whole new set of granular and at the same time multidimensional data. In that sense, Big Data can become our ally. I will briefly come back to this point at the end. Third challenge: the changing role of the financial sector A third challenge to traditional thinking relates to the changing nature and role of financial intermediation, well documented in a research area that literally exploded during the last decade. We have not only witnessed greater fragmentation within the banking sector which has forced us to take unprecedented non-conventional measures to preserve a smooth transmission of monetary policy. We are also observing a slow-moving tendency towards a larger role for nonbanks in the financing of the economy. With the Capital Markets Union, a project I fully endorse, the role of players outside the traditional banking sector will hopefully get bigger. This justifies particular vigilance on the part of the ECB to be ready to monitor developments in this area. We should also make sure we are able to monitor developments in so-called private virtual tokens that aim to play a role as money – even though I tend to think that these developments are not (yet) of macroeconomic relevance. Related to this, the Fintech revolution blurs the traditional boundaries between the financial and the non-financial sector. When such things are becoming more relevant, monetary policy transmission can profoundly change and monitoring the traditional financial indicators can turn out to be inadequate. Therefore, good data coverage of new trends in the financial sector is essential. Fortunately, the Eurosystem plays a proactive role here and I would like to give two examples where new data play a key role. 3/4 BIS central bankers' speeches During the financial crisis, a Eurosystem-wide effort was launched to exploit bank-level data underlying the money and credit aggregates that are monitored in the ECB's monetary analysis. That way, the Governing Council could assess in a fairly granular way the transmission of measures via the banking sector. The data also proved key for calibrating the details of the targeted loans we started giving to banks back in 2014. Thanks to Money Market Statistical Reporting (MMSR), which I recognise is a huge statistical challenge, we also have a better view on the workings of euro area money markets. Moreover, it enables the Eurosystem to provide for a back-up risk-free benchmark rate should currently available private benchmark rates cease to be published. In this respect, it is very good to see how new economic realities are being reflected here: contrary to the current benchmarks, transactions with non-bank money market participants could be included in this new benchmark too. Concrete application and conclusion The three challenges I raised today may not only imply extensive use of existing micro data but also require further efforts to exploit the new world of data opened up by digitalisation – the socalled Big Data. I do not intend to elaborate much on concrete applications and challenges that come with Big Data. These aspects will certainly be more deeply tackled later today, in the third session of this conference. That said, I think technology-driven data bring serious challenges from a practical point of view, above all because their granularity is multi-dimensional. As correctly stated by Andrew (Andy) Haldane from the Bank of England in a speech he gave earlier this year, it runs through their volume (cross-section), their velocity (frequency) and their variety. One needs efficient data analytics tools to use the data properly while being aware of their limitations in terms of privacy and confidentiality. To wrap up, the challenge in future will be how to translate the findings from new data into concrete policy implications. After all, the micro evidence has to add up to policy advice for monetary policy which is a macro policy with a rather limited set of instruments. Therefore, in some cases, other policies – such as macro-prudential, fiscal or structural policies – could be more appropriate for tackling the challenges that new data reveal. Thank you for your attention. 1 Liquidity-constrained households are indeed unable or unwilling to borrow against the future rise in income that the promise of low rates underpins (Kaplan et al.). According to Lenza and Slacalek, the effects of QE and unconventional monetary policy on income via lower unemployment (benefiting the poor) are more significant than the effects of high prices for financial assets (benefiting the wealthy). 3 Globalisation is another structural phenomenon that has the potential to influence our thinking about monetary policy – a view the BIS often emphasises – and which could also have implications for what data to monitor. As Claudio Borio from the BIS suggests, many of the issues surrounding digitalisation could apply in a somewhat similar way for globalisation as well (I refer to his “Through the looking glass" speech from 2017). 4/4 BIS central bankers' speeches
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Keynote address by Mr Jan Smets, Governor of the National Bank of Belgium, at the conference "Ten years after the start of the crisis: contours of a new normal", organised by the Belgian Financial Forum and SUERF, Brussels, 14 September 2018.
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Jan Smets: The future of central banking Keynote address by Mr Jan Smets, Governor of the National Bank of Belgium, at the conference "Ten years after the start of the crisis: contours of a new normal", organised by the Belgian Financial Forum and SUERF, Brussels, 14 September 2018. * * * Ladies and gentlemen, it is a great pleasure for me to address this conference organised by the Belgian Financial Forum and SUERF on the impact of the crisis and how it may have shaped a new normal for the economy, for the financial system and for central banks. I thank the organisers for having invited me to share with you some of my thoughts on the future of central banking. I will not surprise when I say that it is good to first look back before being able to fully understand where we stand now, and, eventually, give insights on where we may go from here. Indeed, the future finds its roots in the past, and the present is precisely what brings both together. So, my plan is to first walk with you through time, starting on 14 September 2008 – the day on which Lehman Brothers failed, now exactly ten years ago and which marked the start of the global financial crisis. I will then say a few words on where we stand in the euro area at the current juncture and seize the opportunity to briefly explain the monetary policy decisions the Governing Council of the ECB took yesterday. Finally, I will devote the remainder of my talk to the challenges for central banks going forward: what is the future of central banking and to what extent will it be different from central banks’ past? As I said, exactly ten years ago we saw the start of the global financial crisis and some of its repercussions are still felt today. Not that there had not been worrying signs before. On the contrary, already back in August 2007 banks started to hoard liquidity and on 9 August 2007 the ECB was the first central bank which had to inject liquidity in the money market. Be assured, I am not going to give you every single detail of the actions we undertook since then. I just want to stress that by then many observers were impressed by the sheer size of the liquidity injection – namely €94 billion - which by now is really small compared to the almost €3.5 trillion increase in the balance sheet of the Eurosystem we have seen in the meantime. Indeed, the worst still had to come and in September 2008 it came abruptly in the form of a fullblown worldwide banking crisis. Those were the days during which in Belgium alone two major cross-border banks had to be rescued in two consecutive weekends. Very soon the real economy was hit too: euro area output dropped by around 4.5% in just two quarters and similar sharp contractions where seen elsewhere. We now refer to this as the “Great recession”, contrasting sharply with the “Great moderation” – the qualification many people had given to the two preceding decades. Just at the time that the real economy started to recover, the euro area was hit by a second recession which came with the sovereign debt crisis. That showed how much imbalances had been built up in the euro area and how ill prepared it was in weathering a severe economic shock, both at the level of the individual member states and at the level of the – indeed – incomplete monetary union. The consequences of the multiple feedback loops between weak banks, weak sovereigns and weak economies were devastating and eventually threatened the euro itself in 2012. That is when the whole EMU deepening agenda was born and since then major progress towards completing the monetary union has been made, particularly in the field of banking union. This process is still unfinished, an aspect which will be discussed in Poul Thomsen’s keynote address at the end of the conference. Still, I think that it was essential in bringing about the recovery, together with the actions of the Eurosystem, namely the Outright Monetary Transactions, the credit easing policies and, finally, the additional stimulus provided in 1/6 BIS central bankers' speeches the form of the Asset Purchase Program and the forward guidance on policy rates. Early 2015 the Governing Council of the ECB indeed decided to significantly step up its accommodation. With a large amount of idle resources and with new headwinds stemming from emerging market economies, inflation had dropped to very low levels and inflation expectations started to show signs of downward drift. Not only was there a risk that the inflation outlook would no longer be in line with our aim of inflation below, but close to, 2% over the medium term, there were also increasing indications that the economy could slip into outright deflation. Compared to that period, the economic situation in the euro area has improved a lot. The recovery has strengthened and broadened. All euro area countries are now growing. Contrary to the previous recovery phase, domestic demand is playing an important role, not in the least because it has been underpinned by our monetary policy measures. Employment creation has been particularly strong and drives households’ consumption spending, while also investment has finally recovered. The pace of economic expansion has recently decreased somewhat, on account mainly of a less favourable external environment where the tendency towards more protectionism and the problems in some emerging market economies dent trade, and uncertainty weighs on confidence. These developments clearly imply downside risks. Still, domestic demand remains robust and the slowdown of growth up to now mainly reflects a normalisation after the particularly strong growth rates seen at the end of 2017. With the absorption of economic slack, wage increases started to strengthen, and that process will eventually result in feeding domestically generated inflation. While headline inflation has recovered on the back of increases in the price of oil, core inflation will gradually benefit from the process of domestic reflation, further supported by receding uncertainty in inflation expectations. In view of these developments, the Governing Council decided yesterday that – very much in line with the view already conveyed in June – progress towards a sustained adjustment in inflation has been substantial so far and that it is confident that the convergence of inflation towards our aim will continue in the period ahead, even after a gradual winding-down of our net asset purchases. Therefore, we decided to reduce the monthly pace of our purchases to €15 billion from October onwards and we anticipate ending them after December 2018, subject to incoming data confirming our medium-term inflation outlook. While this is an important step towards policy normalisation, we are also of the opinion significant monetary policy stimulus continues to be needed to support the further build-up of domestic price pressures. Hence, we reiterated the forward guidance on the reinvestment and on policy rates, implying that we do foresee a very gradual process of policy normalisation. That will allow financing conditions to remain very favourable and to support both the economy and the associated reflationary process we are aiming for. Having outlined where we stand, I should have paved the way for my reflection on the future of central banking. How will it look like? What will be the focus of central banks in the coming years? Well, at the risk of being a bit boring, I claim that central banks will continue doing what they did in the past and that is, building trust and confidence in the money they issue. I see three main dimensions here. As in the past, central banks will care about the value of money. In other words, monetary policy will continue to focus on price stability and in doing so stabilise the purchasing power of money. Central banks will also continue to take care of the safe nature of money, explaining their strong interest in financial stability which has even increased since the crisis. After all, the largest part of the money stock is not directly issued by central banks themselves in the form of base money. On the contrary, it is created in the financial system and is held by the money-holding sector as liabilities of financial intermediaries. A significant part of it is in fact deposits with commercial banks. Without having sound financial institutions, money cannot be truly safe, nor will it be fully trusted by the public. And indeed, during the worst days of the crisis we have seen flight-to-safety flows into banknotes, and away from the deposits held with – by 2/6 BIS central bankers' speeches then, mistrusted - banks. Finally, central banks will continue playing a key role in contributing to the smooth functioning of the payments system and being active in overseeing this part of the financial sector which is crucial to allow economic agents using the money they hold. With this, I think, central banks will be very much in the business of making sure money performs well on each of the three functions we typically attribute to it, namely being a unit of account, a store of value and a medium of exchange. At first sight, there is nothing new here, which confirms what I said earlier about the future finding its roots in the past. Still, it is worth having a closer look at each of these central bank activities, as I think they are subject to changes, be it as a direct consequence of the crisis or because other trends have affected the economy, the financial system or the wider society. Let me start with monetary policy and its focus on price stability. That focus served us well during the crisis. By counterbalancing the disinflation, we avoided the Fisher type of debt deflation effects and facilitated the necessary deleveraging process. It also helped us keeping control over the real rate, at a time controlling it was complicated by the fact that we had to operate very close to – if not at – the effective lower bound for nominal interest rates. This was not only helpful from a macroeconomic perspective but was, I think, also favourable for financial stability. Of course, our ‘low for long’ poses challenges for financial institutions and can lead to specific risks for financial stability. Yet, I do think that some sort of leaning-against-the-wind counterfactual with less monetary accommodation would eventually have been worse for financial stability, mainly resulting from the negative macro feedback effects it would have caused. I am also of the opinion that the associated financial stability risks should be addressed by appropriate prudential policies, particularly macroprudential policies – a point to which I return later. A continued focus on price stability, and on our specific definition of it, will also be very beneficial going forward. By stabilising inflation and hence inflation expectations at a level below, but close to, 2% in the medium term, we make sure that the steady state level of nominal interest rates will be supported by an inflation compensation component of that magnitude. That in turn will be beneficial for financial institutions as in many cases their business models have difficulties in coping with very low nominal interest rates. This inflation buffer will also contribute to safeguard monetary policy’s room for manoeuvre during downturns. While all this is already underlying our definition of price stability from the beginning, the arguments supporting this choice have even gained relevance. Indeed, compared to that period the steady state real rate – often referred to as the natural rate – has dropped and that is, I think, one of the important features of the new normal. This new normal will come with new instances of lower bound incidence. So, central banking of the future should be prepared for such situations and be capable to deploy all tools which we now have labelled unconventional monetary policy. Active use of the central bank balance sheet and forward guidance will very likely become more standard instruments in our toolkit. That of course implies that we should be operationally ready to use them. More importantly, it also implies that we must manage these tools carefully during the normalisation phase, so as to fully safeguard their effectiveness for the future. In that sense it is important that we stick to the conditionality we have introduced in our forward guidance formulation. That does not only facilitate reaching our aim today; it is also an investment in our capacity to use forward guidance in the future. Let me now move to the second domain which will be prominently part of central banking of the future, namely financial stability. While we are still somehow in the process of dealing with the consequences of the credit bubble, it became clear from the outset that just cleaning is no longer an option going forward. Hence a bunch of policy initiatives has been undertaken to mitigate risks and enhance the resilience of the financial system. New standards for regulation and prudential supervision were introduced in the form of more demanding capital and liquidity requirements and the resilience of financial institutions is now also assessed by means of stress-testing. On 3/6 BIS central bankers' speeches top of that, with macroprudential policy, a new policy domain has been created. It is natural to see central banks playing an important role here, given their knowledge of the financial system and their macro reflex typically adopted in the monetary policy domain. That is a clear trend we see worldwide since the crisis. Obviously, being more active in the financial stability domain comes with new challenges and, to some extent, also with new risks for central banks. Despite considerable progress made in the macroprudential policy domain, additional research on its transmission mechanisms is still needed. Such research must also address the issue of interactions with monetary policy. I claimed earlier that monetary policy should keep its primary focus on price stability and that prudential policies should act as the first line of defence against financial instability. That setting indeed comes closest to Tinbergen’s ideal world where two distinct policy instruments are available for two different objectives. Still, it would be naive to think that monetary and macroprudential policy are two fully independent instruments, as they both act through the financial system. So, I think the future of central banking also lies in learning more about possible interactions, complementarities and scope for effective coordination between monetary and macroprudential policy, without blurring, though, the distinction between the different policy domains, their respective mandates and accountability frameworks. I would like to flag one more challenge in this domain, which will have an impact on the future of central banking. Part of the argumentation of having prudential policy as the first actor in the financial stability domain rests on its capability to be more targeted, while monetary policy is often seen as too blunt an instrument for these purposes. However, this more targeted nature tends to come with more pronounced distributional effects. Moreover, financial stability will always be a shared responsibility where fiscal authorities have their role to play. For these reasons, tensions could arise when these instruments are given to independent central banks. But at the same time, there are also forces pushing towards allocating them to independent institutions. Doing so indeed allows coping with the so-called inaction bias, which in this case may be quite pronounced precisely as a result of the targeted, and therefore fairly visible, way these policies work. I do not think we have already reached a new steady state on this, and institutional settings may still evolve depending on further experiences gained in this field. By the way, they now differ quite a bit across jurisdictions which is an indication that the search for the optimal set-up has not yet come to an end. Contributing to the smooth functioning of our payments systems is the third pillar on which future central banking will rest. While often having been a less visible task, it is nonetheless crucial for fostering trust in money. This dimension nowadays gets a lot of more attention than in the past, in view of technological advances and progressing digitalisation. New financial players – socalled Fintechs – often focus their activities on payments services. Evidently, the Fintech agenda is a wider one which affects the entire financial system and which central banks, of course, monitor closely from a financial stability perspective. Moreover, digitalisation and new ways of producing and consuming will have a strong impact on the entire economy. They will drive many macroeconomic variables and questions on the new way of functioning of the economy are popping up, be it from the point of view of measurement or from a more conceptual perspective. Hence, these developments will also shape a new environment for monetary policy. Still, it is in the payments sphere that the technological advances have already had their strongest impact on central bank activities. And that will not change anytime soon. The future of central banking therefore will heavily depend on central banks’ ability to keep up with innovation and digitalisation. One specific phenomenon here, which has drawn a lot of attention lately, is the emergence of so-called crypto currencies. If successful, these alternatives could threaten our monopoly of issuing money and therefore also our ability to conduct monetary policy. Being moreover out of the control of prudential supervision, success of these crypto currencies could also endanger financial stability. That is why we monitor these developments closely. However, given their still limited scope, I do not see pronounced risks at the current juncture. Moreover, the intrinsic 4/6 BIS central bankers' speeches features of crypto currencies – their inherent volatility, particularly – implies they perform poorly as far as the traditional functions of money are concerned, in turn explaining why their success is limited. Still, we should not be complacent. Only to the extent that central banks will be successful on all three fronts I have mentioned, they should not fear outside competition. And at the same time, central banks should be open-minded with respect to the new technologies underlying these developments, as they can potentially be of use for themselves. Somewhat related to this, the idea has been floated that central banks could issue their own digital currency. Let me be clear from the outset, a central bank digital currency is conceptually fundamentally different from the so-called crypto currencies. It would just be another form to hold the same money. While being electronic in nature, it would in terms of risk characteristics, for instance, be very similar to the banknotes we issue. Here too, central banks should be open minded and carefully weigh pros and cons of possibly going this way. On the pro side, different motivations are put forward, ranging from offering an alternative for disappearing cash, to move away from the system of fractional banking or circumventing the lower bound constraint. On the con side, there are concerns regarding the structural changes it would imply for the banking sector, the possibility of having pronounced digital bank runs and the risk of a structurally longer central bank balance sheet and hence a more pronounced allocative role for central banks. Any steps towards a CBDC should therefore be subject fo careful consideration, and further research is warranted. I have done the tour of the most important domains in which central banks will be active in the future and I have highlighted to what extent they may differ from what was done in the past. Before concluding, I would like to make three final observations of a general nature on the way central banks will function. First, with the degree of globalisation we have seen so far and the strong interlinkages between economies in both the real and the financial spheres, I do think that the international dimension will become still more prominent for the central banking of the future. While mandates continue to be geared towards domestic objectives, one’s actions can spill over to other economies, which in turn can generate spillbacks for the own economy or financial system. As a minimum, this calls for an enhanced exchange of information about what is going on in the respective jurisdictions, if not for more active policy cooperation. The Bank of International Settlements in Basel plays already an important role in this respect and this is likely to become more pronounced in the future. Second, we see worldwide that central banks have come under increased scrutiny since the crisis. While initially their prompt reaction to the crisis was widely applauded, support for later actions has weakened and some of them are openly challenged. Calls to restrain the discretion of central banks are openly made. I see several reasons for this. First, a lot of the crisis resolution de facto fell on the shoulders of central banks. That forced them to stretch the interpretation of their mandates, the backlash of which is felt now. It also implied overburdening the central bank and a suboptimal reaction to the crisis, giving rise to the impression that central bank action was not effective. On top of that, many of the policy actions were new and not always well understood. They generated a lot of concern, for instance regarding the risk implications of the balance sheet policies and the distributional effects of the asset purchases, claimed to be regressive in terms of income and wealth distribution – a claim wich however abstracts from the strong macroeconomic effects the asset purchases had as these benefit, via the job creation they entail, to the most vulnerable group in society, namely the unemployed. Finally, the broadening of central banks’ remit into the financial stability domain has also contributed to it, while at the same time complicating somehow the accountability framework. To counter these forces, central banks have to be excellent policy makers. For that a profound knowledge of the economy and the financial system is needed. The future of central banks will therefore very much rest on their ability to be adequate knowledge centres. At the same time, 5/6 BIS central bankers' speeches transparency must be enhanced and appropriate accountability frameworks are needed. Increased communication efforts will have to be made to explain policy actions, not only to the more informed audience of financial markets participants but also to the wider public. The skill to translate central bankers’ knowledge into non-technical terms has to be developed. Finally, just like every other enterprise, central banks must adapt their ways of working to the standards imposed by the changing environment they operate in. Non-hierarchical, multidisciplinary work processes should unlock the knowledge now sometimes contained in local silos. Enhanced diversity of staff should both improve the quality of work and increase society’s association with the central bank and its policies. I conclude. Price stability, financial stability and promoting the smooth functioning of the payments system will also in the future govern most of central banks’ actions.It is the task of central banks, also in the future, to foster trust in money in each of these domains. This trust is not something which falls from heaven; it has to be built, and maintained, on a daily basis. While technical know-how of experts is of course essential, on its own it is not enough. The stability of money is a common good and deserves a quasi-constitutional status. In other words, it is a deep and precious fundamental which must be safeguarded under all circumstances, as a prerequisite for welfare, but also for freedom and fairness. Therefore, it has to rest on strong societal underpinnings and be shielded from the volatility or even arbitrariness resulting from short-termism. Thus, it is fully justified to allocate this goal to institutions which have this stability as their primary task and which are accountable for achieving it. That is precisely the mission of central banks, also in the future. I thank you for your attention and I wish you a pleasant stay at this conference. 6/6 BIS central bankers' speeches
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Keynote address by Mr Jan Smets, Governor of the National Bank of Belgium, at the Colloquium AEDBF Europe, Brussels, 30 November 2018.
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1. Central Banks and money: an everchanging interplay Colloquium AEDBF Europe, 30 November 2018 Keynote address by M. Jan Smets, Governor of the National Bank of Belgium Ladies and gentlemen It is my great pleasure to welcome you today in the premises of the National Bank of Belgium and to have the opportunity to address this interesting colloquium on the vast topic of money and currencies. Money is subject to a constant evolution and central banks must carefully take these evolutions into account when conducting the tasks they are entrusted with. The issuance of euro banknotes is one of the best known and most visible activities of the Eurosystem central banks 1 but, as will become clear hereafter, it is by no means the most important of their tasks. Instead, central banks will take a broad interest in the many different appearances and functions of money. Evolutions like the rise of local currencies or the emergence of digital money such as privately issued cryptocurrencies will certainly not go unnoticed. First, I will briefly touch upon the concept of money, before shedding some light on the difference between commercial bank money and central bank money. I will then clarify the process through which central banks create central bank money, and position central bank money against alternative forms of money such as local currencies and cryptocurrencies. In this process we will examine the impact alternative forms of money have on the central banks’ basic tasks to formulate and implement monetary policy and to contribute to financial stability. Finally, I will talk a little about the promises that the technology underpinning the rise of cryptocurrencies may hold for central banks, especially in view of the possible issuance of a central bank digital currency. WHAT IS MONEY? What is money? It is not easy to give a clear definition. Doctor David Mann, in his standard work on the legal aspect of money, spends no less than fifty pages to clarify the concept of money 2. Not only does money exist in the form of banknotes and coins, it can also take many other forms such as a cheque, a scriptural form (i.e. units in an account) or nowadays even some lines of computer code. Furthermore, money traditionally serves three main functions. First, as a means of exchange, it prevents that we would have to exchange goods and services directly for other goods and services. Secondly, as a unit of account, money enables us to compare the value of different goods and services. It is the standard used to express their prices. In this function, money may be equated with currency, which in the common language is defined as the money or a system of money that is used in a particular country at a particular time. And finally, money acts as a store of value, it is used to accumulate savings which can be quickly and easily converted into any type of good or service. The law, too, does not hail a single and uniform definition of ‘money’. To just give an example, found in EU law: both the Payment Services Directive and the Payment Accounts Directive explicitly define ‘funds’ as banknotes and coins, scriptural money, and electronic money in the sense of the electronic In this contribution the notion of ‘Eurosystem’ is also used to refer to the ‘European System of Central Banks’. CH. PROCTOR, Mann on the legal aspect of money, Oxford University Press, Oxford 2005, 5 – 55. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 2. money directive 3. The Settlement Finality Directive, on the other hand, 4 does not define the notions of ‘funds’ and ‘money’, but from the objectives of this Directive it is clear that only money and funds by means of a book entry are envisaged and not banknotes and coins. So, from a legal perspective, ‘money’ is usually defined with reference to the context in and the objectives for which the concept is being used. CENTRAL BANK MONEY VERSUS COMMERCIAL BANK MONEY Let us now turn to the instances that issue money, and to the money creation process. In modern day society, the most familiar issuers of money are on the one hand central banks which provide central bank money in the form of both banknotes and deposit liabilities, and on the other hand commercial banks, which generally issue private or commercial bank money in the form of deposit liabilities 5. Economic activity can in principle take place without the coexistence of central and commercial bank money. Both solutions - on the one hand, narrow or mono-banking where there was only central bank money and, on the other hand, free banking where there was only commercial bank money have existed in the past. But neither has proved sufficiently stable or efficient to survive on its own. There has been an evolution towards intermediate solutions in which both types of money play an important part in facilitating economic activity. Up till today, it is believed that the most effective and efficient financial system is one in which commercial bank money and central bank money coexist. 2.1 MONEY CREATION BY CENTRAL BANKS How then do central banks create money and influence the quantity of money in the market? In the first place, central banks provide central bank money in the form of banknotes. The issuance of banknotes entails a reduction in the liquidity of credit institutions, since credit institutions must deposit liquid means with the central bank against the withdrawal of the banknotes. Banknotes and coins in euro are the only ones to have legal tender status in the euro area. Secondly, central banks provide central bank money in the form of deposit liabilities. Deposit liabilities are created through the monetary policy that central banks conduct, which aims at maintaining price stability. Central banks maintain price stability through influencing the availability and growth of money in the economy which is operationally implemented through the transmission mechanism of the monetary policy instruments. The quantity of money in euro depends on the liquidity needs of commercial banks and eventually of the market participants like households, companies and the government. The Eurosystem can influence the quantity of money in the economy in three ways. First, the Eurosystem central banks conduct open market operations on the basis of Article 18.1, first indent of the Statute of the ESCB 6. The most important tools are the main refinancing operations, which are regular liquidity-providing reverse transactions conducted with a frequency and maturity of normally one week 7. Since 16 March 2016, the interest rate on main refinancing operations has been pegged at 0.00 percent. Article 4, (25) of Directive (EU) 2015/2366 of the European Parliament and of the Council of 25 November 2015 on payment services in the internal market, and Article 2, (22) of Directive 2014/92/EU of the European Parliament and of the Council of 23 July 2014 on the comparability of fees related to payment accounts, payment account switching and access to payment accounts with basic features. Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems. COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS, The role of central bank money in payment systems, Bank for International Settlements, August 2003, 7. Protocol (No 4) on the Statute of the European System of Central Banks and of the European Central Bank. Other types of open market operations are longer term refinancing operations, fine-tuning operations and structural operations. For more information, see EUROPEAN CENTRAL BANK, The Monetary Policy of the ECB, 2011, 104-108. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 3. Secondly, the Eurosystem implements monetary policy by setting the interest rates on its standing facilities on the basis of Article 18.1, second indent of the Statute of the ESCB. Standing facilities provide or absorb liquidity with an overnight maturity on the initiative of counterparties. Two standing facilities are available to commercial banks: the marginal lending facility (to obtain intraday credit to cover shortages in liquidity) and the deposit facility (to make overnight deposits of excess liquidity). Thirdly, according to Article 19.1 of the Statute of the ESCB, the ECB may require commercial banks to hold minimum reserves (or compulsory deposits) on accounts with the Eurosystem central banks. The intent of the minimum reserve system is to create (or enlarge) a structural liquidity shortage: an increase of minimum reserves entails a reduction of liquidity in the market and vice versa. The reserve requirement of each institution is determined in relation to elements of its balance sheet. 2.2 MONEY CREATION AND FRACTIONAL RESERVE BANKING So how, then, is money created in practice? Let me clarify this process through the monetary policy instrument of the minimum reserves. Commercial banks are limited in the total amount they can loan to customers by, among others, their required minimum reserve ratios which oblige a commercial bank to keep a minimum, predetermined percentage of its deposits in an account with the central bank. This is called the system of fractional reserve banking because commercial banks are required to only hold a fraction of their total deposits in a central bank account. In practice, if the central bank imposes a required minimum reserve ratio of, say, 0.10, then each commercial bank is obliged to keep at least 10% of its total deposits as reserves, i.e. in the account it has with the central bank. The process of money creation can be illustrated with the following simplified example: when a person deposits 100 EUR in a commercial bank, this bank will keep 10 EUR as reserves in the central bank. To make a profit, the commercial bank loans the remaining 90 EUR to another customer. This customer spends the 90 EUR by buying something from a merchant. The merchant deposits the 90 EUR with his bank. The merchant’s bank keeps 9 EUR as reserves in the central bank, and then lends the remaining 81 EUR to another customer. If this chain continues indefinitely then, in the end, an amount close to 1000 EUR has gone into circulation and has therefore become part of the total money supply 8. The system of fractional reserve banking is being criticised by certain scholars since bank deposits are only partially backed by central bank deposits, the difference being used to finance investments in the economy. Short-term deposits fund long-term loans, which renders the banking system inherently vulnerable to bank runs even if prudential regulation and the deposit guarantee system are making banks less prone to such risks 9. It is also deemed to contribute to an enormous build-up of debt, which forms the Achilles’ heel of the financial system. Some therefore propose to move from fractional banking to a so-called “sovereign money system” or to “narrow banking”, where every commercial bank deposit would be fully backed by central bank money. Proponents of a sovereign money system argue that commercial banks would lose their capacity to create money in the form of demand deposits, becoming simple intermediaries between savers and borrowers. Private money creation would be eliminated and replaced exclusively by money creation through the central bank, on behalf of the public interest. Instead of encouraging or discouraging the accumulation of private sector debt by manipulating interest rates, the central bank would moderate the pace of economic activity by directly controlling the rate at which additional money would be created, or, in rare cases, destroyed 10. No matter how tempting a sovereign money system sounds, many issues remain to be examined before considering a move towards narrow banking. For example, such a move could greatly impact This process is known as the money multiplier effect. J. SMETS, “Fintech and Central Banks”, Rev. banc. fin., 2017/1, 11. 10 B. DYSON, G. HODGSON and F. VAN LERVEN, Sovereign money. An introduction, Positive Money, December 2016, 4. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 4. the funding structure of commercial banks, something they are not indifferent to. Some opponents also point to the need to maintain a sufficient degree of credit growth in order to stimulate economic growth 11. Earlier this year Switzerland organised a referendum on the introduction of a sovereign money system called Vollgeld, which requires that every credit granted by a commercial bank is entirely covered by deposits. The proposal was eventually rejected. This does not mean that central banks are entirely indifferent to sovereign money systems, as will become clear in a little while when I talk about central bank digital currencies. ALTERNATIVES TO MONEY IN THE FORM OF EURO BANKNOTES AND DEPOSIT LIABILITIES AT CENTRAL BANKS AND COMMERCIAL BANKS So far, I have been talking about central bank money which is being provided in the form of banknotes and deposit liabilities in euro. But any type of money can potentially be created and issued by for example private entities, as long as it allows in one way or another to fulfil the main functions of money. Let us call these types of money alternative money (in the sense that they are an alternative for both central bank money and for deposits in euro at commercial banks’ accounts). Central banks also take an interest in alternative types of money, even though they would at first sight fall outside the ambit of the central bank’s usual competences. Central banks may have more than one reason for this. For starters, a considerable increase in the quantity and use of alternative money may undermine the efficacy of the central bank’s monetary policy. If the market players were to massively move away from the use of banknotes and deposits in euro, a central bank could find it more difficult to attain its objective of price stability. Indeed, by substitution for regular money such as banknotes and deposits in euro, widely adopted types of alternative money could significantly reduce a central bank’s control over monetary conditions, such as its ability to steer interest rates 12. Furthermore, many central banks, among which the Eurosystem central banks, are entrusted with the task of contributing to the stability of the financial system 13. Financial stability may be impacted by sudden or considerable changes in the quantity and use of alternative types of money 14. 3.1 LOCAL CURRENCIES A local or complementary currency is a currency that can be spent in a particular and usually limited geographical locality, which differs from an official currency (like the euro) and about which a group of private persons, companies or government instances have agreed to accept it as a means of exchange. A local currency therefore acts as a complementary currency to an official currency, rather than replacing it, and aims to encourage spending within a local community or to support the local or social economy. European law does not directly deal with the issue of local or complementary currencies but Article 178bis of the Belgian Penal Code stipulates that whosoever issues a monetary sign which is meant to circulate in public without being authorised by the competent authority, is subject to imprisonment or the payment of a fine. This Article does not clarify which is the competent authority to authorise the issuance of a local or complementary currency, but without a doubt the National Bank of Belgium will have its say, and its opinion is in practice regularly sought by prospective issuers. Article 178bis 11 See J. VEKEMAN, “Het systeem is het probleem, niet de banken”, Trends, 11 October 2018. 12 See A. STEVENS, “Digital Currencies: Threats and Opportunities for Monetary Policy”, NBB Economic Review, June 2017, 89. 13 See Article 127.5 TFEU. 14 See for example FINANCIAL STABILITY BOARD, Crypto-assets: Report to the G20 on the work of the FSB and standard-setting bodies, 16 July 2018. See http://www.fsb.org/wp-content/uploads/P160718-1.pdf. The FSB has published a report setting out the metrics that the FSB will use to monitor crypto-asset markets as part of its ongoing assessment of vulnerabilities in the financial system. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 5. does not apply if a monetary sign is exclusively issued to serve a particular and well-defined purpose or to circulate locally only 15. It should be noted that the prohibition of Article 178bis only applies to the issuance of monetary signs in a material and tangible form, meaning that purely digital representations of an alternative currency are not prohibited by this Article. This does not mean that a local or complementary currency in digital form can be issued without observing any law. If the issuer of a local or complementary currency offers payment services in the sense of the Payment Services Directive 16, for example, the issuer should examine beforehand if he or she must obtain a licence as a payment institution. But even under the Payment Services Directive, the issuer of a local currency that can only be used within a limited network may be exempt from many of its provisions 17. In Belgium the National Bank of Belgium is designated as the competent authority for grating licenses to payment institutions and to assess the compliance with the grounds of exclusion for limited networks. This is a part of the Bank’s tasks of prudential supervision. In case of doubt, prospective issuers of local or complementary currencies in digital form would do well to consult the National Bank on this matter. 3.2 CRYPTOCURRENCIES Let us turn then to this other infamous type of alternative money, known as virtual or cryptocurrencies such as Bitcoin, Litecoin, Ether and many others. The main characteristic of cryptocurrencies is that they are issued, kept and exchanged in a decentralized way (usually based on Distributed Ledger Technology or DLT), removing the need for intermediate players and systems like commercial banks, payment institutions and clearing and settlement systems. Cryptocurrencies can be used only as contractual money, when there is an agreement between buyer and seller in order to accept a given cryptocurrency as a means of payment. In the EU, cryptocurrency is at present not regulated and cannot be regarded as being subject to the Payment Services Directive or the E-money Directive 18. From an economic perspective, most of the cryptocurrencies currently known do not fully meet all the three functions of money that I mentioned before. Cryptocurrencies have a limited function as a medium of exchange because they have a very low level of acceptance among the general public. In addition, the high volatility of their exchange rates to official currencies renders cryptocurrency useless as a store of value even for short-time purposes, let alone for the purpose of being a longerterm savings instrument. Finally, both the low level of acceptance and the high volatility of their exchange rates and thus purchasing power make them unsuitable as a unit of account. Therefore, cryptocurrencies cannot be regarded as full forms of money at the moment 19. Cryptocurrencies are actually fraught with many issues. From a central bank perspective, cryptocurrencies pose a risk for the conduct of monetary policy or for the stability of the financial system. Studies show that cryptocurrencies should not pose a significant threat if they are merely 15 Preparatory works to Article 4 of the Law of 23 December 1988, Senate, 499-1, 1988-89. 16 Transposed in Belgium by the Law of 11 March 2018 on the statute and supervision of payment institutions and institutions for electronic money. 17 See Article 3, (k) of the Payment Services Directive. This Article excludes services based on specific payment instruments that can be used only in a limited way when (i) the payment instruments allow the holder to acquire goods or services only in the premises of the issuer or within a limited network of service providers, or (ii) when these instruments can be used only to acquire a very limited range of goods or services. A third exclusion ground exists when the payment instruments are only valid in a single Member State and are provided at the request of an undertaking or a public-sector entity and regulated by a national or regional public authority for specific social or tax purposes to acquire specific goods or services from suppliers having a commercial agreement with the issuer. 18 EUROPEAN CENTRAL BANK, Virtual Currency Schemes – A Further Analysis, February 2015, 24. 19 Idem, 24. The crypto-community is, however, looking for solutions to this problem, e.g. through the creation of stablecoins. See https://medium.com/fintech-weekly-magazine/stablecoins-what-are-they-actually-fora1bc0732e472. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 6. used as a medium of exchange, since in this case cryptocurrencies would usually be converted back to regular money as soon as the transaction is settled 20. Financial stability risks may, on the other hand, appear if cryptocurrencies were to be widely perceived as a proper store of value, which they are not. This is because unlike commodities such as oil and gold, cryptocurrencies have no intrinsic value. They are nothing more than lines of computer code. Neither do they carry any legal value, in that they are not backed by a sovereign entity as is the case for regular money. The value of cryptocurrencies therefore depends on self-fulfilling expectations, which renders them conducive to speculation and to bubbles 21. Finally, cryptocurrencies could pose a considerable risk for monetary policy and financial stability if they were to be generally accepted and used as units of account. In this case cryptocurrencies would substitute for the bulk of regular money, including central bank money. There is doubt, however, that cryptocurrencies would ever become trusted units of account, among others given their lack of either legal tender or regulatory status 22. In any case, it is not surprising that many national and international authorities have issued warnings against the investment in and use of cryptocurrencies. 3.3 WILL THE PROMISES OF DLT LEAD TO THE ISSUANCE OF CENTRAL BANK DIGITAL CURRENCIES? So, let me wrap up my thoughts. I have thus far briefly explained the process through which central banks create central bank money, as a result of the implementation of the monetary policy. The creation of alternative types of money by private players, such as cryptocurrencies, carries the risk of impairing monetary policy transmission or affecting financial stability. But the advent and rise of cryptocurrencies and its underlying technology also offer opportunities to central banks 23. First, DLT has the potential to improve efficiency and security of existing payment systems. These benefits suggest that DLT could help to further underpin trust in the monetary system. Central banks may, for example, choose to permit interbank payment systems to run on a DLT network 24. Secondly, some central banks have taken interest in DLT to serve as a platform for the issuance of a so-called “central bank digital currency” or “CBDC” 25. A CBDC can be defined as a central bank liability, denominated in an existing unit of account, which serves both as a medium of exchange and a store of value. This would be an innovation for the public at large and for use in retail payments, but not for certain wholesale entities. Indeed, as we have seen, central banks already provide digital money to commercial banks in the form of deposit liabilities 26. Some central banks have completed proofs of concept, for example to simulate if central bank-operated wholesale payment systems could run on DLT-based applications 27. These projects usually show that DLT is not yet mature enough for current adoption, and that the legacy systems are outperforming DLT-based applications. Unlike commercial banks, the public at large is only provided central bank money in the form of banknotes and coins. A general purpose CBDC, open to the public at large, would be a substitute or 20 A. STEVENS, o.c., 81. 21 Idem, 82. 22 Idem, 82. 23 For some other recent documents that take either positive or negative views on the crypto-revolution, see among others: FINANCIAL STABILITY BOARD, Crypto-asset markets. Potential channels for future financial stability implications, 10 October 2018; EUROPEAN PARLIAMENT, Resolution on distributed ledger technologies and blockchains: building trust with disintermediation, 2017/2772(RSP), 3 October 2018. 24 A. STEVENS, o.c. 83. 25 The best-known example today is the Swedish Riksbank’s e-krona project. See https://www.riksbank.se/engb/financial-stability/payments/e-krona/. 26 COMMITTEE ON PAYMENTS AND MARKET INFRASTRUCTURES, “Central Bank Digital Currencies”, Bank for International Settlements, March 2018, 3. See https://www.bis.org/cpmi/publ/d174.pdf. For a taxonomy of CBDCs and the money flower concept, see M. BECH and R. GARRATT, “Central bank cryptocurrencies”, BIS Quarterly Review, September 2017, 55-70. 27 Like the National Bank of Belgium, which has been involved in a research project simulating DLT-based payments in central bank money in Target2. Keynote_Governor_AEDBF_30_Nov_2018_final.docx 7. a complement to cash. Whether the introduction of a CBDC is desirable depends on many different considerations. More research should therefore be devoted to the benefits, drawbacks and implications of the issue of a CBDC. Many questions remain, also of a legal nature. Central banks must, for example, take into account legal considerations when contemplating the issuance of general purpose or retail CBDCs. Issuance may require legislative changes which might not be feasible in the short term. One question is whether CBDCs would have legal tender status just like euro banknotes and coins. It may be necessary to extend the ECB’s monopoly to issue legal tender banknotes to CBDCs. Central banks would also have to take account of Anti Money Laundering (AML) concerns and requirements. Issuing a CBDC that does not adequately comply with these and other supervisory and tax regimes would not be advisable 28. It is currently not clear how AML requirements can be implemented practically for anonymous forms of CBDC. CONCLUSION To conclude, it is no understatement to say that there is an everchanging interplay between money and the central banks’ mandate to implement monetary policy and to safeguard financial stability. The future of money is currently being shaped at an unprecedented pace, thanks to the digital revolution. One of the many emerging trends is the rise of so-called asset-backed cryptocurrencies. This is a cryptocurrency that represents an underlying traditionally valuable, real-world asset to which it is pegged. This trend, called tokenisation, shows similarities with the old gold standard where banknotes issued by central banks were exchangeable for the corresponding value in gold. Tokenisation shows a lot of promise for traditional assets such as gold and diamonds, but is it conceivable that other assets are tokenised and find their way to the financial system and maybe into new forms of money? Many questions to which presently few answers can be offered... So, let me assure you that a lot of challenging work remains to be done in this area, also with respect to the legal issues surrounding them. I wish you all an insightful day! * * * 28 COMMITTEE ON PAYMENTS AND MARKET INFRASTRUCTURES, “Central Bank Digital Currencies”, o.c., 9. On the issue of anonymity of CBDCs, see M. BECH and R. GARRATT, O.C., 65. Keynote_Governor_AEDBF_30_Nov_2018_final.docx
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Keynote speech by Mr Pierre Wunsch, Governor of the National Bank of Belgium, at the 2022 ACCIS Conference hosted by the National Bank of Belgium, Brussels, 14 June 2022.
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1. HOUSEHOLD ACCESS TO CONSUMER CREDIT AND MORTGAGE LOANS Consumer credit Consumer credit market in Belgium: diversified and meets households’ needs, but financially vulnerable borrowers require consideration Regulation has impact on access to finance for certain household categories Changing environment leads to new challenges in regulation Mortgage loans Increasing mortgage debt at BE and EU level Risk pockets: households with high debt ratios or small savings buffers Challenge for central bank: combining prudential measures that ensure financial system stability with access to finance for households ACCIS Conference hosted by the NBB – 14 June 2022 2. HOUSEHOLD ACCESS TO CONSUMER CREDIT AND MORTGAGE LOANS INTRODUCTION Good morning, ladies and gentlemen. Good morning, Enrique. Let me start by saying that it’s an honour for the National Bank of Belgium to host this year’s ACCIS Conference. And it’s with great pleasure that I accepted Enrique’s invitation to welcome you with a few words. As you know, the nature of our credit register is rather different from most other ACCIS members. Belgium has a public register, regulated by specific legislation and managed by the National Bank. And while it’s not a core business of a central bank, we strongly believe in the advantages of this structure. Not only because preventing over-indebtedness is a matter of general interest, but also because credit data are useful in our mission as a prudential supervisor and for different economic studies that we carry out. And the topic of my opening speech, household access to consumer credit and mortgage loans, is a perfect example of this fruitful cooperation between our departments, because it’s partially based on data from our credit register. CONSUMER CREDIT 2.1 CONSUMER CREDIT MARKET IN BELGIUM - VULNERABILITIES Now, Enrique has only allowed me 10 minutes, so let me begin immediately by presenting you with the most important conclusions of a recent study that we did on the consumer credit market in Belgium. To give you an idea of the market size: it totalled 5,1 million loans representing an outstanding amount of 21 billion euro at the end of 2021, and more than half of the adult population has at least one consumer credit. Our study showed that the Belgian market for consumer loans is generally mature and diversified. There are several categories of lenders and the credit they offer, meets various household financing needs. The majority of the loans are also provided at interest rates well below the legal maximum. However, we identified two market segments where that’s less the case and which thus need specific attention in order to ensure access to finance. On the supply side, this concerns credit lines and instalment loans granted for an unspecified purpose. For both credit types, there is much less diversity, with interest rates being very uniform across different lenders and close to the permitted maximum. On the demand side, on the other hand, it seems that there is a negative correlation between being financially more vulnerable and having to pay higher interest rates. Indeed, we saw that the main feature of households paying higher rates, was that they had less net wealth than other categories. Furthermore, a substantial proportion of these high-rate loans are used to repay other consumer credits or to cover current expenditure. In general, consumers contracting this type of credit have significantly lower incomes and net wealth than consumers that borrow for other purposes. 2.2 REGULATION & ACCESS TO THE CONSUMER CREDIT MARKET In Belgium as elsewhere in Europe, national legislation on consumer credit must comply with the Consumer Credit Directive, which aims to ensure transparent and efficient credit markets, while at the same time protecting consumers. It’s obvious that changes to the regulations may have an impact on access to the consumer credit market for certain categories of borrowers. This is especially true for those who are financially more vulnerable. ACCIS Conference hosted by the NBB – 14 June 2022 3. But we must be careful to ensure that changes do achieve the intended goal, because that is not necessarily the case. Let’s take for example the maximum interest rate that can be applied according to the type of credit. While a rise in maximum interest rates offers lenders incentives to grant loans to consumers with a higher risk profile, it’s clear that this could also overburden borrowers. Conversely, a reduction would normally enable households to borrow at more moderate rates. But if the reduction is too large, there is a potential danger that they could be denied access to credit if lenders consider that the lower rates no longer cover the risks. Lowering maximum rates could also have a negative impact on the generation of interest income and consequently, on the lender’s general profitability. This is especially the case if consumer credit makes up a significant share of his business. A lender might consider that the lower maximum rates are no longer enough to generate an adequate profit margin, which could lead to a market situation where lenders cease to offer certain credit types. So, changing the regulations can be a good thing, but we must be aware of potential risks. That’s why it’s important to analyse in advance whether the intended measures can achieve their goal. 2.3 NEW CHALLENGES At the same time, the consumer credit market is undergoing accelerated changes that may lead to new challenges for regulation. One of these changes relates to mobile applications and the proliferation of market channels. Indeed, one of the main problems concerns the cost of credit obtainable at very short notice, especially via mobile applications. It’s speedy but expensive, because the estimated default risk is higher. These very short-term loans for modest amounts, so called “payday loans” or “flash credit”, are often negotiated on loan platforms on a peer-to-peer basis, by-passing national legislation. Companies operating in this segment don’t always assess the consumers’ borrowing capacity correctly, nor do they include any comparable rates in their offers. Some countries, like the Netherlands, have introduced regulations on this type of lending, but that causes these activities to move to other Member States or onto the internet. Such practices show the need for coordination between countries and regulation at European level. On the other hand, in order to maintain sound access to the credit market, we also have to consider some consumer characteristics. Over-indebtedness often goes hand in hand with underdeveloped financial literacy. In that regard, the most vulnerable groups are poorly educated consumers, young people, the unemployed, the elderly and migrants. Research in the United States and Germany also shows that lenders offer products on far less favourable terms to consumers with a lower level of financial literacy. Therefore, programmes offering financial education right from primary school, or providing training for the elderly or for migrants, should be encouraged. And of course, these observations also justify the importance of appropriate regulation. So, without any doubt, regulation can have an impact on access to finance for certain categories of consumers. Any change in the regulations should therefore pay attention to the need for finance and the potential credit constraints, but also to the risk of over-indebtedness. And as the market is open to lenders that are not subject to national regulation, this also highlights the need for uniform legislation throughout the European Union. MORTGAGE LOANS If you allow me, I would also like to say a few words about mortgage loans. At the end of last year, household debt in Belgium stood at 63 % of Belgian gross domestic product, one of its highest levels in recent decades. Overall, it has been increasing since 2002 and for the past six years, it has slightly exceeded the euro area average. This rise is driven almost entirely by mortgage debts, which, with an outstanding amount of 275 billion euro, represent 54 % of GDP. ACCIS Conference hosted by the NBB – 14 June 2022 4. According to a survey by the National Bank, almost three-quarters of Belgian households live in a property that they own. This would not be possible without borrowing: about one third of all households have a mortgage loan, most often contracted to build or buy their main residence. Yet, credit is not equally available to everyone. Households with lower income and wealth levels or those where the family head is unemployed or not working for other reasons than being retired, are more likely to face constraints in obtaining credit. Both loan providers and regulators should also try to avoid a situation where households become over-indebted. Over-indebtedness is very disruptive and distressing for a family or an individual. On a macro-economic scale, it can also aggravate a financial or economic crisis, with serious impact for entire economies. But while household debts have gone up in the aggregate, on average there doesn’t seem to be a higher risk of over-indebtedness in Belgium. Nevertheless, some pockets of risk remain. Younger households have higher debt levels relative to the value of their assets and they need to spend a bigger share of their income on servicing their debt. Indicators of vulnerability are also higher for households with lower incomes. The same goes for single-parent households and adults living on their own. For these reasons, one of the most important challenges for a central bank in its role as prudential supervisor, is to find a way to limit risks for the financial system without restricting people’s access to credit, especially younger households. CLOSING REMARKS Now I could go on for a very long time about the measures that we’ve imposed on banks to ensure financial stability while at the same time safeguarding access to finance for consumers and companies, but I see that Enrique is already looking anxiously at his watch. So, I’ll leave it there :-). All that's left for me to do now is to say that I hope you have a pleasant and instructive day. But seeing the topics and the speakers on today’s programme, I’m absolutely convinced that you will. Thank you! ACCIS Conference hosted by the NBB – 14 June 2022
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Public lecture by Mr Pierre Wunsch, Governor of the National Bank of Belgium, at the International Center for Monetary and Banking Studies, Geneva, 8 November 2022.
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Germs, War and Central Banks Public Lecture by Pierre Wunsch Governor, National Bank of Belgium International Center for Monetary and Banking Studies Geneva, 8 November 2022 As prepared for delivery Introduction Good evening. I would first like to thank Professor Panizza for kindly inviting me to be part of the prestigious ICMB public lecture series. I am truly honoured. Geneva is a unique place to speak about international finance, central banking and, given the circumstances, germs and war. After all, Geneva is home to both the WHO and the UN. With inflation at record-high levels, it’s important to understand how we got here and to take action to bring inflation back to the target rate. What a difference a year makes! In the summer of 2021, inflation narratives were simple and reassuring. As the pandemic abated, the lifting of restrictions unleashed a consumption boom. This was too much for still fragile supply chains and stressed logistics networks to handle. And when supply cannot keep pace with demand, our Econ 101 textbooks say that prices must rise. This is even more true for the energy and commodities markets. Inflation was back, and everyone applauded, for two reasons. First, the spectre of deflation was finally dissipating and, second, since the supply disruptions were deemed temporary in nature, it was expected that inflation would automatically fall. As central banks target inflation over a medium-term horizon, we felt confident we could safely “see through” these fluctuations. Like textbooks, the models told us that inflation would automatically fall. But post-pandemic inflation turned out to be more persistent than initially thought, much more persistent. An alternative narrative has thus developed, according to which the current surge in inflation is attributable, at least in part, to more structural reasons, including the fact that the inflation rate has already risen considerably. In other words, inflation can feed on itself. In this narrative, the persistence of inflation reflects a regime shift which our workhorse models are, by design, ill-equipped to detect. As conflicting inflation narratives are now circulating, there is a tangible risk of a de-anchoring of inflation expectations. And if credibility is the name of the game, we know that policy rates may have to be raised more decisively than what any model in our toolkit would suggest. Tonight, I will look at the possible drivers of inflation through the lens of these two narratives and the consequences for monetary policy. I will also raise some questions about the reference framework, which largely supports the first – benign – inflation narrative. I will focus on the extensive reliance on New Keynesian models and the underlying notion of a falling equilibrium real interest rate, the infamous r-star (r*). Finally, before concluding, I will touch on some current policy issues. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 1 of 11 Drivers of inflation and optimal monetary policy response With regard to the drivers of inflation, let me be clear from the outset: past monetary policy is only one factor driving the current high inflation readings. For years, central banks conducted a very accommodative monetary policy in the face of what was believed to be structurally low demand. And, indeed, inflation remained low and stable. It seems highly unlikely that the effects of monetary accommodation suddenly crystalised to send inflation through the roof. That being said, it should be recognised that an increasingly loose monetary policy stance contributed to an environment conducive to inflation. During the COVID-19 crisis, the scale of policy stimulus was unprecedented. That was the right thing to do in the face of a truly unprecedented shock. What is questionable, however, is the time it took for monetary policy to begin normalising after the start of a V-shaped recovery, the quick tightening of the labour markets and the continuance of fiscal support. That’s why dissenting voices, including mine, were raised, notably to criticise the forward guidance on policy rates. To be sure, seeing through does not mean turning a blind eye. So how did we end up with such high inflation? Despite substantial uncertainty and dissatisfaction with our models, we can still agree that inflation continues to be driven by the combined dynamics of aggregate demand and supply! While the inflation surge is global, some of its sources are local. In the US, a historic fiscal stimulus package boosted demand against the backdrop of a very tight labour market (judging from the unemployment and vacancy rates). The US GDP deflator reached 7.6% in the second quarter of this year compared with 4.3% in the euro area. Predictably, monetary policy tightened faster and more vigorously in the US than in the euro area. In a way, the US story is a textbook case from the perspective of a central banker: red hot demand pushed inflation beyond the target rate and economic activity beyond potential output. Monetary tightening is meant to bring both variables back in line. This is the “divine coincidence” at work. By contrast, in Europe, there is no divine coincidence to speak of: bringing inflation down is bound to take a toll, in terms of economic activity. The euro area was quickly overwhelmed by a succession of supply shocks. Unlike the US, Europe is a net importer of energy and other commodities whose prices have skyrocketed since the end of the pandemic, even more so since the Russian invasion of Ukraine. The rapid appreciation of the US dollar did not help. While not our currency, the dollar is our problem. Looking at recent figures, energy (priced in dollars) accounts for about half the euro area inflation rate. Clearly, the ECB faces greater policy challenges than the Fed. As inflation persists, the growing awareness that supply shocks could have more enduring – perhaps permanent – effects has highlighted the need for a firm monetary policy response.1 Global value chains could be durably affected by the memory of pandemic restrictions and the worsening of geopolitical tensions. As firms de-emphasise efficiency maximisation in favour of resilience (or social responsibility, for instance, when it comes to climate change), supply chains could be shortened. The words “reshoring,” “friendshoring” and “deglobalisation” have become part of our vocabulary. Production costs may thus be on a rising trend for some time. Likewise, energy and food supplies could remain constrained for the foreseeable future. All other factors being equal, the bottom line is lower potential output. Tighter monetary policy will consequently be required to align demand and supply at a level consistent with the desired price dynamics. 1 Reis (2022). ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 2 of 11 More generally, supply shocks with persistent effects could well require a stronger monetary policy response if they contribute to a de-anchoring of inflation expectations. Indeed, the longer inflation persists, the greater the risk of people learning to live with it and adapting their behaviours in ways that perpetuate it. Under such circumstances, decisive monetary policy is required to prevent self-fulfilling prophecies and coordinate target expectations.2 As inflation remains stubbornly high and is testing expectations, the role of models in policymaking is being called into question. Models depict the macroeconomy at business cycle frequency. Shocks have only temporary effects, and expectations are rational. They also tend to estimate r* at a low level, suggesting that policy rates do not have to be raised much in order for monetary policy to become neutral or restrictive. I will now turn to the questions I have about this reference framework. Questioning the reference framework: the use of models and r* Despite their widespread use, a number of caveats apply to models. The first is that many models are likely to miss regime shifts – such as structural or behavioural changes – or the consequences of tail events – like a war, pandemic or financial crisis. Models that allow for regime shifts may need to be fed with a substantial quantity of data before they can detect a shift. In addition, models may not detect the consequences of tail events with a reasonable degree of precision simply because they cannot capture the empirical patterns related to such events. In fact, many models focus on stationary dynamics around a steady state. Eurosystem/ECB staff projections appear to be largely based on stationary models, as shown in the left-hand chart. In stationary models, inflation forecasts always converge to the steady state. For the 2 Schnabel (2022). ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 3 of 11 inflation variable, the steady state can be calibrated, or “hard coded” if you will, at 2% for instance. In general equilibrium models, the assumption of rational expectations typically implies stable inflation dynamics. This assumption postulates that agents form expectations in a forward-looking way, meaning well-anchored inflation expectations are all that is required.3 Broadly speaking, inflation projections invariably show “mean reversion”. This begs the question of how much weight we should give model-based projections, especially in the context of a potential regime shift and rare event.4 Intuitively, more uncertain projections should get less weight. Looking at the history of Eurosystem/ECB staff inflation projections, errors are small for short horizons, as shown on the right-hand chart. The root-mean-squared error (RMSE) for the one-quarter-ahead projection is 10 basis points. Thus, if inflation is projected at 2% for the next quarter, the two-RMSE confidence interval spans a range running from 1.8% to 2.2%. But errors increase rapidly over the projection horizon. At the two-year-ahead horizon, the error is close to 100 basis points for the period up to the COVID-19 crisis.5 If inflation is projected to be 2% for this horizon, the confidence interval goes from 0% to 4%. If the COVID-19 period is considered, projection errors increase further to more than 150 basis points at the two-year horizon.6 As a result, longer-term projections should be particularly discounted in the event of a potential regime shift or rare event, such as we may be experiencing. More fundamentally, the use of stationary models raises the question of whether the endogenous policy response embedded in them is appropriate. Recently, despite the fact that a surge in inflation was already well underway, our models continued to suggest that a mild policy response would suffice and that inflation would converge towards the objective, even with real rates remaining largely negative. Models are also extensively used to estimate the level of the natural interest rate or r*. Here I mean r* as the natural rate of interest implying economic activity at the level of potential output and inflation at the central bank’s target rate in the long term. 3 For a discussion of the assumption of rational expectations, see Mann (2022), IMF (2022) and BIS (2022). 4 ECB (2021). 5 For more information on forecast accuracy, see also Lambrias and Page (2019) and Bok et al. (2017). 6 See Chahad et al. (2022) for a decomposition of forecasting errors in Eurosystem/ECB staff projections. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 4 of 11 There are two main issues related to using r* as a compass for policy decisions. First, there is significant uncertainty surrounding the estimates. The chart refers to the US because estimates for this country are readily available. As can be seen, however, uncertainty is high both within and across models. “Within model uncertainty” means that the confidence intervals for r* estimates are typically quite wide. It is not uncommon to see a 90% confidence interval as wide as 2 percentage points below and above the estimates. “Across model uncertainty” means that r* estimates are model-dependent, so that different models yield different r* estimates. Overall, the level of uncertainty is so overwhelming that central bankers should acknowledge that they don’t know precisely where r* is.7 Second, the relationship between interest rates and inflation may not be so stable. The idea of r* is that when inflation or inflation expectations are below target, real rates should be brought below r* so as to stimulate economic activity and inflation. But there are reasons to believe that this relationship does not apply under all circumstances. The slope of the investment-savings (IS) curve may be different for different levels of interest rates. For instance, when interest rates are at low levels and have been for quite some time, the interest rate sensitivity of demand may be reduced as investment projects could be exhausted and consumption cannot be stimulated forever.8 So, should we, as central bankers, be concerned about this? Not if we all agree that measures of r* are indeed too imprecise to inform real-time policy-making. There now seems to be a consensus on this point. Still, references to low estimates of r* – usually nominal ones – still occasionally pop-up in our discussions. They are part of the argument in favour of a moderate policy response. In any case, despite the uncertainty surrounding model projections and r* estimates, the recent ECB strategy review largely relied on them. The dominant theme was the combination of a low r* and the presence of an effective lower bound. In order to reach a symmetric 2% inflation objective, the monetary policy response must be asymmetric. That is to say, it must be “especially forceful or persistent” when the 7 Brand et al. (2018), Borio et al. (2022), Borio (2021a, 2021b, 2022) and Hillenbrand (2021). 8 Stansbury and Summers (2020), Borio and Hofmann (2017) and Ahmed et al. (2021). See also Brunnermeier and Koby (2018) on the idea of a “reversal rate”. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 5 of 11 economy is close to the lower bound. This will help to avoid the entrenchment of negative deviations from the inflation target. The resulting revised forward guidance, issued in July 2021, was predicated on these notions, with the forecasts suggesting that inflation would smoothly converge back to 2% from below. As a result, the strategy review overlooked the historical asymmetry according to which high inflation has occurred more often in modern times than deflation. So, we might also have to be more “forceful and persistent” when inflation is on the rise. Moreover, despite the strategy review recognising that “financial stability is a precondition for price stability”, the revised forward guidance seemed to have disregarded potential side effects in practice. For one, if r* is estimated to be low, there is no problem in keeping interest rates low. In addition, models often do not allow for the possibility of long-term financial stability risks. These are rare events that are difficult to capture. Still, the reality is that low interest rates generate financial stability risks because they make it easier to borrow. The empirical evidence is clear: credit aggregates contain valuable information about the likelihood of future financial crises.9 In addition, prolonged periods of low financial market volatility, potentially promoted by accommodative monetary policy, have predictive power over the incidence of banking crises.10 I therefore believe that more attention should be paid to the impact of monetary policy on financial stability. That being said, as our mandate focuses on inflation and our models typically ignore financial stability aspects, discussing trade-offs remains difficult, both in theory and in practice. Current policy issues So, what does this mean in terms of policy-making in the coming weeks and months? The most obvious observation is that uncertainty is very high. Beyond that, I am afraid that policy-making is becoming a matter of faith. Informed faith, but faith nonetheless. The greater the reliance on standard models and low r* estimates, the greater the temptation to argue in favour of a gradual and moderate monetary policy response. Conversely, the greater the criticism of models and r* estimates, the greater the temptation to look to the oil shocks of the 1970s and 1980s for inspiration. Neither models nor the past can serve as an ideal guide in the current setting, but I am afraid we don’t have much else to go by. Another way to frame the debate is between a repeated shock narrative and a regime shift narrative. Both could explain the higher inflation persistence observed over the past year, but with quite different policy implications. I could stop here, of course. In a way, all has been said. But many, the press in particular, tend to take a very pragmatic approach to monetary policy and are concerned with “what, when and how much”. So I will try to be a little more specific. If you adhere to the repeated shocks narrative, the recommended course of action is to normalise monetary policy by raising rates to a level slightly above r*. Assuming the nominal 9 See e.g. Schularick and Taylor (2012). 10 Daniellson et al. (2018). ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 6 of 11 neutral rate is around 2%, the policy rate will need to be brought slightly above that level to bring inflation back to 2% within a reasonable timeframe. While this outlook is possible, I believe it to be overly optimistic. On the other hand, if you believe in the regime shift narrative, the situation is potentially more complicated. Broadly speaking, there are two types of regime shifts: one related to fundamentals and the other to inflation dynamics. In the former, the supply shocks we are experiencing could have persistent – or even permanent – effects. Whether this will be the case depends on known unknowns: a resurgence of the pandemic, spillovers from the war in Ukraine on global value chains, a rocky energy transition, deglobalisation and/or unsustainable fiscal trajectories. In the second type of regime shift, inflation could get out of control without a change in fundamentals. This could happen if, for instance, inflation expectations were to de-anchor. De-anchored inflation expectations would most likely require a more forceful policy response, with a greater cost of waiting, in terms of economic activity, reminiscent of the “Volcker shock” in the 1980s. Looking at measures of inflation expectations, as shown on the slide, the evidence leans in favour of expectations remaining anchored, although some risks have started to appear. Market-based measures and the ECB’s surveys of professionals indicate that long-term inflation expectations are broadly anchored. However, there is some evidence of deanchoring in consumer expectations surveys and tentative signs of de-anchoring in the distributions of market and survey-based measures.11 The possible de-anchoring of consumer expectations is worrisome because it could trigger a wage-price spiral. If inflation persists, consumers could become more attentive to it, more “backward looking” when forming expectations. This is nicely captured in the IMF’s latest 11 Górnicka and Meyler (2022); see also Reis (2021) on the ECB’s survey of professional forecasters’ distributions of inflation expectations. For market distributions, see the regular updates of Hilscher et al. (2022) on the website of Ricardo Reis. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 7 of 11 World Economic Outlook, which presents the results of a model with more persistent inflation produced by a shift towards more backward-looking behaviour. Overall, de-emphasising model-based narratives seems warranted to me at this stage. In addition to repeated surprises and worrying signs in terms of expectations, inflation has become more broad-based, another indication of increased persistence. But a consequence of leaving models behind is that the “end game” for monetary policy becomes less clear. With no r* to target and no more specific forward guidance, there is less predictability. This higher uncertainty is reflected in market pricing of future policy rates, as shown on the slide. The €STR forward curve indicates market pricing for the ECB’s deposit facility rate in a de facto floor system. In December 2021, the curve suggested that the deposit facility rate would stay “low for long”, specifically “negative for long”. Today, the curve suggests that the €STR will stabilise at around 3% by the end of 2023. This significant repricing suggests that the policy rate is chasing an unobserved and moving target. My personal take on interest rates is – and has been for a number of months – that we need at least to bring real interest rates back to positive territory. It is indeed difficult to believe that raising real rates slightly above zero could do much damage to the economy. And, indeed, slightly positive real rates are currently priced in by the markets. Looking at the long end of the €STR forward curve, the real policy rate stands at about 1% if inflation expectations remain anchored at 2%. Therefore, the €STR increases that are currently priced in seem reasonable, provided wage growth remains in check. But this condition may not be met in the future and I cannot exclude the possibility that real rates will have to be raised more forcefully in order to rein in inflation. Additional rate forward guidance would probably not be useful at this stage. The level of uncertainty is high, as reflected by recent fluctuations in the €STR forward curve. As my fellow central banker François Villeroy de Galhau has stated, “[…] the greater the ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 8 of 11 uncertainty, the shorter the forward guidance should be”.12 With that in mind, it seems appropriate to make decisions following a meeting-by-meeting approach. Aside from policy rate increases, reducing the size of the Eurosystem’s balance sheet should also be part of the normalisation process. From a stance perspective, there is imperfect substitutability between scaling down the balance sheet and hiking policy rates. Balance sheet policies have a greater effect on longer-term rates, while conventional rate policies tend to affect shorter-term rates. Hence a balanced mix of the two is warranted at the current juncture. The Governing Council will discuss key principles for the reduction of its asset purchase programme portfolio at its next monetary policy meeting in December. Conclusion In conclusion, the recent surge in inflation has been triggered by unexpectedly persistent supply disruptions, very supportive fiscal policies and rising geopolitical tensions. In this environment, monetary policy was slow to react at first but is now clearly focused on reaching our 2% inflation target over the medium term. The jury is still out, however, as to what it will take to get inflation back to target or, put differently, how we can avoid a costly de-anchoring of inflation expectations. Importantly, what we end up doing will depend on what other policymakers do. In particular, fiscal policy, a key transmission channel for monetary easing during the pandemic, should stop feeding aggregate demand. It should start doing so now, with a net reduction of structural deficits, allowing for targeted measures to support the most vulnerable segments of our economies. I know that this is easier said than done. After a long period of cheap money, people expect the government to protect them from external shocks. But all else being equal, loose fiscal policies ultimately provoke a stronger monetary policy response. And if anyone has doubts as to the outcome of a face-off between fiscal and monetary policies, they need only look to the recent UK experience (or rather experiment). More generally, one reason why inflation could be more persistent than initially thought or estimated by our models is that workers and firms still have to agree on who foots the bill for higher energy prices. Firms will try to protect their margins and workers their purchasing power. Both have market power, and it may take a few iterations or, worse, a deeper recession before they can agree on how to share the burden. Thus far, employees have been willing to take most of the hit. But like others, I am not sure that bygones are bygones and therefore expect the pass-through of inflation to wages to increase in the coming months. In any case, our monetary policy response will ultimately depend on the severity of the coming economic slowdown. Two main scenarios could materialise. If the slowdown is shallow and accompanied by a further rise in inflation – and inflation expectations – real interest rates will have to move above the current market consensus. On the other hand, if the slowdown is more severe and leads to lower inflation, leaving expectations broadly anchored, real rates could stabilise at a level close to zero. In closing, my most important takeaway from the current inflation episode is that we know much less about inflation than we thought. We will of course do what needs to be done to 12 Villeroy de Galhau (2022). ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 9 of 11 avoid a de-anchoring of inflation expectations. But it is quite clear to me that we, as policymakers, have lost our moorings. Not only have our models performed poorly but our conceptual framework may need to be revisited. Over the past ten years, our 2% target has been met for only a few months. Perhaps our ambition of stabilising inflation within a narrow range has become, well, a bit too ambitious. Thank you for your attention. References Ahmed R., C. Borio, P. Disyatat and B. Hofmann (2021), “Losing traction? The real effects of monetary policy when interest rates are low”, BIS Working Paper 983. Bank of England, Independent Evaluation Office, “Evaluating Forecast Performance”, November 2015. BIS, Annual Economic Report, June 2022, in particular “The inflation environment”, 53-55. Bok B., D. Caratelli, D. Giannone, A. Sbordone and A. Tambalotti (2017), “Macroeconomic Nowcasting and Forecasting with Big Data”, Federal Reserve Bank of New York Staff Report 830. Borio C. (2021a), “Back to the future: intellectual challenges for monetary policy”, David Finch Lecture, University of Melbourne, 2 September. Borio C. (2021b), “Navigating by r*: safe or hazardous?”, speech at SUERF- Bocconi-OeNB workshop, “How to raise r*?”, 15 September. Borio C. (2022), “Monetary policy: past, present and future”, speech at the Cato Institute’s 40th Annual Monetary Conference, 8 September. Borio C., P. Disyatat, M. Juselius and P. Rungcharoenkitkula (2022), “Why So Low for So Long? A Long-Term View of Real Interest Rates”, International Journal of Central Banking, 18(3), 47-87. Borio C. and B. Hofmann (2017), “Is monetary policy less effective when interest rates are persistently low?”, BIS Working Paper 628. Brand C., M. Bielecki and A. Penalver (2018), “The natural rate of interest: estimates, drivers, and challenges to monetary policy”, ECB Occasional Paper Series, December. Brunnermeier M. K. and Y. Koby (2018) “The reversal interest rate”, NBER Working Paper 25406. Chahad M., A. Hofmann-Drahonsky, B. Meunier, A. Page and M. Tirpák (2022), “What explains recent errors in the inflation projections of Eurosystem and ECB staff?”, ECB Economic Bulletin, Issue 3, April. Daniellson J., M. Valenzuela and I. Zer (2018), “Learning from history: volatility and financial crises”, The Review of Financial Studies, 31(7), 2774-2805. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 10 of 11 ECB (2021), “Review of macroeconomic modelling in the Eurosystem: current practices and scope for improvement”, Occasional Paper 267. Górnicka L. and A. Meyler (2022), “Does the tail wag the dog? A closer look at recent movements in the distributions of inflation expectations”, ECB Economic Bulletin, Issue 6 (box 3), September. Hillenbrand S. (2022), “The Fed and the Secular Decline in Interest Rates”, NYU Stern School of Business, mimeo. Hilscher J., A. Raviv and R. Reis (2022), "How Likely is an Inflation Disaster", CEPR discussion paper, April. IMF October 2022 World Economic Outlook, Analytical Chapter 2. Lambrias K. and A. Page (2019), “The performance of the Eurosystem/ECB staff macroeconomic projections since the financial crisis”, ECB Economic Bulletin, Issue 8, December. Mann C. L. (2022), “Inflation expectations, inflation persistence and monetary policy strategy”, speech at the 53rd Annual Conference of the Money Macro and Finance Society, University of Kent, 5 September. Reis R. (2021), “Losing the inflation anchor”, Brookings Papers on Economic Activity, 307361, Fall. Reis R. (2022), “The Burst of High Inflation in 2021–22: How and Why Did We Get Here?”, CEPR Discussion Paper 17514. Schnabel I. (2022), “Looking through higher energy prices? Monetary policy and the green transition”, “Climate and the Financial System” panel at the American Finance Association’s 2022 Virtual Annual Meeting, 8 January. Schularick M. and A. Taylor (2012), “Credit booms gone bust: monetary policy, leverage cycles and financial crises”, American Economic Review, 102(2), 1029-1061. Stansbury A. and L. Summers (2020), “The End of the Golden Age of Central Banking? Secular stagnation is about more than the zero lower bound”, unpublished manuscript. Villeroy de Galhau F. (2022), “Monetary Policy in Uncertain Times”, speech at the London School of Economics, 15 February. ______________________________________________________________________________________ 20221108 ICMB Public Lecture Pierre Wunsch – National Bank of Belgium Page 11 of 11
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Opening keynote by Mr Pierre Wunsch, Governor of the National Bank of Belgium, at the European Semester Conference "Inter-parliamentary conference on stability, economic coordination and governance in the EU", Brussels, 13 February 2024.
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1. European Semester Conference Inter-parliamentary conference on stability, economic coordination and governance in the EU Strategic investment and reforms in view of enhancing EU’s growth potential Opening keynote by Pierre Wunsch, Governor of the National Bank of Belgium AS PREPARED FOR DELIVERY • It is an honour to open this session on strategic investment and reforms to boost EU’s growth potential. In these uncertain times, this is an even more daunting challenge than ever before. • It is of course impossible to do justice to the richness and complexity of the matter in ten minutes. I can therefore only be impressionistic as Monet, the painter, would have been. • At least since the turn of the century, Europe has been keenly aware of the structural constraints impinging on its economic dynamism. Typically, the policy response has been framed in terms of multi-year plans implying “more Europe” supported by a grand vision and very often big funding announcements in support of transformative projects or policies. • Some of us remember the objective of the Lisbon Strategy, adopted in 2000, which ambitioned to turn the EU into (I quote) “the most competitive and dynamic knowledge-based economy in the world.” All this was to be achieved by 2010 thanks to coordinated and ambitious structural reforms. A similar approach was behind the “Europe 2020” agenda in 2010 or the Commission’s Investment Plan for Europe in 2014 (or Juncker Plan) which aimed at encouraging more than 300 billion euro in additional investment over 3 years. • The most recent incarnation of that think-big-spend-big paradigm are the NGEU and Fit for 55 ambitions. Once again, a cocktail of massive investment and structural reforms should make the EU world champions, this time on the climate front, while still boosting growth and sustainable public finances. • Now, do not get me wrong: we do need structural reforms, and more investments and sound public finances, as much as we need a banking union, a capital market union, a fiscal union, and what not. • But there is a growing feeling, impression, and maybe even a consensus that we are lagging behind… Behind our own ambitions, but also behind the US and others when it comes to investment, innovation and growth. • Recently, the title of an article was reading (I did not read the article, one does not do that anymore, but I should have tweeted about it): “The US innovates, China imitates, and Europe regulates.” Speech EP130224 CLEAN.docx 2. • This might be unfair, but there is certainly a widespread impression that this is, at least partly, true. And indeed, data do not look great. o Data on public and private investment,as well as GDP per capita, shows that despite our many plans, the EA has trailed the US. o Looking at a more granular level, we seem to be stuck between the US (with its digital champions and cheap energy) and China (with its significant cost advantages on the very green technologies we wanted to foster: solar panels, EVs, and even windmills.); all this with no obvious positioning between the two. o On the energy front, US natural gas is at 10€/MWh. Before the war in Ukraine, we were at around 20€/MWh. The new normal for us is now between 30-50€/MWh… to which we must add an additional 20-30€/MWh for carbon capture and/or blue hydrogen. That is 5 to 8 times higher than in the US. So, yes, one might ask : is there a future for EU energy intensive firms ? • Clearly, the challenges presently facing the EU are truly transformative. They require extensive reallocation of resources across sectors, the rapid adoption of new technologies, and disruptive innovations. All three involve ample funding and significant risk taking. • If history is any guide, though, Europe’s economy is bad at reallocations (the old sclerosis story) and slower than its competitors at embracing new technologies. We are by now used to the fact that the digital giants of this World are all American (or Chinese). If anything, the fact that Tesla was born in the US came as a shock. But then again, Elon Musk has a way of doing things that is not quite European. • What I am saying here is that, to some extent, what you see in Europe may be the result of our deep preferences. By that I mean a greater risk aversion than our competitors. And maybe also a stronger preference for leisure? As European elections loom, I detect a fear of greening, a fear of war, a fear of China, and a fear of demographics fuelled by the aging-migration nexus. • Is Europe doomed then? I don’t believe so, but the path to our big goals is relatively narrow and fraught with uncertainties. • European economies are still rich and resourceful; and they still have some time to take advantage of their current wealth in a way that secures future prosperity. • However, when thinking about the transformative period ahead of us, a few facts and lessons from the past seem useful to keep in mind. o First, throwing massive amounts of money at problems just to mitigate their effects is not a panacea. It might be OK for short-term crisis management, as the response to the COVID-19 pandemic showed. But this is not a longerterm strategy. o Second, there is no funding problem. Overall, we still live in a world where too much savings chases too little investment, as shown by interest rates that remain very low when you factor in inflation (the so-called real rates). Debt is not as cheap as it was, but it remains very affordable. The question is why is there too little investment? What are the binding constraints? To be sure, it is not funding. Speech EP130224 CLEAN.docx 3. o Third, I believe we do have a real issue with our regulatory burden (as well as permitting on the climate front). Even as a central banker, how many times have I not heard: “Well, if we follow the opinion of our legal department, then we just cannot do it”. And we are not building anything, just working with computers and data. Faced with the uncertainties of the day, the name of the game cannot be more protection (of our people, our firms, and our markets). And yet, people will demand it. It is a very difficult political equation. • The way out is to provide a vision credible enough to change the mindset. This is far more easily said than done, especially in a fragmented society where individuals can choose information sources that suit their subjective priors. • In my humble opinion, the new mindset will have to recognize some of the difficult trade-offs we are facing. Navigating these trade-offs inevitably creates winners and losers in the short to medium term. • The new mindset will also have to shift from one where easy money can solve all problems (typically after they happen) to one where we have realistic plans to handle difficult transitions (climate, digital, demographic), as well as communication strategies that better recognize the challenges ahead. Let me try to briefly illustrate these considerations with climate policies. Only a small minority lives in denial of the need to act. And I believe that Europe got it right. Its strategy is in my view more credible than the US IRA, which is incredibly costly and detrimental to the US trade partners. [After all, as John Hassler quipped: “If the problem is overfishing, subsidizing chicken will not make it”]. • • • • So where do I see issues in Europe? First, and I would say as usual in Europe, the debate has been largely framed as one of “finding” a lot of money, while at the same time reassuring citizens (and voters) that it would not cost much. The emphasis on “finding money” is misplaced. It is a matter of spending priorities, for the public as well as for the private sector. A combination of adequate regulations (adequate meaning “credible and predictable”) and carbon pricing should shape everyone’s incentives to achieve our climate ambitions. Second, I think we could and should rethink the official communication around the climate transition. We should be more candid. Specifically: o Don’t lure people into thinking that greening carries positive opportunities that could augment GDP and create millions of well-paid jobs. As a macroeconomist, it is my job to tell you that the climate transition is a negative “supply shock,” one that will reduce our growth potential. o So you heard me, this transition is not going to make us collectively richer. o To be sure, there will be winners, but also many losers. And we should say it because if public authorities are caught living in denial, they will lose their most precious asset: credibility. Without credibility, the first concrete signs of emerging problems will encourage popular anger and protests. Just look at farmers... Speech EP130224 CLEAN.docx 4. o Admitting what I just said then forces us answer two difficult questions: how much will it cost and who will pay? In providing answers, we must be clear on the uncertainties surrounding our estimates and the policy contingencies we are prepared to activate if problems materialize. o There is a growing consensus that the costs of the transition are similar in magnitude to a (significant) oil or energy shock, but spread over 26 years, not weeks, as in the 1970s. o So I am one of those who believe that the aggregate shock to our collective wealth should be manageable. o But we should still do our homework on the “who will pay ?” part of the question. This requires a granular and realistic understanding of the costs per sector, but also of other political and technical constraints. Think about gas boilers in Germany... As I am about to close, I must mention the elephant in the room: geopolitics. Everyone understands that global warming is… well, global; and that the EU emits only a small fraction of greenhouse gas. So, the question of who will pay is as much about the different groups in our societies, as it is about other countries around the world, especially the US and China. In the old world of rules-based international relations, a reasonable hope would have been that international policy coordination could provide a satisfactory solution. However, the recent COPs have dashed my hopes. I will not risk my reputation anticipating what the outcome of the strategic interactions between the 3 big players might be. I will only share a few worries and unanswered questions. • First, I am worried about the faith one seems to be putting in the Carbon Border Adjustment Mechanism and in industrial policies of all breeds. As I already mentioned, energy prices in Europe put us at a serious disadvantage compared to the US, which have access to cheap energy, do not intend to tax carbon, and have opted to subsidize clean energy. While we could expect a cheaper euro to correct for part of Europe’s competitiveness gap with the US, a weak currency is not a permanent solution. • Second, although Europe probably never was the most innovative economy, it was good at incremental technological progress, but much less at the disruptive type, which is becoming more important. Besides, looking beyond quantum, superior quality is often associated with our continent: the quality of the products we make, but more broadly, the better quality of life and greater social equity we achieve given a lower GDP per capita than the US. I would nevertheless caution against the sense of complacency that might come out of this line of thinking. Permanently trailing our competitors will ultimately undermine our welfare. That will not be acceptable to the people. • Third, in the great power game now underway, Europe’s traditional foreign policy doctrine comes under stress. While EU countries operate well in the safe environment of rules-based international relations cemented by international organizations and strong transatlantic ties, it seems to be less effective in establishing a “rapport de force” to its advantage in today’s multipolar and transactional world. The readiness to be shrewd, or even disruptive, on the global stage is not something a politically fragmented EU can hope to deliver any time soon. • This leaves us with important open questions: How can we preserve our single market while competing with the US and China? How can we be at the same Speech EP130224 CLEAN.docx 5. time agile and rule-based? How can we fulfil our ambitious climate objectives, while being candid about their implications? At the end of the day, it is all about politics. So, my job is easier than yours. Let that be clear between us. Thank you very much for your attention. Speech EP130224 CLEAN.docx
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Guest lecture by Mr Pierre Wunsch, Governor of the National Bank of Belgium, at the Frankfurt School of Finance & Management, Centre for Central Banking, Frankfurt am Main, 8 May 2024.
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FRANKFURT SCHOOL OF FINANCE & MANAGEMENT, CENTRE FOR CENTRAL BANKING Guest lecture by Pierre Wunsch, Governor, National Bank of Belgium “Beyond hawks and doves: trying to get it right in an uncertain world” 8 May 2024 – Frankfurt Introduction Good afternoon everyone, I am very happy to be here today, at Jens’ kind invitation, to share a few thoughts on the art of conducting monetary policy in uncertain times. The establishment of the Centre for Central Banking by Jens and Emanuel Moench in Frankfurt is a great initiative. I very much look forward to the centre’s contributions to a better understanding of the complex linkages between finance, central banking, and the real economy. Since I joined the ECB’s Governing Council in 2019 (and earlier as a backbencher), I have felt privileged to know Jens, and have learned so much from him. At the beginning, our views may have appeared to contrast somewhat. You might recall Jens being labelled as a “hawkish member” of the Council. My institution, the National Bank of Belgium, was instead considered to be rather “dovish”. And indeed, divergences were not uncommon. In September 2019, the Financial Times tagged Jens as – quote – “opposed in principle” and myself as a – quote – “supporter” of Mario Draghi’s “last big stimulus”.1 My journey through the world of central banking has taught me a few things, and Jens has been instrumental in this. That’s what my speech tonight is all about. In fact, the working title of the speech has long been “The impact of seating arrangements on monetary policy”. Indeed, Jens and I share the privilege of having surnames beginning with “W”, meaning that we were neighbours at the Council table for quite some time. 1 Financial Times, 27 September 2019, “Splits at the ECB top table over Mario Draghi’s last big stimulus”. A key lesson learned from being in Jens’ company is that giving central bankers birds’ names (hawks, doves, owls, parrots, you name it) is simplistic. Let it be noted once and for all: we are all staunch supporters of price stability. Delivering it is our mission. Our mandate is not dual; we don’t do trade-offs. What differentiates us, however, is our perception of risks, and relatedly, our willingness to take risks. That clarity of purpose has been a useful compass on my journey: I have not had to balance multiple goals based on personal preferences. In fact, maintaining inflation at 2% is simply about doing the right thing, conditional on what we think we know about the state of the economy and its likely evolution over the medium term. Under uncertainty, it amounts to managing the risk of missing our goal. Growth, of course, is in the background, but it is not the driver of our decision. Indeed, we know that being extremely risk averse or, on the contrary, reckless about inflation, invariably ends up killing economic growth. Being too tight for too long or having to put the inflation genie back into the bottle both lead to subpar growth or worse. It should now be clear that, in my view, the “hawk/dove” dichotomy cannot capture the true nature of monetary policymaking. Hence, the title of my speech today: “Beyond hawks and doves: trying to get it right in an uncertain world”. Throughout this lecture, I will reflect upon my evolving stance on the primary drivers of monetary policy in recent years. I will also share some personal thoughts on the medium-term trajectory of monetary policy. Finally, I will discuss more fundamental questions around the limits of central bank mandates. Acute crises and urgent issues have clearly tested those limits. I will focus on the role of independent central banks in mitigating climate change and interacting with fiscal policy. Before COVID-19: a well-developed theory that had to be tested Before the COVID-19 pandemic, things seemed reasonably simple, at least by today’s standards. Aggregate demand was seen as structurally weak. For a host of reasons (population ageing, rising income inequality, etc.), ample global savings appeared to be struggling to find sufficient opportunities for profitable investment. Thus, equilibrium real interest rates (often referred to as R* in our simple macro jargon) had to be very low, and inflation hovered below official targets. There were even signs of de-anchoring of long-term inflation expectations. In such circumstances, the conventional wisdom from central bank workhorse models (all of which belong to the class of so-called new Keynesian models) prescribes an extremely stimulative monetary policy. Indeed, in these models, imbalances stem from the demand side of the economy. This means that monetary policy can always handle such imbalances. Models describe a world of “divine coincidence” where closing the output gap (bringing Y to Y*) also brings inflation back to target (that is, pi to pi*). In the end, according to these models, our job is to align the stars (Y with Y*, pi with pi* and R with R*).2 The problem, however, was that monetary policy had precious little room for manoeuvre. Conventional instruments were squeezed between an already low R* and the so-called effective lower bound on interest rates. That lower bound reflects the fact that in an economy where money can be freely converted into cash, the scope for negative nominal interest rates is bounded by the marginal cost of hoarding cash, be it at home under a mattress or in a bank vault. 2 Blanchard and Galí (2007). Quite logically, the dominant view became that central banks had to provide the required stimulus through means other than conventional instruments. Beyond historically low (negative) policy rates, central banks sought to influence longer-term interest rates through forward guidance and asset purchases. They tried to boost the credit channel of monetary policy by providing ample liquidity to commercial banks, hoping they would lend more to their customers. In hindsight, it is evident that this multipronged strategy of serial big bazookas yielded suboptimal outcomes. Inflation remained stubbornly low, while the side effects of that shock therapy became increasingly evident. I will get back to these side effects later. Monetary policy during COVID-19: no regrets The COVID-19 pandemic erupted in this environment of chronically low demand and limited policy space. The shock was deep, sudden, and involved an unlikely combination of dislocated supply chains and suppressed demand. The costs of such disruption could not possibly be insured ex ante by anyone. Only governments could protect economies ex post against potentially huge long-term consequences that far exceeded anything a Schumpeterian creative destruction argument could justify. Instead, scarring was a clear and present danger. As moral hazard was not a consideration either, the case for protection was crystal clear. Of course, the policy response had to be commensurate to the shock: massive, quick, but reversible. Yet, policy space was not only limited on the monetary side but also on the fiscal side, owing to historically high public debt in many countries. In addition, rapid deployment and reversibility are features of fiscal policy, not monetary policy, which only influences macroeconomic outcomes with long and variable time lags. The need for a large-scale macro stimulus in a context of limited policy space brought the “policy mix” concept back to life. In normal times, independent actions by central banks and treasuries often lead to tensions in the mix. Typically, the central bank offsets the demand effect of fiscal policy if it sees the latter as running against price stability. Thus, unwarranted fiscal stimulus leads to tighter monetary policy, and vice versa. Game theorists would say that monetary policy and fiscal policy are strategic substitutes: it is in the best interest of policymakers to offset their respective impacts on aggregate demand. The situation created by the pandemic turned that game on its head. Both monetary and fiscal policies had to be deployed to protect and stabilize the economy. Monetary policy — through the PEPP and other programs — effectively worked by creating the space required for fiscal policy to act. With the onset of the pandemic, inflation further receded. As investors and consumers were unable to respond to lower interest rates and cheap credit, monetary policy could only be effective through the government’s role as the spender of last resort. It became in the best interest of the central bank to fully accommodate and even further encourage fiscal stimulus. During the pandemic, monetary and fiscal policies had temporarily become strategic complements. One fundamental point to emphasise is that the joint fiscal and monetary expansion observed in response to the pandemic reflected the actions of two separate sets of policymakers acting independently within their remits. It was never the result of ex ante coordination or backdoor deal-making. One general lesson from this peculiar episode is that quantitative easing (QE) can be a potent tool in times of significant shocks and constrained policy space. In fact, QE likely proved effective even when operating at the effective lower bound in the sense that it contributed to maintaining government debt servicing costs – denoted as “r” – below the rate of economic growth “g”. A negative differential between r and g improves public debt dynamics and alleviates concerns over debt sustainability. If anything, this episode should allay our apprehensions about the effective lower bound. 2021: a change of heart in view of inflation and financial stability risks By the end of 2020, it became clear that vaccines would help to pull us out of the mire. Predictably, policy normalisation would occur sooner or later. That meant the return of the usual interplay between monetary and fiscal policies and with it, the emergence of a clear risk that delayed fiscal consolidation would require faster and stronger monetary tightening. Logically, I started questioning the wisdom behind our apparent commitment to persistently low interest rates. I became particularly uncomfortable with forward guidance that effectively tied us to such a stance for an extended period. A series of dissents followed, related not only to forward guidance but also to the extremely gradual unwinding of asset purchases. I first dissented on the revision of forward guidance in July 2021, in the wake of the ECB’s strategy review. You might recall that the revised guidance listed three conditions that had to be met before the ECB could consider lifting policy rates.3 On the topic of forward guidance, I felt close to Jens, who had already highlighted several issues in 2019.4 I had two main concerns. Firstly, the revised guidance flew in the face of proportionality when considering financial stability. Although the ECB had explicitly recognised “financial stability [as] a precondition to price stability”, the revision seemed to contradict that statement. Secondly, the stringent conditions for liftoff attached to the revised forward guidance effectively tied our hands in a way that could soon prove untenable. I saw the distinct risk of having to change course suddenly, taking everyone by surprise. In the end, our credibility was in the balance and with it, the very effectiveness of forward guidance itself, and of monetary policy more generally. 3 The three conditions were: (i) inflation reaching 2% well ahead of the end of the projection horizon; (ii) inflation forecasts being at 2% for the rest of the projection horizon; and (iii) underlying inflation being sufficiently advanced so as to be consistent with inflation stabilising at 2% over the medium term. 4 Central Banking, 31 January 2022, “Wunsch sceptical on forward guidance”. For Jens Weidmann’s speech, see “What the future holds – Benefits and limitations of forward guidance”, European Banking Congress, 22 November 2019. My discomfort about the conditions attached to forward guidance related to personal concerns about the weight of models in our strategic thinking. Much of the latter indeed seemed to hinge on models predicting that inflation would smoothly converge to 2%. But how reliable are models in times of unprecedented disturbances and policy actions? What is the value of model-based inflation predictions where the endpoint of 2% is essentially assumed, and where convergence happens quite fast, especially if expectations are rational? Besides, models are bound to miss regime shifts and to struggle with the deep impact of tail events. And since the last significant inflation surge had occurred in the 1970s, models arguably underestimated the persistence of inflation when it started to climb.5 Incidentally, the false sense of knowledge resulting from an overreliance on models was also at the core of the recent review of the Bank of England’s forecasting approach by Ben Bernanke. This review could also inspire us in the Eurosystem.6 On the topic of forecasts in particular, a major issue is that analysts tend to focus on the point estimate of inflation at the end of the forecasting horizon, which is about two to three years ahead. The significant uncertainty surrounding projections is only a second-order consideration. This is an issue if, like me, you believe that policymaking is about risk management. 5 Wunsch (2022). 6 See also Schnabel (2024). One can think of two technical remedies: fan charts and alternative scenarios. Fan charts have the important advantage of providing a broad idea about projection uncertainty. However, fan charts are only as good as the assumptions used to build them. For instance, many fan charts reflect either past forecasting errors — which is not useful if uncertainty rises — or normally distributed shocks calibrated against past empirical moments. Fan charts also routinely ignore model uncertainty itself. In the end, alternative scenarios reflecting various modelling assumptions and shocks might be easier to communicate to the public and might better convey differences of views among Governing Council members. My second material dissent concerned the speed of disposal of the asset portfolio accumulated through QE. I call to mind the additional year of reinvestment under the Pandemic Emergency Purchase Programme (PEPP) sanctioned in December 2021, setting gross purchases in stone until the end of 2024. At the time of this decision, headline inflation was at 5% and core inflation was at almost 3%, but indeed our inflation projection for the end of the projection horizon was at 1.8%. Now, with the pandemic behind us and monetary policy being normalised on multiple fronts, PEPP reinvestment is being continued to honour an old promise. Fortunately, the impact of an additional year of reinvestment is limited. Overall, I disagreed with the revised forward guidance and the slow unwinding of the accumulated portfolio of asset purchases out of concern for inflation and financial stability. With regard to the former, while the inflation spike reflected an energy crisis, it seems hard to deny that highly accommodative monetary policy facilitated the rise in inflation. With regard to financial stability, I was fearful that the serious side effects of loose monetary policy — in the form of misallocations and financial exuberance — had been underestimated. Uppermost in my mind were the potential for over-investment in non-productive assets, the belief that budget constraints were being taken lightly, an overly enthusiastic search for yield, the risks of asset price bubbles, and excessive leverage. Let’s not forget that a long period of monetary policy accommodation had probably increased the likelihood of a systemic financial crisis.7 One might well say that “there is no financial stability issue this time around”. I would reply along the lines of Rajan and Acharya who warned 7 See e.g. Grimm et al. (2023). against “[t]he dangers of forgetting the 2023 banking crisis”. Time is too short to elaborate on this here, but my sense is that the link with the extremely accommodative monetary policy of the preceding years is clear. Of course, the euro area was largely unaffected by the US banking turmoil thanks to robust capital and liquidity buffers. But a change in sentiment might have weighed on credit growth and contributed to disinflation. In such a scenario, monetary policy tightening might have been less aggressive, possibly leading to a pause in rate hikes, similar to the Fed in June 2023.8 This is a good example of how central bankers must navigate uncertain times by remaining agile and avoiding pre-commitments to predetermined policies. To sum up, one should not underestimate financial stability risks going forward.9 Particularly if policy rates have to be kept high for longer. And one should keep in mind that, in principle, a central bank can only act when financial stability issues are related to liquidity and not solvency issues.10 As a consequence, prevention is, as always, better than cure. I could not end a discussion of the side effects of super-accommodative monetary policy without mentioning fiscal sustainability. There are two issues here. The first is that low or negative nominal interest rates on public debt, if maintained for too long, can encourage reckless spending trends. The second is that from the perspective of the consolidated public sector balance sheet, QE amounts to transforming long-term liabilities into overnight ones (bank reserves). The resulting transfer of the interest rate risk away from private sector balance sheets quickly becomes a costly proposition when policy rates must be raised. 11 Central banking today is a loss-making operation, something the public and some academics have a hard time accepting. Here again, Jens’ early warnings impacted my thinking. As early as mid-2020, he reminded us that “large-scale purchases of government bonds are associated with the risk of blurring the line between monetary and fiscal policy”.12 8 Bloomberg, 22 March 2023, “ECB’s Wunsch Wants Time to Assess If Rates Need to Rise Further”. 9 Wunsch (2024a). 10 Schnabel (2023). 11 Hall and Sargent (2022). 12 Weidmann (2020). 2022: I became a “hawk” in the eyes of analysts And inflation ultimately came back with a vengeance! With the pandemic behind us, a surprisingly strong recovery hit supply chains that were still under stress, and price pressures inevitably unwound. I quickly called for higher policy rates, a development that prompted many analysts to conclude decisively that I had aligned myself with the hawkish camp. In the face of mounting inflationary pressures, our workhorse models supported a narrative of temporary developments that did not warrant a policy shift. The accumulation of inflation forecast errors nevertheless encouraged me to question openly the dominant view.13 In early 2022, I characterised the return of nominal interest rates to zero or above by yearend as a “no-brainer”.14 By mid-2022, Russia’s aggression in Ukraine had propelled energy prices in Europe to historic highs. As inflation continued to outpace expectations, the textbook-ish “look through” advice appeared to be increasingly inadequate. I called for a hike of at least 200 basis points to bring real rates to zero, a level at which monetary policy was unlikely to harm economic prospects (monetary policy would be considered broadly neutral), while signalling a clear resolve to deliver on our 13 See e.g. MNI, 13 October 2021, “ECB Risking Wrong Inflation Message”. 14 Reuters, 5 April 2022, “ECB could raise interest rates back to zero this year – Wunsch”. mandate.15 Still, that judgment call had to be made under exceptional uncertainty. Estimates of the neutral policy rate (R*) are notoriously unreliable.16 As Fed Chair Powell succinctly put it, “we are navigating by the stars under cloudy skies”.17 By the end of 2022, I found myself contemplating the prospect of rates reaching 3%. There was little doubt in my mind that inflationary pressures had to be tackled by strong policy action.18 I entered 2023 convinced that rates would reach the 4% threshold, which is where we are today. 19 Summing up and preliminary conclusions Before moving to the current policy landscape, let me briefly recap. Firstly, we’ve seen that quantitative easing proves effective in addressing the effects of tail economic shocks in a context of constrained policy space. QE worked through the monetary-fiscal policy mix. Outside times of acute crisis, QE might well be tantamount to pushing on a string. Neither quantitative easing nor forward guidance proved effective in steering inflation back to our 2% target. Besides, unconventional policies have side effects in terms of inflation persistence, financial stability, and fiscal sustainability. Secondly, models may not always be the reliable compass on which we should rely. We were led to believe that inflation was transitory, only to find out it was not. This underscores the need for a critical re-evaluation of our modelling frameworks and of the role of model-based projections in policymaking. The Bank of England recently indicated a way forward that we’d be well-minded to consider. Thirdly, the costs and risks associated with the effective lower bound might not be as serious as previously thought. On the one hand, the effective lower bound did not prevent an effective response to an acute crisis such as COVID-19. On the other hand, with inflation being a regressive tax felt by all of us, the perceived cost of de-anchoring upward — say above 3% — is 15 Reuters, 28 June 2022, “ECB support should be limitless if fragmentation unwarranted: Wunsch”. 16 Wunsch (2022). 17 Powell, J. H. (2023), “Inflation: Progress and the Path Ahead”, Speech at Jackson Hole. 18 Interview with CNBC, 13 October 2022. 19 Financial Times, 3 March 2023, “ECB officials warn of more interest rate rises as high inflation persists”. arguably higher than the unease one might experience during prolonged episodes of inflation in the 0-1% range. Two policy conclusions can be drawn. Firstly, central banks should engage in aggressive monetary accommodation — through QE and forward guidance — when crises hit, and policy space is scarce. Outside such circumstances, “shock and awe” strategies should be avoided if inflation expectations remain reasonably well-anchored. This realisation requires a recalibration of our policy toolkit. By implication, we should also be prepared to tolerate some flexibility in interpreting the point inflation target of 2.0%. This is to avoid mistakes such as the decision to expand quantitative easing when inflation forecasts hovered around 1.8% in late 2021. Monetary policy at the current juncture Thinking about monetary policy today is fraught with conceptual and practical challenges. To name but a few, I would mention the rising prevalence of supply shocks (or relative price disturbances, if you prefer), heightened uncertainty over key economic relationships that we previously took for granted (mainly the Phillips curve), and slow-moving transitions (population ageing, digitalisation and the advent of AI, climate change, or the shortening of global value chains). Structural transformation means that the models at our disposal are intrinsically uncertain; or rather, even more uncertain than before. In a sense, the good old “Lucas critique” is back! As Bob Lucas warned us almost 50 years ago, trusting fixed parameters and functional forms reflecting past behaviours can be misleading. Conventional wisdom might not be as wise as it used to be, because “intercepts” might shift, and critical “slopes” might have become steeper as a result of thus far unsuspected “non-linearities.” What might at first sound like a curiosity of modelling carries first-order policy implications. A case in point is the traditional advice of “looking through” supply shocks. The argument is simply that if inflation expectations are anchored, the inflation effects of temporary supply shocks will selfcorrect without any policy action. That prescription, which stems from traditional new Keynesian models, partly explains why the ECB did not start raising policy rates as soon as inflation emerged. Meanwhile, as we were “looking through,” real interest rates dived further into negative territory, fuelling inflation. As positive inflation forecast errors piled up, many struggled to understand the drivers of inflation persistence. This is hardly surprising if the most trusted models keep replicating a world of low and stable inflation where actual policy is seen as having little effect on the process (the “flat Phillips curve” view). Besides, many analysts and policymakers took comfort in longterm inflation expectations remaining anchored at 2%. This forces us to think harder about the role of inflation expectations in our policy framework. In my view, we should not rest quietly on the fact that some preferred measure of expected inflation is firmly tied to the official target. Welfare reflects actual inflation, which everybody feels as the painfully regressive tax it is. To put it bluntly, “we do not eat expected inflation.” Of course, anchoring is crucial for macroeconomic stability as a deviation of long-term inflation expectations from 2% would be a sign of waning confidence in the credibility of monetary policy. And as COVID-19 showed, such credibility is crucial to deploying an adequate response during crises. However, stable long-term inflation expectations are only a necessary, not a sufficient, condition for macroeconomic stability. It only tells us the endpoint, not how we will get there. So, to understand inflation persistence — what happens between now and the fixed endpoint — we must look into the role of shorter-term expectations and their effects on wage formation. In fact, new Keynesian models tell us nothing else: long-term expectations play no role beyond their influence on shorter-term expectations.20 And in fact, the textbook new Keynesian Phillips curve features next-period inflation expectations. Empirically, short-term expectations are a key driver of macroeconomic dynamics. Recent evidence from wage growth data supports that view.21 Workers seem to take short-term inflation expectations into account in the wage-bargaining process, in addition to past inflation; while longer-term expectations play virtually no independent role. Indeed, if workers know that 20 Rudd (2022) and Blanchard and Bernanke (2023). 21 Glick, Leduc and Pepper (2022). they can renegotiate their wages every year or every other year, longer-term developments are largely irrelevant. A similar reasoning holds for firms’ pricing behaviours. The role of short-term expectations in price- and wage-setting behaviours feeds into one of my concerns about inflation persistence: the emergence of wage-price spirals. If short-term inflation expectations matter for wage- and price-formation mechanisms, a rise in these expectations would encourage workers to raise wage demands and firms to increase sales prices in a sort of “tit-for-tat” game.22 A terms-of-trade shock makes such tit-for-tat dynamics even more likely, as each agent has an incentive to transfer the impact of the shock onto the other, even though the shock makes the entire economy poorer. Thus, placing a greater emphasis on short-term inflation expectations and wage dynamics seems advisable in order to navigate the current climate.23 As the effects of energy shocks dissipate, firms have tended to reduce profit margins in the face of persistent wage growth. While firms may have taken advantage of the inflationary environment to increase prices (so-called “greedflation”), they may also have anticipated that wages would ultimately 22 Arce, Hahn and Koester (2023). 23 See also Adrian (2023). catch up with price increases. If so, margins would simply play a buffer role, reflecting the greater rigidity of nominal wages compared to prices. While such conjecture appears plausible, theoretical models struggle to capture ongoing inflation dynamics. The formal debate revolves around the specific form of the Phillips curve. For one thing, the stability observed in long-term inflation expectations suggests that the curve did not shift upwards. This means that monetary policy credibility has been preserved. An upward shift in the curve would have meant higher inflation regardless of the state of the real economy, and thus a greater likelihood of tit-for-tat manoeuvres. As such, and as seen in the 1980s, central banks would have had to regain credibility at the cost of causing a protracted slowdown in economic activity, and most probably, a serious recession. There has been even more debate around the shape of the curve, and namely, its slope and curvature. Non-linearity could mean that the slope of the curve depends on the level of inflation. This would be consistent with the view that firms would feel less constrained by competition and would be less hesitant to raise prices in an inflationary context (or one characterised by strong demand24) compared to a low inflation (or depressed) environment. This kind of conjecture would help explain the inflation surge as well as the seemingly painless disinflation process observed so far. Recent empirical evidence concerning the Phillips curve is consistent with signs of a steepening trajectory.25 While models need time to adjust to a new reality, microeconomic evidence points more clearly to an increase in the frequency of price adjustments by firms. 24 Benigno and Eggertson (2023) and Erceg, Lindé and Trabandt (2024). 25 Stevens and Wauters (2021), and Gautier, Le Bihan and Lippi (2023). That said, since the curve does not appear to have shifted upward, policy credibility remains intact, and there is no case for maintaining tight monetary conditions beyond those strictly necessary to stabilise the economy. Not surprisingly, markets have already priced in rate cuts in the short term. Looking at the €STR forward curve, a first cut is expected in June, with one or two additional cuts envisaged by year end. A similar picture emerges from the ECB’s survey of monetary analysts. Of course, uncertainty around such scenarios remains considerable. Distributions of €STR forward rates around the baseline are wide. In addition, the recent volatility in interest rates underscores the need for caution when looking at market prices. After the last rate hike in September 2023, long-term rates plunged by about 90 basis points by the end of the year due to expectations for monetary policy easing after better-thanexpected inflation data. However, since the beginning of this year, long-term rates paired back some of their earlier decline as expectations for rate cuts moderated somewhat. For central banks, dealing with uncertainty means remaining datadependent. Now is not the time to commit to a preset course of action. It is about using our discretion wisely… about getting it right, as information about the state of the economy becomes available. Significant risks remain around the trajectory of wage growth and inflation in wage-intensive services. Despite recent signs of moderation, more will be known about the dynamics of wages and services inflation at the June Governing Council meeting. Of course, data dependence also requires some willingness to take risks, as uncertainty complicates the early detection of new trends.26 To be sure, the road ahead is likely to be a bumpy one for services and core inflation. Realtime inflation readings will likely be quite volatile over the next few months. As wages are intrinsically more rigid than prices, wage growth is expected to remain broadly constant this year. This would imply that real wages catch up with their pre-pandemic levels. Of course, we still cannot exclude that workers demand compensation for several years of depressed purchasing power. 26 Wauters (2023). All in all, and although the outlook remains foggy, I see a path for initiating rate cuts this year. Firstly, our inflation forecasts have recently become more reliable. Secondly, we continue to predict a return of inflation to the official target by end-2025. Thus, with no sign of de-anchoring in the longer term, the costs of remaining tight for too long seem to outweigh those of a premature loosening. This boils down to what I have recently described as the Governing Council having to “make a bet” on inflation staying in line with projections.27 One known unknown remains the role of the exchange rate and the risk of importing inflation. While monetary policy tightening was remarkably synchronous around the world, easing cycles appear unlikely to exhibit similar synchronicity. Diverging economic conditions and policies on both sides of the Atlantic might lead to significant effects from the dollar-euro exchange rate. The mandate under pressure on two main fronts Before concluding, I would like to take a step back and discuss two matters related to the boundaries of central bank mandates. The first pertains to the evolving public discourse on climate change and its implications for 27 Econostream Media, 8 February 2024, “ECB’s Wunsch: ‘At some point, we are going to have to bet on where inflation’s going’”. Reuters, 13 March 2024, “ECB should ‘make a bet’ on rates before long, says Wunsch”. Bloomberg, 13 March 2024, “ECB must take a bet on rate cut as prices abate, Wunsch says”. monetary policy. The second revolves around the interactions between fiscal and monetary policies. While these two considerations might appear to be orthogonal to one another, they were joined at birth by the reference in the ECB’s mandate to Article 3 of the Treaty on European Union (TEU). Taken together, the ECB is expected to support EU policies as long as price stability is not jeopardised. For many, supporting EU policies means using our very deep pockets to tilt relative prices in directions deemed desirable from a social welfare point of view. Specifically, we could buy green assets to lower the funding costs of decarbonisation. We could provide fiscal space to governments so they can meet the ever-increasing demands on already stretched domestic budgets. Let me say it loudly and clearly: be careful what you wish for! Pushing central banks into the inherently political waters of tilting relative prices could open Pandora’s box: never-ending mission creep and ultimately, politicisation would loom large. Let me now take these issues on one at a time. Climate change On climate change, I have gone on the record on two key occasions in 2021 and 2023. As you might guess, Jens had already made interventions in 2019.28 28 Wunsch (2021, 2023b, 2024b), Weidmann (2019b, 2021a, 2021b). There has been a growing chorus of voices calling on central banks to take a more proactive role in addressing climate change. While I acknowledge the criticality of a successful climate transition, let’s keep in mind the inherent limitations of monetary policy in dealing with allocative efficiency issues. Monetary policy is a blunt instrument and one unfit to tweak relative prices in socially desirable ways. To achieve the latter, an array of fiscal instruments are available which embody the key virtues of being quick, targeted and reversible. Admittedly, my view is a minority one within the ECB Governing Council. I nevertheless take some comfort in the fact that this view is more popular in the Anglo-Saxon world. Chairman Powell famously said last year that “We [the Fed] are not, and will not be, a climate policymaker”. Another source of relief for me is that integrating climate change in monetary policy has so far remained a largely conceptual discussion. The actions taken to tilt corporate bond purchases and the collateral framework have been rather symbolic. I would be more concerned if actions went beyond symbols in the future. That said, when discussing climate change in relation to monetary policy instruments, one should distinguish between direct action on relative prices and a risk-based approach. A risk-based approach should be understood as recognising the higher risks of default at the firm level arising from exposure to climate developments or policies. In that case, it is natural to consider that risk when implementing monetary policy through asset purchases or when accepting collateral. Central banks impose similar requirements on the commercial banks they supervise. As Jens put it: “[c]entral banks should practise what they preach”. Central banks should factor in climate-related financial risks into their risk management, as they do for many other risks. Beyond default risks at the firm level, central banks also look at climate risks from a financial stability perspective. Here, stress tests are a relevant tool. These should consider the relatively low duration of bank balance sheets. One should for instance avoid conducting stress tests with static balance sheets over long periods. The calibration of stress tests is a difficult balancing act. Recently, the ECB conducted a stress test with carbon prices of $600/tCO2 in a so-called “orderly” scenario and $1 000/tCO2 by 2050 in a “disorderly” scenario.29 The latter corresponds to a shock which would push the price of oil up to almost $450 per barrel. Now, how likely is it that governments would produce a shock bigger than the recent energy crisis while at the same time not offering any support to the economy? Not very likely, I would say, at least, not if recent opinion polls on the coming European elections are any guide. Regarding action on relative prices beyond individual risks of default, the role of monetary policy is most contentious. The short version of the argument is that textbooks usually give monetary policy no role in terms of allocative efficiency. Now, as a group of Belgian NGOs has actively campaigned against my reappointment as governor given my position on the topic, I might as well give you the somewhat longer version. Proponents of an active role for the ECB in greening our economies mention Article 3 of the TEU, to which the ECB mandate refers. The mandate reads: “Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union […]”. The general economic policies laid out in Article 3 cover many objectives. By isolating action on climate change, an “animal farm” reading of the Treaty would put us in the position of prioritising the issue without clear criteria for making such a choice nor the political legitimacy to do so. 29 ECB (2022). Moreover, the condition “[W]ithout prejudice to the objective of price stability” is a weak one: with the ECB balance sheet running at about €7 trillion, one could argue in favour of spending €10 billion on any policy issue without really affecting the monetary policy stance and hence without immediate prejudice to the primary mandate. More crucially, is a central bank’s involvement in climate policy about supporting policy or correcting policy failures? Conceptually, the economists’ first best recommendation to fight climate change would be to introduce a Pigouvian tax on carbon, to force polluters to account for their externalities. Now, if elected authorities were to set the CO2 price at the socially optimal level, monetary policy would not have any additional role to play. And if authorities were to set the price too low, changing this price through monetary policy would be tantamount to correcting a policy failure, which is controversial. Once again, unelected policymakers cannot legitimately make choices with first-order redistributive implications. As soon as one recognises that fighting climate change implies trade-offs, there is a very fine line between supporting policy and making policy. Conceptually, one would need to change the nature of the trade-off, with more efficient instruments than those available to policymakers, to be on safer grounds. But this is unlikely to be the case for the reasons I just explained. Finally, monetary policy faces a communication challenge when dealing with climate change. Many people believe that central banks are just another kind of bank providing credit to the economy. But they are not. It is therefore crucial to avoid creating expectations that central banks can finance the energy transition. Fiscal-monetary policy interactions Another issue at the frontier of discussions around central bank mandates is the relationship between monetary and fiscal policies. I have already made some key points when discussing the role of the policy mix during the COVID19 pandemic, but I’d like briefly to elaborate on a few more general considerations. Since the 1990s, granting political independence to central banks, along with a well-defined mandate to achieve price stability, has been one of the most widespread and successful institutional reforms in the world. It brought macroeconomic stability that was sorely lacking during the 1980s. The core idea is simple and intuitive. To avoid inflationary monetary policy, it makes sense to keep the insatiable appetite of governments for spending well separated from a creditor with potentially infinitely-deep pockets and offering very generous funding terms (zero interest). It remains that even if they live separate lives, monetary and fiscal authorities are tied by the intertemporal budget constraint of the consolidated public sector. The question then becomes: who will ultimately assume responsibility for fulfilling that budget constraint? If monetary policy is to be credibly assigned to preserving price stability, then the Treasury must assume the sole responsibility for sticking to the budget constraint. This is sometimes known as ensuring a regime of monetary dominance, and it explains why many governments (in Europe and elsewhere) have committed to specific fiscal rules banning excessive deficits and debts. The opposite situation, in which the central bank is forced to fulfil the budget constraint, is labelled as fiscal dominance. Recent years have blurred the previously neat demarcation lines between the two policy realms. Firstly, as discussed earlier, the COVID-19 pandemic created a situation in which both sets of instruments were strategic complements: it was in the best interest of monetary policy to create space for fiscal policy, and in the best interest of fiscal policy to use that space to respond to the crisis. However, this made us forget that the normal situation is one of strategic substitutability, in which monetary policy offsets the effects of fiscal policy on aggregate demand. I am afraid that to this day, too many governments are continuing to sleepwalk into a world in which central banks are expected to continue to help at any cost, given the magnitude and multiplicity of the challenges we all face. My view is different: two years of strategic complementarity and crisis management might have left governments with a sense that it was OK not to make difficult choices anymore. Well, it’s not OK. Secondly, jitters in sovereign debt markets have prompted some central banks to intervene to avoid costly panics and preserve the stability of the financial system. A prominent example is the intervention by the Bank of England to avert a bout of panic related to overambitious fiscal announcements. In the euro area, the fragmentation of the fiscal landscape — one central bank and many national treasuries — led to the creation of explicit, conditional stabilization tools — OMT and TPI — aimed at avoiding unwarranted market panic. Of course, these instruments only make sense in order to prevent intrinsically solvent governments being subject to devastating liquidity crises. Other mechanisms outside the ESCB — namely ESM loans — exist to handle fundamental fiscal sustainability issues. Thirdly, a persistent combination of unsound public finances and accommodative monetary policy could have contributed to the undermining of commitments to fiscal responsibility. Jens’ cautionary words from 2020 resonate loudly today: “Cheap money may be increasingly seen as the normal state. Under those conditions, even high debt burdens may appear sustainable to governments. But what if conditions change?”.30 These considerations leave me with an uneasy feeling that fragile public sector balance sheets and mounting fiscal challenges (population ageing, defence, climate action) might become a persistent concern for central bankers. In a world in which governments have emerged from a series of crises as highly effective financiers and insurers of last resort, they are, perhaps more than ever before, too important to fail… The implication is that the risk of fiscal crisis might have become a shadow constraint on monetary policy. This is what I characterised a year ago, at the ECB Watchers conference, as a weak form of fiscal dominance.31 Coming back to Article 3, does it mean that we should support sound fiscal policies and tilt our purchases against high debt or deficit countries? That doing so is actually mandated by the Treaty? I do not believe so. But it does illustrate the need to better define the limits of our mandates and actions. In short, be careful what you wish for. Conclusion 30 Weidmann (2020). 31 Wunsch (2023a). Let me now try to conclude this long voyage through the land of hawks and doves. By now, I hope that I have convinced you that we have learned a lot from the experiences of the last few years. And also, that monetary policy is about much more than a fight between two established camps, that it is more than a football match. In a nutshell, aside from times of crisis, monetary policy has been more constrained by the effective lower bound than we thought. Persistent inflation — which our models had essentially assumed away — has come back with a vengeance, although medium-term expectations remain wellanchored. This points to the need to revisit the reliance on some instruments and tools. While QE proved effective in the midst of crises, it failed to bring us back to target within a reasonable timeframe. As regards forward guidance, it also proved relatively inefficient compared to the cost of tying our hands. Where does this leave us? Probably with a humbler form of monetary policy. One that tolerates some more deviation from our target when economic conditions are benign and when risks of larger deviations are contained. This is more art than science. Beyond these lessons on the inflation front, I have briefly discussed two issues pertaining to the limits of our mandates. I have argued that we are both testing these limits, with our climate policies, and being tested, with a weak form of fiscal dominance. None of the two are particularly salient as I deliver this lecture, but they could become more prominent in the coming years, especially if public deficits do not decline as planned, and if our climate ambitions move from the symbolic to the more impactful. Central bank independence is a humbling privilege for unelected officials. It should come with a narrow mandate. As Jens (him again) once said, “central bankers are not superheroes”.32 Yet they must show extraordinary agility to adapt and respond to extraordinary circumstances. Be it during the recent COVID-19 pandemic or the “whatever it takes” episode, we may be called upon as architects and enablers of effective solutions. But however forceful these actions may be, they should remain exceptional and temporary. They should also pass a simple smell test: do we have tools at our disposal that elected politicians do not have, that are more efficient, and that they would want us to use? Thank you for bearing with me. 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Vladu (2024), “Inflation (de-)anchoring in the euro area,” European Central Bank, Working Paper (forthcoming). ECB (2022), “2022 climate risk stress test”. Erceg, C., J. Lindé and M. Trabandt (2024), “Monetary Policy and Inflation Scares”, International Monetary Fund, Working Paper (forthcoming). Gautier, E., H. Le Bihan and F. Lippi (2023), “Why prices transmit large-scale shocks more quickly”, Banque de France, Blog, 5 October. Glick, R., S. Leduc and M. Pepper (2022), “Will Workers Demand Cost-ofLiving Adjustments?”, Federal Reserve Bank of San Francisco, Economic Letter 21. Grimm, M., Ò. Jordà, M. Schularick, A. M. Taylor (2023), “Loose Monetary Policy and Financial Instability”, Federal Reserve Bank of San Francisco, Working Paper 06. Hall, G. J. and T. J. Sargent (2022), “Three world wars: Fiscal-monetary consequences”, Proceedings of the National Academy of Sciences, Research Article. Kashyap, A. K. and J. C. Stein (2023), “Monetary Policy When the Central Bank Shapes Financial-Market Sentiment”, Journal of Economic Perspectives, 37(1), 53-76. Rajan, R. G. and V. V. Acharya (2024), “The Danger of Forgetting the 2023 Banking Crisis”, Project Syndicate, 8 February. Rudd, J. (2022), “Why do we think that inflation expectations matter for inflation? (And should we?)”, Review of Keynesian Economics, 10(1), 25-45. Schnabel, I. (2023), “Monetary and financial stability – can they be separated?”, Speech at the Conference on Financial Stability and Monetary Policy in the honour of Charles Goodhart, 19 May. Schnabel, I. (2024), “The future of inflation (forecast) targeting”, Keynote speech at the thirteenth conference organised by the International Research Forum on Monetary Policy, “Monetary Policy Challenges during Uncertain Times”, at the Federal Reserve Board, Washington, D.C., 17 April. Stevens, A. and J. Wauters (2021), “Is euro area lowflation here to stay? Insights from a time-varying parameter model with survey data”, Journal of Applied Econometrics, 36, 566-586. Wauters, J. (2023), “The perils of tracking year-on-year inflation”, National Bank of Belgium, Blog, 21 April. Weidmann, J. (2019a), “The role of the central bank in a modern economy - a European perspective”, Speech at the University of South Africa (UNISA), Pretoria, 12 February. Weidmann, J. (2019b), “Climate change and central banks”, Welcome address at the Deutsche Bundesbank’s second financial market conference, Frankfurt am Main, 29 October. Weidmann, J. (2020), “Too close for comfort? The relationship between monetary and fiscal policy”, Speech at the OMFIF Virtual Panel, 5 November. Weidmann, J. (2021a), “Climate risks, financial markets and central banks’ risk management”, Speech at the Green Swan 2021 Global Virtual Conference, 2 June. Weidmann, J. (2021b), “What role should central banks play in combating climate change?”, Remarks at the ILF Online-Conference “Green Banking and Green Central Banking: What are the right concepts?”, Goethe University Frankfurt, 25 January. Weidmann, J. (2020), “The current crisis and the challenges it poses for economic and monetary policy”, Frankfurt Finance Summit, 22 June. Wunsch, P. (2021), “Climate change and the European Central Bank - we need both enthusiasm and realism”, Keynote speech at the Trends CFO of the Year 2021 Award, Brussels, 20 October. Wunsch, P. (2022), “Germs, War and Central Banks”, Public Lecture at the International Center for Monetary and Banking Studies, Geneva, 8 November. Wunsch, P. (2023a), “Two sides of the same coin: money supply, budget deficits and inflation”, National Bank of Belgium, Blog, 19 April. Wunsch, P. (2023b), “The macroeconomic aspects of climate neutrality – a European perspective”, Keynote speech at the Peterson Institute for International Economics, 5 June. Wunsch, P. (2024a), “Too good to be true? Financial stability and the great reversal in interest rates,” The EuroFi Magazine, February. Wunsch, P. (2024b), “Strategic investment and reforms in view of enhancing EU’s growth potential”, Opening Keynote, 13 February.
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Keynote speech by Mr Steven Vanackere, Vice-Governor of the National Bank of Belgium, at the European Association of Cooperative Banks (EACB) High-Level Roundtable on the occasion of the Eurofi Conference, Gent, 21 February 2024.
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Steven Vanackere: One year after the 2023 market turmoil - outlook for banks and key supervisory take-aways Keynote speech by Mr Steven Vanackere, Vice-Governor of the National Bank of Belgium, at the European Association of Cooperative Banks (EACB) High-Level Roundtable on the occasion of the Eurofi Conference, Gent, 21 February 2024. *** Distinguished guests, ladies and gentlemen, thank you for the opportunity to deliver this speech at the welcome dinner of the EACB high-level roundtable. I thought it might be a good idea, one year after the banking turmoil of March 2023, triggered by the failure of several US banks and of Crédit Suisse, to give you my perspective on the current outlook for EU banks and more specifically on the lessons to be learnt from this global turmoil. Last year, the combination of slow growth, high inflation, and a historically very rapid increase in monetary policy interest rates resulted in unrest in the financial markets, with significant impact on the banking sector. 1. The higher rates reduced the market value of fixed-rate, long-term assets and implied unrealised losses on banks' balance sheets. 2. They increased banks' funding costs and created expectations of higher interest rates on deposits, which added to worries about of a potential more volatile behavior of this stable funding source. 3. They impact the debt burden of households and corporates, especially in jurisdictions with more short-term maturity or variable rate loans. Against this background, the quality of banks' credit portfolios and their interest rate and liquidity risks became important points of attention. Investors viewed with suspicion the impact of interest rate increases on the profitability and solvency of financial institutions. In the United States, this led to an abrupt and large-scale outflow of deposits from several medium-sized regional credit institutions. These banks had a number of specific vulnerabilities in common, such as a business model focused on a single economic sector or activity (e.g. start-ups in the tech sector, services related to crypto-assets or banking services for of high net worth individuals) and a large share of uninsured deposits. Even more importantly, inadequate management of interest rate and liquidity risks forced these institutions to recognize large losses in the profit and loss account, undermining depositor confidence. Earlier deregulation under the Trump administration no longer subjected these banks to the Basel minimum standards. Finally, it was recognized that also insufficiently decisive supervision played an important role. 1/5 BIS - Central bankers' speeches To ensure the stability of the US banking system and prevent a further expansion of the crisis, US authorities had to intervene, securing uninsured deposits, providing liquidity, and ultimately taking control of these banks. Subsequently, Crédit Suisse also lost confidence of financial markets and had to be rescued, through a remarkable, publicly supported 'private' operation, of which the Swiss insisted à la Magritte: "Ceci n'est pas une résolution." So what happened to the credo "Higher interest rates are good for banks"? Let's not exaggerate. The long period (2019-2022) with very low (and even negative) interest rates put downward pressure on banks' interest margins, as the cost of a large amount of liabilities reached a floor, while the yield on assets continued to decline. This led to a drop of their net interest margin. Banks compensated this negative impact on their profitability by boosting lending volumes, which partly compensated declining margins in the core business of banks, and definitely of co-operative banks: deposit-taking from and lending to the retail sector and small businesses and corporates. But since the second half of 2022, as interest rates increased, there was a significant recovery of the net interest margin. It contributed to a significant increase in bank profitability, to levels not seen since 2014, also driven by a lower than expected repricing of retail deposits in some countries. So, apart from the accidents in Switzerland and the United States, the credo of higher interest rates being good for banks remained valid, although the current inverse yield curve is not helpful. Good asset quality and low loan losses also contributed to this increase of bank profitability in Europe. So far, the higher interest rates do not yet seem to have led to an important increase in loan defaults, notwithstanding rising debt service costs for debtors with variable interest rates or for debtors needing to refinance a maturing loan. The immediate conclusion on the impact of monetary policy tightening on EU banks hence seems to be a message of "so far, so good". But we might have not yet seen all the consequences of the transition from an ECB deposit facility rate at -0,5% in July 2022 towards 4% in September 2023, in 14 months' time. Transmission to the real economy takes time and is not yet complete. Credit losses related to the increased cost of debt will most probably still materialise in the quarters ahead, even if market interest rates would now stabilise or start decreasing from current levels. Specific pockets of risks exist in highly leveraged sectors that have been impacted more heavily (or structurally) by Covid or by the increased energy prices, such as for example the commercial real estate sector. 2/5 BIS - Central bankers' speeches In addition, higher borrowing costs have led to a slowdown in the amount of new lending. As liquidity becomes tighter, competition for deposit funding may intensify and deposit rates might rise, which could reverse to some extent the improvement in the net interest margins that we have seen so far. Notwithstanding these caveats, European banks seem well placed to deal with potential challenges going forward, given their high profitability and quite comfortable capital and liquidity ratios. But no room for complacency. In the weeks after the interventions by the US and Swiss authorities, there was great nervousness amongst financial market players, looking for vulnerabilities in the banking sector, with a focus on those exposed by the US problems. Concentration of business models and depositors was scrutinised, as well as the size of the amounts not covered by deposit insurance. Institutions with a concentrated deposit base or a high percentage of uninsured deposits were seen as more vulnerable. The crisis of confidence did fortunately not spread further to other European countries' banking sectors. It is true that the situation of European banks differs in many ways from those of banks like SVB or Crédit Suisse. And the supervisory framework also differs, particularly from that which applied in the United States to medium-sized banks that were not subject to the Basel standards (while they apply to all European banks). Yet, and that is my basic message of tonight's talk, introspection following these turbulences is also needed for European banks, supervisors, and regulators, be it in terms of the regulation in force, the effectiveness of the banking supervision and the framework for resolving failing banks. The crisis highlighted that we need to remain committed to a rigorous and credible regulatory and supervisory framework. It strengthens the stability of the banking system and contributes to the confidence of investors and depositors. The adoption of the final elements of the reformed and tightened Basel-III standards into European banking regulation under the form of the Banking Package is therefore more than welcome. It is regrettable, however, that European regulators have once again inserted a number of significant deviations from the Basel standards have inserted and provided for very long transition periods. This is all the more regrettable as the EU is currently already the sole jurisdiction of the Basel Committee whose regulations deviate materially from the global Basel standards in terms of capital requirements. These deviations dilute the rules applicable to European banks and have the potential to set in motion a global 'race to the bottom' in terms of banking standards. The Basel Committee will also consider the impact of the crisis and the adequacy of its internationally applicable standards. The Committee already published a report and analysis of events with reflections on the impact on supervision and regulation. Among these, attention was paid to liquidity regulation in the context of the possible increased volatility of certain funding sources and deposits in the digital age and the lack of rules around deposit concentration. 3/5 BIS - Central bankers' speeches The regulatory approach to interest rate risk management comes under scrutiny, while it currently includes many regulatory degrees of freedom (as it remains subject to a so-called pillar 2 approach without one-size-fits-all minimum capital standards for IRRBB). The report also looked into loss absorbency capacity of AT1 bonds. Also, the SSM has reviewed its priorities against this challenging backdrop. The postmortem analyses of the problems at some US banks by US regulators refer inter alia to poor risk management and governance at the management of the credit institutions concerned and to inefficiencies in the supervision and applicable regulation of these institutions. I also firmly believe that good corporate governance and an adequate risk culture lay at the heart of a stable and robust banking - and by extension financial - system. The European supervisory authorities have stepped up their monitoring of banks' sensitivity to rising interest rates and liquidity position. The adequacy of interest rate risk management, funding plans and potential emergency liquidity measures to be taken by banks will also remain a prudential priority in the short term, and rightly so in my view. Last but not least, the bank failures in the first half of 2023 (in the United States and even more so in Switzerland) were the first real large-scale test of the international resolution framework established in the wake of the 2008 financial crisis. The lessons learnt are hence very relevant for the operation of the European resolution regulatory framework. The ability of resolution authorities to deal with the failure of systemically important banks must be further developed. The measures by the Swiss authorities served as a reminder that, in the event of the failure of a large group, sufficient alternatives must be available. Secondly, the action of resolution authorities must remain sufficiently predictable. In this context, ECB, SRB and EBA quickly reaffirmed in a joint communiqué the sequence that would prevail in the event of a bail-in within the Banking Union, thereby helping to strengthen understanding (among banks, authorities, markets) on how the bail-in instrument would be used. Finally, the crises of 2023 showed how sudden liquidity withdrawals can very quickly weaken a credit institution. The speed with which the depositors of Silicon Valley Bank depositors withdrew their assets was unprecedented. This reminds us of the need to provide a decisive response, within the framework of the European Banking Union, to the issue of liquidity provision in resolution, which to date remains insufficiently addressed. Dear ladies and gentlemen, this brings me to the end of my talk. The banking sector has weathered the recent storm on financial markets quite well, but weather predictions continue to be far from rosy. So, precautionary measures should stay on the top of both regulators' and banks' minds. The tightening of monetary policy has to some extent "normalised" the interest rate environment, which forms the setting of your core businesses, retail and corporate 4/5 BIS - Central bankers' speeches deposit taking and lending, but the sheer speed of adjustments to interest rates coupled to the unstable macro-economic and geopolitical conditions will continue to prove challenging. The bread and butter interest income business of co-operative banks might have become more profitable but credit, interest rate and liquidity risks, as well as risk culture in general deserve particular attention, more than ever. Enjoy your meal and I wish you a wonderful rest of the evening and an interesting set of meetings here in the beautiful city of Ghent. 5/5 BIS - Central bankers' speeches
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 6th European Congress of the Association des Cambistes d¿Internationaux (ACI) (Financial Markets Association), Luxembourg, 25 May 2002.
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Yves Mersch: In the run-up to an enlarged Europe Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 6th European Congress of the Association des Cambistes d’Internationaux (ACI) (Financial Markets Association), Luxembourg, 25 May 2002. * * * Ladies and Gentlemen, I should first like to thank the organisers for having invited me to the 6th European Congress of the ACI. It is a real pleasure to address today's audience. I had been tempted to speak about the Luxembourg central bank which in the meantime is the second largest provider of liquidity to the European banking system, second only to the Bundesbank. But I think it is more important being in Luxembourg to show you that we can only decline our national identity in relation to European integration. European integration is an ongoing dynamic process. Enlargement is not something threatening Europe. It is not something new. We have had experience with enlargement in history, and we also should not consider enlargement as only limited to the institutional sphere and the immediate neighbourhood of Europe. I think you should know that with the introduction of the euro, Europe has now relations with more than 56 countries in the world, which use the euro to some extent as an anchor currency. These countries represent about 20% of world population, but barely represent 5% of world GDP. There are a number of relations with those countries through the euro or through association arrangements. Basically, we can say that in all cases Europe is the largest creditor to those countries: this applies to the European banking system, but also to the status as an official creditor. In some of those countries the euro is only used as a private mean of transactions, mainly as an investment currency; in some other countries the link exists through exchange rate policy. In some other countries, the euro has been introduced as a de facto currency (euroisation). My subject today is focusing more closely on the accession countries of which you had some representatives speaking to you in the previous days, and I would like to recall that the first six countries which tried to build up an European integration process from 1951 on did not think of integration until the 60's. It was in Luxembourg in 1970 that we decided to open negotiations with four countries: the UK, Denmark, Ireland and Norway. When the accession decisions were concluded in 1973, one country, Norway, decided through referendum to step back, and we only enlarged for the first time to three new countries. The next enlargement was in 1981 when Greece joined Europe, Spain and Portugal both following in 1986. When we started the Maastricht negotiations, we knew already that there would be three additional candidates which joined Europe in 1995: Finland, Austria and Sweden. Even though the Maastricht Treaty was ratified in 1992, you ought to know that during the discussions and negotiations, we already tried to take into account the enlarged Europe when we designed the built-up of the institutions that were to run the single currency. It is of course this time a little bid different insofar that the block of countries which are on the way to access Europe is much larger. Thus, thirteen countries are standing ready to join the new European area and later on the European currency zone as well. Where do we stand as of today? We defined thirty-one chapters to be discussed with twelve countries. With one country, Turkey, negotiations have not yet started. Progress has been encouraging, but, as you know, you always start with the easiest chapters and you leave the most difficult ones to the end. So, as of end of April 2002, 73% of total chapters were concluded. The most advanced country had still four open chapters, one of them being agriculture of course. The European Summit last year decided that the negotiations ought to be concluded by the end of this year. Now, with two elections looming in the two largest countries of the European Union, it is sometimes a little bid difficult to come to common positions especially on the most difficult chapters that are still open. I can only express hope that the objective of concluding the negotiations by the end of this year will be fulfilled, and that it will not be due to a lack of common positions of the existing European Member States that we are not able to come to final conclusions. If we would not come to final conclusions by the end of this year, it would become too tight to have any new accession country participating in the next European Parliament elections to take place in 2004. But let us not forget that even at this stage, part of the internal preparations that the EU has embarked on is not yet finished. I speak about the so-called Nice Treaty which is to prepare partly the European institutions for the enlargement and which has not been ratified in all of our countries. But on the other hand, we have also in the meantime started a new exercise, the Convention, which also has to come to an end and to be ratified in order to prepare the European Union for enlargement. But I don't want to dwell too much on the political aspects and give you the view of the Eurosystem in the monetary field. Even if we are not taking part in the official negotiations, the Eurosystem is tightly involved in cooperation with the central banks of the candidate countries. This process started in 1999 with a high-level seminar organised in Helsinki, which defined the five principles on which the European system of central banks would approach its cooperation: 1. First, the principle of competence. That means the Eurosystem is involved in all fields falling in its exclusive or shared competence: monetary policy, exchange rate policy, payment systems and financial stability meaning not only oversight of payment systems where the Eurosystem has not a shared responsibility, but an exclusive one, but also banking supervision where the Eurosystem is of the opinion that it has a shared responsibility just as it is stated in the Maastricht Treaty; 2. The second principle is to preserve the Eurosystem's primary objective. The Eurosystem's involvement in the accession process must be without prejudice to its independence and its primary objective to preserve price stability; 3. Third, the principle of openness. The Eurosystem has a positive attitude to the prospect of accession of new EU Member States; 4. Fourth, the principle of equality of treatment. The criteria on which we will assess the ability of countries to join the European Union and later on the euro should be implemented in a strict and effective manner while also avoiding any discrimination; 5. Finally, the principle of plurality of approaches which means the possibility to choose different paths and ways to join the European Union without compromising equality of treatment. The cooperation activities between the Eurosystem and the accession countries are intense and have increased considerably between 2000 and 2001. In line with the principle of competence I just mentioned, the fields covered by the cooperation are the following: operational framework for monetary policy, operational framework for foreign exchange policy, economic analysis, internal control and procedures, payment systems, statistical systems, accounting, communication network architecture, legal issues, banknotes, prudential supervision, capital account liberalisation and of course the transition to the adoption to the euro. To give you an idea of the intensity of those joint efforts in all the fields I just have mentioned, let me quantify them by giving you two figures: since 2000, the Eurosystem has conducted (or plans to conduct) more than 800 activities accounting for around 19.000 working days in the accession countries. Let me now say a word about the criteria. The criteria accession countries have to comply with are often thought to be constricted to the Maastricht criteria, which are nominal criteria, but we ought not to forget that there is another second set of Copenhagen criteria, by the number of three, which have been set up in 1993 already: 1. The first is a political criterion. It encompasses the stability of institutions guaranteeing democracy, the rule of law, human rights and, what is important in some of the new accession countries, the respect for protection of minorities as well. 2. The second Copenhagen criterion is of economic nature. Accession countries should demonstrate the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces which are the key rules in the European Union. 3. Finally, the third Copenhagen criterion relates to the acquis communautaire. We must be convinced that it can be implemented, that means the ability to take on the existing obligations of membership including adherence to the aims of political, economic and monetary union. Let me now elaborate on three issues that I consider of importance: convergence, currency regimes as well as policy mix. 1. Convergence • Nominal convergence is necessary but not sufficient. Thus, real convergence has to be pursued in parallel. Why also real convergence? Because the Maastricht Treaty very clearly spells out that the criteria must be fulfilled in a sustainable way and not result from a point lending at one day in the year; • Real convergence is also the translation of the second Copenhagen criteria, which very clearly says that you have to demonstrate your capacity to cope with competitive pressure and market forces. That is why real convergence is also important and has to be pursued in parallel. This process will allow a closing of the gap between accession and euro zone countries as it is stated in the objectives of the Union as defined in Article 2 of the Treaty of the Union and Article 2 of the Community Treaty. The recent economic policies have shown that this parallel convergence is possible and has been pursued and achieved in many existing European Union countries. On the nominal side, convergence to the bottom has occurred in long-term interest rates already in most accession countries, showing that financial markets pay some credibility to the current policy frameworks and consider the announced accession timetable as being credible. Real convergence is proceeding further but I must say at a rather slow pace. Indeed, accession countries still show important gaps in terms of income levels versus the EU. So at the end of 2001, that are the latest figures I have come across, income levels in accession countries were 44% of the EU average in terms of PPP. With a growth rate scenario of 4% per year, all accession countries would reach by the year 2026 the same income level of Greece when it joined the EU in 1981, namely 62.4%. If I look at the level Greece had reached when it joined the euro zone twenty years later, then it would take the accession countries about to year 2033 before they would be at the level of the country with most catch-up need that has so far joined the euro zone. Therefore the right policies, concentrating on liberalisation and macroeconomic stabilisation, have to be implemented and pursued in order to foster growth and enhance the catching-up process. 2. Currency regimes • First principle: There are no "one fits all" exchange rate strategies in the wake of accession. Different regimes are possible as long as they are supported by a stability-oriented policy stance; • Second principle: An exchange rate regime should be assessed on its ability to contribute to a stable macroeconomic environment by supporting an exchange rate level consistent with underlying fundamentals and expectations; • Third principle: For non-key currencies, corner solutions are not necessarily the best solution. Intermediate options may be a relevant alternative, especially for small open economies with a dominant trading partner that maintains price stability as it is the case for most accession countries. In addition, I would like to make one personal remark on currency boards arrangements, which has become fashionable at one point in the time: • • Euro-based CBAs are not a substitution for participation in the European Exchange Rate Mechanism, ERM II. Like all countries having entered EMU, the ERM II passage is compulsory and I would give three reasons: 1. To be able to assess on the basis of equal treatment whether the fulfilment of the exchange rate criterion is satisfied, it has to be done in an equivalent multilateral environment, namely ERM II; 2. In full respect of the principle of equal treatment we cannot assess exchange rate stability inside ERM II for past accessions and outside ERM II for new accessions; 3. I think the ERM II and the assessment of the exchange rate stability criteria is also part of the second Copenhagen criteria. However, under certain circumstances, an unilateral CBA can be a suitable option in order to enhance the commitment to foreign exchange stability deriving from ERM II, but I would like to underline that this will not and cannot impose any unilateral obligation on the ECB besides those that are related to ERM II participation per se; • The discipline entailed by CBAs may be a good incentive to pursue stability-oriented macroeconomic policies in order to enhance convergence efforts before EMU participation. Nonetheless, this stability is not automatically warranted, the cause being related to complex adjustment mechanisms through which accession countries being in a market economy transition phase have to go; • Accession countries operating a sustainable CBA would not necessarily have to face a double regime shift. However, if a CBA would prove to be weak and not adapted to the ERM II framework, the ECB has made it very clear it would speak up and tell this country its opinion and make its concern known; • And finally, I think the fashion of CBA has also to be viewed within the recent experiences as for example in Argentina. The exit strategy is key. 3. Policy-mix • On average, fiscal deficits have widened in 2001 in accession countries. The sustainability of the budgetary situation in some countries is at stake. The forthcoming parliamentary elections in some countries, as well as large accession-related expenditures, are subject to amplifying this situation. Monetary policy should be supported by an adequate fiscal policy in order to avoid a large risk of overburdening monetary policy. This is not only true for accession countries however. Some concern already has been expressed towards some Member States of the present euro area and I would like to voice it again. I want to stress that the strict compliance with the Stability and Growth Pact is important just in order to give back to the political sphere the margin of manoeuvre to do policy in the fiscal area and record it is key to the credibility of the policy-mix and therefore also to the orderly functioning of EMU. This understanding has been steady from its inception and now it is crucial to keep EMU perennial; • In the framework of the policy-mix, the ECB has accepted to be involved in an informal dialogue with governments and other political actors. This institutional setting has however been questioned recently. Some voices have been heard advocating a reinforcement of the policy-mix coordination, even in this country, in view to achieve overarching recommendations applying to all areas of policy-mix. I would like to underline that from the point of view of the ESCB there should not be any ambiguity. The implication of the ECB in this informal dialogue has as sole purpose to share information. Any form of ex-ante coordination would undermine the ECB's credibility in fulfilling its mandate and would be considered to be in opposition to the terms of the Treaty; • Let me come back to the accession countries now. In the monetary sphere, continuous efforts are necessary in order to bring down inflation. Inflation has been brought down from 12.4% in the accession countries in the year 2000 to 8.8% in 2001. In the present year, inflation is expected to be around 6-7%. This track record is quite encouraging and ought to be pursued. Some challenges however remain, likely to generate pressure on prices: the liberalisation of administered prices in many accession countries, the so-called BalassaSamuelson effect, which on average has been considered to represent between 2 and 4 % of inflation for accession countries, as well as the sliding fiscal policy stance in some countries. All are upward risks to price stability. In addition, the weight of energy-related items in most accession countries' HICPs is higher than in European countries. In accession countries they vary between 22% and 31%, while the average in the euro area is only 11%. The rising oil prices hence add a further element to the balance of risks for inflation inside the accession countries. • The catching-up process will bring inflation rates above those prevailing in the euro area before they will converge slowly. Let me stress in this respect that no additional criteria will be added for accession countries but that, as for the actual members, the entry in the euro area will be based on the strict fulfilment of the existing convergence criteria as they have been applied in the past, without new interpretations. The run-up to an enlarged Europe also is an opportunity to stress what I would call two core principles for the functioning and the strategy of the Eurosystem. 4. Independence In Europe, independence is a quite recent principle. Today it is also acknowledged that it is an indisputable one. Independence is one of the key items to be implemented in the framework of the acquis communautaire. But this issue does not only relay to accession countries. As you have seen in the recent convergence report of Sweden, we consider that the present Swedish law is still not compliant with the requests needed for the Swedish central bank to enter the euro. The same of course holds true for the UK. Some mixed signals emerged from some accession countries, the most lately being the Czech Republic and most alarmingly Poland. Independence of central banks is, as you know, declined at least in two different forms. On the one hand, the independence of the institution, but also the independence of the people working in the institution, the so-called personal independence. The institutional independence has again two functions. One is the operational independence. Each central bank must have all the instruments at its disposal and at its free disposal in order to execute all operations related to a central bank's core activity, in particular in the area of monetary policy, foreign exchange, as well as payment systems. On the other hand, I think the financial independence is also increasingly attracting attention. It means that a central bank ought to rely on a robust balance sheet in order to underline its independence. But financial independence also applies to the personal independence of the people running the central bank. I think that as a Luxemburger I should not give anyone a lesson in this respect. The Treaty has made the ECB responsible and accountable for the maintenance of price stability over the medium term. That is why it also has been shielded from political pressures. Medium term price stability should not be sacrificed to meet short-term objectives linked to political and electoral considerations, risking to weaken the stability of the currency. 5. Consensus building The second important element in the functioning of the European monetary institutions is the underlying principle of decision-making, namely consensus building. The approach of seeking a broad consensus rather than to resort to voting in my opinion has the following advantages. • It is shielding from pressures arising from national authorities; • It allows continuous, multilateral check of time consistency and policy direction within the Council, thus imposing a discipline on monetary policy and • It is countering any public suspicion that national bias may inform policy decisions. I think this approach has been a key element in the efficient functioning of the Governing Council of the European Central Bank up to now. It is representative of an European culture of decision-making which has served us well until now. Therefore I think it ought also to be pursued in the perspective of accession countries adopting the euro in the medium term. Now finally a word about monetary policy strategy. The monetary policy of the Eurosystem, as well as the set-up of its operational toolkit, has been designed as to accommodate the specific environment in which it evolves and this is an environment of hugely diversified financial structures and cultural diversity as well. This gives me the opportunity to underline once more that the designing of our strategy is and should not be a transposition of other models like for instance that of the Federal Reserve System which is designed by a different historical development. But I think I ought not too much dwell on the difference between the FED and the Eurosystem, although that is a very interesting subject in itself. Let me just limit myself to say a few words concerning the inter-relation between our primary objective and the question whether there is a so-called second objective. You know that without prejudice to our overriding objective, the Eurosystem supports the general policies of the Community according to the Treaty. This support of economic policies in our opinion is fully encompassed in the overriding objective of the ECB. Monetary policy is neutral on output and employment in the long run and there should be no short-term trade-off between output and prices. The marginal gains on the output-side in the very short-term have to be weighted against the building of inflationary pressures and unrealistic expectations about the monetary policy's impact on output. This approach would entail incoherent monetary policy decisions and be detrimental to the ECB's credibility in fulfilling its mandate. However, this does not mean that the Governing Council does not take into account the economic sphere, all to the contrary. When we assess every month the risk to price stability over the medium term, we do not only take into account the information from the first pillar, the so-called monetary pillar, we also look into the second pillar. The shape of the yield curve, exchange rate, oil prices or labor market developments, are examples of the variables analysed in the second pillar. As a consequence, the two parts of the mandate enshrined in the Treaty should not be considered separately but in conjunction. Let me add on this point that the maintenance of price stability as such over the medium term is the best contribution to fostering an environment favourable to sustainable growth in the longer run. Price stability is to be achieved in the medium term and in the whole euro area. First, this mandate is based on the fact that short-term, volatile factors cannot be controlled by monetary policy and that monetary policy acts within long and variable lags. Second, the mandate underlines that price stability is assessed euro area wide, the Governing Council not reacting to national or regional developments. The ongoing accession process will have no impact on this underlying philosophy. Our will to be as transparent as possible so as to allow agents to internalise stable price developments in their expectations is key to accountability and will remain so with accession. In order to underline that we pay great attention to developments in the real economy, I am very glad that I am able also now to invite a representative of the real economy to this rostrum, namely the chief financial officer of the largest steel company in the world. I am very glad to count him among the supervisory board of the Luxembourg central bank. I think very appropriately that he will also dwell on something which is similar to my mind, namely that you also have to see globalisation from Luxembourg and not go the other way around and start with globalisation and then try to come back to your national attitude. We only can realise our aims in the context of the international environment and therefore I am very glad and interested to hear now what Mr. Michel Wurth will have to tell us. Thank you very much for your attention.
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central bank of luxembourg
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Introductory speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ALFI 2003 Spring Conference, Luxembourg, 11 March 2003.
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Yves Mersch: Financial sector Luxembourg - recent developments and financial stability Introductory speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ALFI 2003 Spring Conference, Luxembourg, 11 March 2003. * * * Chairman, Ladies and Gentlemen, It is an honor and a pleasure for me to be invited to join the 2003 Spring conference of the Luxembourg Investment Fund Association and to hold its introductory speech. My presentation comprises two main sections. The first section is devoted to recent developments in the financial sector, with a specific focus on Luxembourg. The second section relates to financial stability issues. 1. Recent developments in the financial sector The year 2002 has been, as you all know, a difficult year for the financial industry as a whole. Weak economic and financial market conditions have translated into a deterioration in the profitability of the European banks. This deterioration appears to be the consequence of a combination of two major adverse developments in their operating environment. - First, the deterioration in the economic cycle and in the borrowers’ credit quality, resulting in increased loan loss provisions. - Second, the plunge in global and in particular in European stock markets, coupled with increased risk aversion and uncertainty in other financial markets, entailing reduced commissions and trading income from capital-market related businesses. The Luxembourg financial sector, characterized by its high degree of openness, has not escaped from the impact of the depressed general environment. In the year 2002, the Luxembourg banking sector has seen its net results deteriorating on an aggregated basis by 6%, although the evolution is unequally spread among the individual financial institutions. While interest margins and commissions, which are their key sources of profitability, have declined in total by 7% and 6% respectively, a compensation of this negative trend has partly been achieved at the level of certain individual institutions through an increase in their one-off exceptional revenues and/or a release of previously created general provisions. The one-off exceptional revenues increased in total by 525 million euros, or 132%, and are related for the major part to capital gains income through the sell-off of the stock-holdings by several banks in Cedel, this in the context of the total acquisition of the Luxembourg based embedded payment and securities settlement system by Deutsche Boerse AG. The level of provisions on a net aggregated basis has increased by 595 million euros, or 84% compared to 2001. A closer look at the figures highlights that within this general increase, which is related in particular to a new net creation of specific risk provisions, some individual banks have released previously created so called general provisions, thus allowing for an improvement in their end-of-year results. General provisions have here played the role of reserve buffer. Recent discussions on the implementation of new rules and regulations in the banking sector will certainly pose challenges and call for new risk mitigation techniques. I will only mention as examples the discussion in relation to the introduction of the IAS accounting standards for the banking sector, including full fair value accounting for the banking book , as well as the information disclosure of the quarterly results, which will most likely increase the short term volatility of the banking results; the future introduction of the new capital adequacy rules which risks having a negative pro-cyclical impact of the loan-loss provisions on the financial sector. The concept of dynamic provisioning could be a step in the right direction in this context. If we disregard in the banks’ accounts from the results the miscellaneous income, including capital gains, the picture of the banking sector appears even more alarming. Banks’ income before provisions and taxes would show a decrease of 7% in 2002 instead of an increase of 6%; their net results would be almost 30% lower than the year before, instead of a modest decline of 6%. Amid these adverse developments, banks have succeeded in containing their costs. Administrative costs have been reduced by 6% over the year under review, while staff costs have only slightly increased by 3%. Possible further cost reductions into the year 2003 are however not unlimited. The cost/income ratio of Luxembourg banks stands at 40% at the end of 2002, down from 41% in 2001, and is already more efficient than for most other European banks. It compares indeed to an average ratio of 66% EU-wide in 2001. An important part of potential further cost cuts on the European level is most probably already incorporated in the Luxembourg results. Other gauges of banking activity are not encouraging either. A look at the banks’ aggregated balance sheet shows a decrease of 58,4 billion euros, a decrease of 8% compared to 2001 and contrasting with a continuous growth over the past twenty years. Even employment, typically a lagged indicator, decreased by close to 600 units in 2002, or 2% in relative terms, and the total number of employees stands at 23 300 at the end of December 2002. This reduction is however attenuated by an increase of about 200 staff members within the ”Other professionals of the financial sector”, whose employment comes close to 20% of the employment of the banking sector. Staff redundancies via social plans have however so far been the exception. As concerns the number of banks, 178 at the end of January 2003, we have witnessed a reduction of nine units compared to the end of 2001 and a notable decrease compared to the peak of 223 banks in June 1996. This movement is mainly the result of mergers resulting from restructuring within the banking groups, cross-border as well as cross sectoral, at the international level. The tendency has abated for now, but is likely to revive once the economy recovers. This restructuring process can lead among others to the concentration of specific activities within banking groups into one single handling unit. IT-infrastructure, back-office, trading and accounting are some prime examples. While acknowledging the possible economic benefits of this concentration, care should be taken that outsourcing does not create gaps, neither in risk management nor in supervision. From a macro-prudential perspective, the banks have been able, partly due however to the aforementioned factors in their profit and loss accounts, to cope with the harsh external environment. On an aggregated basis, the global net constitution of value adjustments, related to their own funds, has increased from 1.9% in 2001 to 5.1% in 2002. Their return on assets, in terms of net results at 0.4% at the end of 2002, has fallen back to its level of 1999. Their global aggregated capital ratio has improved from its stance of 14% at the end of 2001, to 16% at the end of 2002, comfortably above the prudential 8% threshold. The investment fund business has equally not been spared by the unfavorable external environment. The UCIs, numbering 1 941 at the end of 2002, albeit showing a modest increase of 33 units over the past year, has seen its growing trend reversed from October 2002 to December 2002 by 19 units. The value of assets under management, at close to 845 billion euros at the end of 2002, has diminished by 9% as compared to 2001. This decline seems however to be mainly the result of the reduced market value of assets. Positively, a net accumulation of 57 billion euros in new capital invested in 2002 has taken place. Ladies and Gentlemen, although the current picture does not look favorable, the sector has remained resilient. Ultimately, the sector’s outlook hinges on developments in the economic and financial markets environment. We are facing a quite unusual synchronized slowdown in the world’s three major economies, Europe, the United States and Japan. Today, the words that can appropriately characterize the future outlook are uncertainty, fragility and volatility in relation to the timing and pace of economic recovery overshadowed by geopolitical tensions. We should remain vigilant. 2. Issues of financial stability The combination of the central banks’ role in issuing money and the participation of commercial banks in the money creation process results in the involvement of central banks in financial stability. Commercial banks’ money represents a large share of the total money stock, and its value is dependent on the creditworthiness of commercial banks. The concern of central banks for the orderly functioning and stability of the banking system arises hence from the need to maintain the public good of a stable means of payment. Banking is plagued by inherent instability. The banking sector functions as a closely inter-linked system, which is prone to contagion risks through the payment system and the interbank markets. Central banks, as issuer of money, need, like any other sound managed financial institution, to monitor the quality of their counterparts. This is an addition to their role as ultimate provider of a safe settlement medium and of liquidity to ensure the orderly functioning of the financial system. Price stability supports sound investment and sustainable growth, which in turn is conducive to financial stability. Since the fragility of banks and their counterparts tend to be more frequent when prices are unstable, the pursuit of price stability can be seen as a crucial contribution to financial stability. Day-to-day monetary policy tools are to a significant extend associated with financial stability considerations. Lending- and deposit facilities at the central bank and fine tuning money market operations are primarily aimed at providing sufficient liquidity to the money market and facilitating an orderly liquidity management by individual banks. A specific question relates to the relationship between asset prices, financial stability and monetary policy. How should a central bank position itself with regard to price changes in assets? Asset price targeting beyond the pursuit of price stability could set conflicting signals. One could certainly question central banks’ superior ability for asset price targeting; different asset classes could require conflicting action. Based on an indicator for maintaining price stability over the medium term, the present ECB strategy takes note of movements of exchange rates, stock prices and properties prices. The mission attributed to the ESCB in the field of financial stability is threefold: First, it has the task to contribute to the policies carried out by the competent authorities in the field of prudential supervision of credit institutions and the stability of the financial sector; second, it is entrusted with an advisory role in the rule-making process; third, it has the obligation to promote the smooth operation of payment systems. The BCL has put in place a system of macro-prudential indicators, allowing for a regular monitoring of the Luxembourg financial sector. The International Monetary Fund has in the context of its recent article IV consultation and Financial Sector Assessment Program (FSAP) welcomed the establishment by the BCL of the aforementioned indicators; those have served among others as a basis for the IMF assessment of the soundness of the financial sector, the systemic importance of which is highlighted in the respective reports. During six months, from June to December 1998, the BCL has been endowed with the mission of supervising financial institutions on a micro-prudential level. This mission has however subsequently been removed and delegated to the Commission de surveillance du secteur financier, created at the beginning of 1999. The legislator was most probably not aware of the fact that this decision would lead to an exceptional situation within the Monetary Union, as it entails a total absence of formal bilateral co-operation between the micro-prudential and macro-prudential supervision of the financial sector. Central banks of the Eurosystem assume today either direct responsibility for micro-prudential supervision, or are closely involved in this mission, or have formal co-operation arrangements in place. The role for central banks, to be embedded in an appropriate overall supervisory regime due to their involvement in financial stability, is based on their mission in payment systems; the obligation to communicate and comment in the field of financial stability and to maintain a communication network with other central banks; the need of disseminating information to markets; and the possible need for liquidity injection in emergency situations or for crises management. Therefore, the role for central banks to act as a global co-ordinator in crises situation directly derives from the fact the central banks have the special expertise, information and tools necessary to perform co-ordination and liquidity support functions. The smooth functioning of the payment systems is instrumental to the efficient allocation of financial resources in the economy. Through the payment systems, banks are interconnected and channel liquidity to the financial sector and to the rest of the economy, and thus contribute to the smooth economic development and to financial stability. The participants in those systems are linked in a network that provides a channel for contagion risk. The failure of a counterpart can trigger systemic problems. The same is true for securities settlement systems. With the transposition of the Settlement Finality Directive into Luxembourg law in January 2001, the legislator has endowed the banking supervisory authority with the surveillance of the systems, and on an exceptional basis the BCL, under the condition that the BCL is a participant in those systems. For the time being, BCL is in charge of the oversight of Lips-Gross, the Luxembourg component of Target, Lips-Net, the local retail payment system, including its technical agent Cetrel and the securities settlement system operated by Clearstream, including its technical agent Clearstream Services. The BCL has notified these systems to the European Commission. It monitors the observance by the systems of the requirements laid down in its oversight policies and procedures. Those are based on international standards and recommendations. They comprise among others, issues related to corporate governance and corporate structure, the latter aiming at avoiding the emergence of oversight gaps or loopholes at the level of the system operator. The BCL participates in the discussions at the ESCB on issues regarding oversight of the payment and securities settlement systems. At the ESCB level, a Memorandum of Understanding was concluded in 2001 between the overseers of payment systems and the supervisory authorities. This non-legally binding document relates to the co-operation and exchange of prudential information which may have an impact on financial stability and on aspects which call for a co-operation between the ESBC and banking supervisors on a crossborder level. Even though synergies between price stability and financial stability should prevail in the longer run, successful monetary policy will not always be sufficient by itself to prevent financial instability. In rare circumstances, the need to provide liquidity to individual illiquid institutions cannot be excluded. A form of involvement of central banks which carries fewer moral hazard implications than the provision of liquidity consists of the central banks acting as a co-ordinator to facilitate private sector solutions. In this case, the central banks can act as “honest broker”. Due to their unique position in the financial system, their independence from political considerations, their possession of special expertise, information and tools, they appear best placed to assume the role of overall co-ordinator. 3. Conclusions Potential future risks and vulnerabilities in the financial sector continue to have their source in the European and global macro-economic environment. Further needs for additional risk provisioning and continued lower income from trading activities and retail banking in general could further impair banks’ profits. The financial results of the first quarter of 2003 will give us a first indication in this respect. The banking sector has been resilient so far and I believe, without being complacent, that this sector has the potential to withstand possible further shocks. Enhanced risk management, increased reserve buffers and continued strategies aiming at increasing profitability are certainly steps in the right direction. Ladies and Gentlemen, since the creation of an euro area financial system, financial stability concerns have developed into a euro area wide issue. The unique challenge the eurosystem is facing lies in the threefold separation between the regulatory body, which is the European union, the single currency area and country specific supervisory jurisdictions. This separation requires special forms of co-operation between public bodies. As liquidity and contagion risk is increasing in importance, one should expect the role of central banks in financial stability to increase. Care should be taken in relation to risks arising from the non-banking financial sector activities and from financial market price developments. Despite improvements in risk management techniques and procedures, in prudential supervision and in the oversight of payment and securities settlement systems, the occurrence of a future financial crises is not excluded. Central banks’ role as global co-ordinator in those situations is of crucial importance. To repeat and summarize: Central banks are involved in financial stability: being banks themselves with business operations, it is necessary for central banks to control the soundness of their counterparts; in addition central banks are entrusted with the exclusive task of providing ultimate liquidity. They play an important role in crises management and in maintaining financial stability, regardless of the institutional structure for supervision which is adopted in the respective jurisdiction. However, close formal co-operation and information sharing arrangements, between central banks and supervisory authorities, which should work not only in theory but also in practice, is a pre-condition to address issues of financial stability in an adequate way. Thank for your kind attention.
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central bank of luxembourg
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ALGAFI General Assembly, Luxembourg, 12 March 2003.
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Yves Mersch: The interplay between monetary policy and fiscal policy in EMU Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ALGAFI General Assembly, Luxembourg, 12 March 2003. * * * Introduction It is a pleasure for me to take part in this ALGAFI General Assembly in Luxembourg. I am all the more satisfied because ALGAFI gave me the opportunity to discuss an extremely interesting issue, namely the interplay between monetary and fiscal policy in EMU. For obvious reasons, I will not refer to the specific case of Luxembourg but will instead primarily talk about the European Monetary Union (EMU) as a whole. However, I will privilege the Luxembourg dimension when the need emerges to illustrate some of my contentions. The advent of EMU has prompted a renewal of the debate on the interplay between fiscal and monetary policy. Although this debate is multifaceted, I will narrow it down to three basic questions. In my opinion, these questions address the most relevant issues at stake. The first question is whether the co-ordination of fiscal and monetary policy should be enhanced in the euro area, in order to secure a more efficient policy mix. There would exist strong arguments for an enhanced coordination at first sight, because of the existence of many interaction channels between monetary policy and fiscal policy. On the one hand, monetary policy affects the interest rate conditions, which have a significant impact on interest rate expenditure. Let me remember you that interest charges represent 4% of GDP in the euro area considered as a whole, and close to 6,5% in Belgium, Italy and Greece. On the other hand, fiscal policy has an influence on aggregate demand and long-term interest rates, which are of course taken on board in the elaboration of monetary policy. Furthermore, aggregate demand and interest rates have a direct impact on the balance sheet of financial intermediaries and, hence, on the transmission channels of monetary policy. The second question is conceptually linked to the first one, as will become clear in my answer. This question is whether fiscal policy should play a more prominent role in EMU, in order to palliate the so-called asymmetric shocks in a context where monetary policy is no longer defined at the national level. By definition, these shocks affect a subset of countries and do not embrace the euro area as a whole. For this reason, they do not play a central role in the conduct of the area-wide monetary policy. On the other hand, however, asymmetric shocks could inflict macroeconomic instability on the Member States concerned. On a priori grounds, this would justify an enhanced role for an active fiscal policy at the national level. The third and last question is related to whether the fiscal policy rules encapsulated in the European Union Treaty and in the Stability and Growth Pact have a constraining or a favorable impact on the way monetary policy is conducted and implemented, and whether they do not unduly restrict the room for maneuver of national government in a context where monetary policy is no longer designed at the national level. My conclusion is centered on the mutual reinforcement between stability-oriented monetary and fiscal policies. First question Let me now provide my answers to these three questions. As regards the first one, I would simply say that an enhanced coordination of fiscal and monetary policy is in no way a necessary condition for a smooth functioning of monetary policy in the euro area. From a purely theoretical viewpoint, an improved coordination could help achieve a more appropriate combination between monetary policy and fiscal policy. The resulting policy mix would be more efficient, in the sense that the authorities would be able to fine tune their policy action in response to the type of economic shock they face. However, the conceptual validity of this contention is not so guaranteed as widely held, because several necessary conditions for the design of an adequate policy mix are not fulfilled. First, it is usually extremely difficult to differentiate the type of economic shock involved - whether the shock is permanent or transitory, or whether it is a demand or a supply shock - except maybe several years after the occurrence of the problem. A fortiori, it is therefore impossible to pick up the policy mix that is best suited to the economic circumstances. This undoubtedly casts a shadow on the feasibility of an active and explicit coordination of monetary and fiscal policy. The second “practical” argument is in my opinion even more powerful. The cornerstone of the “coordination paradigm” is the contention that fiscal policy is able to impact on aggregate demand in a timely and significant way. For this reason, it can be combined with monetary policy in an effective way, depending on the state of the economy and the nature of the underlying shocks. However, the “ideal policy mix” would turn into a lame duck in circumstances where fiscal policy cannot be activated in a timely fashion and with the expected impact on the macroeconomic situation. In other words, the co-ordination between monetary policy and fiscal policy can be compared to a walking man, who has to stand firm on both legs. Should one of the legs fail to respond in a timely and coordinated way for whatever reason, many adverse consequences would inevitably follow. Although fiscal policy is of course extremely useful in many respects, I am quite skeptical as regards this specific feature that is so important for the elaboration of an appropriate policy mix, namely the stabilisation properties of an active fiscal policy geared towards macroeconomic fine-tuning. This “leg” seems quite unreliable to me, for several reasons. First of all, experience shows that fiscal impulses are frequently implemented too late, after the occurrence of the shock. These delays simply reflect a time-consuming decision-making process. Let me draw your attention on the various steps involved: the identification of the problem, the elaboration of the required measures, the discussion of these measures and their political adoption, their implementation and the time it takes before they exert an impact on aggregate demand. There are many examples of allegedly contra-cyclical policies that turn out to exert a procyclical impact on the economy because of the time lags involved. In these circumstances, fiscal impulses could contribute to magnify economic cycles. In addition, long and variable delays increase the uncertainty about the impact of discretionary measures on the economy. This “impact uncertainty” will increase the uncertainty for economic agents and monetary policy-makers. Furthermore, any stabilisation policy has to be conducted in a symmetrical way in order to avoid a systematic drift in the level of public expenditure. This condition is unfortunately difficult to fulfill, because many expenditure items are not flexible downwards. They could be increased in an easy way when the policy mix requires an expansionary fiscal policy, but a decline of the same magnitude will in all probability not be implemented when a restrictive stance becomes more appropriate. Let me give the example of Luxembourg to illustrate the validity of this point. The compensation of employees and social transfers - two expenditure categories characterised by a weak downward flexibility for evident reasons - jointly account for about 70% of total general government expenditure. On a priori grounds, only the intermediate consumption of general government could be used in a symmetric way and in a timely manner, but this expenditure item does not account for more than 3% of GDP. In addition, it is split between the central government and local governments, which would also require a close co-ordination between these two entities. The weak magnitude of fiscal multipliers in Europe cast some additional doubts on the validity of the fine-tuning approach. All the available empirical evidence indeed shows that the so-called leakage effects are very significant in the euro area countries, due to the high import content of expenditure and, as far as revenue are concerned, a high propensity to save. Multipliers are of course also very small in Luxembourg, especially on the government revenue side, because Luxembourg is really the epitome of a small, open economy. A final reason to be skeptical about the ability of fiscal policy to fine-tune the economy at discretion is the existence of the so-called “non-Keynesian” effects. Although the concept may seem complicated at first sight, it merely refers to the impact of expected budgetary developments on private consumption. These non-Keynesian effects could further dampen the impact of an active budget policy. For instance, private consumers might be inclined to save more when government expenditure tend to increase, because they expect that more taxes will be levied in the future in order to finance the budgetary imbalance associated with the fiscal impulse. According to the specialised economic literature, these effects would be higher the higher the level of public debt and the tax burden. Given the very low public debt in Luxembourg, this factor does not play a prominent role in this country at first sight. However, I am convinced that non-Keynesian effects could emerge also in the Luxembourg context, in case the long-term sustainability of public finances is no longer guaranteed. Thus the need to monitor for instance the budgetary consequences of population ageing and the inflow of cross-border and foreign workers. These various practical problems make it extremely difficult to design an appropriate combination between monetary policy and fiscal policy, and this is further complicated by the fact that monetary policy has to be conducted in a proactive way, on the basis of some projections about future inflationary developments. My answer to the question “is the co-ordination of fiscal and monetary policy a necessary condition for a smooth monetary policy” is therefore clearly negative. In many circumstances, such coordination could even turn out to be counterproductive. It would blur the clear delineation of responsibilities between policy makers and would undermine the commitment of national governments to fiscal discipline. Second question My answer to the second question - whether fiscal policy should play a more prominent role due to the fact that monetary policy is no longer conducted at the national level - is also extremely clear. At first sight, fiscal policy could be used in a more active way in the Member States in order to palliate the disappearance of a specifically national monetary policy. This more active use of fiscal policy would dampen asymmetric shocks, which would contribute to reinforce the homogeneity of the euro area economy. This argument is conceptually appealing, but in practice its foundations are rather shaky, to say the least. More specifically, I think that it would be extremely difficult to iron out the impact of asymmetric shocks via an active fiscal policy. This is simply a particular case of my general contention that a fine-tuning, demand management strategy would be extremely difficult to carry out at the national level. This contention has just been made in relation with the first question on co-ordination. My answer to the second question is therefore that an increased role of fiscal policy is not justified on practical grounds, at least as far as an active fiscal policy is concerned. However, the absence of a national monetary policy conducted at the national level also magnifies the importance of what I would call a “passive” form of fiscal policy, based on the free play of automatic fiscal stabilisers. The reliance on automatic stabilisers - basically unemployment expenditure and taxes - would in general be preferable to a more active fiscal policy, because they have a more immediate impact on aggregate demand. In addition, unlike most discretionary policies, they do not have a persistent effect on fiscal variables, since they are reversed as soon as economic conditions change. In Luxembourg, automatic stabilisers tend to exert a more stabilising impact than public investments, because investment programmes typically have to go through heavy legal procedures, which results in long and variable implementation lags. Of course, the free play of automatic stabilisers presupposes the attainment of a sound budgetary position, as will be demonstrated in my answer to the third question. Third question But before I address the third question, let me briefly recall the salient point of the fiscal rules encapsulated in the Treaty establishing the European Community and in the Stability and Growth Pact. The Treaty (and some protocols annexed to it) contains three crucial rules related to fiscal discipline. Since they are widely known, I will describe them in a concise way. A first rule basically states that the general government deficit should not exceed a reference value of 3% of GDP. A second, stock-oriented rule requires that general government debt should not be higher than 60% of GDP, unless the ratio “is sufficiently diminishing and approaching the reference value at a satisfactory pace”. A third rule prohibits the monetary financing of the different subcomponents of the public sector and of Community institutions or bodies. The Treaty is supplemented by the Stability and Growth Pact. The cornerstones of the Pact are two council regulations adopted in 1997. Under the Pact, Member States are expected to adhere to the medium-term objective of general government balances close to balance or in surplus. In order to establish this adherence, Member States are required to present stability and convergence programmes each year. These programmes present inter alia the medium-term objectives for the budgetary balance and the adjustment path towards the “close to surplus or in balance” position. The ECOFIN Council is required to deliver an opinion on each national programme, which gives way to “peer pressure”. In case of a failure to adhere to the Treaty reference values, an “Excessive deficit procedure” is in principle implemented. Sanctions could be applied in case an excessive deficit is established. In my opinion, this framework is in no way an impediment to the smooth conduct and implementation of the single monetary policy. I would indeed argue that the aforementioned fiscal rules are clearly supportive of a stable monetary policy, for at least three reasons. - First, the prohibition of any monetary financing coupled with the high degree of independence of the ECB and the National Central Banks ensures that a potentially destabilising link between fiscal and monetary policy will no longer exists. A regime in which monetary financing is allowed is indeed characterised by a “soft” intertemporal budget constraint. In such a situation, the government may be tempted to resort to the inflation tax in order to finance budgetary deficits. The resulting situation could be “mutually destructive” for monetary and fiscal policy. In such a context, fiscal discipline could indeed degenerate into a loose fiscal policy, and the latter would in turn contaminate monetary policy. Monetary policy would therefore become unpredictable and would increase the volatility of the monetary base and of the inflation rate. In the extreme case, this situation could lead to hyperinflation, as illustrated for instance by the situation of Germany under the Weimar Republic. EMU is congenitally immune from such episodes, owing to the prohibition of monetary financing and the independence of central banks in the euro area. - Second, I am convinced that the fiscal rules embedded in the Treaty and in the Stability and Growth Pact are not incompatible with the free play of automatic stabilisers. As I told you earlier, automatic stabilisers are especially important, because they help counteract asymmetric shocks at the national level in a situation where monetary policy is conducted at the euro area level. Provided that Member States are able to reach a close to balance or in surplus position, they could indeed let automatic stabilisers operate in full, without incurring the risk of breaching the 3% reference value. A close to balance or in surplus position indeed means that the cyclically adjusted fiscal balance should be in equilibrium. In such a situation, it would require a very negative output gap, equal to about 6% of GDP, to reach a nominal deficit in excess of 3% because of the free play of automatic stabilisers. This underlines the overriding importance of the attainment of a close to balance or in surplus position. Let me also highlight that such a position would requires a nominal surplus under favorable economic circumstances. In other words, it is essential to apply a strict fiscal discipline also during economic upturns. - Third, the attainment of a sound fiscal position compatible with the Treaty and the Stability and Growth Pact would facilitate to a considerable extent the conduct of monetary policy. The absence of clear and binding fiscal rules could have resulted in a non-cooperative equilibrium, characterised by higher long-term interest rates. This can be illustrated by the example of an individual Member State willing to tolerate higher deficits and to issue more debt securities in order to finance the resulting gap. This additional debt issuance would in all likelihood give way to a crowding out effect - namely to an upward pressure on interest rates due to the drain on private savings. The key point is that in EMU - where there exists a single currency and a high degree of integration between national financial markets - this additional burden would be borne by the euro area as a whole, and not just by the individual Member State responsible for the additional debt issuance. This kind of spillover effects could encourage each Member State to issue excessive amounts of debts. As a result, the euro area-wide interest rates would tend to be higher than required by economic fundamentals. Such a situation could complicate to a considerable extent the conduct of monetary policy, which underlines the need to resort to commonly shared rules of fiscal restraints. Conclusion Let me conclude with the statement that the relationship between monetary and fiscal policy runs both ways. First, I would like to point out that the more predictable fiscal policy fostered by the aforementioned fiscal rules would produce a more stable environment as regards, for instance, the inflation rate, aggregate demand or the tax burden. Such an environment would be conducive to economic and financial stability, which would enhance the efficiency of monetary policy. It also goes without saying that a more predictable monetary policy is supportive of fiscal discipline. More predictable short-term interest changes are indeed liable to impact on the budgetary equilibrium in several Member States. In addition, a stable monetary policy able to anchor the inflation expectations of economic agents will generate lower and less volatile long-term interest rates, which will further dampen the risk of budgetary slippages induces by unforeseen interest rate developments. More predictable interest rates are also extremely important for the Luxembourg general government, in spite of the extremely low public debt level observed in Luxembourg. First, the assets of the Luxembourg general government - including the accumulated reserves of the investments and special fund and the assets held by the general pension regime - are quite substantial, and the associated income is primarily dependent on short and long-term interest rate developments. Second, the soundness and profitability of the financial sector, which accounts for more than one third of all taxes collected by the Luxembourg central government, is very sensitive to the level of short-term interest rates, to the slope of the yield curve and also to stock exchange prices, namely three variables that are either directly fixed or strongly influenced by monetary policy. The importance of a predictable monetary policy for the Luxembourg government is particularly apparent in such a context.
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central bank of luxembourg
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Panel statement by Mr Yves Mersch, President of the Central Bank of Luxembourg and Member of the Governing Council of the ECB, at the Central Bankers' Panel, European Banking & Financial Forum Prague, 25 March 2003.
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Yves Mersch: The reform of the Governing Council of the ECB Panel statement by Mr Yves Mersch, President of the Central Bank of Luxembourg and Member of the Governing Council of the ECB, at the Central Bankers' Panel, European Banking & Financial Forum Prague, 25 March 2003. * * * Ladies and Gentlemen, It is a pleasure for me to participate once again in the European Banking and Financial Forum and to be back in Prague in order to speak before such a distinguished audience. My brief presentation will perhaps not directly cover the topic "When and how Europe can again become the global superpower" but is nevertheless closely related to both Europe and power. It will deal with how power, and more specifically voting power at the ECB's Governing Council, will be reallocated in order to cope with the ongoing expansion of the EU. It is also an excellent example of how the EU works: decisions are taking after a vigorous democratic debate, and a consensus is sought whereby the interests of all those involved are taken into account. My presentation is structured as follows: 1. I will start by briefly describing the Governing Council and how, as a result of enlargement, it was considered necessary to reform its voting procedure. 2. Subsequently, I will analyse how the discussions in the Governing Council led to the approval of a dynamic rotation model and the utilisation of a composite indicator, made up of both an economic and a financial variable. I will also go in some detail in the formal ECB recommendation, notably in terms of group composition and voting frequency. 3. Before concluding, I will look at the reactions of all the institutions involved in the enabling clause procedure: the Council, the Commission and the European Parliament (EP). 1. The need for reform 1.1. The Governing Council The Governing Council is the supreme decision-making power of the ECB. It comprises the members of the Executive Board of the ECB and the Governors of the national central banks or NCBs. The Executive Board has 6 members: the President, the Vice President and 4 other members. They are all nominated by a European procedure, contrary to the NCB governors who are appointed at the national level. The Treaty and the Statute assign to the Governing Council the power to take the most important and strategically significant decisions for the Eurosystem. It defines and implements the monetary policy of the euro area. In particular when taking monetary policy decisions, the Governing Council normally acts by a simple majority of the votes cast by the members who are present in person. Each member has one vote. The principle of 'one member, one vote' reflects the status of all the members of the Governing Council, including the governors of the NCBs of the Eurosystem, who are appointed in their personal capacity and not as representatives of their Member States. For some decisions on financial matters relating to the status of the NCB as shareholders of the capital of the ECB, the votes of the Governing Council are weighted according to the NCBs' share in the subscribed capital of the ECB. On such occasions the votes of the members of the Executive Board are zero-weighted. At the time of the Maastricht Treaty, the EU counted 12 Member States and the arrival of 3 new members was widely expected.Consequently the Treaty envisaged Governing Council eventually comprising 21 members: 6 Executive Board Members and 15 NCB Governors. 1.2. Enlargement 1.2.1. The enabling clause of the Treaty of Nice In order to cope with the EU's current enlargement, the Treaty of Nice, which became effective on February 1 of this year, called for a revision of the decision-making procedures for, or composition of, several European institutions such as the Commission, the Council, the European Parliament and the ECB. Indeed, many feared that the Governing Council's capacity for efficient and timely decision-making would be hampered if its membership expanded to up to 33 members, namely 6 Executive Board Members and, eventually, 27 NCB Governors. A solution therefore implies that the overall number of Governing Council members having voting rights would have to be smaller than the overall number of Governing Council members. To this end, the Treaty of Nice contained a so-called enabling clause which, in essence, enabled the Council to amend Article 10.2 of the ECB Statute on a recommendation from either the ECB or the Commission. In case of an ECB recommendation, the procedure also involved consulting the Commission and the European Parliament. It should be emphasised that the reform of the Governing Council should in no way be compared to the reform of other institutions such as the Council. It is also remarkable that the Treaty of Nice included the possibility for the ECB to come up with a recommendation for its own reform. It should also be underlined that the enabling clause is limited in scope. It concerns only the voting rights of the Governing Council and does not, for example, allow modifying the composition of the Governing Council or of the Executive Board. Similarly, it does not allow to restrict the membership of the Governing Council; or to some form of Monetary Policy Committee or Board. Moreover, the procedure is very complex. The ECB recommendation had to be taken by unanimity, and to be approved unanimously by the Council, meeting in its composition of Heads of State or Government, before ratification by all Member States according to their respective constitutional requirements. Within these constraints and on 3 February 2003, only two days after the Nice Treaty took effect, the ECB adopted unanimously a recommendation, which I will explain and discuss in more detail. However, prior to doing so, I would like to turn a moment to the expansion of the Eurosystem, in order to clearly distinguish this from EU enlargement. 1.2.2. The expansion of the Eurosystem The Eurosystem consists of the ECB and of the NCBs of all countries having adopted the euro. The timing of its expansion from the current 12 to the eventual "steady state" of 27 members is, however, highly uncertain. Currently three EU countries are outside the euro area. The United Kingdom and Denmark have an exemption, while Sweden has the statute of a country with derogation. All the new members will, upon joining the EU, automatically have the statute of countries with a derogation, that is to say with a clear commitment to join the euro area at a later stage. According to a position published by the ECB, the adoption of the euro is considered the result of a complex convergence process, rather than a mere exchange rate measure. Hence unilateral euroisation is considered unacceptable. The accession countries have to respect the converge criteria set by the Maastricht Treaty in terms of inflation, public finances and interest rates, and are expected to achieve high levels of real and nominal convergence, meaning that their economic structure and inflation levels have to converge to EU levels. In addition, they have to participate for at least two years in ERM II. 2. The ECB recommendation 2.1. Initial discussions Initially a multitude of possible solutions were analysed. Relatively soon, a constituency model, a capital key inspired voting system and a double majority system, to name only the principal proposals, were all abandoned. • A constituency model, based on regional groupings like in the IMF and the World Bank, was rejected as it was felt that this would violate the principle of total independence of the individual NCB governors because a representative of a constituency would probably feel obliged to defend the interests of his / her constituency in the Governing Council. This is contrary to the current system, whereby each NCB Governor votes with the interests of the entire euro area at heart, rather than on basis of national interests. • A system of weighted voting which, by the way, is also used in the Bretton Woods institutions, is contrary to the "one member, one vote" principle of the EU Treaty. As we have seen earlier, the Statute of the ESCB foresees only this scenario for voting related to shareholdership, i.e. national central banks, issues. In these circumstances the Executive Board has, accordingly, a zero-weight. • A double majority system, inspired by the revision of voting in the Council as decided by the Nice Treaty, was also rejected. First, the Council is not a relevant example for the ECB as the former is an intergovernmental body while the latter is a supranational institution. Second, many members felt this would result in a directoire, dominated by the largest countries. Under one version of this model, a proposal first requires approval by a majority of the Governing Council, including at least 3 of the 6 Executive Board Members. Moreover, any Governing Council member would have the right to request verification that a pre-set GDP level is represented. In case this representativeness level is set at for example 62%, Germany and France jointly could block any decision. Interestingly, as we shall see later, the European Parliament, with a German rapporteur, also made a proposal for a double majority, consisting of, first, the population and second, the total size of the economy and the financial sector. • The creation of a Monetary Board, consisting of theExecutive Board and a few additional members, as sometimes suggested in the press or academia, was rejected for being incompatible with the model and the structure of the Governing Council. It violates the principle of decentralisation, on which the Eurosystem is based. When large areas of policy making are still national in the EU, the case for excessive concentration of decision making seems out of touch with political reality. As the EU is not a single nation, the structure from the ECB is different from the Fed's structure. • An election system could appear appropriate but entails many practical difficulties in a body like the Governing Council. An unrestricted election might not fulfil the representativeness criteria and might lead to a "market" for votes and a less cooperative atmosphere in the Governing Council. Imposing certain conditions or safeguard clauses concerning representativeness, and maximum and minimum participation though simple in theory may well, in practice, present many drawbacks. 2.2. Dynamic rotation models and representativeness In order to allay fears that decisions in the Governing Council might be taken by a majority not necessarily representative of the euro area's economy, discussions turned to a system of dynamic rotation models, whereby governors are allocated to different groups with varying voting rights on basis of a to be defined economic criterion. Such a system would maintain the principle of equal treatment for the NCB governors and ensure sufficient levels of representativeness. 2.2.1. Fundamental principles A dynamic rotation system was considered the most equitable, efficient and acceptable way of assigning voting rights among the governors, particularly as the design of the rotation system was guided by a handful of guiding principles: • 'One member, one vote' and 'ad personam participation': All members of the Governing Council will continue to attend meetings in a personal and independent capacity, and the "one member, one vote" principle, as opposed to weighted voting, will continue to apply to those NCB Governors exercising a voting right. • Representativeness: At any moment, the NCB Governors with the right to vote must, as a whole, be representative of the euro area. • Transparency: The language of the revised Article 10.2 of the Statute has to be reasonably accessible and meet the requirements of primary Community Law. • Consistency. During the transition phase, great care should be taken in order to avoid that governors of certain NCBs move randomly up and down between certain groups. 2.2.2. Number and Composition of Groups, voting rights, composite indicator and representativeness • Two-group versus three-group models. A long debate went on concerning the number of groups and their composition. Three-group models for the steady state were favoured from the outset, although a two-group model, consisting of 15 and 12 countries was also considered. In the final event, preference was given to a three-group model, which allows, roughly speaking, to rank countries according to whether they are large, medium or small. However, in an intermediary phase a two-group model will be used. • Voting rights. At one stage it was discussed to limit the number of votes to the current 18. A consensus was eventually reached to set the number of votes at 21, (6 for the Executive Board and 15 for the NCB Governors). It was also decided to grant the 6 Executive Board permanent voting rights, as they are appointed by a special European procedure. • Representativeness indicator. As the ECB is an economic and not a political body, the use of the population criterion appeared as inappropriate, even if it is used for the capital key together with GDP, and initially using exclusively GDP was favoured. However, it was increasingly found that the contribution of the financial sector, through which the ECB steers liquidity and interest rates, should also be taken into consideration. Moreover, the financial criterion, in contrast to GDP or population, is not purely national, but reflects the effective contribution of the various central banks to the Eurosystem. It is also in line with the experience of the American Federal Reserve System where no reference has been made to the relative weight of the various US states. Instead, according to section 2 of the Federal Reserve Act, the criteria are based on convenience and "customary course of business". Reflecting their importance as financial centres, the Presidents of the New York and Chicago Federal Reserve Banks enjoy respectively a permanent voting right and a 50% voting right in the Federal Open Market Committee (FOMC), against a 33% voting right for virtually all other Fed Presidents. Several financial indicators such as the monetary aggregate M3, capital of credit institutions, bank deposits / loans and the Total Aggregated Balance Sheet of the Monetary Financial Institutions were analysed. Preference was given to TABS-MFI for conceptual, legal and statistical considerations. From a conceptual point of view, TABS-MFI is the broadest measure for the size of the financial sector. A legal definition exists in Community law and the statistical framework is well established and consistent. • Concerning the relative weights for the composite indicator, the ECB proposed in its official th th recommendation to give GDP a weight of 5/6 , against a relative weight of 1/6 for TABS-MFI 2.3. Technical elements of the ECB recommendation In its recommendation, the ECB proposed a dynamic rotation model which, in the steady state, will have 21 voting rights. The Executive Board will have 6 permanent voting rights while the 27 governors, allocated to three groups on basis of the composite GDP-TABS indicator, will have 15 voting rights. In an initial phase, the model will consist of 2 groups. The detailed implementation provisions, including the possible decision to postpone the start of the rotation system so as to avoid the situation that governors within any voting group have a voting frequency of 100%, are to be adopted by the Governing Council, acting by a two-thirds majority of all its members, with and without a voting right. The ECB recommends introducing a two-group rotation system when the number of euro area Member States ranges from 16 to 21 Member States. Once the number of euro area Member States exceeds 21, a rotation system based on three groups will start operating. Group composition in the steady state In a euro area with 27 Member States, and on basis of the available figures for GDP and TABS-MFI, the first group would consist of the 5 Governors of Germany, the United Kingdom, France, Italy and Spain. NCB Governors in this group would have a voting frequency of 80%. The second group would consist of 14 members, namely the NCB Governors of the Netherlands, Belgium, Sweden, Austria, Denmark, Poland, Finland, Greece, Portugal, Ireland, Luxembourg, the Czech Republic, Hungary and Romania. These Governors would vote 8 times out of 14, equivalent to a voting frequency of 57%. The third group would consist of the remaining 8 NCB Governors and have a voting frequency of 3/8 or 37,5%. This can be compared to their cumulative share in the composite GDP-TABS indicator of less than 1 %. In the steady state, the 3 groups of NCB governors will thus be made up of respectively 5, 14 and 8 members. This is the result of a pragmatic and empirical approach, which attempted, to the extent possible, to have clear separations between the different groups. Thus, the first member of the second group, the Netherlands, has a composite indicator which is 41% inferior to the indicator for the last country of the first group, Spain. The corresponding figure for the separation between the last country of the second group -Romania- and the first country of the third group -the Slovak Republic- is an even more striking 80%. 3. Follow up to the ECB recommendation The Council unanimously accepted the ECB's recommendation on 21 March, after a positive opinion from the European Commission and a non-binding rejection by the European Parliament. The Council also confirmed that the model for voting modalities in the Governing Council of the ECB should not be seen as a precedent for other EU-institutions. It is now up to the Member States to ratify therecommendation according to their own constitutional procedure. Let me add that, as the Treaty of Nice was already ratified, there seems to be no need for national referenda, something which should facilitate this gratification process. It is noteworthy, however, that both the Commission and the EP favoured a more comprehensive revision of the functioning of the Governing Council in the framework of the upcoming Intergovernmental Conference. I will analyse the position of these two institutions in more detail. 3.1. The Commission's opinion On 19 February, roughly two weeks after the ECB made its recommendation, the Commission issued a press release in which it indicated that, and I quote, "…the proposed model constitutes a step towards securing the continued efficiency of decision-making within the ECB in the perspective of enlargement." The Commission also emphasised that, and I quote, "…the severe limitations of the enabling clause of Art.10.6. of the ECB statutes…More fundamental and comprehensive reform of the ECB's governance structures could not be envisaged on this basis, but can only be achieved in the wider framework of the Convention and the upcoming IGC." On the same occasion, the Commission reiterated also the importance it attaches to the "population" criterion, a matter I have dealt with above. 3.2. The European Parliament's opinion The EP rejected on 11 March the ECB's recommendation, notably on the grounds "that it has been widely criticised for being excessively complex". In the short term the EP "…reaffirms the existing rule whereby all central bank governors of Member States in the eurozone have full and unrestricted voting rights, and whereby the Governing Council of the ECB takes decisions by simple majority." In the longer term, however, the EP "…Calls for the adoption of a solution at the next Intergovernmental Conference, after consulting the EP, which would distinguish between operational decisions, to be taken by an enlarged Executive Board of nine Members, adequately representing the euro area economy, and strategic and general monetary policy decisions, to be taken by the Governing Council acting on a double majority, based on the population of the Member States, the total size of the economy and the relative size within it of the financial services sector;" The essential points of the EP consist therefore of: • maintaining the statu quo in the short term, meaning that each NCB Governor has a vote; • requesting the Intergovernmental Conference to create an enlarged Executive Board of nine members. Such an enlarged Board may well turn out be similar to the Monetary Board some academics and journalists have in mind; • Most interestingly, the EP accepts the use of a composite indicator, based partly on a financial criterion. 4. Conclusion Please let me finish my presentation with a few concluding remarks. One of my fellow countrymen, Member of the European Parliament, stated during the recent debate in this institution, less than 2 weeks ago, that the debate about the enabling clause seemed to result from the fact that larger countries suffer from a Gulliver syndrome: they fear to be bound and tied up by the Lilliputians who outnumber them and, by definition, act in an irresponsible manner. Interestingly, this MEP reminded the Parliament that most blockages to European integration originated from the large, rather than from the small nations. Similarly, the small nations are the ones who abide punctiliously by the Growth and Stability Pact. Nevertheless, the fear seems to exist among larger Member States that the smaller ones might impose a lax monetary policy, even though it is generally accepted that NCB governors vote in the Governing Council on an ad personam basis and in the interest of the entire euro area. To this MEP, the whole debate about the enabling clause seemed therefore somewhat artificial and taken under unnecessary time pressure. All this was two weeks ago and in the meantime the Council approved the enabling clause. Particularly important and heartening, in my eyes, is the fact that a handful of guiding principles which the ECB considered of particular relevance were respected such as 'one member, one vote', ad personam participation, representativeness and transparency. Moreover, the ECB recommendation managed to avoid several perilous pitfalls: • As I mentioned, the 'one member, one vote' principle is maintained, even though all governors do not vote all of the time. However, whenever they are entitled to vote, the votes of all Governors carry the same weight and this is an important element of fairness between large and smaller countries. • There is no re-nationalisation of monetary policy, as would have been the case if the Governing Council had moved to a system of IMF-style regional constituencies. • Similarly, the fact that no Governor member of the Governing Council has a permanent voting right, and that they are all subject to a rotation scheme, is another important element of fairness between large and smaller countries. • Finally, in the steady state, 4 new member countries are expected to become member of the second group while many of the remaining countries will gradually move from the third to the second group as real convergence, or "catching up" in plain English, progresses. In this respect, the ECB proposal also strikes a fair balance between current and new members, an important point I wish to emphasise here in Prague.
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Speech by Yves Mersch, Governor of the Central Bank of Luxembourg, at the 33rd ISC-Symposium, St. Gallen, Switzerland, 23 May 2003.
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Yves Mersch: Reflections on the eurosystem’s monetary policy strategy after four years Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 33rd ISCSymposium, St. Gallen, Switzerland, 23 May 2003. Introduction The primary objective of the single monetary policy is the maintenance of price stability. However, the Eurosystem, like all central banks, cannot control the price level directly but faces a complex transmission process. Because the latter is complex, the preparation, discussion and presentation of monetary policy decisions must be placed in a coherent clarifying framework. This is the role of the monetary policy strategy. The strategy fulfils two crucial tasks. First, the strategy imposes a clear structure on the policy-making process itself. It must ensure that the Governing Council has the information and analysis required by an effective monetary policy that will maintain price stability. Second, the monetary policy strategy is a vehicle for communicating with the public. Monetary policy is most effective when it is credible. The strategy must therefore facilitate the communication of decisions taken and convince the public that the objective will be achieved. In October 1998 the ECB Governing Council announced that the Eurosystem would adopt a monetary policy strategy consisting of three key elements. The first element was a quantitative definition of price stability. The second and third elements were the "two pillars" of the strategy used to achieve this objective, namely the assignment of a “prominent role to money” and a "broadly based assessment of the outlook for price developments and risks to price stability". The Eurosystem took the position that policymaking should not become dominated by inflation-forecast-targeting type preoccupations. Eurosystem monetary policy, thus, does not react mechanically to a forecast at a fixed horizon but rather tailors the policy response depending on the nature of the shock hitting the economy. This is documented by its medium-term orientation and reflects why the medium-term has not been defined quantitatively. As the single monetary policy faces uncertainty about the functioning of the economy, the robustness of information stemming from various sources is checked. Furthermore, policy decisions are based on a judgment on the likelihood of certain scenarios occurring. The distinct character of the two-pillar strategy is also stressed by the announcement of a reference value for monetary growthsignalling the prominent role assigned to money. On the contrary, strong focus on a single inflation forecast would not do justice to the complexity of the decision-making process and at the same time not be a transparent means to communicate this complexity. Overall, projection exercises provide a main element within the second pillar, but they do not offer an all-encompassing summary device. Four and a half years have elapsed since the announcement of the Eurosystem's monetary policy strategy. These years provide a wealth of information, in terms of direct experience and of views by external observers. In December 2002 the President of the ECB announced that the Eurosystem would conduct an extensive analysis of its strategy. The evaluation encompassed a thorough assessment of comments from academics, analysts and journalists. In plain analogy with the majority of the comments received, the evaluation process focused on three aspects, namely a) the definition of price stability, b) the role of money and c) the two-pillar architecture. 1. The definition of price stability The Treaty (Art. 105.1) assigns to the Eurosystem the primary objective of maintaining price stability. On 13 October 1998 the ECB Governing Council defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%". Price stability according to this definition "is to be maintained over the medium term". Critics mainly addressed three aspects of this definition, namely the choice of the price index, the choice of the quantitative value for the objective and the format of the definition. 1.1 The choice of the price index The HICP For the purpose of setting a quantitative objective for monetary policy, a price index should embody a number of essential properties, such as credibility, reliability, timeliness and frequency. The HICP was initially created for the assessment of price convergence in Stage Two of EMU and is largely harmonised across euro area countries. It scores particularly high in the above criteria. There is no controversy in that Eurostat provides a high quality price index at international standards. Headline inflation versus core inflation The choice of the headline measure has the advantage of transparency: It provides the measure that most closely approximates the price of a representative basket of consumption goods and services purchased by euro area households. In theory, core inflation represents an appealing concept in that it filters out the more volatile components and/or temporary factors, which should be disregarded for monetary policy purposes. In practice though, measures of underlying inflation may lack credibility with the public. Furthermore, there is no unique method to derive such measures and different measures often provide very different figures. In any case, the medium-term orientation of the Eurosystem's monetary policy strategy ensures that the Governing Council will duly discount short-term price volatility in its deliberations. 1.2 The choice of the quantitative value for the objective The announcement of a quantitative definition of price stability is an essential element of the Eurosystem's monetary policy strategy. It provides a clear and measurable benchmark against which the public can hold the Eurosystem accountable. It enhances the transparency of the monetary policy framework, and gives guidance to expectations of price developments, thereby helping to stabilize the economy. Ultimately, any assessment of the appropriateness of the specific quantitative value requires weighing off the costs of inflation and the rationales for tolerating small positive inflation rates. The costs of inflation Recent evidence confirms a negative and significant effect of inflation on long-term growth, even at moderate rates of inflation. Furthermore, inflation has been found to negatively affect aggregate welfare through a number of channels, such as non-indexed tax systems, nominal rigidities, distortions in relative prices, income redistribution, "shoe-leather costs", excessive financial sector growth, inflation uncertainty, risk premia etc. Evidence that has become available since the inception of the Eurosystem strategy suggests that the costs of inflation may be higher than previously thought and that even moderate rates of inflation could entail significant costs. The rationales for tolerating small positive inflation rates Nevertheless, a number of considerations suggest that maintaining a moderate positive rate of inflation would be desirable. These relate to the presence of measurement bias in the price index, the existence of downward rigidities in labour and goods markets, sustained inflation differentials across euro area countries and the existence of a lower bound for nominal interest rates. Measurement bias Inflation may be subject to a positive measurement error, due to a number of sources (e.g., substitution bias, quality bias, outlet bias and new good bias). Assuming a positive measurement bias, an environment of very low inflation may hide a situation of 'de facto' deflation. However, the level of uncertainty surrounding the possible bias remains very high. With respect to the HICP, however, the continuous improvements implemented by Eurostat suggest that the measurement bias is likely to be very small and to further decline in the future. Downward nominal rigidities In the presence of limited downward flexibility in prices and nominal wages, the economic adjustment to shocks may become too sluggish. A small positive inflation rate may "grease" the real adjustment if workers show resistance to nominal wage cuts. According to more recent evidence, however, the importance of downward nominal rigidities in the euro area is limited (trend towards flexible wage components; likely to decline in sustained low inflation environment and/or with structural reforms; positive trend productivity growth). If downward nominal rigidities were pervasive, it is unclear whether monetary policy should accommodate them in the setting of the policy objective since this could make them even more 'entrenched'. Sustained inflation differentials across euro area countries It is acknowledged that inflation in countries at the lower end of the inflation distribution under price stability in the area as a whole seems to be quite low. Sustained inflation differentials may result for different reasons ("Balassa-Samuelson effect"; flexibility of markets; price level convergence; etc.). The current assessment for the euro area, however, suggests that the magnitude of the Balassa-Samuelson effect is rather small, even after enlargement. In addition, the price stability definition refers to the euro area as a whole and inflation dispersion most probably will be observed in virtually any monetary area. Regional deflationary spirals seem to be extremely unlikely as long as there is no deflationary spiral in the area as a whole. The zero lower bound in nominal interest rates Maintaining a small positive inflation rate rather than strict price stability reduces the probability of approaching very low levels of nominal interest rates. Such a safety margin is desirable, as the event of hitting the zero lower bound is linked to a diminished effectiveness of monetary policy and a higher risk of a deflationary spiral. The Japanese experience of protracted financial and monetary instability, however, can not be directly transposed to the euro area. Furthermore, evidence from simulation exercises indicate that the likelihood of hitting the zero lower bound of nominal interest rates and/or experiencing a deflationary spiral is rather small when the inflation objective is above 1%. 1.3 The format of the price stability objective Here, the discussion refers to two separate aspects, namely the issue of symmetry in the objective and whether it is preferable to specify the objective in the form of a range for allowable inflation rates or in terms of a specific rate of inflation. Symmetry There seems to be a perception of a lack of symmetry in the Eurosystem's definition of price stability, as it clearly defines an upper bound at below 2%, while not explicitly mentioning a lower bound. Asymmetry could entail two types of difficulties. Firstly, it may have led to an excessive focus by the public on the 2% upper-mark as a benchmark for future developments in financial contracts and wage negotiations. In fact, inflation expectations indeed have settled close to the upper bound. The lack of a more precise aim within the existing definition may make it more difficult for the Eurosystem to maintain price stability. Secondly, a lack of symmetry may not be conducive to the clarity of communication, especially when the arguments for lowering policy rates need to be explained. However, the Eurosystem clarified a) that the use of the word "increase" excludes deflation and b) that the lack of an explicit lower bound acknowledges the existence of an unknown and possibly time-varying measurement bias in the HICP. Range versus focal point The choice between setting the objective of price stability by means of a range or a specific rate of inflation is subject to certain trade-offs. Critics of the current format suggest that a single point rate of inflation has stronger signaling properties. However, international evidence suggests that, once the objective embodies a quantitative announcement, its use in the form of a point or a range for admissible inflation rates makes no appreciable difference for firmly anchoring long-term inflation expectations. One advantage of a range is that it signals the uncertainty regarding the optimal inflation rate and conveys to the public the message that the control of inflation is inherently imperfect. This may be conducive to the credibility of the central bank: It contributes to limiting its accountability for moderate variations in inflation over the short term.Furthermore, a range is fully compatible with a gradual shift in the optimal inflation rate due to permanent shifts in productivity growth or other structural shocks.On the other hand, a range could be interpreted as a zone of indifference, with policy responding only when inflation approaches the edges. If a range is announced around the point target, it is important that the edges are interpreted as "soft-edged" and not as triggers for policy, thus allowing for a gradual and medium-term approach to monetary policy. The definition of price stability: main conclusions The review of the definition of price stability has confirmed its overall successful performance within the Eurosystem's strategic framework.Inflation expectations are perfectly compatible with the definition of price stability. Small and declining volatility of long-term inflation expectations document the successful anchoring of inflation expectations in the euro area. The analysis has shown that there is no viable alternative to headline HICP inflation for defining the primary objective. At the same time, the Eurosystem will continue to monitor measures of “underlying inflation” as indicator variables in the context of regular analysis and in external communication. However, the Governing Council wished to further clarify the existing definition of price stability. To this end, the Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% ("from below") over the medium term. This clarification underlines the Eurosystem's commitment to provide a sufficient safety margin to guard against any major risks of deflation. It also takes due account of the possible presence of a measurement bias in the HICP andother factorsthe implications of inflation differentials within the euro area. In addition, it perfectly reflects the medium-term orientation of the single monetary policy. 2. The role of money Inflation is ultimately a monetary phenomenon. The Governing Council therefore recognized that giving money a prominent role was important. Two properties were identified in October 1998 justifying a prominent indicator role for a monetary aggregates, namely its leading indicator properties for price developments and its stable relationship with its long-run determinants (notably the price level, real income, interest rates). Both properties triggered criticism and it was important to review whether the underlying conditions are still satisfied. The leading indicator property of money A large number of studies confirm that empirical evidence continues to support that broad monetary aggregates have important indicator properties for euro area inflation. The leading indicator properties of money are optimal at medium to longer-term horizons. There is also evidence that narrow monetary aggregates have leading indicator properties for cyclical developments. And finally, careful analysis of money and credit growth may provide early information on the development of financial instability in addition to other indicators. Such information is of relevance for monetary policy as the emergence of financial imbalances or bubbles could have a de-stabilising impact on activity and, ultimately, prices in the medium term. The stability of money demand The relevance of monetary aggregates for the conduct of monetary policy hinges on the long-run stability of money demand. There is substantial evidence suggesting that long-run euro area money demand is stable. This finding is robust with respect to a number of methodological issues (aggregation method, sample period, etc.). However, the empirical work has shown that over the most recent period, there were signs of instability in the short-term mechanism by which deviations of the demand for M3 from its long-term equilibrium are corrected. At present, information from various sources (Balance of Payments, Financial Accounts) suggest that current developments in the demand for M3 in the euro area seem to be associated with a heightened preference for liquidity induced by an exceptionally prolonged period of asset price volatility. However, it may not be taken for granted that stable money demand will last endlessly. One concern relates to possible future structural changes in the composition of wealth due to the increased sophistication of private investors. Historically, instability was primarily due to financial innovation or tax changes affecting the relative net return of holding money. However, there have not been significant changes in any of these factors recently which would justify to expect a continued instability in money demand. The role of money: main conclusions Broad money reveals strong leading indicator properties for developments in prices. Narrow money aggregates have leading indicator properties for cyclical developments. Excess money and credit growth may provide early information for identifying financial imbalances and/or asset price bubbles, which ultimately may impact on price developments. At present, there is no evidence suggesting that the long-run link between money and prices has become obsolete. Both conditions motivating the assignment of a prominent role to money, thus, are still satisfied. However, monetary growth has been subject to substantial volatility in the short-run. Against this background, the Eurosystem will continue with its monetary analysis to interpret short-term trends in monetary aggregates with caution and to conduct studies on money demand. 3. The two-pillar architecture The Eurosystem's monetary policy strategy was designed to take account of the uncertainty monetary policy faces about the functioning of the economy. To this end, a twin pillar architecture is employed in organizing, assessing and cross-checking all information relevant for an assessment of the risks to price stability. Within the first pillar, the Eurosystem has announced a quantitative reference value for the growth rate of M3, as a benchmark against which monetary developments can be assessed and described to the public. Analysis under the second pillar focuses on the short-to-medium-term risks to price stability. It is based on a broad range of information about wages, commodity prices and exchange rates, asset prices, wealth, external demand, fiscal policy, and domestic financing conditions and costs. The Eurosystem's approach to structuring its analysis under two pillars was innovative. Not surprisingly, it triggered many discussions as well as criticism. The latter focused on the reference value and the co-existence of two distinct pillars. The first pillar and the use of the reference value Much of the criticism owes to an overly simplistic understanding of the first pillar as a simple comparison between observed monetary growth and the reference value. Contrary to much journalistic discussion, however, M3 growth away from the reference value over shorter periods may not be interpreted as a policy failure. In fact, the relationship between interest rates and monetary growth is complex, it may vary over time and it is shock specific. Most importantly, monetary policy actions are not geared to returning M3 growth to the reference value as quickly as possible, but to achieving the objective of price stability over the medium term. It seems that M3 has been more sensitive to short-term developments in financial markets than one may have expected. As a consequence, monthly changes in M3 growth became quite volatile and measures of short-term trends in monetary aggregates have to be interpreted with caution. Most importantly, in order to overcome the limited signalling properties of money in the short-run, the scope of monetary analysis has been enriched over time and goes well beyond the narrow study of deviations between the growth rate of M3 and its reference value. The monetary analysis undertaken by the Eurosystem consists of a comprehensive assessment of the liquidity situation based on information from a large number of sources, ranging from Monetary and Banking Statistics to Balance of Payments and Financial Accounts. It involves a thorough analysis of components of monetary aggregates (in particular M3 and M1) as well as their counterpartsfrom both MFI liabilities and MFI assets(in particular loans to the private sector). Various money gap measures, concepts of excess liquidity and monetary models are used to identify the factors underlying the developments in money and credit and to best extract the information contained in money for longer term price developments. Monetary analysis and the reference value: main conclusions The Governing Council acknowledged the need to communicate more convincingly the enriched scope of monetary analysis and stressed the rich choice of data and methods used. To underscore the longer-term nature of the reference value as a benchmark for assessing monetary developments, the Governing Council decided to no longer conduct a review of the reference value on an annual basis. Importantly, the reference value for M3 is based on medium-term assumptions for real GDP growth and velocity. The mere announcement of the annual review, however, unintentionally seems to have affected expectations. Its legend annual review appears to have added to the misperception that the reference value is announced "for a specific year" and to confusions with an annual targeting of M3 growth. The Governing Council agreed to continue to assess the stability properties of money demand and the validity of the assumptions underlying the reference value with respect to trends in income velocity and output growth. The Governing Council will change the reference value if necessary. However, the experience has shown that the underlying assumptions change over longer periods only. The Governing Council therefore refrains from announcing a specific frequency at which the reference value will be reviewed. The co-existence of two pillars The twin pillar architecture triggered a good deal of criticism, much of which seems to neglect the specific merit of the twin architecture. First, the two-pillar strategy perfectly reflects the difference in the time perspectives relevant for analysis under the economic and the monetary analysis. It is widely acknowledged that long-term price movements are driven by trend money growth, while higher frequency inflation developments appear to reflect the interplay between demand and supply conditions at short- to medium-term horizons. From the perspective of central bankers, the kind of information provided by both the economic and the monetary analysis is equally relevant, but differs qualitatively. Second, the two-pillar architecture serves as an instrument to organise and convey information to the Governing Council and the public. At present, monetary phenomena are not fully captured by conventional economic models. The two-pillar structure represents an analytical commitment on the part of the Eurosystem to ensure the robustness of monetary policy by taking due account of different paradigms in policy considerations. Third, the two-pillar architecture serves as a communication device. It allows conveying monetary policy decisions and the underlying rationales to the public in a most transparent manner. Empirical evidence suggests that nowadays interest rate decisions by the Governing Council are very well anticipated by market participants. The co-existence of economic and monetary analysis: main conclusions Economic and monetary analysis operate under different time horizons. The Governing Council wishes to clarify communication on the cross-checking of information in deriving its unified overall judgement on the risks to price stability. To this end, the introductory statement of the President will henceforth follow a new structure. It will start with the economic analysis to identify short- to medium-term risks to price stability. As in the past, economic analysis is based on further developments in structural models, tools and models in forecasting, etc. It will include analysis of shocks hitting the euro area economy and projections of key macroeconomic variables. The Governing Council recalled that since the inception of the single monetary policy the economic analysis has been deepened. The Governing Council confirmed the importance of projections, but also recalled that they will not exhaust the economic analysis. The monetary analysis will then follow to assess medium to long-term trends in inflation in view of the close relationship between money and prices over extended periods. It will take into account developments in the extended range of monetary indicators including not only M3, but also its components and counterparts, notably credit, and various measures of excess liquidity (money gaps, monetary overhang, etc.). In essence, monetary analysis mainly will serve as a means of cross-checking, from a medium- to long-term perspective, the short to medium-term indications coming from economic analysis. This cross-checking ensures that monetary policy has a nominal anchor beyond the conventional projection horizon. The Governing Council confirmed that both, the short-term assessment from economic analysis and the medium- to long-term assessment based on monetary analysis lead to a compound single assessment. This single assessment is the fundament of Governing Council decisions. This new structure of the introductory statement better illustrates that the two perspectives offer complementary analytical frameworks to support the overall assessment of risks to price stability. Overall conclusion To sum up, the strategy evaluation by and large confirmed the key elements of the existing strategy. In different fields, the decisions taken by the Governing Council ensure a high degree of continuity: First, the Governing Council continues to reject a strategy of inflation targeting. Second, the strategy will continue to entail three main elements, namely a quantitative definition of the primary objective of price stability and the "two pillars" of the strategy used to achieve this objective. Third, the quantitative definition of price stability continues to refrain from rejects a corridor for inflation outcomes. Fourth, the type of analysis undertaken under both economic and monetary pillars is unchanged. Within the existing framework, though, the Governing Council undertook distinct clarifications. First, the quantitative definition of price stability has been clarified by defining the aim of the Eurosystem within the existing definition (i.e. close to 2% "from below"). Second, by restructuring the introductory statement of the President the Governing Council has – and will continue to do so – clarified the scope of the enriched monetary analysis and its use in monetary policy making as a means of cross-checking. In order to avoid confusion with monetary targeting and to stress the long-term character of the reference value, the Governing Council decided to no longer conduct its review on an annual basis.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a financial seminar, Hong Kong, 11 November 2004.
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Yves Mersch: The international role of the euro Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a financial seminar, Hong Kong, 11 November 2004. * * * Ladies and Gentlemen, Since its inception, the euro’s international role has grown in a gradual but steady way. At the outset I would like to recall the Eurosystem’s policy position vis-à-vis the internationalisation of the euro. The Governing Council of the ECB sees the internationalisation of the euro as a market-driven process. Nevertheless, we analyse developments closely, as we are keen to know how the euro is used and by whom. Thus, I will first review the main developments in more detail. Then, I will turn to the Eurosystem’s policy stance towards the international role of the euro. I will conclude by shortly highlighting the Eurosystem’s stance on reserve management services. The gradual development of the international role of the euro In order to consider the main developments in the international use of the euro for the last 5 years, I will distinguish the varied use of the euro outside the euro area, by public authorities on the one hand and private agents on the other. Let me start with public authorities. There are about 50 countries with an exchange rate regime linked to the euro, including those EU Member States that have not yet joined the euro area. Non-EU countries that use the euro as an anchor currency are mainly located in the EU’s neighbouring regions or are countries that have established special institutional arrangements with the EU or some of the EU Member States. In most of these countries, the euro is also the main or the sole intervention currency used by the authorities to stabilise the exchange rates of their respective currencies. Additionally, in these countries euro-denominated assets account for a substantial share of the foreign exchange reserves held by the respective authorities. The role of the euro as an anchor currency in third countries outside the euro area has remained stable overall. Changes in exchange rate regimes involving the euro mainly involved the new EU Member States, as three of them joined the Exchange Rate Mechanism II end-June 2004. The global reserve build-up continued at a rapid pace, with Japan and other emerging Asian economies accounting for the largest share in the total increase. Benefiting from the appreciation against other international currencies, the share of the euro in official foreign exchange reserves has continued to increase gradually, from 19.3% in 2002 to 19.7% in 2003. As an intervention currency, the euro was predominantly used in euro area neighbouring countries. Turning to private users, the internationalisation of the euro has been most visible when it comes to the role of the euro as an international financing currency. In 2003, the share of the euro in the stock of international issues amounts to more than 30%. A significant share of euro-denominated securities have been targeted at, and purchased by, euro area investors. In using the euro as an issuance currency, financial institutions and corporations, mainly from mature economies (USA, UK), have taken advantage of the greater size and liquidity provided by the increasingly integrated eurodenominated bond markets. With regard to the share of the euro in foreign exchange transactions preliminary results from the 2004 BIS triennial survey, point to a notable increase in activity in foreign exchange trading. Based on these preliminary results, the euro was the second most actively traded currency in foreign exchange markets worldwide, and accounted for 37% of foreign exchange transactions, broadly the same as in 2001. Globally, the euro continued to be traded predominantly against the US dollar, as 76% of total worldwide foreign exchange activity involving the euro was with the US dollar. To sum up, the euro has been firmly and credibly established as the world’s second international currency during the first five years of Monetary Union, and its gradually increased use in several market segments highlights the degree of confidence non-euro area residents have in the euro. The ECB and the international role of the euro This brings me to the stance adopted by the Eurosystem on the international role of its currency. I will start by emphasising a key characteristic of the international use of any currency: there is no “sovereign” power that can enforce its use. This is why the international use of a currency is, in essence, a market-driven process. The main economic factors underpinning the internationalisation are: 1. Domestic stability, that is a low inflation rate, making the currency attractive as a store of value; 2. A high degree of openness to international trade and finance. This is a key determinant for the currency’s use as a medium of exchange and a unit of account; and 3. A developed financial system with deep and liquid markets offering participants a wide range of services and products in terms of borrowing, investing and hedging. Against this background, the Eurosystem takes a neutral stance on the internationalisation of its currency. This means that we neither hinder nor actively promote the development of this role. For example, decisions taken by non-euro area authorities to use the euro as an anchor, reserve or intervention currency have to be fully seen as unilateral measures. They do not involve any commitment on the part of the Eurosystem. This rule knows only one exception: the Exchange Rate Mechanism II. With regard to this stance, it has of course to be noted that the Eurosystem contributes to the international role of the euro in indirect ways. Price stability is a key precondition for the development of the international role of a currency. Thus, the stability-oriented monetary policy of the ECB contributes to the euro’s potential for expanding its international role. The Eurosystem has also been a strong supporter of financial market integration in the EU. The introduction of the euro itself has undoubtedly led to a deeper and more integrated financial market. The evidence strongly suggests that this has supported the development of the international role of the euro. And when we refer to the fact that potential gains from monetary union will only be fully realised when European financial integration is fully achieved, this also applies to the euro’s use as an international financing and investment currency. Let me stress that by being neutral we are not indifferent to the international role of the euro. Indeed, we pay special attention to the international use of our currency and provide regular information to the public on related developments in the international financial arena, for example the recent build-up in foreign exchange reserves. The Eurosystem’s reserve management services This leads me to say a few words on the Eurosystem’s reserve management services. We have seen that the euro has firmly established its role as an important reserve currency, supported by its gradually increasing use at an international level. The Eurosystem has therefore developed a new framework that specifically addresses the type of services required to support the management of euro-denominated reserve portfolios. The new framework builds on the well-established reserve management services infrastructures already in place at certain Eurosystem central banks. Consistent with the manner in which reserve management services have been provided over the years, the new ‘standardized or harmonized’ framework continues to be based on the core principles of financial security, legal security and confidentiality. This basis allows central bank customers to comprehensively manage their euro-denominated reserve assets in a safe, confidential and reliable environment. The services themselves are provided by certain national central banks of the Eurosystem, identified as “Eurosystem service providers”, among which the Luxembourg Central Bank. These providers have committed to offering the complete set of reserve management services falling under the new framework. Eurosystem service providers and the other central banks of the Eurosystem may also offer specific reserve management services on an individual basis. The Eurosystem’s services are tailor-made to address the special needs and concerns of those institutions that operate in the same area of central banking activities as the Eurosystem itself. The services offered under the new framework, as well as other non-standardised and non-harmonised services offered by those central banks with extended know-how in professional asset management, among which the Luxembourg central bank, help this core group of customers to manage their euro-denominated reserve assets more effectively and with greater flexibility and will thus accompany the deepening of financial markets in Europe and the expanding role of the EU currency. Thank you for your attention.
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central bank of luxembourg
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the AMCHAM (American Chamber of Commerce) Financial Services Committee¿s Networking, Luxembourg, 15 February 2005.
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Yves Mersch: The evolution of the European model of integration Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the AMCHAM (American Chamber of Commerce) Financial Services Committee’s Networking, Luxembourg, 15 February 2005. * * * The year 2005 in Europe should be marked by the ratification of the European Constitution. This provides an opportunity for trying to assess the quality of European integration over the last 50 years, especially in view of a comment I have recently read in an American newspaper published in Europe, which describes this integration process as shaky and unsure. Before forming an opinion it is important to recall that the views we might have on our surroundings are deeply influenced by the historical dimension, as well as by the various systems of governance in our different countries and continents. We must not forget that for the United States an overriding event in its history was the Civil War (1861 – 1865), which was followed by well over a century of peace on its own territory. That does not mean that the United States was not involved in wars overseas. But that is very different from having war on your own territory. A second essential element of difference concerns personal or family history. The vast majority of people living in the United States stem from the immigration of economically weak classes or people who were persecuted because of their religion or other ideological beliefs. This has led to a strong feeling of distrust vis-à-vis central government and also to a feeling of strong individualism that is expressed in the national laws and the institutional framework, as well as in the prominence of moral values. Europe, on its side, has a quite different pattern of collective and family memories. In order to understand, one has to go back as far as the feudal Middle Ages, when there were many small states in Europe, which tried to gain power or wealth in 2 ways so as to achieve mergers and take-overs with other States: one way was to marry, another was to wage war. The consequence was a permanent state of war on the continent. This led to great poverty and ultimately to revolutions, out of which came a new concept, that of the Nation State, which is also familiar to the US, as Madame Secretary of State so eloquently recalled at IEP in Paris a week ago. This Nation State also meant in many cases the end of feudalism and the transfer of sovereignty through marriage. The policy of acquiring lands through marriage was so successful in the case of the Habsburgs that the saying was: “Tu felix Austria, nube", or “Thou happy Austria, marry"? But it did not mean the end of war. Even though many small states coalesced to form larger Nations in the 19th century (for example Germany and Italy), that did not mean the end of war, but the start of more or less “holy alliances? that were continuously shifting. Thus larger Nations tried to grow even bigger by grabbing up smaller nation states, and we had at least one war per generation on this continent. After World War II we tried another way. As a consequence, larger states were to give up their sovereignty in two key areas, which used to be important for the war industry, coal and steel. They thus vowed to renounce war and yielded a disproportionately large share of decision-making in common affairs to smaller countries. Above and beyond that a referee was appointed, a European centralized executive, even though its power was to be limited. As a consequence we now have inside the European Union a totally new situation in which for the first time in centuries, in Europe, one generation has been able to accumulate wealth and transfer it to the next generation, so creating a very strong sentiment of support in most countries of the continent and a quest for yet more progress in this sense which is still present in the agenda that Europe is pursuing right now. Of course the question could be asked whether this equilibrium of power can still be maintained in an enlarged Union, since the Union at the outset was not designed for such a large number of countries, and especially since many of the new countries belong to the category of small Member States. Further, they have only recently recovered their sovereignty and might be rather reluctant to yield it again so soon to a super-power. Don’t forget that the latest new member countries represent less in economic terms than previous enlargements from 6 to 9 or 9 to 12. All the new countries have also been very closely associated with the history of “core Europe". This question will of course be even more valid for future enlargements. But the divergences in Europe are not only due to the different histories of the countries of the continent, but also because different paths for development were taken by different nations, which brought about different policy approaches. In this respect the role of ideology is prominent. In most countries history shaped the understanding that each people has of the role and rights of the individual versus the role and rights of the collectivity. Do not forget that the 2 most forceful concepts of ideology have their cradle on the European continent; nationalism and socialism, which have galvanized many million people, while creating problems for the whole continent. Though these 2 concepts are still embraced by many people in Europe; many others reject both of them. Others adhere to nationalism and reject socialism; yet others are internationalists and socialists at the same time. In the heads of people it is still very heterogeneous. This of course has an influence on how people organize themselves, how the institutional framework is shaped. We have had some very centralized states, like France for example, and to some extent even the UK. And after World War II the Americans imposed an extremely decentralized constitution on Germany, whose efficiency is now put into question. Italy is also a country that, moving from a federal state, came closer and closer to a centralized state, while now moving again in the direction of decentralization. How does this affect European integration? I take monetary policy as an example. In the UK the central bank acts through a certain small number of money centers which are large systemic banks, which act as primary dealers, while in the case of Germany the central bank has contacts with every single small bank and every single small bank feels also entitled to be part of this national framework. When we defined European monetary policy, we had to bridge these differences and invent compromises between the two. As a result we have centralized decision-making, but decentralized preparatory work and also decentralized implementation of decisions. The different views of the role of the individual and the collectivity are also reflected in our legal systems, which are very different. Again I would like to take my examples from the area of finance. Financial assets and their utilization in a sophisticated financial and monetary system depend very largely on the attitude a country has vis-à-vis bankruptcies. This attitude is very different from one country to another. The protection you give either to the debtor or the creditor can hugely influence the amount and the availability of collateral that is so much needed in order to leverage an economy. Another example is accounting. You have the French system, which is ruled like the legal system by concepts and where a credit is a credit whether it is given to a bank or to an individual, and the same goes for a debt. In the UK you have a functional approach. You have very different systems for consumer credit or for corporate credit, and different levels of protection. It also depends on what you consider as more important, and this came to the fore once more again with the debate on the IAS 39 Fair Value rule. The International Accounting Standards Board (the members of which are dominated by people originating from the UK and from the US) considered in their logic that the information given to the investor about the financial value of an asset is paramount. In the rest of Europe we consider that there are other values to be respected. For example, we consider that companies are not only financial assets; companies are also corporate citizens that give jobs to people and pay taxes to buy public goods. We consider that the fair value could be extremely destabilizing for the financial system, because it would favor erratic results and procyclical behaviour by banks. I will limit myself to some examples, which are interesting in the context of the pension system. In Germany the social laws were part of the nation-building effort aimed at fostering cohesion. In a fast growing nation a pay-as-you-go pension system creates inter-generational solidarity, while in other countries the responsibility of the individual to behave irresponsibly is his own decision, and it is accepted therefore that his fate ought to depend on his own decisions to save and invest or not. In consequence, in these countries poverty is not considered a collective responsibility but a moral one. In other countries where poverty led to civil war, regime change and a loss of influence of religion, Governments had to step in. Progressive income tax was also part of social cohesion, for example in Germany, invented under Bismarck. In France more than half of all households do not pay direct taxes, and most of the income from the budget has traditionally come from indirect taxation. France has also always had a tradition of taxing wealth, or the stock rather than the flow. Is what is appropriate after most of the stock has vanished, more appropriate today? All these decisions are influenced by history, and you imagine the difficult debates you have among nation states to harmonize any of these areas at European level. But it is not only history. It is also the diversity of economic thinking. And as I mentioned before, in the seventies in many French universities, economics meant a centrally planned economy. I remember when I first went to working groups in Brussels, the discussion was on fine-tuning the economy. Not surprisingly, when the first oil shock created havoc on a global level, some EU countries resorted to financing deficits thinking this situation was temporary, while other countries resorted to a structural adjustment. The consequence of this was the implosion of the first attempt to create a monetary union in Europe. The Werner Plan (1970) failed largely, among other reasons, because of this difference in economic thinking. And in 1982, the beginning of the Mitterrand years, there was even a plan by a nationalist and socialist element within the French Government to resort to competitive devaluation, to control capital and goods at borders, and to resort to protectionism vis-à-vis other European countries, the end of the Union. Fortunately Mitterrand sided with Delors, and the Union continued, but the Germans were deeply distrustful of the ability of France to abide by a social market economy. And it was not until several years later, in 1989, that the first study to embark on an Economic and Monetary Union was completed, because since the middle of the eighties, a true "pensée unique" in economic terms, a true belief in the same economic values, namely a social market economy had developed, that allowed the establishment of a single currency. In order to proceed you need agreement on the underlying objectives. Do we see a market economy as an instrument to achieve the individual’s quest to maximize his happiness expressed by his financial balance? Or is, alternatively, the market economy a way to improve collective happiness measured by the Gini factor (wealth distribution), peace, culture and quality and quantity of common goods available to the largest number? The answer will hugely influence your tax system, your social security system, your accounting system and so on. In the US the democratic debate is not about socialism or a market economy, not even a social market economy, at most about the size of deficits or jobs. What decides elections is abortion, gay marriages, God. Do you recognize there the roots of US history? In Europe however, religion and its issues are a non-event as electoral movers. What is moving Europeans is war, and what is moving Europeans, is welfare. That is the agenda of Europe. If you use this grid of an explanation, it explains many of the gridlocks that are depicted with great pleasure in some newspapers. But it also explains some of the difficult moments of the transatlantic dialogue. However, I am not pessimistic. By being aware of our diversities and sensibilities, we still can squeeze a lot more of shared positions out of our relative societal frameworks, both inside the EU and between the EU and the United States. This is what we should concentrate on.
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Introduction by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, to the speech by Vaclav Klaus, President of the Czech Republic, at the Bridge Forum Dialogue conference, Luxembourg, 8 March 2006.
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Yves Mersch: Bridge Forum Dialogue Introduction by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, to the speech by Vaclav Klaus, President of the Czech Republic, at the Bridge Forum Dialogue conference, Luxembourg, 8 March 2006. * * * Mr. President, Your Excellencies, Ladies and gentlemen, Dear Friends, In the Bridge Forum Dialogue, we are most honoured to have with us, this evening, as guest speaker the Head of State of the Czech Republic. We, in Luxembourg, have a special place in our hearts for the Czech Republic dating back to the period when the House of Luxembourg and Bohemia were united between 1310 and 1437. Vaclav Klaus is such an eminent figure that it is almost unnecessary to introduce him. So, just a minimum of facts to refresh our memories. His academic field is economics which he studied in Prague, and later, taking advantage of a period of relative liberalization, under Communist rule, in Italy and the United States. Later, he taught economics at the Charles University and the Prague University of Economics. In his political career Mr. Klaus has been, successively, Finance Minister of the former Czechoslovakia and then Prime Minister, Chairman of the Parliament and, since February 2003, President of the Czech Republic. He played a leading role in the "Velvet separation" of the Czech and Slovak Republics. President Klaus has written more than 20 books on political, economic and social themes and has received many prizes and honorary doctorates all over the world. Mr. Klaus has chosen as the title of his speech "Some doubts about the EU’s ever-closer future". He is known to be an excellent, even charismatic, speaker and he is fearless in expounding his own personal vision of Europe. I have studied a number of recent speeches in which Mr. Klaus has set out his vision of Europe. The points I shall make are not aimed at contradicting our distinguished speaker but merely at stimulating the debate. As a small country, Luxembourg is staunchly expressing its confidence in further European integration and is deeply attached to the welfare state. As such but also as a seat of the European institutions, we are following the debate about "our Europe" with great interest and the polls show that people in this spot of Europe are better informed about and more aware of European matters than elsewhere. President Klaus has strong views on Europe and begs to differ from mainstream thinking, but on the European constitution he believes that "a new constitutional document will have to be created". Reading through his most recent publications, it seems to me that President Klaus’s views are anchored in a two-pillar philosophy (like the ECB policy strategy) • the first pillar is the traditional divide between the individual and the collectivity, or the private sphere and the public sphere, and • the second pillar is the appropriate level at which to deliver public goods, the European level or the national one. On the first pillar he describes himself "as a conservative economist and politician… reading Mises, Hayek or Friedman and … being their follower and true believer". As such his views have been compared with those of former Prime Minister Margaret Thatcher who also opposed conservative liberalism to mainstream conservative ideas embedded in the idea of a social market economy. President Klaus considers that this latter thinking leads to "a European paternalistic, overregulated welfare state" and that "extensive regulation of economic activities has structural similarities with the communist past". He writes that “slow economic growth, high unemployment, loss of competitiveness, the aging of the European population, the crises of pension systems or of health-care systems, the insufficient quality of education, the problem of immigration and multiculturalism all have their roots in this freedomconstraining welfare system. These views are more often reflected among economic observers. Martin Wolf recently wrote in the Financial Times: “There is something rotten in the welfare state of Europe. The time has come for Europeans to ask themselves the unthinkable: can their vaunted social model endure"? Wolf speaks of "the hypertrophy of the state" which is "maternal, protective, but also infantilising: its high taxes and benefits discourage anybody from doing too well, while ensuring that nobody does badly. Its services are available to all, but are also mediocre and inflexible." We are in the trap, Hayek denounced: the view that society can be rationally planned and directed. Our question, as pragmatists, is: Can the system be mended? Is the Lisbon agenda not an appropriate response? Is there no middle ground between the invisible hand that creates very visible wounds and a stifling overregulation unable to deliver growth and jobs? What about the Nordic model combining welfare state and growth? What does history teach us? Is communism not rooted in the excesses of unrestricted economic freedom? How do we best prevent economic, social and even political difficulties in this respect? But the same question is valid for the second pillar of President Klaus’s thinking: what is the appropriate level of public intervention: the nation state or the European level? President Klaus believes in culturally or ethnically homogenous societies as opposed to multiculturalism. Therefore a Parliament can only be legitimate at the level of a nation, which does not exist in Europe. As a consequence supranational institutions are not democratic. “The European preoccupation with Europe is connected with the fact that Europeans were made to believe that the era of nation states is over and that, because of omnipresent externalities and because of artificially built belief in the importance and inevitability of continental-wide public goods, Europe must be unified and therefore organized, constructed, controlled and regulated from above, said Mr. Klaus in a recent visit to India. Giving more power to the European Parliament is an illusion. “Softening the rules and relying on the offer of variable geometry would be a mistake. Such procedures already exist (Euro, Schengen, defense, many temporary exceptions) and have always been something of a ratchet. While the idea of European federalism certainly has followers in every European nation, at the level of decision-makers, the prevalence of nation states seems to be unquestioned in the present perspective. The long-term objectives are more open, and one has to admit that European integration is seen as a dynamic difficult to stop. In a speech "Small countries and Europe – 90 years after Masaryk", you quote Tomas Garregue Masaryk who stressed that "history is a process of integration, but at the same time of disintegration". In a globalised world are there really no common goods that are better delivered at a supranational level? Have education, security, health research, for example, not a European dimension? How can nation states react or accompany economic agents in activities which are less and less linked to the nation state? Is the real debate not better encapsulated in a clearer consensus on subsidiarity? Are the present boundaries in Europe representative of homogenous nation states? What do we do about emerging regionalism? Again, as with the first pillar, what can we learn from the history of our continent which has experienced different models: domination of one nation state over Europe, more or less holy alliances among the biggest, stifling coalitions, anarchy of a myriad of small states etc. The present model, based on fitting together certain areas of policy making, retaining others and giving a proportionally larger say in decision-making to smaller countries is two generations old. Did it serve us well or do we have to roll it back? The chief economist of the London based Centre for European Reform, Katinka Barysch, questions whether in the current political climate, EU member states would be ready to reaffirm their support for the “four freedoms of capital, goods, services and people, which President Klaus strongly endorses. President Klaus, you said your vision is not about closing ourselves in. Is protectionism not the most imminent danger? Barysch argues that "the nature of the single market and competition has changed since enlargement", pointing out that the much wider gulf between highwage and low-wage countries has fuelled fears among workers in old Europe. President Klaus, few have been able to stimulate our thinking about our socio-economic and political environment in a way you do. You abhor intellectual cosiness. We are eager to listen to you. We have a fascinating evening before us, especially since President Klaus has kindly agreed to reply to questions at the end of his speech. Mr. Klaus, you have the floor.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, on the occasion of the Annual Meetings of the ACIIA (Association of Certified International Investment Analysts) and the EFFAS (the European Federation of Financial Analysts Societies), Luxembourg, 28 June 2006.
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Yves Mersch: Monetary policy-making in the euro area Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, on the occasion of the Annual Meetings of the ACIIA (Association of Certified International Investment Analysts) and the EFFAS (the European Federation of Financial Analysts Societies), Luxembourg, 28 June 2006. * * * Ladies and Gentlemen, It is a pleasure for me to be here again today and to address such a distinguished audience of highly qualified professionals and specialists from the financial sector. Your work in developing financial skills and promoting professionalism and knowledge is commendable. It is also important for this financial centre. The topic I have been asked to cover today is extremely broad. I will start by briefly outlining the institutional framework, strategy and objective of the Eurosystem. Subsequently, I will address what seems to be a permanent feature of central banking, and perhaps also of human destiny, namely the need to take decisions in an uncertain environment and based on imperfect knowledge. 1. Essential features of the Eurosystem’s monetary policy • Central Bank independence Crucial to this novel framework are the concepts of central bank independence and the assignment of a clear mandate to the ECB and the Eurosystem. The movement towards central bank independence is not limited to the euro area. Based on the experience gained during the inflation-prone period ranging from approximately the mid-1960s to the mid1980s, a broad consensus emerged that price stability is the responsibility of the central bank, at least over the medium term, and that fighting inflation is best ensured by an independent central bank. • The Eurosystem’s mandate The Treaty is equally unequivocal when it comes to the ESCB’s primary objective, which, according to article 105, “…is to maintain price stability”. It is only “Without prejudice to the objective of price stability,” that “…the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2.” Summarising, one can therefore state that the independence of the ECB and the NCBs of the Eurosystem is particularly strong, as it is enshrined in an EU Treaty and therefore far more complex to modify than a national act of legislation. Similarly, the primary objective of the Eurosystem is clearly defined. By contrast, certain other central banks have to meet several objectives, including e.g. employment. • The Eurosystem’s definition of price stability The Treaty did not define the concept of price stability and in October 1998, the Governing Council of the ECB announced the following definition: “Price stability shall be defined as a year-on-year increase in the HICP for the euro area of below 2%. Price stability is to be maintained over the medium term.” Every word in this definition is important and I would like to highlight the following points: - The ECB is one of the few central banks to have quantified its inflation objective. This contributes to anchoring expectations and makes it easier for the public at large and for financial markets to judge how the Eurosystem is delivering on its mandate. - By setting the upper bound for inflation above zero, the ECB takes into account the possibility of measured inflation overstating true inflation as a result of small but positive measurement errors. Such errors may, e.g., arise if prices are not adequately adjusted for changes in quality. Moreover, a zero inflation rate for the Eurosystem as a whole would necessarily entail that if some euro area Member States experienced positive inflation rates, this would have to be compensated by deflation in other euro area Member States. - Headline inflation, rather than some core inflation concept is taken into consideration. Oil prices are high largely due to demand effects from countries which at the same moment provide the euro area with low import prices and pressure on wages. Eliminating therefore oil from the price index would risk creating a downward pressure to the true inflationary pressures. - Headline inflation is measured by means of an index of consumer prices whose statistical methodology has been harmonised for all EU Member States. This Harmonised Index of Consumer Prices, or HICP, is compiled by Eurostat. - This definition makes clear that in implementing its monetary policy, the Governing Council does not look at individual countries, but at the euro area as a whole. - Finally, in order to avoid a hectic and possibly pro-cyclical monetary policy, the ECB explicitly states that price stability has to be maintained over the medium term. This reflects the fact that monetary policy affects price developments with significant and variable time lags and that an economy is continuously subject to large unforeseeable shocks. In May 2003, after more than four years of conducting monetary policy, the ECB undertook a thorough evaluation of its monetary policy strategy and, while confirming its initial price definition, it clarified its position by stating that “…it will aim to maintain inflation rates close to 2% over the medium term “. The goal is thus to keep inflation rates below, but close to 2%, emphasising that the ECB wishes to provide a sufficient safety margin against the risks of deflation. • The Eurosystem’s two-pillar strategy The Eurosystem analyses the risks to price stability from two analytical perspectives, economic analysis and monetary analysis, which together constitute its two-pillar strategy. The main purpose of this two-pillar strategy is to analyse all relevant information and to cross-check it from two different analytical points of view. The economic analysis focuses on real activity and the interplay of supply and demand in the goods, services and factor markets in order to assess the short to medium-term determinants of price developments. The monetary analysis focuses on a longer-term horizon, analysing the long-run link between money and prices. With these two analyses, the ECB covers the entire chronological spectrum. The monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications from the economic analysis. • Communication, transparency and accountability The move towards central bank independence has been accompanied by great progress in the areas of accountability and independence. The concept of accountability refers to the legal and political obligation of an independent central bank to justify and explain its decisions to its constituents, finance Ministers, analysts and academics as well as to the citizens and their elected representatives. Transparency is more of an economic concept and can be defined as an environment in which the central bank provides in an open, clear and timely manner all relevant information on its mandate, strategy, assessments and policy decisions as well as its procedures both to the general public and to markets. We have seen earlier that the Treaty gave a clear mandate to the ECB: to ensure price stability. Moreover, the Governing Council of the ECB quantified this primary objective and stated that it will aim to maintain inflation rates below but close to 2% over the medium term and explained in great detail its two-pillar strategy. Overall the ECB uses a combination of rules and judgment and its approach is one of constrained discretion. 2. Imperfect knowledge and the conduct of monetary policy Since the introduction of the euro, inflation rates averaged slightly more than 2% in the euro area and this in a complex environment, characterised by a series of external and temporary shocks such as the bursting of the dotcom bubble, terrorist attacks, geopolitical tensions and a continuous increase in the prices of commodities, notably oil. However, since the introduction of the euro, inflation expectations – notably average long term expectations as measured for example by Consensus Economic Forecast or the Survey of Professional Forecasters- are firmly anchored at a level consistent with the Eurosystem’s quantified inflation objective of below but close to 2%. Break-even inflation rates, defined as the yield differential between conventional nominal bonds and inflation-linked bonds, are slightly above 2% but this may reflect risk premia for the latter type of bonds due to liquidity constraints or technical factors. This anchoring of expectations at these levels is of vital importance, as it confirms the credibility of the Eurosystem and its forward-looking, medium term orientation and as expectations play an important role in shaping economic dynamics. Taking decisions based under conditions of uncertainty is an unavoidable element, and perhaps even a characteristic ingredient, of central banking. This uncertainty stems from two elements. - First, economic knowledge is imperfect. There is no model, however sophisticated, which can faithfully replicate the exact functioning of the economy. More particularly, uncertainty clouds our knowledge of the transmission mechanism from interest rates to prices. This transmission is characterised by long, variable and uncertain lags. Our imperfect knowledge of the economy and the monetary transmission mechanism is further compounded by the delays with which economic and financial data become available, and sometimes also by the quality of these data, and this despite all efforts and progress made in the area of statistics. - Second, the future is uncertain. Economic developments are continuously influenced by a large variety of demand and supply shocks. Fiscal policies may turn out different than expected. Exchange rates may move by more than warranted by underlying fundamentals. Commodity prices not only depend on supply and demand but also on geopolitical tensions. It is therefore a permanent challenge for the central bank to extract relevant information from diffuse data and events and to determine the appropriate path of monetary policy. Since the introduction of the euro, the Eurosystem systematically analysed and cross-checked economic and monetary information under its two-pillar strategy, in the context of its forward-looking, medium-term framework. • In 2001 the economic outlook deteriorated rapidly and medium-term inflation expectations were in line with the Eurosystem’s objective. The rapid expansion of M3 during the 2001-03 period was not considered a threat to price stability, as it reflected a portfolio shift to less risky assets during a period of uncertainty. Consequently, it was possible to lower interest rates during this period. • By contrast, in December 2005, after a lengthy period of unchanged interest rates, the Governing Council of the ECB decided to raise the rate on the main refinancing operation. The re-acceleration of real GDP growth in the first months of 2006 materialised, confirming the Eurosystem’s views that economic growth is broadening and becoming more sustained. The June 2006 Eurosystem staff projections foresee growth in the 1.8-2.4% range in 2006 and between 1.3 and 2.3% in 2007. Risks to price stability are signalled by the 2 pillars of the monetary policy strategy. The first pillar, which indicates short-term to medium-term risks to price stability, shows inflation above 2% for that period. The monetary pillar, which signals medium-term to long-term risks to price stability, also indicates heightened risks to price stability as reported in the latest Monthly Bulletin. This is the case even if one would filter out a certain amount of noise in the statistics such as e.g. portfolio shifts. In this vein one could also discuss whether there is a structural break in trend velocity developments in the euro zone or whether the statistics are influenced by institutional product or regulatory developments. However, even if these elements are discarded, we would still find a large monetary overhang in the euro zone with heightened risks for unloading into transactions balances and therefore into inflationary pressures. As President Trichet 1 remarked during a lecture at the Banco de España in early June, other central banks, such as the US Federal Reserve system, changed interest rates more frequently and by larger amounts during the 1999-2006 period than the ECB. This is very clear on this slide, which shows the MRO rates in blue and the target Federal funds rate in red. While phases of interest rate hikes and decreases broadly coincide on both sides of the Atlantic, the Eurosystem modified interest rates 18 times from 1999 until today, while Federal Reserve changes were about twice as frequent (35). MRO and Federal Funds Target- January 1999 - June 2006 7,00% 6,00% 5,00% 4,00% 3,00% 2,00% 1,00% 0,00% 99 199 199 199 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 /200 /200 /200 /200 /200 /200 /200 /200 /200 /200 / / / / / / / / / / / / / / / / / / /1 / 01 /04 /07 /10 /01 /04 /07 /10 /01 /04 5/07 5/10 5/01 5/04 5/07 5/10 5/01 5/04 5/07 5/10 5/01 5/04 5/07 5/10 5/01 5/04 5/07 5/10 5/01 5/04 / 05 05 05 05 05 05 05 05 05 05 0 Does this mean that the Eurosystem is passive, or at least relatively more passive than other central banks? In the opinion of the Eurosystem, activism cannot be quantified by the frequency or size of changes in interest rates. Activism refers to a strategy, not to policy implementation or changes in a policy instrument. A central bank should be as active as it needs to be in order to fulfil its mandate. What matters, is that the Eurosystem is permanently pursuing its primary objective and that it is constantly on alert to risks to price stability. Moreover, how often and by how much a central bank should adjust interest rates in order to maintain price stability depends also on the structure of an economy and the type and frequency of shocks it is subject to. Several remarks can be made here. - The euro area, compared with the USA, is more rigid and a central bank operating in a relatively rigid economy is able to deliver the same degree of monetary accommodation by adjusting its interest rate in more moderate steps than in a more flexible economy. - The type of shocks affects the optimal reaction by the central bank. In case of a demand shock, forecasted inflation and output move in the same direction, leading the central bank to adjust rates more often and to a greater extent. By contrast, supply shocks cause more substantial transitory increases in inflation, possibly followed by second round effects. It is advisable for the central bank to adjust its policy instrument only to the extent needed to neutralise the anticipated more permanent effects of the shock on inflation over the following months or quarters. As, relative to the USA, the euro area seems to be exposed to demand shocks of smaller magnitude but to be hit more frequently by supply shocks 2 , less frequent and less forceful changes in the policy instrument seemed appropriate. J-C. Trichet, “Lecture on activism and alertness in monetary policy”, at the conference on Central Banks in the 21 Century, organised by the Banco de España, Madrid, 8 June 2006. F. Smets and R. Wouters, “Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach”, Journal of Applied Econometrics, 20(1), January 2005. st - In addition, important structural elements of an economy, that influence the relation between inflation and the shocks to which an economy is subject are price flexibility and the anchoring of price setting. In the euro area prices are less flexible than in the US 3 . Retailers reprice their products every 13 months, compared to 6.7 months in the US. Stickier prices imply that adjustments to external shocks operate more through changes in output, income and employment than would be the case in a situation where prices are more flexible. They also imply an increased persistence of inflation. Nevertheless, despite these rigidities, inflationary shocks dissipate quickly in the euro area. An ECB study 4 shows that this paradox is explained by the fact that the impact of the ECB’s inflation objective on the evolution of inflation outweighs the influence of past shocks and thus at least partly compensates for the added inertia resulting from a more rigid economic structure. In other words, when the economy adopts the central bank’s objective, the inflation process becomes less persistent and more forward-looking. All economic agents anticipate that the central bank will eventually bring inflation back to its pre-shock level and treat past inflationary shocks as transitory and inconsequential for the future. In an economy like the one of the euro area, where expectations are well-anchored, monetary policy can be more patient and focused on the medium-term when confronting a cost-push shock. The reverse side of the coin is that deviations of expectations from the inflation objective could prove more costly to correct at a later stage and therefore require a stronger policy response in terms of timing and or size. Expectations that inflation will not diverge from its anchor afford some short-term flexibility to respond to economic disturbances. Establishing and maintaining its credibility is therefore of paramount importance for the central bank and requires commitment to a systematic strategy. The fact that the Eurosystem is particularly transparent by having a clearly defined primary objective, a quantified inflation target, a well-documented two-pillar strategy and has implemented its monetary policy in a consistent manner since 1999 explains this success in anchoring inflationary expectations, even in turbulent times. Success in anchoring inflation expectations and facilitating the task of the public and the financial markets in predicting future monetary policy decisions is not, however, tantamount to pre-committing the Eurosystem to a certain policy path. Vigilance for the Eurosystem requires keeping all options open, including a quick change in policy if warranted by new information. There is no pattern of historical monetary policy decisions that could simply be repeated or mechanically extrapolated into the future. The ECB will continue to check carefully all available information concerning risks to price stability under both the economic and the monetary analysis of its two-pillar strategy in order to avoid acting belatedly and to anchor inflation expectations. Ladies and Gentlemen, I thank you for your attention and stand ready to reply to your questions. E. Dhyne, L. Alvarez, H. Le Bihan, G. Veronese, D. Dias, J. Hoffmann, N. Jonker, P. Lünnemann, F. Rumler and J. Vilmunen, “Price-setting in the euro area: some stylised facts from individual consumer price data”, ECB Working paper No 524, 2005, see also M. Bils and P. Klenow in “Some evidence on the importance of sticky prices”; Journal of Political Economy 112, 2005. L. Christiano, R. Motto and M. Rostagno, “Financial factors in business cycles”, presented at the IMF-IRF Conference on DSGE Modelling at Policymaking Institutions: Progress and Prospects hosted by the Federal Reserve Board of Governors (Washington, 2-3 December 2005).
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the NOBELUX Seminar, Luxembourg, 11 September 2006.
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Yves Mersch: Monetary policy and time inconsistency in an uncertain environment Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the NOBELUX Seminar, Luxembourg, 11 September 2006. * Time inconsistency and policy 1.1 About time inconsistency * * On October 11, 2004 Fynn Kydland and Edward Prescott were rewarded the "Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel". One of the reasons for granting them the so-called "Nobel-prize in economics", was that they enriched the economics profession with an insight that was to change the thinking about economic policy. At first, their research was meant to merely shed some light on the execution of control theory in dynamic systems. All of a sudden, however, they ran into a problem, which although seemingly harmless, was to direct their work into a completely unexpected direction. They discovered the power of expectations in a policy planning framework. In the late 1960s, the role of expectations was investigated thoroughly and they were found to be important variables, which may determine economic outcomes. Academics like Milton Friedman and Edmund Phelps strongly contributed to this line of research in the framework of monetary policy. Later Robert Lucas introduced the concept of "rational" expectations. According to this concept, individuals form their expectations rationally, using all information available to them. The information includes the functioning of the economy, the objectives of the government and all other relevant variables. This concept implies that a government (or the monetary authority) cannot systematically betray market participants by pretending to follow a certain policy and subsequently acting differently. Using this argument, Kydland and Prescott included government behaviour in their model and assumed that individuals form rational expectations. They showed that even if the government and its citizens pursue the same objectives, i.e. maximising the welfare of the population, discretionary policy is subject to a fundamental time consistency problem. The fundamental problem is that a government policy that is optimal at a certain point in time may not be optimal later on. Since individuals form rational expectations, they realize that the government has this incentive to deviate from its previously announced policy, and behave accordingly. The point is that the population’s expectations put an extra constraint on government policy and so if the government has an incentive to deviate, consistent policy will not be optimal and an optimal policy will not be time consistent. If, for example, the government chooses the policy optimal at a certain point in time, it does not take into account the expectations previously formed by the private sector. Since the private sector did take some economic decisions based upon these expectations, the government policy is not time consistent. On the contrary, if the government were to follow a time consistent policy, this would not be optimal. To illustrate this theory, Kydland and Prescott used some very accessible examples such as the following. Imagine a flood plain in which the government does not want its citizens to build their houses because it would have to construct dams in order to protect the houses. If there were houses in this plain, however, it would be optimal for the government to construct dams to protect its citizens. Consequently, if rational agents are certain that the government is not going to build dams to protect the plain, they will not build houses, which would be the best outcome for the economy as a whole. On the other hand, since the citizens know that, once the houses are there, the optimal choice for the government is to construct the dams and hence rational citizens will build houses in the flood plain. Now, what is the solution to this time inconsistency problem? The only solution can be summarized in one single word: commitment. Commitment in this case means that the government abandons control over certain policy options in order to credibly communicate to its subjects that policy is not going to be changed in the future. In the above example, if the government could enact a law that prohibits it from constructing dams in the flood plain, implying that the decision on dams would no longer be in its hands, citizens would not expect the government to change its mind and consequently they would not build their houses in the flood plain. Whenever a time consistency problem arises, policy rules of some kind are clearly superior to discretionary policy. Policy rules can be understood as any mechanism that helps the government to credibly commit to a certain policy and which prevents it from changing its mind later on. In the domain of monetary economics, the issue of policy rules was picked up in the late 1980s. Most important was the work of Bennet McCallum but also of John Taylor who introduced the famous "Taylor rule". Bounded discretion versus explicit policy rules The idea behind rules is to give up the discretionary influence that policy makers have upon monetary policy. This is to make credible that monetary policy only depends upon the predetermined factors that are included in the rule. Since economic agents can cross check the results, credibility can easily be achieved. Another advantage of rules is the ease with which the public can determine its expectations. Under a regime led by rules, at least some if not all elements that guide monetary policy are observable and thus agents can derive future monetary policy by means of the rule. But policy rules do have important drawbacks, which in the end are the reason why they are never used in practice as a guide for the conduct of monetary policy. John Taylor himself notes it in his famous 1993 article that "[…] operating the rule requires judgement and cannot be done by the computer". What he means is that policy rules have the disadvantage of being inflexible. Since a rule must include some variables at the expense of others, it is obviously ill-prepared to unforeseen shocks that affect the economy. For example some demand shocks might require a quick response by the monetary authority in order to guarantee price stability. A solution to this problem consists in using a broader definition of a policy rule. Taylor gives the example of patent laws. If an inventor obtains a patent, he has the right to exploit a certain principle for a couple of years. The details of the invention are not subject to the patent. In a similar way, a policy rule can be understood as a set of objectives and targets subject to which the monetary authority takes its decisions. In this sense, bounded discretion is a systematic collection of discretionary policy actions which, while leaving the flexibility to react to unforeseen events, offers the credibility and purposefulness of a rule. 1.2 Time inconsistency and policy There are hardly any scientific publications in economics that had as important an impact on day-today policy-making as the contribution of Kydland and Prescott. Soon after identifying the inherent time inconsistency problem of optimal policy plans with rational expectations, similar problems were discovered in many areas of economic policy. The most important and influential ones were the time inconsistency problems concerning capital taxation in fiscal policy and the output inflation trade-off in monetary policy. Although both problems reside in different domains of public policy the core of both remains the same. In addition to dealing with these, I will also review a peculiar kind of time inconsistency related to fiscal sustainability. 1.2.1 Fiscal policy One important finding in the domain of public finance is the Ramsey principle of optimal factor income taxation. Developed in 1927 by the economist Frank Ramsey, it asserts that the input factor with the lowest elasticity of substitution should be taxed most. In order to keep the distortionary effects of taxation as moderate as possible, those factors that react least to taxation should be taxed most. Since the savings of today are the capital stock of tomorrow, a problem of time inconsistency arises in capital taxation. In order to promote savings and assure the capital stock of tomorrow, the government has to be wary of the elasticity of substitution of capital. That is to say, the government must account for the relatively high mobility of capital. This implies setting a low tax rate on capital income. Ex-post however, once capital is installed, its mobility drops to zero. Applying the same Ramsey principle then, implies taxing capital at 100 %. Of course rational individuals would anticipate this outcome, and not save in the first place. Again the government needs a commitment mechanism that helps it to credibly communicate that it won’t change its mind. In this case, reputation serves in part as such a mechanism. Besides the Ramsey principle, time inconsistency could feed through to another avenue in public finance. At a given point in time, governments could be tempted to depart from the optimal strategy, i.e. fiscal soundness. They could, for instance, increase public expenditure in order to accommodate the demands of the median voter or specific constituencies. This move would of course result in higher deficits and therefore future taxes. However, governments are in a position to conceal this uncomfortable message over the short or even the medium term, at least if the "rational expectations" assumption is relaxed. First, it could make overly optimistic macroeconomic projections in order to hide the challenge to fiscal sustainability. Second, it could throw a veil of mist on this problem by capitalising on the uncertainty inherent in the definition and measurement of sustainability, especially over a long-term horizon. In many cases, the "true state of the world" will be disclosed well after the government responsible for higher expenditure has departed. This form of time inconsistency is quite peculiar and distinct from the concept I referred to so far. In the latter, as already said, the government might "betray" the citizens by pretending to follow a certain policy and by acting differently ex post. In the current, "peculiar" form of the concept, the government would confuse the citizens ex ante by pretending to follow a rigorous fiscal policy. The "true state of the world" would manifest itself through higher deficits or other breaches of sustainability, probably when it would be too late to address this challenge in an efficient way. The government does not renege on its promises in an active way, through the implementation of new, explicit measures, but it distorts ex ante the "true state of the world". Two commitment mechanisms could mitigate this peculiar kind of time inconsistency. First, independent budgetary institutions could be set up. They would endeavour to lift the veil of uncertainty, for instance by conducting independent macroeconomic projections. These projections could be the cornerstone of the elaboration of general government budgets (central government, social security, State and local governments). Independent institutions could also be in charge of measuring and monitoring fiscal sustainability based on long-term projections. Such institutions are already in place in many countries, in particular in small, open economies. Let me mention as examples Belgium (High Council of Finance), The Netherlands (the Central Planning Bureau provides independent macroeconomic and budgetary forecasts), Denmark (Economic Council) and Austria (Government Debt Committee). In Luxembourg, to a certain extent, the BCL assumes the role of an independent fiscal institution. Accordingly the BCL staff continuously analyses the situation and structure of the Luxembourg economy. This enables the BCL to comment on the fiscal sustainability and time consistency of policy actions taken by the government. Examples for this are the general government budget deficit, which amounted to 1.9% of GDP in 2005 after significant surpluses from 1993 to 2002 and a balanced situation in 2003. The BCL explicitly warned the government of risks to the fiscal balance well in advance, already in 2002. Furthermore, the demographical and macroeconomic challenge to the pension system, which by now is widely acknowledged, was subject to a BCL working paper in 2003. The health system was also under scrutiny in several issues of the BCL monthly bulletin. In these respects the BCL by adding an independent and critical point of view to the policy of the government enhances consistency in the process of policy-making in Luxembourg. The major problem the BCL faces in these independent monitoring tasks is the absence of sufficiently detailed information on budget outturns, in particular as regards direct taxes and the implementation of the expenditure programmes of the so-called "special" extra-budgetary funds. The setting up of an independent council – for instance along the lines of the Belgian "Conseil Supérieur des Finances" – with a transparent flow of information between the participants could help overcome this problem. Numerical fiscal rules and multi-annual budgetary frameworks are also essential in this respect. Since they constrain ex ante the behaviour of governments, for instance via expenditure limits, the scope for time inconsistent policies is narrowed. Independent budgetary institutions could be in charge of monitoring the implementation of fiscal rules. These institutions could contribute to improving the definition of fiscal rules, which is of paramount importance. For instance, expenditure rules will not effectively influence budgetary outcomes if they overlook the transactions carried out by extrabudgetary institutions or funds. The rules and their definitions would ideally be enshrined in law. The fact that legal acts are more difficult to change is a protection against time inconsistency. According to a recent study of the European Commission, legally binding rules tend to be more efficient than softer rules. 1.2.2 Monetary policy In 1958 London School of Economics professor A. W. Phillips published an article in which he showed an empirical connection between wage inflation and unemployment. His data on British wage inflation and the unemployment rate covered the timeperiod between 1861 and 1957 and showed a negative relation between the rate of change in nominal wages and the number of people without a job. Of course the idea that a trade-off between employment and inflation exists was and still is a very tempting one to politicians. The so-called Phillips curve could then be interpreted as a menu card that allows politicians to choose whether they want to have high inflation or high unemployment. Soon the temptation was followed and many governments tried to fight unemployment by conducting inflationary monetary policy. However, when the attempt was made to exploit the above relationship, it collapsed. The employment-inflation trade-off that seemed stable for a whole century broke down during the late 1960s and early 1970s. All of a sudden, those countries that tried to fight unemployment with inflationary policy ended up with both: high inflation and unemployment. Time inconsistency, could again be made responsible for this puzzling fact. Moreover, the solution to the collapse of the Phillips curve was to become the foundation of modern central banking. The output-inflation trade-off example In the late 1960s and the first half of the 1970s, the reason for the breakdown of the relationship discovered by Phillips was found. It was mainly due to Friedman, Phelps and Lucas that the difficulty with the simplistic "menu-card" view of politics was unveiled. The newly discovered expectations played a main role in their arguments. The most important thing to comprehend, these academics claimed, was that the relationship between unemployment and inflation was stable only when inflation expectations were stable. If this was not the case, then the relationship itself would change in structure, and hence collapse. The Phillips curve would simply shift. The key argument was that inflation expectations of individuals enter the relationship between unemployment and inflation because individuals need a measure of inflation to determine the next periods’ real wage. In the end, real variables like unemployment or output can only be determined by real variables like the real wage. Once individuals have adapted their expectations to the accommodative monetary policy of the monetary authority, further monetary expansion is like pushing on a string. It can only lead to high inflation, leaving unemployment unaltered. The time inconsistency nature of this problem lies in the fact that only unanticipated inflation leads to lower unemployment because it depresses real wages. Again, the socially optimal strategy of the monetary authority changes between periods. Ex-ante it is optimal to follow a restrictive monetary policy aiming at low inflation. Ex-post however, when expectations of the public are formed, and have induced a certain behaviour of the agents, it is optimal for the monetary authority to defect and produce "surprise"-inflation. The monetary authority, however, cannot permanently fool agents with rational expectations, because they are aware of the incentives of the monetary authority to regress on its decision about inflation. So in the end, any attempt of the monetary authority to exploit the Phillipsrelationship is doomed to produce inflation without reducing unemployment. A related example in the Luxembourgish context consists in the nominal wage-indexation rule, which characterizes wage setting behaviour in the Grand Duchy. The wage-indexation rule may in a model of the Phillips curve, prima facie, seem as a device to stabilize inflation expectations, and alleviate the inflationary bias. However some important caveats do apply. Wage-indexation is per definition backward looking so that information concerning expectations is ignored. Moreover, it is prone to supply shocks that strike the economy and may, through second-round effects, heat the wage-price spiral. Recent oil price increases, to name but the most prominent example, have fed into price increases, which in turn have triggered several increases of the index. Through this channel supply shocks have a stronger and more lasting effect than they would without indexation. Several alternatives to resolve this problem have been suggested, mostly by excluding goods with high price volatility from the relevant inflation measure or by tying the index to price developments in neighbouring countries. Further caveats concerning wage-indexation point out that it introduces rigidities into labour markets, which hampers adjustment processes. Lastly by mitigating the cost of inflation for wage earners it may reduce the will to fight inflation. Hereby wage-indexation influences the incentives and hence the credibility of the authorities. The monetary policy of the Eurosystem and the time inconsistency problem 2.1 Central banking and the time inconsistency problem The insight on the time inconsistency problem of monetary policy made it clear that some sort of commitment device was necessary in order to overcome the inflation bias of monetary policy. Research had shown that under discretionary monetary policy certain equilibria were not attainable in the presence of rational agents. In the 1980s several proposals were made on how to resolve this problem. One idea was for the monetary authority to invest in "good reputation" by continuously fighting inflation and by this shape the expectations of the private sector concerning future inflation. In the end it was the economist Kenneth Rogoff who showed that a good solution was to delegate monetary policy to an independent central bank. The incentives set for the central bank had to be such that it would be able to make economic agents believe in its determination to deliver price stability. For instance, one could make the central bank president’s wage depend on the degree of price stability that his policy delivers. New Zealand went even further as according to his employment contract, the Governor can be dismissed if the inflation rate exceeds the target. The Governor of the Bank of England has to explain the underlying reasons and to present appropriate monetary policy measures if inflation deviates more than 1 p. p. from the target set by the Government. So to delegate monetary policy to an independent central bank was supposed to allow for a good balance between credibility and flexibility. On the grounds of these arguments central banks throughout the world were reformed with a special focus on giving them more operational independence. Independent central banks have to keep in touch with markets and guide market participants through sensible monetary policy. The central banks’ obligations are mainly twofold. On the one hand a central bank has to conduct monetary policy such that price stability is maintained. On the other hand, central banks can help to stabilise the economy, when it is shaken by fluctuations. Those obligations are two sides to one medal and what is of utmost importance to fulfil them is credibility. On February 7th 1991 the Treaty on European Union was signed in Maastricht. After having experienced an extended period of very high inflation between the mid 1960s and the mid 1980s, an essential aim of the participating nations was to assure price stability. In order to achieve this, the aim of price stability and the independence of the European System of Central Banks (ESCB) were enshrined in the Treaty. Next, I will present the strategy of the Eurosystem to you, thereby focusing especially on the issue of time consistency. 2.2 The Eurosystem monetary policy As a relatively young organisation, the ESCB with at its heart the ECB was able from start to cherish the fruits of the research I just presented. As a result, many important results were implemented straightaway. The first and foremost example thereof is the crucial role that is given to price stability. To manifest this importance, Article 105 of the Treaty on European Union stipulates that the primary objective of the ESCB "[…] is to maintain price stability". All other objectives are subordinate to this. Obviously, this is to make clear to the public, that the ESCB is committed to price stability only. To emphasise this, the article continues: "[w]ithout prejudice to the goal of price stability, the ESCB shall support the general economic policies in the Community with a view to contribute to the achievement of the objectives of the Community […]". 2.2.1 Commitment devices of the Eurosystem As I just described, it is not only important to clearly state a certain goal in order to influence expectations. The other important and presumably more difficult part is to make that statement credible to the public. In order to make its monetary policy ambitions credible, the Eurosystem needs devices that prove its determination to maintain price stability. A key ingredient, if not the most important, for credibility, is a clear quantitative definition of price stability. Milton Friedman, at the time, trusted neither politicians nor central bankers and thus advocated a constitutional rule that required constant money growth. Constitutions are devices well suited to prove the seriousness of a purpose. Since it is hard to change them, even for politicians, they provide a strong insurance against a government changing its mind. It is certainly with this fact in mind that the price stability target was included in the article 105 of the Treaty on European Union. As a primordial prerequisite for the monetary union and considering the above-mentioned time inconsistency issues, the Treaty is the appropriate place for defining the major objective of the ESCB. In order to further clarify this target, the Governing Council of the ECB defined price stability in October 1998 as: "[…] a year-on-year increase in the HICP for the euro area of below 2 %". In May 2003 the Governing Council further narrowed its target by restraining inflation rates to be "[…] below but close to 2 % over the medium term". A clearly defined and appropriately fixed objective is one part of ensuring credibility. The other part is taking responsibility for the results of monetary policy. This gives the public the opportunity to hold the Eurosystem accountable. The fact that the target is clearly defined makes it easier to evaluate the results of the policy measures taken. Accountability is important since with central bank independence it is difficult to sanction its actions. Transparency is a key prerequisite for accountability. An important part of transparency lies in the definition of the targeted inflation rate. Furthermore, the steps taken to achieve this goal have to be clarified as well. An important instrument in this respect is the two-pillar strategy of the Eurosystem. By analysing the real and the monetary side of the economy and by subsequently cross checking the results of this analysis all decisions can be justified. Moreover, policy decisions, once they have been taken, understood easily by the public, since the underlying data is published regularly. The ECB tries to meet all these communication requirements with its wide range of publications and press conferences. The credibility and the independence of monetary policy is enhanced if fiscal discipline prevails. In spite of the monetary union, fiscal policy remains in the hands of the national states. In order to guarantee the soundness of national budgets and to avoid any disruptions to the mechanisms of monetary transmission induced by fiscal imbalances, the Treaty and the Stability and Growth Pact puts certain constraints upon the ability of Member States to run deficits and make debt. 2.2.2 Inflation and expected inflation in the Euro area Central banks throughout the world have built up their reputation over time. Among the best known are obviously the United States’ Federal Reserve, the Bank of England or previously the Bundesbank. This tradition implies that market participants have some experience on how those central banks conduct their monetary policy, how they react to shocks and how "hawkish" or "dovish" they are on inflation. Reputation helps those central banks enhance their credibility and stabilize markets because it reduces uncertainty. The Eurosystem did not have such a track record when it started its mission in 1999. Market participants first had to collect some experience on the Eurosystem monetary policy conduct. Since the introduction of the Euro in 1999, the average HICP inflation rate according to Eurostat was 1,97 percent, since 2000 the average lies around 2,1 percent. This is very close to the price stability set. As I laid out to you, stabilising prices implies stabilising expectations on prices, since inflation expectations are as important to economic processes as actual inflation is. In order to gauge the public’s assessment on how committed the Eurosystem is to fight inflation, I will report the results of the Survey of Professional Forecasters to you. This survey has been carried out by the ECB since early 1999, and consists of a questionnaire on expectations sent to experts affiliated with financial or non-financial institutions based within the EU. The expectations are reported for several time-periods. For example, one year ahead inflation expectations started off at a level of 1,2 percent in the first quarter 1999. They reached a temporary maximum in the second quarter 2002 at a value of 1,9 and during the whole period from 1999 until the beginning of 2006 they never crossed the 2 percent barrier. Only recently, in the second quarter of 2006, did one year ahead inflation forecasts rise to 2,1 percent reflecting the oil price and fiscal shocks (i.e. the German VAT increase) the Euro area is undergoing. Concerning longer-term expectations, the forecasts are similar. Expectations on two year ahead HICP inflation rates vary mainly between 1,5 and 1,9 percentage points. These results can be interpreted as a proof of confidence of the "expert" public in the ability of the Eurosystem to achieve its target. Important and complementary indicators for the credibility the Eurosystem are longer term inflation expectations. These are more stable and less affected by different shocks than short term expectations. For example, short-term expectations are for the moment influenced by rising oil prices or the insecure political situation in the middle East. In the long run, the fundamental economic data are of more relevance for inflation expectations. Long term average inflation expectations as reported by the ECB’s Survey of professional forecasters have been at 1,9 % for the last 18 quarters consecutively. Very similar results have also been extracted from other surveys like that of ‘Consensus Economics’ or the ‘Euro Zone Barometer’. Overall, the Eurosystem has achieved credibility among market participants. This is also very important considering the uncertain environment, which the Governing Council of the ECB faces, in its day-to-day decision-making. In what follows, I am going to touch on this issue. Monetary policy and uncertainty Far from the deterministic world of models in which researchers can exactly predict the effects of a change in a certain variable, there is the real world, which the Governing Council of the ECB faces at its monthly meetings. There are many possible disturbances that feed the monetary framework with uncertainty in numerous respects. In the recent past, we had to deal with terrorist attacks, asset price bubbles and extraordinary rises in the oil price, just to mention a few. All of these events affect and change the structure of the framework a central bank has to deal with and add uncertainty to the process of conducting monetary policy. Among the many forms of uncertainty the most relevant for central banks is twofold. The first concerns the transmission mechanism of monetary policy, the second is about the current state of the economy. Concerning the mechanism of monetary policy transmission first of all, since the introduction of the Euro we have noticed an important move towards a closer integration of capital markets and the banking system. This has impacting repercussions on the way and the amount by which interest rate decisions are passed through to the economies. Nevertheless, since the Euro area still remains heterogeneous in structure, the pass-through may be quick in one region while it is rather stodgy in another. Recent labour market reforms in several member states as well as changes in social security systems influence the transmission mechanism further. All this continuously affects the process at hand and the Euro area of today may well be quite different from that of 1999. The second important source of uncertainty concerns the state of the economy. Again the division can be made between aggregate uncertainty and uncertainty at the country level. Among experts the opinion is not always unanimous concerning the state of the economy. There are many indicators and many ways of interpreting them, so discriminating between a temporary slowdown of the economy and the beginning of a recession or between a sound recovery and irrational exuberance is not always obvious. It is no wonder that at times reference is made to the "art of central banking". In order to cope with the special situation of the Euro area and with uncertainty in general the Eurosystem applies several instruments, which are either substitutes or complementary to each other. To start with, a solid foundation for monetary policy was created. The detailed and published monetary policy strategy reduces the uncertainty on behalf of the public concerning the objectives and behaviour of the Eurosystem. As I have just explained the Eurosystem tries to achieve the highest possible reliability by means of a clear objective and a high degree of transparency and accountability. The Eurosystem tries to reduce uncertainty about the structure of the economy to the maximum extent possible through the systematized analysis of the full information set, i.e. the renowned two-pillar strategy. By closely monitoring the real and the monetary side of the economic situation of the Euro area, the Eurosystem gathers all available information and by cross checking this information, the uncertainty is reduced to a minimum. Furthermore, in order to be prepared for broader changes in market structure and to foster the understanding of economics a heavy weight is laid on the conduct of genuine research. Lastly considering the remaining uncertainty, policy is generally conducted in a cautious manner. Indeed, the main body of literature considers a "non-activist" and gradualist policy conduct to be optimal in most cases of parameter uncertainty. Conclusion Kydland and Prescott have shown in their work about time inconsistency of policy, how important it is for a government (or a monetary authority) to make itself and its policy credible among the public. This has led to widespread reforms in the sector of central banking throughout the world in the mid- to late1980s and the Authors of the Maastricht Treaty on European Union have integrated these insights. By carefully adopting a specific monetary policy strategy appropriate for the Euro zone, the Eurosystem succeeded, even without a track record and in spite of many turbulences and shocks of various markets, to keep inflation low and close to its target. Moreover, inflation expectations, a key indicator for the trust of the public in the policy of the Eurosystem, were also kept at a level compatible with the announced definition of price stability. In conclusion the time inconsistency problem has been well solved in the practice of modern central banking, notably by the Eurosystem. Even if uncertainty and unforeseen events, have in the past and will in the future prevail, the ECB has had a good start and achieved credibility with the public. This has been achieved by means of a framework that on the one hand delivers the determination necessary for credibility and on the other gives the flexibility that is essential to react to unforeseen events. References Eurostat (2006), Harmonized Index on Consumer Prices, Eurostat web page, downloaded on 08.08.2006. Friedman, M. (1968), The Role of Monetary Policy, American Economic Review, vol. 58. Garcia, J., A. (2003), An Introduction to the ECB’s Survey of Professional Forecasters, Occasional Paper Series No. 8, September 2003, European Central Bank. Heinemann, F. (2005), Wage Indexation and Monetary Policy, Working Papers Ludwig-MaximiliansUniversität, München. Kydland, F. and E., Prescott (1977), Rules Rather than Discretion: The Inconsistency of Optimal Plans, Journal of Political Economy, vol. 85, no. 3. Lucas, R. (1976), Econometric Policy Evaluation: A Critique, Journal of Monetary Economics, supplement. McCallum, B. (1988), Robustness Properties of a Rule for Monetary Policy, Carnegie-Rochester Conference series on Public Policy, 29, North-Holland. Muth, J. (1961), Rational Expectations and the Theory of Price Movements, Econometrica, vol. 29. Phelps, E. (1967), Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time, Economica, vol. 34. Phelps, E. (1968), Money Wage Dynamics and Labor Market Equilibrium, Journal of Political Economy, vol. 76. Phillips, A., W. (1958), The Relationship between Unemployment and the Rate of Change of Money Wages in the UK 1861-1957, Economica. Ramsey, F. (1927), A Contribution to the Theory of Taxation, Economic Journal, vol. 37. Rogoff, K. (1985), The Optimal Degree of Precommitment to an Intermediate Monetary Target, Journal of International Economics, 18. Taylor, J. (1993), Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference series on Public Policy, 39, North-Holland.
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central bank of luxembourg
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a conference of ALFI and the American Chamber of Commerce (AMCHAM), Luxembourg, 14 June 2007.
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Yves Mersch: AMCHAM – principles versus rules Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a conference of ALFI and the American Chamber of Commerce (AMCHAM), Luxembourg, 14 June 2007. * * * Ladies and gentleman, I would like to thank ALFI and American Chamber of Commerce (AMCHAM) for inviting me to participate in this conference. I am sure that this conference will reveal interesting views on the topics regarding principles versus rules-based approach. We will surely return home with new insights and suggestions for further research and developments. Through my own research, I observed, as underlined by one member of the US Securities and Exchange Commission, that there is confusion as to the difference between rules and principles. Principles are frequently defined as “accepted and professed rules of action or conduct”. This confusion about rules and principles leads me to approach this topic from different angles. 1. In my view, rules have the benefits of being precise and durable. Further, they are widely accepted and adhered to by the industry and they generally achieve the sought objectives. Finally a rule reflects the consensus of past situations and can only address circumstances known or anticipated by regulators at the time of implementation. Thus, rules become outdated as circumstances change. While principles are characterized by less preciseness, they remain more durable and widely accepted. However, their implementation is weaker and thus leaves more room for judgment. The setting of principles may be more appropriate in a rapidly changing environment marked by financial innovation and growing cross-border financial activities. Indeed, principles leave an open window to adapt judgments in case of changing circumstances and thus, need less frequent changes which would spread out confusion. But we have to be conscious that principles ought to lead to rules just like a constitution needs laws to be effective. The constitution of the Soviet Union, which was considered as one of the most democratic, went unheeded due to the gap in practice between this constitution and laws. 2. Of course, there are differences between private and public rules, only the latter benefiting from the monopoly of forceful implementation. Principles may also have private or public sources. Therefore the question of rules versus principles is often addressed through the criteria of the degree of cooperation or responsibility of the private sector. But additional criteria can be added such as the implication of the private sector in the elaboration and implementation of rules or principles. This conducts to reduce the potential conflicts and improve the identification of regulatory objectives, and the effectiveness of regulatory policy. From this point of view, reinforcing cooperation between regulators and the industry actors, offers greater efficiency and flexibility than does the unilateral top down approach by which the regulator imposes the structure and details of rules to the industry. One recent example of a positive implication of the private sector was the response to regulatory concerns regarding the transparency issue on hedge funds. It seems that voluntary industry codes can facilitate market-based solutions and thereby relieve pressure on supervisory resources. Such an approach will be probably more appropriate to solve problems, particularly in the context of increasing market innovation. 3. Another way looking at the principles versus rules-based approach is the ultimate goal of the standards. Indeed, the means needed might vary from a strongly rules-based towards a soft-law approach. While if your ultimate goal is consumer or investor protection or market abuse, rules may be the right response. For other objectives such as avoidance of systemic risks and macroeconomic stability, it may be more appropriate for the regulator to favor principles. In this context, the policy makers have to strike the right balance to reconcile the desirable clarity of rules with the idiosyncratic flexibility of the principles-based approach. 4. Yet another way to assess the rules versus principles debate is the scope of both standards i.e. what needs to be covered by rules and what can be left to principles. This scope can evolve over time. One of the main points in case is accounting. This topic has been raised after the collapses of some important players combined with other fraudulent accounting practices. These collapses lead some to question whether overly prescriptive regulation may conduct to perverse incentives, whereas others argue that the reasons reside in the lack of judgment on the level of the audit function, rather than in the non-compliance with rules. Within the European Union, the impetus for accounting reforms stands mainly from the objective of creating a fully-fledged single market. The need to overcome differences in accounting standards between member states is a crucial step towards the integration of financial markets. In accordance with this process, the goal of the International Accounting Standards Board (IASB) is to develop harmonised accounting standards in order to increase comparability and transparency and facilitate better capital allocation. The IFRS/IAS standards issued by this Board, which is jointly financed by public and private resources, are expected to be endorsed by the European Commission. In this regard, these principle-based standards offer an adequate framework for cross-border convergence of accounting practices. However, their application on the national level may be completed with more specific rules in the course of time. 5. A last angle of view is what method is most conducive to cross-border activities. In recent years a wide range of financial innovations and a growing interdependence among financial institutions have drastically modified the international financial landscape. This will require an open and transparent discussion among the industry and regulators on the international level. In Europe, the Lamfalussy framework, based on the concept of comitology, fosters the important issue of cooperation among relevant authorities and actors. The success of the Lamfalussy process in the securities field prompted EU authorities and member States to propose its extension to, inter alia, the field of banking regulation and supervision. This process should lead to a more flexible regulatory process and more consistent implementation of legislations and rules in member states. The success of current efforts to develop consistent cross-border banking supervision depends partly on an active and effective role of the industry actors. On the one hand, supervisory authorities have to deepen their understanding of the international dimensions of regulatory practices and make adjustments to national approaches in order to enhance supervisory convergence. A reinforced cooperation between national regulators is necessary in this process. On the other hand, suggestions and commitments of market participants regarding risk management principles are necessary for the soundness of the financial system. Thus the CEBS (Committee of European Banking Supervisors) is conducting public consultation with relevant actors before submitting advice to the Commission or publishing standards, guidelines and recommendations. This work has significantly contributed to build the foundations of the EU supervisory convergence which should be able to promote further banking integration and maintain at the same time its effectiveness in pursuing financial stability in a more integrated financial system. Furthermore, the discussion held under the initiative of the Basel Committee on Banking Supervision has led to several important international agreements, which have been taken to improve capital adequacy, supervisory framework and market discipline. The implementation of these international standards should strengthen banks’ capital worldwide and improve systemic stability. We in Europe, remain notably in favor of the multilateral approach. We would hope that international principles elaborated in international fora will also be timely implemented by all those involved in these agreements, unless a purely bilateral approach is considered superior. 6. To conclude, I would like to underline that effective rules and efficient principles, in my view, are both essential to promote financial integration and reinforce financial stability. It is delusory to think that principles applied on a standalone basis can eliminate the need for rules. Further, the rules-based system does not prevent the industry actors from the resort to interpretation and judgment. I believe that in a financial environment characterized by a fast innovation process, the regulator could grant sufficient time for the industry to develop robust practices and principles. If such principles turn out to be persistent and shared by all the actors of the industry, the regulator could adopt them as benchmark rules. However, in the absence of convergence of such market-based principles, the regulator might lay down guiding principles in order to provide incentives rather than imposing prescriptive and detailed rules But at this stage we need to develop a strategic view on how progress can be made on a cross-border level to reconcile market actors’ and regulators’ objectives. As you know, full harmonisation would neither be feasible nor desirable in light of substantial differences in the legal settings even inside the European Union countries. However, a variety of regulatory instruments may be employed, ranging from fully market-based solutions to monitored selfregulation, principles-based public regulation and detailed legal rules. In order to identify the appropriate tools, the problem must be approached with due regard on the potential negative impact that regulatory and supervisory inefficiencies can have on global risk management and liquidity management practices as well as business structures. These issues need further consideration. Again further cooperation between supervisors, policy makers and industry actors is desirable for the task of defining legal standards. The success of such a process depends mainly on making the best possible effort to ensure consistency and reduce complexity in practice. Thank you for your attention.
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central bank of luxembourg
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 50th anniversary of ACI Luxembourg, Luxembourg, 12 October 2007.
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Yves Mersch: Recent financial market developments Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 50th anniversary of ACI Luxembourg, Luxembourg, 12 October 2007. * * * Since my first invitation to an ACI event as a speaker a few months after assuming my first mandate 9 years ago, the markets have undergone many turbulent sequences, although I could not detect a correlation between market upheavals and my regular appearance at ACI events. Let me therefore thank the Luxembourg chapter for inviting me again today. I feel honoured. After a first ripple in the first quarter of this year and an increasing number of central banks pointing to the need to reprice certain risks (I gave a warning in that respect at a conference by the European Institute in Washington in April) the market reaction over the last couple of months witnessed what needs to be seen as a basically healthy reaction to mispricing. This reaction however was accompanied by the unpleasant effects of a crisis of confidence among the participants of the global credit markets prompting central bank intervention. Since I agreed to speak about the turbulence in financial markets, many actions have been taken and a policy agenda for drawing the lessons is emerging. Allow me therefore briefly to highlight the main events, before commenting on the experience we acquired inside the Eurosystem during these weeks and months with our elaborate toolbox of instruments and operations. I will conclude with some tentative lessons to be drawn in terms of transparency, valuation, market functioning and supervisory framework adjustment. At this stage of collecting evidence, I will not dwell on the macroeconomic consequences of this turbulence which took place against the background of a strong performance of the global economy. The momentum of past dynamics still outweighs potential downward risks to the baseline scenario. I. What happened in the markets If many expected turbulence, the specific features and the transmission mechanisms were less clearly anticipated. Many were barking up the wrong tree: Hedge funds and private equity were not the main culprits but suffered. Let me sum up the unfolding of events in 6 points: 1. Credit spreads reach record lows in the first half of 2007. The combination of relatively low interest rates for a long period of time, the trend to lay off credit risk out of balance sheets and to securitize and an increasing focus on short-term returns have led to a strong demand for credit risk, especially from nonbank investors. As a result credit spreads fell to all-time lows, leading to a mispricing of credit risks. Additionally, many investors relied greatly on credit rating agencies for the valuation of complex financial instruments and their use as collateral. 2. Strong economies and higher commodity prices were fuelling expectations of tighter monetary policy before the crisis started. In the first half of the year the economic situation proved to be very robust. Most major central banks were normalising interest rates. Strong demand for commodities put upward pressure on prices so that interest rates were rising in the first half of the year. 3. Mortgage rate re-settings at higher interest rate levels caused delinquency rates to rise, most pronounced in the sub-prime mortgage market. This led to losses in the hedge fund sector and increasing difficulties in finding a fair value price for structured deals. Moreover, investment funds experienced difficulties in NAV pricing, resulting in the temporary closures of some funds. Asset-backed securities with high credit ratings have proved not to be as sound, nor as liquid as they appeared. Some of those structured investment vehicles or conduits were extensively leveraged and strongly dependent on short-term funding. In the absence of liquidity, sponsoring banks had to fund off-balance-sheet vehicles from their own balance sheet. This led to de-leveraging and forced asset sales. 4. Higher default rates caused the first bankruptcies in the US and credit spreads started to rise. Risk aversion spread to all asset classes. Forced sales to cover margin requirements saw volatility rise sharply (VIX doubled from 15 to 30 %). The unwinding of riskier positions caused stock markets to fall (Stoxx50 -11 %) and carry trades were liquidated (EURJPY fell from 169 to 152, a 10 % appreciation). As markets fell, margin requirements rose further. The uncertainty about the pricing of some instruments added additional pressure. 5. As the credit crisis spread further short-term liquidity evaporated. Short-term funding in the interbank market became unavailable, causing casualties amongst banks and funds. In Europe, IKB and Landesbank Sachsen were rescued from insolvency. Northern Rock followed later. Funding in the primary market was impossible for banks. Trading in the secondary market stopped, with the exception of government issues. 6. The effective shut-down of the refinancing pipeline left banks to rely on shortterm funding from central banks. Neither primary issues nor short-term papers, such as ABS or ABCP, could be placed in the market. Banks hoarded liquidity in order to be safe from unexpected outflows or the unknown extent of write-downs. Because the usual market refinancing possibilities were blocked banks relied on highly rated collateral for their funding and the liquidity provided by the central bank. The spread between EONIA and three-month Euribor rose to the highest level ever at 70 bps and has remained high. Unsecured trading in the money market beyond one week effectively ceased to exist. II. Central bank reaction function As liquidity retracted first from the credit markets, then money markets, intermediation vanishing, central banks had to move in: to restore orderly market conditions; ensure the integrity of monetary transmission channels, and to ensure financial stability or prevent a systemic crisis. In view of the confidence crisis among market participants, due to uncertainty about financial individual exposures, the issues at stake were: 1) to have money market rates evolve close to the policy rates; 2) to address the term structure problem to the extent that it was threatening the first issue; 3) and thirdly to address the distributional problem of liquidity among market participants for reasons of financial stability. The somewhat more complex and elaborate toolbox of the Eurosystem proved very valuable in this respect. - this applies to the instruments used to provide liquidity: the MRO and LTRO - this applies to minimum reserve features - this applies to the number of counterparties with direct access to central bank money - this applies finally to the range of eligible collateral Let me say a word about each of these features of the Eurosystem operational framework: 1. At moments of term structure difficulties and shortening of the liquidity constraints, it is of advantage to have both: one-week and three-month liquidity providing tenders conducted weekly and monthly. Fine tuning operations and extraordinary additional tenders, according to standard procedures, allowed a commensurate response within a familiar context, rather than adding to prevailing uncertainty by introducing, in an emergency context, untested new facilities, instruments or procedures. 2. In monetary policy operations, the Eurosystem grants direct access to liquidity to a large number of credit institutions. All euro-area institutions subject to minimum reserve requirements and which fulfil the relevant contractual or regulatory arrangements applied by their respective NCB, may access the standing facilities and/or participate in open market operations based on standard tenders. At the end of August 07, 1 676 counterparties had access to the open market operations, 2 809 to the facility, and 2 141 to the marginal lending facility. 3. The combination of relatively high reserve requirements at 2% and the monthly averaging principle allowed banks to dip into their reserves to meet their liquidity needs. This averaging principle, which grants the banks more flexibility in meeting their reserve requirements, is conducive to more orderly market conditions. Since the start of EMU in January 1999 the ECB has been providing its (weekly) refinancing to the euro area banking system based on the concept of a benchmark allotment. This benchmark allotment is defined by the ECB as the allotment amount which allows counterparties to smoothly fulfil their reserve requirements until the end of the day before the settlement of the next MRO, when taking into account the aggregate liquidity need of the banking system. 4. The Eurosystem accepts a wide range of collateral to underlie its operations, including marketable and non-marketable assets. The Eurosystem has put in place a single framework for eligible collateral, which covers marketable and non-marketable assets that fulfil euro area-wide eligibility criteria. As far as marketable assets are concerned, there are four liquidity categories: The first and best category is made up by central government debt instruments, the second by jumbo covered bonds, agency, and local or regional government debt instruments, the third by covered and uncovered bank bonds and the fourth by asset backed securities. There are two types of non-marketable assets that are accepted as collateral: credit claims and non-marketable retail mortgage-backed debt instruments. Although different levels of haircuts are applied to the different categories, one might say that the Eurosystem also allows banks to use collateral easily where either the interbank Repo markets are less liquid (such as in category 3+4) or where there is even no interbank Repo market at all (such as for non-marketable assets). Banks have the choice to use more or less liquid assets as collateral, a facility which constitutes a big advantage in critical liquidity conditions such as those currently experienced by market participants. Some recent figures: The available eligible marketable collateral amounts to EUR 9 trillion. While the amount submitted to the Eurosystem nearly reached 11% of all eligible collateral by 31 August 2007 (nearly EUR 1 trillion), around 6% is effectively used to collateralize outstanding credit operations with the Eurosystem. By the end of 2006, uncovered bank bonds had become the largest single asset class put forward in Eurosystem operations (31%), surpassing government bonds for the first time (21%). ABS have also shown a steady growth, reaching 11.4 % of all collateral submitted by the end of 2006, and 19% by the end of August 2007 (+4% in August 2007). The year 2007 has also shown a steady increase in the use of credit claims, which by end of July 2007 represented roughly 10% of all assets submitted as collateral to the Eurosystem. Even though handling procedures for credit claims are sometime more cumbersome, counterparties show an increasing interest for this asset class with very low opportunity cost. The bottom line of these figures is that the increasing use of lower opportunity cost collateral shows that a growing number of counterparties are becoming more active and efficient in managing their collateral, and thus their liquidity. Finally, the recent market turmoil provided tangible evidence that the collateral framework of the Eurosystem is broad enough to ensure that counterparties do not face collateral shortages, even in difficult situations. Where do we stand today? The degree of uncertainty concerning risk – where is it?, how much?, at what price? – is declining with every forthcoming disclosure. Some asset classes have already fully recovered their risk appetite. Bank profits will be impacted, but their capacity to absorb adverse developments has also been strengthened by buoyant results over the last years. However, we are not back to normal yet, especially in the unsecured interbank term money market. We are not fully safe from a low probability but potentially high impact negative event. Before drawing some tentative lessons, let me add that there is no trade-off between liquidity provision and monetary policy, with its primary objective of maintaining price stability to which we are resolutely attached. III. Key issues At the international and at EU level a tentative agenda is emerging around 4 axes for further examination. First: Transparency Enhance transparency for investors, markets and regulators (including improvements at the level of data reporting). Credit risk transfer has facilitated the dispersion and sharing of risks across the financial markets, thus potentially enhancing their efficiency and stability. However, the recent market turbulence confirmed concerns about the risks stemming from the lack of transparency as to where the risks ultimately reside in the financial system, and in particular if those risks have been acquired by market participants that can properly manage them. The existing reporting requirements of the banking sector did not allow for a full assessment of banks’ exposures to the structured products, leading to the absence of accurate and timely information. Are Basel II requirements sufficient concerning the sponsoring by banks of SPV? Is bank disclosure of securitization operations, and exposures to SIV adequate? Questions also arise in relation to the functioning of markets for complex financial instruments. How to inform the individual investor when there are difficulties in measuring risk in structured finance products and valuate them? In this category of improved transparency, I shall also mention the need to implement ESCBCESR standards for payment and settlement including ICSDs and large custodians in order obtain more information on intraday market liquidity. Second: Valuation More work is needed on standards to ensure reliable valuation of assets particularly of those assets where markets are potentially illiquid in time of stress. At the same time compatibility with international financial reporting standards must be assured. Third: Market functioning I have to mention first the assessment of the role of credit rating agencies, their small number, the transparency of their rating methodology, possible conflicts of interest in particular as regards structured finance instruments. Excessive exclusive reliance on credit ratings by investors without carrying out due diligence or conducting further own risk assessment is a problem as well. The road map also includes a reflection on the consequences of the originate and distribute model of banks for credit markets. Does it induce wrong incentives? A last item in this list relates to non-regulated debt markets and mortgage markets, which might deserve a hard look in the light of recent experience. Finally: The regulatory framework Above all, liquidity risk management relating to complex structured products needs to be investigated. We need a wider concept of concentration risk including wholesale and interbank markets as well as intragroup exposures. We have to look at warehousing and pipeline risk, deal with possible regulatory incentives to move risk off balance sheet into SPVs. We have to assess the links between the regulated and the non-regulated part of the system, including the optimal perimeter of supervision. Special purpose investment vehicles and conduits were used as off-balance sheet investment vehicles. These were prone to liquidity mismatches between their assets and liabilities, causing contingent credit and liquidity lines to be drawn on banks, and resulting in an increased demand for money market liquidity. Closer examination of procyclical effects of credit market developments and the treatment of risk embedded in structured products held for trading is also warranted. The Deposit Guarantee Schemes, in the light of recent events, also need to be revisited. This is a piece of advice I would most urgently give to the authorities of this country with its unfunded DGS. Last but not least If there is one major lesson recent market developments have clearly shown, it is the shortcoming of a prudential framework which sidelines the central bank. Cooperation at international level is only as good as cooperation at domestic level. Liquidity issues cannot be segmented between an FSA and a central bank with no contacts of an institutional nature. With this personal remark for domestic consumption I thank you for your attention.
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Introductory speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg and President of the Bridge Forum Dialogue, at the Conference ¿Globalisation: Can Europe manage it?¿, Luxembourg, 22 January 2008.
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Yves Mersch: Globalisation – can Europe manage it? Introductory speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg and President of the Bridge Forum Dialogue, at the Conference “Globalisation: Can Europe manage it?”, Luxembourg, 22 January 2008. * * * Your Royal Highnesses, Mr. Minister, Mr. President of the European Court of Auditors, Mr. Vice President of the European Central Bank, Your Excellencies, Representatives of the European and National Institutions, Ladies and gentlemen, It is a great pleasure for me to welcome you today. I would like to start by thanking you for participating in this event to discuss a crucial issue that has gained increasing prominence and touches upon many aspects of our lives and our economy: “Globalisation: Can Europe manage it?”. I should also like to thank both the Bridge Forum Dialogue and the BCL staff who contributed with their efforts and support to the organisation of this event. The integration of emerging economies into world markets, the offshoring of production and services, the rising global competition in markets, and the growing awareness that economic stability and development, but also policy issues related to energy, the environment or migration require a global perspective and at times even cooperative responses, have put globalisation at the centre of international policy debates. According to different sets of surveys inside Europe, the strongest supporters of globalisation seem to be the Nordic countries, such as Denmark and Sweden, and new EU member states, such as the Czech Republic and Poland (with 77%, 59%, 50% and 47% of the population who regard globalisation as “an opportunity”). Opposition seems to be strongest in France and in Greece (with 64% of both countries’ population considering globalisation as “a threat”). Within countries, surveys carried out in Asian and European countries suggest that riskaverse respondents tend to oppose globalisation most. Moreover, support for government safety nets also appears to be positively correlated with opposition to globalisation. What is perhaps more surprising is that exposure to international competition plays less of a role. Political orientation is not found to matter decisively either, as supporters and opponents can be found across the whole political spectrum. The rapid development of trading in tasks and offshoring in the course of last decade’s wave of globalisation has contributed to make the distributional effects of globalisation more unpredictable in mature economies. The globalisation of finance has been even swifter than that of trade, with cross-border financial flows between mature economies almost tripling over the last quarter of a century. In parallel, financial innovation has developed faster than the regulatory framework. What lessons to draw? This conference should provide the forum with an enlightening discussion on the issue, and with an opportunity to share your views and experience, as academics, central bankers, economists and representatives of EU institutions constitute the audience. Having set the scene for I trust a stimulating discussion on such a complex topic, I am very honoured to have with us three eminent authorities on globalisation issues. Let me say just a few words about our distinguished guest speakers. First is Professor Ken Rogoff. He is a Professor of Economics at Harvard University. As you know, he has previously been Chief Economist and Director of Research of the International Monetary Fund (IMF) from 2001 to 2003 and beforehand he has served as an economist at the IMF and also at the Board of Governors of the Federal Reserve System. Professor Rogoff has published extensively on policy issues in international finance, including both exchange rates and international monetary policy. Let me also welcome Lucas Papademos, the Vice-President of the ECB since 2002. Previously, he was Governor of the Bank of Greece from 1994 to 2002 and he served as a Senior Economist at the Federal Reserve Bank of Boston in 1980. Lucas Papademos has also been a Professor of Economics at the University of Athens since 1988, and he is author of numerous articles and essays on both economic and monetary policies. Let me also mention that among other competences, he is in charge of financial stability issues within the Executive Board of the ECB. Our third speaker is Lars Heikensten. He has been a member of the European Court of Auditors since November 2005. He previously was Governor of the Sveriges Riksbank from 2003 to 2005, and prior to that Deputy Governor since 1995. He had been Chief Economist at Svenska Handelsbanken between 1992 and 1995, and had served as Under-Secretary for Economic Affairs at the Swedish Ministry of Finance between 1990 and 1992. Mr Heikensten, wrote academic papers and books, and conducted research in the area of industrial policy, labour market and foreign aid. Again, I would like to thank the three of you, for coming to discuss globalisation. Let me now proceed with the conference organisation. Professor Rogoff will be our first speaker, followed by Lucas Papademos and then Lars Heikensten. Thereafter, a discussion will follow. You will understand that under present circumstances and high market volatility, the speakers would like to focus on questions directly related to the subject of tonight’s conference. I beg for understanding that we decline to comment the most recent market or policy developments. Let’s welcome Professor Rogoff.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 2007 EUROSTAT Conference ¿Modern Statistics for Modern Society¿, Luxembourg, 7 December 2007.
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Yves Mersch: Society forming changes and their impact on information needs Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 2007 EUROSTAT Conference “Modern Statistics for Modern Society“, Luxembourg, 7 December 2007. * * * In 1999 the late Eugenio Domingo Solans gave a speech in Luxembourg during which he insisted on the importance of good statistics for the conduct of monetary policy. Since then euro area statistics have considerably improved and yet, as users of statistics, we are constantly requesting improvements of existing statistics or even the establishment of new requirements. So, are we users just experts in statistical harassment, as one may say, or are we modifying our data requests because we need to do so? I strongly believe that we need to do so because of the non-static nature of our modern societies and the necessity to dispose of statistical data describing the underlying nature of the changes to the stakeholders. Indeed, the economy that statistics are supposed to cover is changing at an impressive speed and should statistics be useful, then they have to keep up with the pace and adapt to the changing environment. According to this view, one of the important roles of statistics is to provide policy makers with data and tools necessary to assess the level of uncertainties and to provide common reference points when entering decision-making processes. Only by using statistical data are we able to clear the view and guess what is the best way forward thus optimizing the rules versus discretion trade-off. So, statistical data collection, compilation and dissemination is not an aim in itself but a necessity to achieve, and share, an efficient decision-making process at all levels of society. But, what are these changes that impact our need for information? Commissioner Almunia has already provided some important definitions concerning modern society and modern statistics. I would like to emphasis some factors requiring changes to our societies today which find their origin in: • political and institutional changes • economical and financial evolution • exogenous factors Political and institutional changes During the last 50 years, the institutional set up has been subject to various changes such as the creation of the IMF, the EEC, the OECD etc. Most of these new bodies required new types of data compared with the data needed by previous institutions. The most recent examples are the introduction of the single European currency and the creation of the European Central Bank (ECB) which are at the start of new information needs. Indeed, monetary policy is almost impossible without good statistics. Therefore, once European States had decided to go in the direction of a Monetary Union, the point was not only to put some people together in a room to take decisions but to enable that group of people to take good and transparent decisions. In view of the different cultural backgrounds, different operational and institutional frameworks were underpinned by different data requirements. With a common policy making-set-up what would be the statistical adjustment requirement? The only way forward was to establish a common framework for existing statistics as well as developing a set of new statistics. This work started well before the start of Monetary Union and there still remains room for improvement. In this regard, I would like to highlight the important work done by the European system of statistics. So, faced with a new type of user requirements (i.e. monetary policy for what is at present a monetary union of soon 13 countries), the European Statistical System (ESS) and the European System of Central Banks (ESCB) statistical services successfully established the needed statistical framework. It was therefore important to define a set of harmonised data to be collected by the respective national authorities, be they central banks or national statistical institutes, in all of the euro area member countries. At the same time it should be highlighted that most of these national institutions already collected data for their own national needs and that the development of the euro-zone statistical needs did not necessarily offset the national statistical requirements designed for and evolved in a national policy-making environment. In this regard, it may be pointed out that part of the existing national and euro area statistical needs are unfortunately not totally coherent reflecting the transfer of monetary policy making to the higher European level while retaining other areas of economic policy at the national level. In this regard, I strongly urge users of statistics i.e. policy makers as well as compilers to reflect on the fact that reacting to changing societies does not only imply the development of new statistics but also a strong reflection on the need to maintain currently available “old” statistics. This phenomenon probably reflects the inertia of existing institutions and the resistance of national bureaucracies to transferring competences to the supranational level. Very often these needs are defined without consultation of other institutions already collecting data, or there is consultation, but minor differences concerning the data needs used to collect different sets of data persist. What would be better would be to try to overcome these differences and to collect a single set. A single set might not be perfect for all the regulators concerned but it would be adequate and cost less. Economic and financial evolution During the debt crisis in Latin America in the late 1980's, most of the actors involved had to accept the fact that they had been surprised by the crisis. In the aftermath of the crisis, the IMF decided to introduce a new data standard, the Special Data Dissemination Standard, in order to collect additional information on the situation of its member countries and to publish this information much faster than it had been done in the past. This new data requirement was felt necessary since it is supposed to better inform economic actors and therefore create an early warning system for financial crises. The “new economy” and its important productivity gains due to information technologies generated the need for more detailed data concerning prices – for instance Hedonic prices to capture ever faster changes. The present crisis in the American mortgage market will also call for additional information. Indeed financial innovation supposed to spread risk and thus liberate capital and increase liquidity was found not to be stress resistant. Credit risk transfer with increased complexity and dissemination in parallel decreased both access to information and the exercise of due diligence. The lack of transparency triggered a wave of mistrust impairing the proper functioning of whole segments of financial markets. It had been expected that the generalized phenomenon of the mispricing of assets had its origin in some institutional developments such as Hedge funds or Private equity and increased disclosure was requested in this direction. However, the unfolding of the turbulence identifies a lack of transparency associated with the “originate and distribute” model, the role of rating agencies and the limits to the supervisory boundaries. The foreseeable response will be more disclosure, better information and increased statistical coverage. In all, greater transparency. Exogenous factors The terrorist attacks on 11 September 2001 were also at the beginning of additional information needs. In the recent past, the US customs have requested more private information from people travelling into the USA and most countries are now introducing new biometric passports. In the same vein, the United-States, in the war against terror, requested as much information as possible about financial transactions in order to reduce the financing of terrorists. Hence, they obtained access to additional and mainly very confidential information on financial transactions worldwide through SWIFT. Where is the end? Will we continuously increase data needs or are there limits? There are at least two limits. • data production generates costs The increasing data requests on the part of regulators generate increased production costs and therefore decreases competitiveness. • privacy concerns Access to more detailed data going as far as the data collected through SIWFT in foreign jurisdiction raises concerns about privacy. Indeed, regulators and authorities nowadays have access to more detailed information about individuals through various databases established for taxation, war against terror, business statistics etc. Not only is there a risk that we collect too detailed and confidential information but also that these databases are interlinked. The constitutional checks and balances have to be adjusted to these developments as well as our consensus concerning the rights of an individual versus the rights of society as a whole. Conclusion The essential question is to know whether all these data requests are really necessary. Indeed, is it necessary to collect so much specific and detailed data? I think that is not the case and there are several possible ways forward in order to reduce the associated reporting burden. • Better cooperation between regulators and the political will to abandon some very specific and detailed requests made by a single regulator in order to build up common needs and data requests. • Collect more appropriate data: when introducing new data requests, statisticians should review their needs in order to abandon those that are not important in order to maintain the burden at an appropriate level and avoid increasing it constantly. It should be said that policy makers must also accept a certain loss of detailed information since policy makers are the driving force behind the data requests. • Collect the important information and derive details on the basis of less frequent surveys. Thank you for your attention.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the conference ¿The ageing of Europe¿s population ¿ consequences and reforms¿, organized by the Bank of Greece, Athens, 17 January 2008.
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Yves Mersch: The Luxembourg experience, resistance to reform and main avenues for change in Europe Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the conference “The ageing of Europe’s population – consequences and reforms”, organized by the Bank of Greece, Athens, 17 January 2008. * * * Ladies and gentlemen, It is certainly a pleasure to address such a distinguished audience on the subject of ageing populations and the ensuing need for reform. Economic change is accelerating. Globalisation and technological evolution are drivers of change, but the dramatic consequence of slow adjustment of national economies is further exacerbated by the dramatic and structural demographic change in Europe. Low fertility rates, the continuous extension of life expectancy and the retirement of the baby boom generations will in the coming decades exert professional, economic, budgetary and social consequences. The impact of ageing population on real economic activity feeds through many channels. A recent survey by the European Commission (EC) and the Economic Policy Committee (EPC) has focused on the labour market, education, long-term care and health care as well as pensions. The main finding is that between 2004 and 2011, both demographic and employment developments will be supportive of growth. This period can be viewed as a window of opportunity for pursuing structural reforms. Between 2012 and 2017 rising employment rates will roughly offset the decline in the working-age population. During this period the working age population will start to decline as the baby-boom generation enters retirement. The continued projected increase in the employment rates of women and older workers might to some extent alleviate the demographic factors, but we might also witness tightening labour market conditions, growing skill mismatches and the risk of heightened wage pressures. The ageing effect will dominate as of 2018 and both the size of the working age population and the number of persons employed will be on a downward trajectory. As a result potential GDP growth rate is expected to fall from 2.2% in the first period to 1.8% from 2011-2030 and 1.3% thereafter. Employment will have a negative contribution to growth that would mostly depend on labour productivity or technological progress. For the euro area public spending is projected to increase by about 4% a year between now and 2050. I will focus on the pension issue, since the rise in the old age dependency ratio is the dominant factor increasing public spending in the coming decades. This is in particular the case in reform lagging countries with particular generous pension systems, like Luxembourg and Greece. Indeed pension reforms have been enacted in most countries of the EC and in half of them appear to have curtailed significantly the projected increase in public spending on pensions. Pension spending appears to be most sensitive to changes in life expectancy that rip apart the actuarial equilibrium of pay-as-you-go schemes. These pension schemes are nationally grown and closely associated with the history and culture of a society. I will first try to examine why the most generous systems seem to be the most resistant to change, then go through some of the arguments used against reform and finally establish a scoreboard of possible reforms. I. Resistance to change According to the E.C. the largest challenges on pension expenditure in the EU are faced by Portugal, Luxembourg and Spain. Greece is however missing in the statistics. Within the new EU countries Cyprus, Slovenia, Hungary and the Czech Republic would face the biggest challenges. Among these countries the OECD 2007 report “Pensions at a glance” ranks the countries according to the generosity of pension promises. Different retirement-income indicators put Greece and Luxembourg at the top. Gross pension replacement rates in the OECD tend to be the lowest in the six mainly English-speaking countries with stronger neoliberal influences. They are the highest in the five Southern European nations, Greece, Italy, Portugal, Spain and Turkey. If we look at the low earners the highest replacement rate is found in Denmark, while among the high earners Greece offers the highest pension reflecting both a high accrual rate and a high ceiling on pensionable earnings. 1) This shows the first problem for reform. Pension schemes tend to mix an insurance policy for the level of living with social policy with redistributive elements. The border line between these two elements is not clear, but is fertile ground for inconclusive discussions. Whether the efficiency of the redistributive element beyond the level of a safety net is to be gauged is another question. In Denmark a low-income worker earns more once a pensioner than during his productive life. In other countries, the spectrum of benefit design is more oriented towards an insurance scheme which aims to pay the same replacement rate to all workers when they retire. This table shows that the most generous schemes are actually closer to insurance schemes and the need for actuarial equilibrium is therefore all the more necessary. But inevitably pensions interact with tax. Therefore the better measure might be net replacement rates. 2) Second insight. A pension reform with lower benefits in order to mitigate longer life expectancy and hence preserve the financial balance of pension schemes might result in demands for more generous tax treatment (deductions, allowances, credits) and the final result on public finances therefore needs careful observation. While the net replacement rate is on average 70% in the OECD, the gross replacement figure is 11% lower. For example Belgium and Germany have considerably higher net replacement rates than gross. However, Germany is now gradually withdrawing the current, very generous fiscal treatment of pension income. The OECD report notes that “the ‘traditional’ way of encouraging voluntary savings for retirement has been through tax incentives. However these can be expensive and there is strong evidence that they are inefficient, in that much of the saving would have happened anyway without the incentive; in addition tax incentives are counterproductive from the social perspective, as they tend to be worth more for higher earners, for example.” New insights of behavioural economics about people’s natural inertia encourage private pension saving through soft coercion. In New Zealand people are required to save unless they opt out. What matters for governments, however, is only the replacement rate, for how long the pension benefit must be paid and how its value evolves over time, that is the stock of future flows of pension benefits. According to the OECD report, Luxembourg pays to each pensioner close to 1 Mio € or 20 times individual earnings at the time of retirement! The Netherlands and Greece rank second and third on this measure. If we look at net pension wealth, taking taxes and social security contributions into account, there is no change in country ratings according to the generosity of their pension promises. Please do not look at the graphics but at the note. At BCL we have reassessed the assumptions of the OECD calculations. Even using the most conservative assumptions the actuarial disequilibrium, namely the disequilibrium between the present value of social security contributions and of future pensions amounts to a bonus of roughly 300.000,- EUR in Luxembourg at a life expectancy of 87 years for a retirement at 65. The system is however skewed towards inciting contributors to leave at age 60, which brings us closer to the OECD figures mentioned (the apparent discrepancy with the OECD also reflects the fact that the OECD calculated the present value of future pensions, whereas the BCL figure refers to the difference between (i) the present value of future pensions and (ii) the present value of social contributions paid during the career). 3) History is in many respects an explanation for the capacity to change. The most radical reforms were enacted in some of the new member countries eager to switch to a market economy. On the other hand, hysteresis seems to prevent reforms, especially in countries where the introduction of pension promises was achieved by social struggle. In the case of Luxembourg, the legal retirement age was introduced in 1925 for men and in 1931 for women. The quite generous promises were to be measured against an average life expectancy of 55 years only at that time! Steel and mining represented 1/3 of GDP, more in terms of employment. Today the banker has displaced the miner, but the schemes are the same. However, the institutions that run the pension schemes as well as the social dialogue continue to be dominated on the employer’s side as well as on the employee side by heavy industry. Today, the latter represents less than 7% of GDP, and even less in terms of employment. Much of the restructuring of the economy from industry to services was done in a consensual way by early retirement schemes, or other measures at the expense of pension schemes. The success of this social change management with generous promises in the past might now be at the origin of resistance to measures aimed at curbing benefits today in order to live-up to longer life expectancy tomorrow. 4) Another sociological barrier appear to be the numerous special regimes in many countries run by separate administrative structures. The defence of sectoral privileges, often intricate and deeply-rooted in our history, complicates the social dialogue necessary to address solutions commensurate to the needs of our societies in the long run. The first advantage of streamlining regimes is savings in administrative costs, as many of these institutionalised regimes duplicate work. Since these administrative structures are the official dialogue partners, they have a vested interest in resisting administrative efficiency, even if the benefits of their regime would remain untouched. Italy started its pension reform with administrative unification back in the 90’s, while ensuing step-by-step harmonization of the benefits system is still on the way. For example, only this month the retirement age for Senate staff is to be lifted from 50 to 53 years. France is also about to streamline its “special” regimes. In Luxembourg administrative unification is about to be implemented as a first step. 5) This brings me to the largest impediment to reforms: timing. Pension reform inherently means short-term pain for long-term gains. This does not square well with the electoral cycle. Therefore methods already considered were: - big reforms at the beginning of a legislature, - small steps over the whole legislature, - reforms agreed to be enacted only in subsequent legislatures, - reforms on a trial base, - opt ins with sweeteners, - reforms by stealth etc…. There seems to be no miracle remedy. At the opposite end even parties which explicitly campaigned on a “no need to reform” platform or pensioners’ parties have also not succeeded. Today the situation in pension reform can be compared to the situation in fiscal reforms prior to the advent of the euro: The first reaction is to argue that your country is a special case, that the rules do not fit it and to list excuses. The second reaction is to buy time by taking one-off or temporary measures or window dressing. Only in the third wave do we face the inevitable structural reform. II. Excuses What are the excuses as regards pension reform? 1) Demographic pressure is delayed The peak in the level of public spending will occur already by 2030 in Austria and Finland. Both countries have enacted reforms: Austria in such a way that it is the only EU country with an expected decrease of spending on the pension burden, Finland by accumulating reserves. At the other extreme you find countries with peaks in 2050 only: Germany, Czech Republic, Cyprus, Hungary, Ireland, Portugal, Luxembourg. Greek data are missing. Except for Germany these are the countries that you find in the list of problem countries where reform is lagging. Even the consciousness of a need for reform seems to have eluded some of these countries. Inside the EU 4 countries (Greece did not provide data) foresee that average pension benefits will increase relative to wages: Cyprus, Ireland, Hungary, and Luxembourg. A quick comparison with present inflation rates or unit labour costs shows that mostly the same countries are already today at the top of the league for future competitiveness problems in a monetary union. 2) Or is it that these countries which also have some of the highest growth figures feel unable to communicate a decrease in benefits in such circumstances. In the case of Cyprus, Ireland and Luxembourg the main motor of fast growth is employment more than labour productivity. Is today’s growth the scourge of tomorrow if it is not put to good use? For Luxembourg growth is due to cross-border workers, who today represent more than one third of the labour force, foreign workers another third, the remaining third of locals being increasingly occupied in the public or protected sector. Younger than average migrants and cross-border workers act like a doping shot on economic growth and public sector finance. Cross-border commuters alone account for 30% of social contributions and receive 18% of old age and health care. This is equivalent to our 2% of GDP social security surplus, which is used as an argument against adjustment. Some years ago, a significant part of this surplus was even used for increasing the generosity of pension promises. In fact these temporary present surpluses are insufficient to face the financing requirements of pension promises over the long run, due to the longevity risk and to the generosity of average pensions. The BCL has calculated that our pension promise is equivalent to a Government bond with an 8% coupon for representative individuals. In order to stabilize public sector expenditure we would need the economy to grow in excess of 5.2% a year which requires more than 1 million cross-border workers for a population of 0.5 million. We could alternatively see a doubling of contribution rates stifling growth or incur liabilities of 50% of GDP by 2050 and more than 150% of GDP by 2085. With a growth rate only fuelled by labour productivity according to long term trend, the deficit of pension reserves would reach 100% of GDP by 2050 and even about 300% of GDP by the end of our projection horizon (2085). We suggested strengthening the revenue side of the actuarial imbalance by increasing the property incomes of the private sector pension regime through better management of the reserves (which is being implemented in the aftermath of a law adopted in May 2004 but with a rather conservative strategy) and through increasing reserves to reach a fully funded system according to the Modigliani/Muralidhar reform proposal. The latter proposal would request a prefunding effort to step up present reserves to the needed present value of future outlay. The trade-off between the speed of adjustment and intergenerational fairness inherent in this proposal seems however to crash into a “political wall”. 3) Reform seems all the more difficult in the context of relatively balanced public finances and an exceptionally low debt rate of 7% in the Luxembourg case. Already now 1/3 of pension contributions, which are equal to 24% of gross contributory incomes, are paid from the general budget. The buoyant growth rates - mainly from financial services - over the last decade helped finance the adjustment from an industrial society to a service-oriented economy. These growth rates masked above all high structural public expenditure, since the latter are matched by equivalent, but to a large extent cyclical or temporary, revenues. However this situation leaves a small and relatively undiversified open economy vulnerable to idiosyncratic shocks. The dominant financial sector might mature and yield lower growth with an end to the snowballing influx of cross-border workers. Luxembourg would then hit the so-called “pension wall” in the absence of far-reaching reforms. The volatility of public revenue is already now twice that of larger, more diversified economies such as Germany of France. The illusion of the balanced public budget has to be seen against the background of the depletion of budget reserves and even the occurrence of deficits during the last economic turn-down. The low debt level would only bring temporary relief, but acts as an encouragement to delay action. The currently favourable situation of the pension regime seems to encourage complacency rather than to be seen as a window of opportunity to set aside large assets. This is unfortunate, because the corresponding property incomes would offset the rising costs of generous pension benefits, at least if pension assets were equal to about 150-200% of GDP. If the actuarial neutrality of pension promises, unsettled by longevity risk, cannot be mitigated by action on the asset side, like accumulating reserves and managing them more professionally or snow-balling influxes of young foreign workers to prevent rising contributions to threaten competitivity, then one must also start to look at corrections on the liability side. Let me just add that expanding the contributive base with migration or commuters also has a cost in terms of expense in public goods in order to stay attractive and to provide additional transportation and housing facilities. III. The scoreboard of benefits reform According to the EU Commission 70% of the pressure on public spending covered by demographic developments is projected to be offset by action on factors such as the employment rate, the eligibility rate and the relative benefit level of pensions. In the new member states of the Union this percentage is supposed to reach 100%. Generally speaking public pension expenditure projections are most sensitive to assumptions of life expectancy, especially in defined benefit schemes. Higher or lower labour productivity assumptions affect pension spending through their link to wage increases. If pensions are linked to wages the productivity and concomitant wage and pension increase cannot of course relieve pension spending. Interest rates only matter in case of funded or partially funded schemes. Employment rates also matter less in most countries, since they tend to affect both the contribution and the benefit side as well as the level of GDP. However in the case of a defined benefit system, the increase of the eligibility age through longer working time and less generous early retirement helps considerably in re-establishing an actuarial neutrality. 1) Life expectancy: Links between earnings and benefits Systemic reforms to meet demographic pressure that adjust benefits or the pension age to increasing life expectancy have been proposed or implemented in around half of OECD countries. Defined contribution schemes funded or with notional accounts exist in Hungary, Poland, Slovakia, Italy, Sweden; a points system exists in Germany; financial sustainability adjustments were introduced in Austria, Finland, Portugal, Denmark and France. Some countries introduced private or partly private DC schemes as a substitute for part of the public earnings-related scheme. However there is still a transfer of resources between generations from workers to retirees and the overall financial effect remains uncertain. Social effects on lower earners remain untested since financial sustainability adjustments, due to increases in average life expectancy, might hit lower earners disproportionally. Since much of the pressure on pension costs is yet to come, some countries have resorted to measures like broadening the contribution base (by increasing ceilings or contributions or by financing some costs from general revenue). Increasing numbers of cross border workers would also fall in this category of temporary short-term or self-defeating measures with a high long term cost for the economy. The EPC found that only 4 smaller euro member states (Cyprus, Ireland, Luxembourg and Malta) are expecting considerably increased employment by 2050 as shown in the chart on slide 10. 2) Benefits adjustment Adjustment towards financial sustainability or actuarial neutrality is mostly done through changes in the statutory retirement age and less generous indexation to price or real wage developments or valorisation. a) take-up ratio Most OECD countries now have a standard retirement age of 65. Denmark, Germany and the United Kingdom are in the process of legislating increases. Retirement ages for men and women are being equalized. In most countries efforts tend to close the gap between the legal retirement age and the effective retirement age in order to re-establish normal careers from the contributive side; expenses not directly related to old-age pensions such as disability benefits ought not to distort the actuarial balance. Fictive contribution periods or credits for missing contributions are being curtailed or financed through social policies. One of the most damaging economic theories in Europe has been the idea of distributing a finite amount of employment through early retirement. Company and sector related economic restructuring was thus socialized at the expense of the long-term equilibrium of pension schemes. To fight young age unemployment with early retirement incentives in fact only alleviated the employer’s labour cost with subsidies from the pension schemes. Such attempts can be seen, above all but not only, in monolithic smaller economies. Today penalties for early retirement or increases in the number of years of contributions required to receive a full pension have been introduced or increased in many countries. Other countries have introduced or increased the increments or bonuses to late retirement. At some point in stage, countries had a general interdiction for retirees to work or earn a salary beyond a minimum amount! In Finland, older workers are given higher accrual rates. Austria, France, Germany and Portugal increased the benefit reductions for early retirement and increments for late retirement. Large decreases in the take up ratio of pensions are furthermore projected in Hungary, Poland, Czech Republic, Italy and Slovenia. In Luxembourg, pensions are increased beyond two thresholds related to age and the length of the career, respectively. Abolishing credited fictive contributions is not only improving financial sustainability but also equity between workers. b) calculated benefits At one extreme in Luxembourg non-funded public sector pensions are still linked for elder public employees to last day salary and many final promotions are made for a couple of months only in order to increase pension entitlements. Since 1999 reform aligned this scheme to reforms in 17 out of 22 OECD countries which now use lifetime earnings or a close proxy of them to calculate benefits rather than a few years of final or last earnings. These reforms usually carry no costs from a social point of view since low-skilled workers typically have flatter real age earning profiles, as do women. Furthermore progressive annuities are also increasingly being built in to discourage empty career periods. Unemployment or caring benefits for example can also be subject to social security contributions. c) valorisation of past earnings In all earnings-related public pension schemes past contributions or earnings are rescaled to adjust to changes in living standards between the time pension rights accrued and the time they are claimed. This valorisation of past earnings is mostly done in line with economy-wide wage growth or with labour productivity increase. France now rescales according to price growth only. Such an approach would considerably decrease the implicit liabilities of the pension system in Luxembourg. Finland, Portugal and Poland rescale according to a mix of wage and price growth with evolving benefits. d) indexation of pensions Price indexation protects purchasing power; wage indexation protects living standards. Is a pensioner entitled to benefit from productivity gains in which he did not participate? The traditional life cycle consumption pattern assumes that old age people consume less or differently by increasing health care consumption. Since health care is largely socialized or subsidized, productivity increases should benefit more wage income than pension income. This is all the more so as the labour force diminishes and the dependency ratio increases. In response one can argue that the increase in life expectancy also influences the consumption behaviour of old age. This is already reflected in private banking wealth management profiles. Looking at the number of countries that have moved away from indexation of pensions to future wages the answer seems to be that political and financial sustainability do not seem to be mutually exclusive. But only piecemeal moves are observed in this area. Some adjust to a mix of wage growth and price inflation and change the weighting. In Italy, higher pensions are increased by less than price inflation. Portugal also gives larger increases to smaller pensions. Austria introduced a cap on price inflation adjustment. In Belgium price indexation is linked to a trimmed down index excluding volatile elements such as oil products, alcohol or tobacco. In Luxembourg, we do not only fully index wages but also pensions. We share this situation with Slovenia. Conclusion A year ago, at a conference on structural reforms at the Central Bank of Luxembourg, Governor Garganas said that “Addressing the challenges for Greece’s fiscal position and international competitiveness will require, first and foremost, sustained further progress towards fiscal consolidation, including measures to put the public pension system on a sound basis.” These words have to be seen in the light of the EPC report that shows for Greece a below EU average evolving labour productivity rate and one of the strongest declines in labour supply. There is a clear trend towards a reduced pension promise, as shown as a consequence of pension reform in 16 OECD countries. Six of the 10 countries with the highest expenditure on pensions in the 1990s took action including Finland. 4 saw little or no change over that period according to the OECD. They are Greece, Luxembourg, Belgium and Spain. Of course pension reforms have profound social and distributional implications. Old age poverty is not compatible with the objectives of the European Union. But is not the art of governance long term planning under short-term pressures? I therefore conclude with 2 observations from an investment bank report: One to show how we consistently misjudged life expectancy is the UK. This country example is probably also true in a continental perspective. The final synthetic view is the new retirement landscape to which we have to adjust according to the research team of a major investment bank: “Retirement, in its current form, will soon be a thing of the past as demographic, financial and lifestyle factors lay siege to the traditional model. People are living longer than ever before, but not necessarily working longer, which has led to a surge in the number of people collecting pension benefits. State pension plans are under growing pressure to reform and will likely resort to some combination of reduced benefits or increased taxes to bring the programs into fiscal balance. The same forces affecting public pension provision are also taking a toll on corporate pension plans. Meanwhile, medical and healthcare spending is rising, putting government finances under additional strain.” (Robin Miranda and Kurt E. Reiman) Bibliography - The impact of ageing on public expenditure: projections for the EU25 Member States on pensions, health care, long-term care, education and unemployment transfers (2004-2050): Report prepared by the Economic Policy Committee and the European Commission (DG ECFIN) - Pensions at a Glance – Public policies across OECD countries: OECD 2007 - Annual Report 2006: Banque centrale du Luxembourg - The transition from PAYG to funding: Application to the Luxembourg private sector pension system: Working paper n° 23 July 2006 by Muriel Bouchet - Banque centrale du Luxembourg - Essentials 2008: UBS – Transition to Retirement by Robin Miranda and Kurt E. Reiman - Franco Modigliani and Arun S. Muralidhar, Rethinking Pension Reform, Cambridge University Press, 2004.
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central bank of luxembourg
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Association of the Luxembourg Fund Industry (ALFI) Spring Conference, Luxembourg, 19 March 2008.
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Yves Mersch: The recent sub-prime turbulences and their consequences for Luxembourg Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Association of the Luxembourg Fund Industry (ALFI) Spring Conference, Luxembourg, 19 March 2008. * * * Ladies and Gentlemen, I want to thank the ALFI organisers’ for inviting me to this conference and share with you some thoughts on the challenging question regarding the recent sub-prime turbulences and their consequences for Luxembourg. In fact, several months after the beginning of the financial turbulences as we experience yet another wave shock of a propagating crisis, this conference is now timely appropriate for such an exchange of views in order to assess, in an environment still characterized by vast uncertainties, the impact of the turmoil and identify areas for action to minimize risks and safeguard our financial system. Factors underlying contemporaneous financial turbulences diffusion process Let me begin by recalling that until recently, the valuation of the impact of the sub-prime turbulences was focused on asset-backed securities, and particularly those backed by US sub-prime mortgages and to some extent leveraged loans. Given that the origin of the turbulences is mainly linked to the US mortgage market, some experts were suggesting that the developments linked to this negative shock would remain to a large extent confined to the US Economy. However, there are several reasons to wander from this optimistic view. First, the process of globalization in the financial system has advanced more rapidly than in other economic sectors. This is particularly relevant for the money market, bonds and equities markets, OTC and derivatives markets. Unfortunately, as usual, one aspect of this process is: “there are no free lunches in the economy” which means that globalization has also negative effects on financial stability. The outcome of globalization might certainly spread risks but in the same time pave the way for shocks to propagate rapidly among markets and participants. Contagion becomes a realistic scenario. Secondly, large banking or financial institutions now operate internationally either through branches and subsidiaries or through several segments of the financial system, thereby easing co-movements and exposure to common shocks. A simple measure of the intensity of the geographical scope of foreign activities is the total assets held by banks outside their home country and/or world-wide assets held by intermediaries in their balance sheets. In this respect, the foreign assets held in non–EU countries by the EU key cross-border banking groups’ account on average for 29% of total foreign assets of these groups, reaching up to around 50% for some institutions. An additional indicator illustrates the increasing intensity and scope of the international financial activities relative to the world trade one. In this regards, chart 1 shows both the proportions of global trade and cross-border holdings of assets that are accounted for by developed economies. It is certainly useful to notice that over the past decade, the world trade share of these economies has declined significantly, while their holdings of the cross-border financial assets have increased substantially. This indicates that foreign markets have become as important as domestic markets, and banks now compete throughout the world. Indeed, the globalization process enlarges the opportunity for banks to diversify their portfolios and risks associated with their financial decisions. However, while this may be true for individual intermediaries, the system as a whole may become less diversified if its exposure to the same sources of risks or shocks increases. The third reason is that IT technologies and technical progress has contributed significantly to minimizing costs of conducting financial activities around the world. In this context, we all agree that the appearance of a shock in one country or financial difficulties affecting a sector or an individual banking group may spread to other countries through numerous channels which are more or less known. The US sub-prime market crisis, although not the only one, illustrates the speed of the spill over and its severity for other areas and asset classes. The recent sub-prime crisis: contagion effects and implications I would now like to move to the development of the contagion process in relation to the recent financial turbulences. To that end, four distinguished phases can be identified: • From August 2007 until December 2007, emergence of market liquidity problems and decrease of investors’ risk appetite. Individual actions of central banks combined to coordinated liquidity operations since December have led to a short term easing of strains in money and interbank markets and contributed to diminish the risk of downward market turbulences to go forward. Without a flexible and rapid response by central banks, the widening of strengthened market liquidity constraints would be harmful to financial stability. Notwithstanding the improvement in conditions in short term money and banking markets, there are indications that funding markets continue to be a cause of concern for several banking groups. • Given the magnitude of the sub-prime shock, the second phase relates to the emergence of problems closer to solvency issues. The impact was indeed less pronounced in the EU compared to the US, but, we have to be conscious that in some cases and without public interventions, as in Germany and the UK, a few banks would have been in serious trouble. At a recent conference at Banque de France, Professor H. Rey of London Business School assigns the contagion from relatively small losses in the U.S. sub-prime market of a magnitude of USD 200 billion into a global financial turmoil to three major market dysfunctionalities: 1) the first one is due to the originate and distribute model; 2) the second one can be explained by a process referred to as the CDS vicious circle; and the third one 3) is attributed to mark to market asset valuation. In fact, one of the core lessons of the current financial turbulences is the failure of the “originate-and distribute” business model. Until the sub-prime crisis, a number of experts argued that securitization had contributed to a stabilizing effect on the global financial system through diminishing the degree of risk on the banking sector by sharing it more widely. Theoretically, this will be the case. But, excessive recourse to securitization in reality may create a lot of uncertainty and increase the opaqueness of the financial market. Indeed, several financial institutions were unable to give us their real exposure to the sub-prime market. In addition, the still heterogeneous disclosure across firms raises doubts on the realism of the valuation provided by the industry. Many have to confess that they did not understand the complexity of various financial products they use. In addition, the impact of the US mortgage defaults has spread to other asset classes and across the global financial system. Investors did not know which parties were exposed and how big their exposures were! Uncertainty got settled and gave rise to both more market volatility as we have seen in recent months and to a sharp increase of investors’ risk aversion (see chart 2). • Since December 2007, attention has been drawn to insurance companies and their monoline financial guaranty activities. The monoline insurers became the next potential victim of both sub-prime crisis and financial market turmoil. Until the recent turbulences, monoline insurers were very successful at avoiding losses and their business model exhibited a very high operating leverage with a fairly low capital base and reserve positions compared to the amount of insured risk. This common practice was allowed in the past, but has become a major source of concern at present. In this context, I would just recall that monoliners activity was traditionally limited to guarantee US-municipal bond issues with low default probabilities that involve small capital cushions. However, extending their activities through insuring ABS structures coupled to current market conditions are putting pressure on their capital cushions. In fact, the loss assumptions for the bucket of structured finance bonds wrapped by monolines, which are partly formed by US sub-prime mortgages and CDOs, have been revised sharply higher. Under these new assumptions, the excess capital of many monoliners is insufficient and requires fund injections to meet their capital requirements or avoid a downgrading. In addition, banks may exhibit numerous types of exposures to monoline insurers. In the case of materialization of these risks, banks are likely to face more provisioning or write-offs. • As for the CDS vicious circle (see chart 3) some banks with no exposure to subprime saw a sharp rise of the spread of their traded CDS from 30 basis points in July 2007 to 700 basis points during the recent turbulences. This is mainly due to a pronounced increase of doubts and uncertainties. In this context, banks cannot raise as much funds on the market as they need because of both rising costs and fierce competition for collecting customer deposits. As a consequence, the balance sheets of banks deteriorate. The CDS spreads widen further and downgrading looms potentially intensifying the negative impact on capital cost and balance sheets. Overall, the procyclical spiralling down of asset values stems from the implementation of the so called fair value accounting methodology. As we know, in distressed times, the mark to market valuation is even worse for illiquid and/or senior asset classes with long maturities. The recent experience shows that this is typically the case for most of the assets hold by financial intermediaries, banks and insurers. The impact on banks’ net worth has henceforth been more noticeable. This is due to falling mark to market investment values rather than to impaired credit quality or defaults. • Still, the impact of turbulences on the real economy is the current focus of attention. As you know, in recent decades many countries have experienced some financial turbulences and banking crises. Much of the economic literature reveals that financial turbulences involving the banking or financial sectors may lead to disruptions in the real economy. The past banking crises in the developed countries illustrate the importance of the damage, both in terms of direct fiscal costs relating mainly to managing the crisis and loss of economic activity. In this regard, an academic article published in Journal of Banking and Finance in 2003, assessed the cumulative consequences of past banking crises in terms of output dip and fiscal costs for nine developed countries. As indicated in the table (1), the impact for Japan, since 1992, amounts to 28% in terms of GDP and 20% in terms of fiscal costs. While the fiscal costs of the 91-94 crisis in Finland reached 11% and the output dip was around 23% of GDP. While all of these results are consistent with the credit and exchange rate channels theories regarding the impact of banking instability on real economic activity, we need to explore other alternative explanations of the recent financial turbulences before drawing any hasty conclusion. In particular, we need more understanding of the financial market channel, which is usually neglected in economic theory as well in empirical studies. In this context, let me briefly touch upon the differences between the US and the Eurozone financial structure as illustrated by table (2) below. While the US financial system is often described as a market based system, the Eurozone financial system is recognized as a bank-based system. Given this idiosyncratic feature, the financial market channel could be favoured to assess the consequences of the financial turmoil on the US real economy, whereas the credit channel seems to be more suitable in the Euro area. This means that monetary policy in the euro area can more easily affect the balance sheet of banks and may affect the economy in a wider sense compared to the US. Beside, the impact of the Eurosystem interventions in order to prevent or limit contagion may materialize in shorter time-frame. So far for theory. Nevertheless, the views should not be confined to this divergent financial system structures. Indeed, the euro area financial system shows a trend towards more financial market activities. The growth of securitization market in the euro area has been remarkable despite the recent slowdown owing to the unravelling of the credit market turmoil since mid-2007 (see chart 4). Thus, the annualized issuance of the euro-denominated asset-backed securities increased from €50 billion in 1999 to almost €400 billion in mid-2007. It is worth noting, however, that securitization activity in the euro area despite the strong growth observed in recent years remains well below the level of activity in the US and the UK. In fact, chart 5 shows that the amount of securitization in the euro area remains at a marginal level (less than 3% of GDP), while in the US the peak reached 16% of the GDP in 2005 and in the UK the peak reached 11% in 2006. Similarly, the issuance of euro-denominated collateralized debt obligation (CDOs), as illustrated by chart 6, increased from basically nil in 1999 to a peak of almost €70 billion in 2006. While at a global level, the issuance of CDOs between 2004 and 2006 has tripled amounting to around €330 billion in 2006. A major part of the CDOs are so-called synthetic securitization instruments and collateralized loan obligations (CLOs) have been the predominant type of CDO in the euro area (see chart 7). However, it is useful to note the substantial drop of these figures in the most recent months. I draw the attention to the deceleration of securities issues in the euro area published one hour ago. These developments reveal a gradual decline during the past decades in importance of the traditional model of financial intermediation in the euro area whereby banks obtain funding mainly via deposits and use these funds to grant loans that they hold to maturity. In fact, as already mentioned, a new business model qualified as the “originate-and-distribute” business model was in the process of replacing, if not complementing the traditional one. Through the originate-and-distribute model, banks are increasingly relying on market-based funding and transfer a significant part of their credit risk off-balance sheet. However, this new model raises several issues due in particular to the loosening of the link between the debtor and the creditor. Whereas in the conventional model, banks favour customer relationships meaning that banks have the necessary incentives to monitor carefully the lending activities and assess properly credit risks. The convergence towards the new business model stimulates an increasing information asymmetry and uncertainty and thus affects the degree of market efficiency. Recent experience has shown the limits of this model and the opacity emerged from the use of highly complex instruments and derivatives. In this context, how strong is the risk of adverse selection underlying this model in particular in securitizations? Is the substitution process between the two models reversible? If not, what are the corrective measures to be taken to promote financial stability? Reflections on the implications for Luxembourg In the next part of my speech, I will try to shed light on how Luxembourg has been impacted by these turbulences and what we expect in the near future. As regards the most pressing concerns, the liquidity position of the Luxembourg banking sector was hardly affected according to the standard indicators which display a liquidity level considerably higher than the minimum required which is currently set at 30%. However, as central bank we follow with a great attention the liquidity needs of the Luxembourg banking system. As a result, during the turmoil months, we have observed the participation of 4 to 5 additional counterparties for some MROs even if on the average the number of bidders has remained unchanged. Furthermore, as regards LTRO operations, we have also noticed an increase in the average bid amount from €3.9 to €4.3 billion. However, the average aggregate amount of liquidity provided by the BCL to its counterparties has not risen compared to the end of July. Notwithstanding this fact, an increase of 20 % in the total collateral deposited at the BCL by our counterparties has been observed from July to December 2007. By this, counterparties might have intended to ensure a potential access to liquidity if needed. Finally, the BCL as a member of the Eurosystem is participating in the joint actions of the ECB and the Federal Reserve, providing US dollar funding to Luxembourg counterparties. The relative portion of central bank provision of liquidity shows, however, that other national central banks than Luxembourg have increased their shares in the total liquidity provisions. This would allow for two deductions: Either the Luxembourg financial sector is less affected by the crisis and the stable need of domestic intermediaries for central bank liquidity may reflect the net creditor position and the soundness of the aggregate balance sheet as well as the relative independence of these banks inside their groups. Or, as a consequence of the crisis, core functions of banking groups have been further centralized and funding and liquidity management is concentrated even more at headquarters than before. Let me add that the relative share of Luxembourg banks in securitization is low relative to international standards. Therefore, banks in Luxembourg might be less affected on the liquidity side of the balance sheet than on the asset side. As regards the impact on the economic activity, the fallout from the US housing market problems has provoked a downturn that proves to be more severe and more protracted than initially assumed. In this respect, the euro area and the Luxembourg economy can hardly escape the ripple effects of the slowing US demand and possibly also the exchange rate channel. A fortnight ago, the Eurosystem published an updated set of the staff macroeconomic projections, which, in the context of the financial market turmoil, are characterised by an exceptionally high level of uncertainty. Currently, the ECB staff expects real GDP growth to turn out at around an average of 1.7% in 2008 and 1.8% in 2009 while the inflation forecast has been revised upward respectively. to 2.9 and 2.1%. But beyond these traditional channels, are there symptoms of impending problems with potentially more profound consequences? It is well-known that the banks have in the past relaxed their lending standards, by accepting higher loan-to-value ratios or by lengthening the duration of mortgage loans, from the typically 20 years to up to 30 years or more. A more aggressive pricing policy via a lowering of the compensation for the incurred risk has also been observed. But that is still a far cry from the practices of some US banks. So-called subprime loans are also not relevant for Luxembourg. That may actually be the direct consequence of a more conservative approach to financial innovation. Though Luxembourg cherishes its position as an international financial centre and ought to promote the innovation process, it should nevertheless be wary of excesses and perverse side-effects. Unlike in the USA, the securitization of mortgage loans is not widespread and these loans usually remain on the banks’ books. That in itself should provide – and it probably has provided – the necessary incentive for the banks to monitor carefully their lending activities and to assess properly the reimbursement capacity of the borrowers. What were the immediate consequences of the financial market turbulences on the Luxembourg financial centre? Despite recent favourable information on the relative growth performance of the Luxembourg fund industry, monthly data as illustrated by chart 8, show a decreasing trend of net asset growth rates. This trend can be attributed to both the cyclicality of funds’ activities and their dependence on market performance as well as to a strong competition from other major financial centres. . The sharp drop in financial markets prices and the ensuing prudent behaviour of customers has also impacted on the banks’ trading income. According to the banking sector’s aggregate profit and loss account, the net trading fees have fallen continuously, though not at dramatic proportions, since the beginning of 2007. These developments are also borne out in the National Accounts data. However, for 2008 interest income may still benefit from the positive impact of business inertia. Amid a sharp drop in gross value added in the financial services sector, real GDP growth in 2007Q3 turned out at 0.7%, below trend estimates. The decline of net results for 2007 by 11.5% does also not warrant optimism for the contribution of the financial sector to GDP in the last quarter of the year. This figure is, however, not yet published for Luxembourg. The renewed fall in equity markets at the beginning of the year coupled with a 5% drop in January of net assets of the fund industry, is also likely to be a further drag on economic activity in Luxembourg. Among the series of stress testing tools and macro-prudential indicators designed by the BCL, the BCL built its own index to evaluate the degree of the banking sector’s vulnerability. The recent estimates (see chart 9) show an increase of the degree of banks’ vulnerability from the end of 2006 to the third quarter of 2007. However, the index forecast for 2008 and 2009, based on the December Eurosystem macro-economic projections, seems to indicate that the degree of vulnerability would tend towards its average level. Still, it remains to be seen how profitability in 2008 will be affected adversely by further valuation losses, increased funding costs, slowing credit growths, declining non-interest income. The BCL’s retail interest rate statistics reveal that the banks’ response to the money market disruptions and the increase in wholesale funding costs falls short of what several observers had feared. According to the data up to December 2007, the bank lending rates applied on new loans (at variable rates) to households for house purchase have in the course of 2007 actually eased by 20 basis points relative to the 50 basis points increase in the ECB minimum rate. As regards non-financial corporations, the reference rate of loans at variable rates is very often the 3-month Euribor. On this segment, we have noted a strong impact as the lending rates rose by more than 70 basis points in 2007, hence 20 basis points more than the adjustment in the key central bank rates. But that is still substantially lower than the rise in the money market rates which, at their peak, reached more than 100 basis points since January 2007. Interest rates however are only one criterion of credit conditions. Banks can also adapt to more stringent credit standards by raising the collateral requirements for example. Our bank lending survey, which is part of the wider Eurosystem bank lending survey, provides very useful information on issues such as the banks’ lending policies, their demand perceptions and their risk assessments. The September 2007 and January 2008 results highlighted the tightening in credit conditions on accounts of the higher cost of funding. They were nevertheless more optimistic than those of the euro area, and banks reported particularly sustained demand by both non-financial corporations and households. Reminiscent of the effects of the 2001-2003 downturn on financial markets, fiscal policy in Luxembourg is not oblivious to the current developments. The financial services sector accounts for about 30% of total tax receipts and complacency in the early stages can have dire consequences for the medium term policy. After three years of significant revenue windfalls, the development in 2007 continued to be stronger than what could have been expected on the basis of the regular tax assessment bases. According to the preliminary results, the central government balance also returned to a surplus equivalent to 0.7% of GDP, for the first time after five years. Nevertheless, the outlook for 2008 is highly uncertain, and, if the downturn on financial markets were to persist or to worsen, that would, akin to the real GDP prospects, weigh on tax receipts. Lessons to be drawn and concluding remarks Let me now share with you some reflections about lessons that may be drawn from the recent turmoil. There are a number of weaknesses that have been highlighted during the recent months and call for corrective actions by the private and public sectors. A financial sector that generates on the one hand huge revenues for some of its participants but on the other hand regular crises with high costs for non-participants, is in my view ripe for a hard look at the balance of existing incentives. The first issue that I would like to stress is the obvious underestimation by financial actors and supervisors of the actual degree of leverage in the financial system. This leverage is not only generated by traditional banking activities but also by highly leveraged institutions, SIVs, conduits, LBO-financed firms etc. Yet there has been an imperfect assessment of the existing risks arising from the linkage between the banking sector and all these SIVs and conduits. Indeed, the recent financial turbulences have pointed out that significant risks may be transferred back to banks using puts, guarantees, credit lines or other mechanisms. Hence it seems urgent for the financial industry to improve its risk management practices and the transparency in this respect. These characteristics, coupled with inadequate pricing and valuation, were at the heart of the present liquidity turbulences, implying a high degree of uncertainty about the size and location of the risks in the securities market. Another key issue of concern is related to the respective responsibility of credit rating agencies and professional investors. Banks appear to have outsourced a significant part of their risk assessment and due diligence to rating agencies and credit scoring programs. It might however be worth recalling that credit agencies only measure the probability of default but with no responsibility or legal liability to those who use the ratings. In that sense, the information provided by rating agencies to investors on structured finance products definitely needs to be enhanced in order to increase investors’ awareness of the effective risks associated with these products. Also, I believe that the market needs to find a better balance between investor due diligence and agency ratings. Finally, potential conflict of interest should be raised in this context, whereby rating agencies are paid by the issuer they rate. In response to these critics, the three major rating agencies have now taken a first step in announcing a set of measures intended to address these diverging interests and enhance their valuation methods. Besides self-regulatory responses to be urged in the areas of risk management, disclosure, asset valuation and credit rating agencies, several initiatives have been launched recently or are currently being discussed by regulators, supervisors and central banks in order to promote a stable financial system. There is a consensus towards the need to strengthen EU’s prudential framework for the banking sector, in particular regarding the treatment of large exposures, banks’ capital requirements for securitisation including liquidity facilities for SPV’s as well as liquidity management. Do we need supplementary capital buffers to complement risk-based capital measures? Do we need to address the procyclicality still embedded in the new Basel II capital standards? Supervisors should also undergo an analysis of the incentives that prompted banks to move some assets off balance sheet, even though they still held the risk exposure. As I mentioned, the new IAS/IFRS accounting standards raises some concerns regarding procyclicality of mark to market valuation. It might be appropriate from a financial stability point of view to reflect again on the proposal of a dynamic provisioning approach. Let me now bring up a final area that has been recently emphasized by the finance ministers and central bank governors alike. Indeed, the past turbulences have highlighted the necessity of adequate cooperation and information exchange mechanisms between central bankers, bank supervisors, and financial regulators at the national and international level. These mechanisms should ensure a timely and appropriate response to market and institutions in stress situations. The prominent role of recent central banks in the resolution of potential financial or banking crisis by the provision of liquidity has again been underlined during the recent months. It seems to me that central banks have the ultimate responsibility for financial stability and central banks alone have the resources to serve as potential lender of last resort when the need arises. In order to allow for a timely decision by a central bank to potentially grant emergency liquidity assistance, it is of outmost importance that it has access, in normal and in times of crisis, to adequate information. And this includes supervisory information. Looking at the Luxembourg legal and institutional framework for crisis prevention and management, important weaknesses need to be settled. Given the relevance of the financial sector, I hope that the legislator will in the end acknowledge the mission of the BCL in that field. I will also not repeat my concerns about the non funded depositor guarantee scheme in Luxembourg. Let me conclude by saying that the present financial crisis will probably drag on for longer than initially foreseen. The process of deleveraging and re-intermediation, the repricing and quality deterioration of assets amplify uncertainties. The later will persist until the full magnitude of losses on individual financial institutions will be clear. Given the size of our financial sector and its role of engine for the economy, Luxembourg authorities need to take a step ahead and put in place an institutional framework that allows for an effective response to stress situations and thus, ensures the promotion of a stable financial system. Thank you for your attention.
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central bank of luxembourg
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Opening remarks by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the BCL-SUERF Conference on 'Productivity in the Financial Services Sector', Luxembourg, 11-12 November 2008.
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Yves Mersch: Productivity in the financial services sector Opening remarks by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the BCL-SUERF Conference on “Productivity in the Financial Services Sector”, Luxembourg, 11-12 November 2008. * * * It is my pleasure to welcome you on behalf of the Banque centrale du Luxembourg. You probably know that ours is a relatively young institution and hat we are hosting this conference as part of the celebrations for our 10th anniversary. You are here to discuss productivity in financial services, and you re probably aware that tomorrow evening (following the end of this conference) here will be a High-Level Panel where three senior central bankers will provide heir perspective on the challenges for monetary policy represented by financial sector growth and productivity. We hope this will give you a chance to see how some of the issues raised in your research are implemented in practice and also how new issues appear in the policy context requiring further study. In any case, you are warmly invited and I hope at least some of you will be able to stay with s for this interesting discussion. The subject today is productivity in the financial sector, and as a central banker, I o not need to remind you that this sector is going through what are sometimes called “interesting times”. During the recent financial turmoil, central banks responded to short-term tensions and contributed to stabilising conditions for borrowers and lenders. The focus until now has been on liquidity and financial stability issues; however, as light appears at the end of the tunnel, policymakers are asking themselves how to avoid repeating the same mistakes next time. An overhaul of the regulatory framework seems inevitable and in this context, it is crucial to understand the structural issues in the sector behind the short-term volatility. This is why I believe that careful study of financial sector productivity is required to improve our understanding of the current situation and to shape our long-term response to recent events. I will organise my remarks around three inter-related questions: First, to measure productivity, how should we measure the level of production in financial services? Second, what do existing measures of financial sector productivity tell us about its sources of productivity growth? Finally, I will attempt to identify which aspects of productivity in financial services have been given new urgency by recent events. Let me begin with the measurement of financial services output. Not long ago, national accounts methodology underwent a significant improvement in evaluating and allocating financial services indirectly measured (FISIM). The new methodology is based on the observation that depositors are usually paid an interest flow that is below the risk-free reference rate. The difference represents the value of depositor services produced by banks, in the form of safekeeping, bookkeeping and payment services. On the other hand, borrowers almost always pay an interest flow above the risk-free reference rate. In this case, the difference represents the value of borrower services provided by banks in the form of credit-rating and monitoring. Using a reference rate to split banks’ interest margin into depositor and borrower services makes it possible to allocate the consumption of these services to households and firms, thus distinguishing between financial services destined for intermediate and for final consumption. For Luxembourg in particular, this change to national accounts methodology was important because our financial services industry primarily serves the export market, so the previous practice of allocating all such production to intermediate consumption by a fictitious sector was particularly implausible. While national accounts methodology has been much improved by this change, some open questions still remain. In particular, what is the appropriate reference rate? For the average depositor, it may be true that something close to the risk-free rate could be earned by forgoing the services attached to a bank account and instead investing in the money market. However, for the average borrower it is not reasonable to assume that funds would be available at the risk-free rate by issuing securities instead of approaching a bank for a loan. Term-mismatch between savers and borrowers and informational asymmetries explain why the financial intermediation services provided by banks are so important for the operation of market economies. This suggests that to measure borrower services accurately the appropriate reference rate must take account of the term-structure and the risk profile f the resulting bank assets. I am glad to see from the program that several papers presented in this conference will address these issues. Another open question is how to measure prices in financial services. Value added in the financial intermediation has grown faster than real GDP in the euro area, but it has retained a constant share in nominal terms. This suggests that prices have been rising more slowly in this part of the economy. In Luxembourg we could be tempted to congratulate ourselves for specialising in an industry with above average real growth and below average price inflation. But is this really the case or is it an artefact of how prices are measured in financial intermediation? When banks double the value of the assets and liabilities on their balance sheet, this does not necessarily double the number of transactions, or the amount of labour or physical capital required to produce the necessary services. This observation seems to undermine the justification for deflating asset values using a general price index such as the GDP deflator or the consumer price index. Furthermore, the recent fall in asset prices and the de-leveraging process under way may lead to some surprising results in the breakdown of financial services into prices and quantities. Let me turn to my second set of remarks, concerning existing measures of productivity in the financial sector and what they tell us about its sources. Perhaps the most natural starting point is the measurement of scale economies, an issue on which academic researchers have long provided advice for competition policy. Empirical evidence on returns to scale in the banking industry has sometimes suggested that larger institutions benefit from greater cost efficiency. However, studies of mergers and acquisitions have often failed to find such improvements. I think it is important to improve methods in this area for at least two reasons. First, increasing European financial market integration is likely to raise the size of the average bank. Central banks often repeat that the European financial services industry is excessively fragmented. Increasing integration should allow a more efficient provision of financial services, improving the allocation of capital to investments with better risk-return profiles and therefore raising the potential for economic growth. Second, the recent depressed value of financial equity and public intervention in the banking sector to rescue distressed institutions will probably accelerate the process of mergers and acquisitions as the outlook recovers. Thus the existence and extent of scale economies remain timely questions for research and policy. Scale economies are only one source of productivity growth. What used to be called scope economies are improvements in efficiency obtained by altering the mix of outputs or the mix of inputs. In academic research, these have proven even more difficult to measure than scale economies. However, I would encourage you to think about these issues in light of recent events. The demise of the investment bank suggests a return to universal banking, with large groups taking over specialised financial institutions. Such a development may be motivated by a need to improve risk management, but it could also bring benefits in terms of an improved mix of different financial outputs that are jointly produced. Finally, an additional source of productivity growth is efficiency change, meaning the extent to which individual banks move towards (or away from) the best-practice frontier. Again, looking at the conference programme, I notice a couple of papers that ask whether past trends towards deregulation or the creation of a single market in Europe have encouraged convergence towards a best-practice frontier. Unfortunately, a common result in the literature is that there is convergence towards average efficiency levels rather than convergence towards the best efficiency levels. This suggests that some isolated financial institutions may be pushing the frontier forward while the majority are falling steadily behind (a failure of the catching-up hypothesis). It is hard to interpret this result: is it good news because it means that technology is improving rapidly? Or is it a sign that even banks with low efficiency can survive, meaning that there is little incentive to adopt innovations? One may speculate that the answers depend on how one defines the best-practice frontier and whether it is valid to assume that the same technology is available to all institutions. It is common to link the efficiency of individual banks to environmental variables, the quality of management, wage dispersion, or information technology investment. Such an approach may help to identify unrealistic assumptions concerning the availability of a common technology. I have come to the third part of my remarks. Following the recent financial turmoil, what are the priorities in the study of productivity in financial services? I have already mentioned that the recent wave of restructuring is likely to increase the size of the average bank. As I have said, this means we need better tools to measure not only scale economies but also scope economies, as activities that were once performed by separate institutions are brought under a single roof. On the issue of optimal size, public interventions have prompted some recent commentators to observe that while some banks are “too big to fail” others may be “too big to save”. It is not clear that there is such a trade-off between scale economies and financial stability. Rather, the “too big to fail” label stresses the need for better international co-operation in regulation and supervision, an objective that should by now be familiar but that has takes on greater urgency as the international links in the financial industry become more apparent. Another aspect of financial productivity that merits closer scrutiny is the treatment of risk. I am not going to add to the discussion of “black swans” and the impact of rare events on Value-at-Risk models used by traders (and regulators). Instead, I am referring to the more “mundane” issues raised in my previous remarks. In terms of measuring bank output, interest flows usually include a risk premium that will generally be more important when measuring borrower services produced by a bank. Therefore, the appropriate reference rates should be chosen to more closely match the risk characteristics of a bank’s loan portfolio. Failure to allow for risk will lead to an overstatement of bank output that will distort productivity measures. It is therefore important to consider banks’ risk when studying their efficiency or productivity and I am pleased to see that several papers on the conference programme address these issues. Closely related to banks risk profile is their degree of output diversification, which is likely to increase as specialised financial institutions seek safety in larger and more diversified groups. In principle, diversification lowers risk, but it may also lead to cost savings when jointly producing several outputs. Greater output diversification is a likely concomitant of the increase in average bank size that will accompany consolidation in the banking sector. By now, academic research generally recognises that banks must be modelled as multi-output firms, but more work is needed on the measurement of the costs and benefits of joint production. Finally, on the priorities for research emerging from the financial turmoil, I would like to leave you with an open question: The bursting of asset price bubbles is likely to lead to a decline in balance sheet values and a fall in productivity. Is this a problem of measuring prices or measuring productivity? I realise that this is a very difficult question as even central bankers have a hard time distinguishing bubbles from the fundamental level of prices. However, recent events have focussed our attention on the real consequences of assuming that asset prices are always at equilibrium. If we are going to discuss productivity in financial services, we need some indication of how far our measures will be distorted by asset price bubbles. In conclusion, I am pleased to see you here in Luxembourg, where the financial services industry is such an important part of our national economy. It only remains to me to wish you a fruitful discussion and an enjoyable visit to our country.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Seminar on Financial Stability, Central Bank of the Republic of Turkey, Ankara, 21 October 2008.
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Yves Mersch: Financial stability – quo vadis? Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Seminar on Financial Stability, Central Bank of the Republic of Turkey, Ankara, 21 October 2008. * * * Let me start by thanking the Central Bank of Turkey for having provided the opportunity to present my views on financial stability, likely the most discussed policy issue these days. I shall not dwell on the description of where financial markets and economies stand today as this is well known by this audience. Instead, I shall discuss the evolution of financial stability frameworks in general – and in the EU in particular – and, profiting from the ongoing financial markets crisis, I shall draw lessons that could guide us in enhancing the EU framework of financial stability. Noblesse oblige, I will stress the crucial role played by central banks in that endeavor given the accrued importance of liquidity in preserving financial stability in the modern world of structured finance. The bottom line is that we will have to go well beyond implementing changes in accounting rules, in the modus operandi of rating agencies and in the risk management procedures of financial institutions. This is hardly a time to herald the joy of central banking! At the time of writing, news of financial instability and ample central bank-coordinated increases in liquidity fill up our screens. Lehman Brothers Holdings filed for Chapter 11 bankruptcy protection a seminal event in the intensification and broadening of financial turmoil. Bank of America purchased Merrill Lynch for $50bn; in an unprecedented action, the Fed agreed to provide an $85bn loan to AIG in exchange for an 80 percent stake in the troubled insurer; Fortis was bailed out, with the Benelux governments agreeing to inject €11.2bn and taking a 49 percent stake in the group as a result; the U.K. government took over Bradford & Bingley, nationalizing its loan book and selling its branches and savings operations to Spain’s Santander; Iceland’s financial system collapsed; Belgian bank Dexia received a €6.4bn capital injection from Belgian, French and Luxembourgish governments. Huge public sector interventions were set in motion in the United Kingdom, France, Germany, Ireland, Denmark, Austria and Switzerland among others either in form of guaranties, recapitalizations or distressed assets relief. In the U.S., the Treasury obtained Congressional approval for sweeping powers to purchase $700bn worth of illiquid U.S. mortgage-related assets created prior to September 17, 2008. In addition, a $50bn U.S. state guarantee became necessary to stop institutional investors withdrawing funds from U.S. money markets funds. Hedge funds and money market funds are facing intense redemption pressures and several emerging markets are experiencing financial difficulties and calls for IMF support are suddenly back on the agenda. Interest rates have been further cut in several countries and deposit guarantees increased. In fine, leaders from 15 nations committed to a coordinated effort to bolster financial systems with rescue packages totaling nearly 1.9tn euros and central banks offered unlimited dollar funding to banks in short-and medium-term maturities at fixed rates and longer maturities. Financial stability and liquidity, and the evolution of the supervision paradigm It is noteworthy that there is neither a widely agreed definition of financial stability nor of liquidity. Definitions of financial stability and liquidity vary significantly in academic papers and among policy makers. Definitions are more than amusing conceptual constructs; they are useful tools to discuss the evolution of financial frameworks and the role of central banks in financial stability. I suggest as definition of financial stability a dynamic one: I view financial stability as a range of states in which the financial system facilitates the performance of the monetary economy, and is able to dissipate financial imbalances originated either endogenously or as a result of adverse unanticipated events. The key elements of the definition are that financial stability is best viewed as a process and as such, it is uncertain, it has intertemporal and evolutionary features. In addition, this process occurs in a monetary economy, one based on fiat money, where resources and risks are mobilized efficiently. Finally, the process has self-equilibrating mechanisms that preclude that arising imbalances trigger a crisis. “Liquidity is an elusive concept”. That is the first sentence of the Banque de France’s February 2008 Financial Stability Review. As with financial stability, I suggest as working definition of liquidity a dynamic one: I view liquidity as the ability of market participants to take risks on each other as they seek to fund asset purchases and meet obligations, both over normal and stressful environments. As it was the case with the definition of financial stability, this definition of liquidity stresses its dynamic aspects. The endogeneity of liquidity indicates that it is best viewed as the outcome of confidence among market participants on the risk distribution of the decisions they make, and thus the monetary price they pay or receive. Liquidity is not an intrinsic, static, feature of financial instruments or markets. This definition of liquidity is compatible with the evidence that modern financial markets may be subject to instability due to liquidity rapidly drying up in interbank markets. One should also disentangle concepts like systemic liquidity, market liquidity and instrument liquidity. Liquidity and financial stability are therefore intimately linked in a monetary economy. When central banks were created, partly to protect the economy from recurrent episodes of financial instability, their monopoly power to issue the generally accepted means of settlement and their role as bankers’ bank made of them the natural guarantors of financial stability. Central banks in Europe, in contrast to the Fed in the U.S., were not explicitly mandated to regulate and supervise financial markets; this was viewed as part of their role in preserving financial stability. Over time, technological events and the interplay of ideas and experiences modified the role of central banks in financial stability. The Great Depression brought, like major crises normally do, a shift toward increased regulation and the introduction in the U.S. of deposit insurance. In the 1970s, pushed by developments in academia and the limitations of the functioning of deposit insurance, the pendulum turned back toward a more market friendly regulation. Administrative restrictions on banking were increasingly replaced by prudential standards. The main issue at stake was the inherent vulnerability of banks as transformers of short-term liabilities into long-term illiquid assets, and the moral hazard that resulted from the safety net put in place to preserve financial stability via deposit insurance and the lender of last resort. With the advent of big conglomerates and the interrelationships between banking and insurance, growing concerns about the concentration of supervisory powers and monetary policy responsibilities started a trend toward removing supervision from central banks’ responsibilities. The trend toward the elimination of supervision from central banks’ role was naturally accompanied by a trend toward integrated supervision. 1 The development of conglomerates blurred the distinction between financial institutions and markets. In addition, the liberalization of capital flows fostered mergers and acquisitions and the appearance of large and complex financial institutions. The experience with the Latin American crisis, and closer to home, with the Finish and Swedish crises, stressed the importance of enhancing risk diversification. Structured finance became the response to that need as it allowed financial institutions to transfer and diversify risk. By pooling together assets such as loans, mortgages or commercial paper, techniques such as securitization made it possible to transfer risk, and separate the underlying assets from the original seller. In addition, central banks’ core competence became more structured via monetary policy frameworks with an explicit mandate for price stability and a high degree of technical independence. Central banks’ involvement in financial stability was justified by the need to preserve the well A fully integrated supervisory agency is responsible for the supervision of banking, insurance, and securities markets (e.g., Germany). In contrast, a partially integrated one is responsible for at least two of those markets (e.g., Luxembourg). functioning of the clearing and settlement payment systems as well as by their role as ultimate providers of emergency liquidity and participation in crisis management. Financial innovation has brought new vulnerabilities and is forcing again a change in the financial stability paradigm toward a greater involvement of central banks. The reversal of Glass-Steagall in 1999 set off a leverage race outside the banking system, largely unregulated. As capital markets developed in depth and scope, structured complex products further blurred the distinction between banks, insurance and security firms. Property and risk were transferred from the banks’ balance sheets to investors, while insurers provided liquidity lines linking thereby, in an inextricable manner, banks, insurance firms and non-bank financial institutions. The expansion of banks’ funding sources beyond deposits came, however, at the expense of a more complex assessment of risks. And the spreading of risk expanded the possible sources of instability in ways not always transparent. As a result, the sources of financial instability changed once more: financial instability could also result from market instability (the recent suspensions of short-selling in several countries acknowledge it), from non-bank financial institutions and from ever larger, private clearing and settlement systems. Moreover, liquidity itself could become a contagion channel by triggering discreet changes in asset prices, in the capital base of financial institutions, and thus by feedback onto banks’ funding capacity. As a result, interbank markets have now become a source of crisis, or even aggravate a crisis, as fundamental uncertainty makes it too costly for banks to assess counterparty risk. This eventuality, observed in the current crisis, constitutes a clear example of the endogeneity of liquidity. 2 As the role of liquidity and contagion has become more important, central banks’ special role in financial stability has been reinforced. Regarding financial institutions, their next generation models of risk management will have to incorporate the non-linearities and discontinuities of modern financial markets. We may have already moved toward some form of a new international monetary framework. To conclude this section, I remark that the wide range of coordinated responses to the crisis that we are witnessing, a characteristic feature of which has been the predominant role played by central banks, has perhaps sawn the seeds of a global monetary framework. I think of massive recapitalizations of systemically-large institutions and crossborder financial firms and the boosting of deposit insurance limits. At monetary policy level we have witnessed not only concerted action in lowering the policy rate but also narrowing the policy corridor and through asset swaps, provision of cross-border liquidity in US$ and € in unlimited amounts as well as a lengthening of the term funding. This coordination has been accompanied by the enlargement of counterparties either directly or indirectly and we have also seen a broadening of eligible collateral. This new emerging monetary policy framework adjusted in emergency times was required by large cross-border and globalized financial institutions and products. The more flexible and diversified framework of the ECB has, in this respect, proven its benchmark capacity in times of duress even if itself has been enhanced since. The world has moved toward a much more significant coordinated role of central banks in preserving world financial stability. After the times of duress we are living, it is likely that this de facto framework might evolve toward a more institutionalized set with some ingredients of a world system of information sharing, with world collateral and world monetary policy. From a system of national regulators and supervisors to an EU stability framework Financial stability frameworks in the EU are largely national. Each country’s supervisory authorities drive their legitimacy from national parliaments, are subject to national accountability mechanisms, and are financed nationally. Each country’s authority is These features of crises were already present in the case of Continental Illinois (1984), and more recently in the Barings’ crisis (1995) and LTCM collapse (1998). responsible for the consolidated supervision of financial institutions domiciled in that country for which it is the home supervisor. Host supervisors are responsible for subsidiaries of institutions from other countries operating in their territories. National authorities are organized differently in the EU, e.g., as a single authority, or according to a sectoral model. Their mandates also differ with some including financial stability, the protection of investors and creditors, or depositors. Additional tasks such as responsibility over market conduct, consumer protection and market competition are unified to a larger or smaller extent. Each national central bank is responsible for ELA to financial institutions domiciled in its territory with the obligation of informing the ECB. Beyond national banks, the ECB also manages the overall liquidity of the euro area according to market needs. But the ECB does not have direct supervisory authority, and many central banks have few prudential supervisory responsibilities. An EU umbrella superstructure seeks to facilitate cooperation across national stability frameworks. Many MOUs have been signed to obtain a regular exchange of information and cooperation, and some MOUs have been signed to deal with banks of regional systemic importance. Colleges of supervisors are responsible for monitoring insurance groups and some banks. Lamfalussy committees have been established to promote financial integration and make proposals for the coordination of regulation and supervision in the EU. Level 3 committees, for instance, develop guidelines for the functioning of supervisory colleges and the assessment of financial sector vulnerabilities that are reported to the Financial Stability Table of ECOFIN. EU regulations are applicable to all EU countries (e.g., CRD, MiFID, and Solvency II), but countries can choose the form and methods to implement those regulations nationally. Sometimes national options are numerous: in the CRD more than 100 options were exercised! The EU Commission has enforcement powers in matters related to the completion of the common market, and thus on mergers and acquisitions of financial institutions and injections of state capital. Finally, international organizations and international standard setters such as the BIS, the IMF, the FSF, IAIS and IOSCO also affect EU legislation. The current EU financial stability framework is a rational outcome of a long evolution, but the current financial crisis, by highlighting its limits, suggests a rethinking is timely. The attribution of responsibilities at the lowest level that can effectively meet them, the principle of subsidiarity, has served the EU well. Yet, it is a principle, and as such it requires that the EU financial stability framework that it has delivered so far evolves in tandem with financial innovation. But proximity of supervision is also reflecting the fragmentation of the banking landscape with more than 7.000 banks and only 40 large cross border banks. The EU financial stability framework should ideally deal with the full spectrum of risks, including cross-border risks, at a minimum cost to the taxpayer who remains national. This requires rapid decision-making and quick implementation of remedial actions. Outside observers assert that the operation of large committees and reliance on consensus may slow decision-making while financial innovation keeps accelerating; disparate current national practices hinder integration and competition, as well as increase the regulatory burden; the complexity of regulations and arrangements risks favoring national interests and limiting the exchange of information among supervisors. As the current crisis shows, the outside observer’s view might however be clouded by his prejudice. At political level, decision making in Europe was nimble and decisive at all levels – Eurogroup, ECOFIN, Euro area Summit, European Union Summit, European Commission and European Parliament – within a short time frame. They delivered a more powerful and clearer message in shorter time than other constituencies. The same goes for the monetary policy level. The decentralized operational modus operandi of the Eurosystem was no hinderness to swift adjustment. During the last month, the Governing Council had 13 non physical decision-making gatherings, outside its 2 physical meetings in Frankfurt, in order to take several dozens of decisions, all implemented since. Overcentralization is no panacea for optimal decision-making as it might hamper collegial wisdom and creative thinking. Each EU Member State has to be concerned by the soundness of financial institutions in other Member States. In this respect, the decision to include a European mandate for national supervisors could increase the speed of decisiontaking, reduce the regulatory burden and favor EU integration. The main lesson from the current crisis is that EU financial stability benefits from a commonly shared philosophy. This commonly shared philosophy appears in Europe in the area of Government intervention. The increased need for cross-border cooperation was initiated in a first Memorandum of Understanding in 2005 and has been reinforced with a Memorandum of Understanding signed by all Treasuries, Supervisors and Central Banks during last summer, to be implemented by the end of the year. A sense of urgency is instilled in the task of developing a stability framework with an explicit ex-ante, EU-wide, crisis prevention mechanism that increases confidence among national authorities that necessary actions will be taken; that information will flow; that there will be adequate representation of their interests in decision10 making and implementation; and that authorities at all levels (i.e., EU, national, institutional) will be accountable for the stability aspects they control. This Memorandum of Understanding covers crisis prevention, management and resolution. Importantly, at the national level, stability frameworks should develop institutional mechanisms that ensure the ex-ante compatibility between microprudential and financial stability objectives. While there has been significant progress in setting standards (e.g., via the CRD), there is no agreement yet on a common set of procedures for early action. For example, there is an array of national triggers for remedial action, different degrees of discretion in the use of sanctions across countries as well as a wide degree of central banks’ involvement in the supervision of national market liquidity and in the evaluation of market operators’ liquidity risk management. The current crisis has shown that central banks’ role in supervising liquidity management must become proactive and forward looking so as to be compatible with the dynamic nature of liquidity. In addition, cooperation between central banks and authorities responsible for microprudential supervision needs to be enhanced in several EU countries. The mismatch between responsibilities and accountability in crisis management should be alleviated. Crisis management remains a national responsibility, but streamlined in the 2008 Memorandum of Understanding which has set the direction toward more information sharing and better allocation of responsibilities in case of crisis. However, the current crisis has shown that rapid, and low cost decision-making is possible. In the case of existing ELA arrangements, the same misguided outside observer reflects that it will be necessary to correct the current situation whereby host countries are responsible for ELA for subsidiaries and branches, but do not have access to supervisory information about branches, and thus, have no way of assessing the risks involved in the ELA operations they undertake. As a result, the distinction between liquidity and solvency, and the ensuing impact on the sharing of the costs of the operation, would remain opaque. Moreover, host country supervisors would not have the incentive to provide liquidity support because funds could flow back from a troubled branch to the parent company due to EU ring-fencing prohibitions. On the other hand, home-country authorities might delay providing information or taking crisis-management actions to avoid capital losses, reputational effects or political backlashes. So the home authority would not always have the incentive to keep smallcountry host authorities informed in an acceptable way. In turn, host country authorities would seek to retain as much intervention authority as possible. I beg to disagree. Fact is that the broadening of the operational and instrumental framework of the ECB, especially concerning eligible collateral and broad institutional access to central bank liquidity, has created a kind of informal euro area liquidity assistance. Furthermore national ELA operations need to be flagged by the Governing Council and allow for extensive information sharing reinforced by bilateral contacts on a “know as you need” basis. Crossborder institutions benefited from nationally coordinated ELA, not only in the Benelux case of Fortis, but involved in other cases extensive cooperation between 2 or even 3 countries. An EU-level crisis resolution framework, especially for systemic banks, is however pending. Like crisis prevention and management, crisis resolution was fundamentally national up to this crisis. Differences across countries’ approach to financial institutions’ failure vary enormously. Even for banks, there is little harmonization. Some countries have only a few bank-specific regulations; general commerce bankruptcy laws apply despite the winding up directive after BCCI. As shown again during the current crisis, banks have a liquidation value that is well below their value as going concerns. So, recapitalization is less expensive than liquidation. In the case of a large cross-border banks (LCBB), the problem is even worse as the focus of bankruptcy law is on the right of creditors in some countries, protecting debtors in some others. Yet, the disparate history of legal regimes in the EU suggests that institutional changes will be slow. Also, despite moves in deposit insurance toward harmonization, notably via the Deposit Insurance Directive, there are glaring differences across countries regarding the definition of deposits, co-insurance, risk-based premia, and funding. This situation creates perverse incentives, uncertainty, and regulatory arbitrage opportunities. Since the crisis, however, change seems to be faster. The provision of recapitalization funds and guarantees for bank debt, though nationally implemented, will follow common rules. Yesterday the Eurosystem agreed on 10 recommendations sent to national Governments covering pricing modalities, timing, eligibility criteria, etc.. At a cross-border level, as no EU agreement exists on the financing of insolvent institutions, home country authorities may be reluctant to spend resources that will benefit host countries, or will be faced with situations in which they will not be able to save financial institutions because they are “too big to save”. On the other hand, host countries may not be able to restore the bank as a going concern because the subsidiary may not be viable. An EU-level framework with ex-ante fiscal cost sharing mechanisms should move national authorities’ incentives away from a sole regard for the costs for the country. The recent approval by ECOFIN of a uniform EU deposit insurance limit is a step in the right direction. 3 Finally, an EU framework would reduce the costs of dealing with troubled LCBB by making transparent the conditions under which solvency support to a failing financial institution implies state aid and becomes incompatible with EU competition rules. The Commission has to this end empowered one Commissioner for rapid decision-making. I wish to finish on a hopeful note reminiscent of Schumpeter’s celebrated “creative destruction” concept. Technological developments, by changing economic agents’ constraints, modify their actions and prompt a new equilibrium. Institutional changes also become necessary to preserve a level playing field given that asymmetric information, herding behavior, and the notorious difficulties of economic agents to measure the evolution of risk over time, make financial markets incomplete. Effective institutions should affect behavior and will, in turn, suggest the need for a new equilibrium. Therefore, the current crisis, by having sent the financial system way far from an old equilibrium, may end up being useful in bringing forward necessary changes to the EU financial stability framework. It may do so by moving discussions from a nearly exclusive focus on what can be delivered under the existing framework to what a framework of financial stability should deliver. Thank you for your attention. The scheme increases the coverage of deposit protection to 100.000 Euros, removes all co-insurance, and is applicable to branches and subsidiaries.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 2nd Islamic Financial Services Board Public Lecture on Financial Policy and Stability, Kuala Lumpur, 8 February 2009.
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Yves Mersch: About the role of central banks in financial stability and prudential liquidity supervision, and the attractiveness of Islamic Finance Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 2nd Islamic Financial Services Board Public Lecture on Financial Policy and Stability, Kuala Lumpur, 8 February 2009. The author thanks Li-Chun Yuan and Charles Hurt for their contribution to the preparation of this paper. The original speech, which contains various links to the documents mentioned, can be found on the Central Bank of Luxembourg’s website. * * * Excellencies, Ladies and Gentlemen, Introduction It is my honour and great pleasure to address this distinguished audience at the celebration of the 50th anniversary of the Bank Negara Malaysia. The current crisis has revealed very strong information-related synergies between the central banking and the prudential supervisory functions. To discharge their core function of maintaining systemic stability, central banks are searching for information relating to individual institutions’ liquidity and solvency positions, intra-group exposures, banks’ liquidity and funding policies as well as data related to potential channels of contagion. Supervisory authorities on their side look for information on money and financial markets, banks’ liquidity positions and collateral provided by banks in open market operations, patterns of banks’ recourse to payment systems and volumes in post-trading systems. To summarize, liquidity-related information is of the utmost importance both for central banks and prudential supervisors. This is also the reason why on 1 June 2008 the Ministers of Finance, the supervisory authorities and the central banks of the European Union signed a Memorandum of Understanding on cooperation between the financial supervisory authorities, central banks and finance ministries of the European Union on cross-border financial stability. This Memorandum applies both in times of financial distress and in normal periods. It has the benefit of containing an allocation of tasks between the authorities in charge of financial stability. Depending on the nature of the issues at stake, one of those authorities will coordinate, as the “national coordinator”, activities in order to enhance preparedness in normal times and facilitate the management and resolution of a crisis at the national level in a particular crisis situation. The national coordinator is designated by virtue of its legal competences in the field of financial stability. Consequently the Memorandum of Understanding confers upon central banks the role of national coordinator in case a liquidity crisis could affect a cross-border financial group with a potential for systemic implications 1 . See, Memorandum of Understanding on cooperation between the financial supervisory authorities, central banks and finance ministries of the European Union on cross-border financial stability, 1 June 2008, point 4.4 second indent. The role of central banks in financial stability - Liquidity – a central bank remit for financial stability - The BCL’s new competences with regard to prudential supervision of liquidity - The importance of liquidity supervision in ensuring confidence in the currency and in the financial system - Islamic Finance and Liquidity Liquidity – a central bank remit for financial stability Liquidity is defined as “the ease and speed with which a financial asset can be converted into cash or used to settle a liability. Cash is thus a highly liquid asset. The term “liquidity” is also often used as a synonym for money” 2 . In this respect, three fundamental tasks contained in the EC Treaty are designed to serve financial stability. All of them evolve from the central banks’ role with respect to liquidity. • Monetary policy stands for liquidity injections in (a) normal times (monetary policy operations) and also (b) in times of financial distress (lender of last resort). • The smooth functioning of payment systems induces (c) the oversight of payment and settlement systems as well as payment instruments. The role of a central bank in financial stability or more accurately “systemic stability” 3 is to prevent the economy from systemic risk defined as being the risk that the failure of one participant in a transfer system, or in financial markets generally, to meet its required obligations will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a transfer system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets and the effectiveness of the monetary transmission mechanism 4 . Liquidity is thus at the very heart of systemic stability. Due to asymmetric information, a liquidity crisis at one bank can lead to increasing uncertainty in the wholesale and retail markets with respect to the liquidity situation of other banks, which in severe cases could lead to a drying-up of money market liquidity and/or to a bank run. In less severe cases, it could raise refinancing costs for other banks and increase uncertainty with respect to future cash-flows and market conditions, which would exacerbate liquidity management. Second, the large and increasing share of interbank exposures and money market instruments in banks’ funding can cause a knock-on effect, as liquidity problems at one bank directly translate into increasing liquidity pressure (e.g. due to reductions in cash-inflows and unexpected refinancing requirements) on its interbank counterparties. Third, asset fire sales can lead to a market meltdown under certain circumstances, which in turn decreases the counterbalancing capacity of all banks and, consequently, their liquidity risk-bearing capacity. In the potential emergence of a liquidity crisis, central banks need to assess the scale of the liquidity problem and the potential systemic implications of liquidity stress 5 . ECB, Glossary; http://www.ecb.eu/home/glossary/html/glossl.en.html. LAMFALUSSY Alexandre Baron de, Central banks and financial stability, 2cd Pierre Werner Lecture, 26 October 2004, Luxembourg p. 3; http://www.bcl.lu/fr/media/discours/2004/20041026/index.html. ECB, Glossary, http://www.ecb.eu/home/glossary/html/glosss.en.html. ECB, Opinion of 10 September 2008 at the request of the Banque centrale du Luxembourg on amendments to the draft law improving the legislative framework for Luxembourg as a financial centre and amending the Law of 23 December 1998 on monetary status and on the Banque centrale du Luxembourg, (CON/2008/42); http://www.ecb.int/ecb/legal/pdf/en_con_2008_42.pdf. Therefore central banks act as overseers of payment systems which consist of a set of instruments, banking procedures and, typically, interbank funds transfer systems which facilitate the circulation of money 6 . As payment systems refer to the circulation of money 7 , liquidity is thus also the essence of payment systems and the reason why central banks are responsible for overseeing the smooth functioning of such payment systems. A major malfunctioning of payment systems is likely to affect the stability of financial institutions and markets. To prevent that, the Eurosystem operates Target 2 (the Trans European Automated Real Time Gross Settlement Express Transfer System) that channels liquidity through accounts held by financial institutions with central banks. The advantage in terms of systemic stability is that Target 2 operates in “risk-free” central bank money and provides immediate intraday finality and thereby mitigates systemic risks. A fortiori, central banks are also concerned with the oversight of private payment systems operating in commercial bank money and with deferred settlement especially when they carry systemic risk. In general interbank markets can become a source of crisis, or even aggravate a crisis, if fundamental uncertainty makes it too costly for banks to assess counterparty risks. This possibility, observed in the current crisis, represents a clear example of the endogeneity of liquidity. The risk of a macro liquidity shock via contagion provides the rationale for central banks’ involvement in prudential supervision, liquidity regulation, supervision and macro-prudential surveillance. As Walter Bagehot pointed out in 1873: “In wild periods of alarm, one failure makes many, and the best way to prevent these derivative failures is to arrest the primary failure which caused them”. The EC Treaty recognizes this fundamental link between financial stability and the core functions of the ESCB relating to liquidity and prudential supervision 8 . For that purpose the EC Treaty requires the ESCB to “…contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system” 9 and allows the EU Council to confer upon the ECB “… specific tasks concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings” 10 . While the extension of the present mandate into macro prudential supervision, including liquidity supervision, risk concentration, stress testing and leverage ratios, seems uncontroversial, different models are under discussion concerning regional coordination, mediation, advisory and standardisation functions. A different set of solutions is available when it comes to supervision of individual institutions, as suggested by the report issued by the de Larosière Group 11 . ECB, Glossary, http://www.ecb.eu/home/glossary/html/glossl.en.html. See, PADOA-SCHIOPPA Tommaso, Central Banks and financial stability: Exploring an intermediate land, Second ECB central banking conference, 24 & 25 October 2002, Frankfurt am Main p. 6. See, Commentaires J. MEGRET, Le rôle des autorités prudentielles et des banques centrales, in Intégration des marches financiers, dir. Dominique Servais, 3 éd., 2007, p. 59. Article 105 (5) of the EC Treaty. Article 105 (6) of the EC Treaty. DE LAROSIÈRE, Report by the High-Level Group on Financial Supervision in the EU, 25 February 2009; http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf. The BCL’s new competences with regard to prudential supervision of liquidity According to the BCL’s organic law: “The Central Bank shall be responsible for supervising the general liquidity situation on the markets as well as evaluating market operators for this purpose…” 12 . These core central bank tasks in the field of financial stability are accompanied by new cooperation mechanisms between the Central Bank and the other prudential supervisors 13 granting the Central Bank access to full supervisory information. Moreover a new draft law (which is under way) confers upon the BCL a general oversight competence over all payment and settlement systems as well as payment instruments 14 . The scope of the BCL’s competence in the field of liquidity embraces two aspects of liquidity supervision. The first aspect focuses on market liquidity. Financial market liquidity is usually thought of as a measure of the ability of market participants to undertake securities transactions without triggering large changes in their prices. While it is challenging to precisely measure financial market liquidity, it is generally agreed that highly liquid markets are characterised by a myriad of buyers and sellers who are willing to trade. Moreover, prices in such markets ordinarily carry low liquidity risk premiums – that is the compensation demanded by investors (and bid into expected rates of return) for uncertainties associated with the ease with which transactions can be executed in the future 15 . Market liquidity and funding liquidity are strongly linked. Funding liquidity measures the ability of a given financial institution to settle an obligation when due. As highlighted in the ECB’s financial stability review of December 2008, correlations between market liquidity and funding liquidity become perceptible in times of financial crisis. Since the beginning of the financial turmoil, an increase in funding liquidity risk has gone alongside a decrease in market liquidity. Unfortunately this correlation can only be evidenced at the outbreak of a financial crisis 16 . A second aspect of liquidity supervision therefore covers financial operators’ liquidity risk management. A liquidity shock in a financial institution may disrupt the stability of the moneymarket through contagion. This is due to asymmetric information, the ever larger role of interbank markets and the well documented difficulty of economic agents in assessing and measuring risk over time. So, liquidity itself can become a contagion channel by triggering changes in asset prices, in the capital base of financial institutions, and thus by feedback into banks’ funding capacity. Article 2 (4) of the law of 23 December 1998 concerning the monetary status and the Central Bank of Luxembourg. Article 2 paragraphs 4 and 5 of the law of 23 December 1998 concerning the monetary status and the Central Bank of Luxembourg. Under the current legislation, according to Articles 34-3 and 47-1 of the Law of 5 April 1993 on the financial sector, the BCL only oversees payments systems in which it participates. The draft law on payment services, electronic money institutions and on settlement finality in payment and securities settlement systems extends the BCL’s oversight competence to all payment and securities settlement systems as well as payment instruments; see, http://www.chd.lu/servlet/DisplayServlet?id=78979&path=/export/exped/sexpdata/Mag/094/712/079131.pdf ECB, Financial stability review, June 2007, p. 10, also see p. 81. Indeed, a negative relationship between high funding liquidity risk and low market liquidity can be observed only after the start of the crisis, while in “normal” times the two indicators show no correlation. This supports the thesis that interactions between the two measures emerge only when common shocks to funding liquidity push banks to take analogous positions, so that forced asset sales lead to depressed asset prices and dire consequences for overall market liquidity. The loop is then closed when lower asset prices and lower market liquidity lead to higher collateral requirements in the money-market, which in turn increase funding liquidity risk, contribute to further asset sales and increase the probability of a downward liquidity spiral. What is the subordinated aim of liquidity supervision? The importance of liquidity supervision in ensuring confidence in the currency and in the financial system The current crisis is a liquidity crisis and thus a crisis of confidence. In January the EU Commission registered the lowest confidence rate ever measured in the Eurozone 17 . Everything started with the developing suspicions relating to the counterparty’s solvency as a result of the undervaluation of exposures to sub-prime related financial instruments and a lack of transparency concerning reporting accounts. The deterioration of confidence infected the entire financial system and its ability to assess the proper value of assets and liabilities. In this context, consumption and investment decrease. Portfolio investments are reoriented away from risk towards more liquid assets and banks do not lend to each other. Finally lending to the real economy is negatively affected 18 . Some observers blame the lack of liquidity as being the outcome of a shift from the classical originate-to-hold to the modern originate-to-distribute model. Through the originate-and-distribute model, banks are increasingly relying on market-based funding and transfer a significant part of their credit risk off-balance sheet. However, this new model raises several issues due in particular to the loosening of the link between the debtor and the creditor. Whereas in the conventional model, banks favour customer relationships meaning that banks have the necessary incentives to monitor carefully lending activities and assess properly credit risks. The convergence towards the new business model stimulates an increasing information asymmetry and uncertainty and thus affects the degree of market efficiency. Recent experience has shown the limits of this model and has revealed the opacity that emerged from the use of highly complex instruments and derivatives. In this context, is the substitution process between the two models reversible? If not, what are the possible alternatives? In this respect particular attention is drawn to Islamic finance grounded on fundamental principles like risk-sharing, materiality (a financial transaction must be linked to a real economic transaction), no exploitation, no financing of sinful activities 19 . Islamic finance and liquidity In the light of the previous developments liquidity supervision and regulation are a cornerstone of financial stability. It is obvious that in conventional finance, the interest element plays a very important role. Interest has been viewed not only as an integral part of the price mechanism whereby savings and investments are regulated in a "laissez faire" system but also as an important policy instrument with which central bank interventions can be made to influence and control inflation and in a wider sense the economy. Monetary 67,1 points. See, Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central Bank, on the panel: “Society, State, Market: a European Answer” at the International Forum Economia e Società Aperta “Uscire della crisi”, organised by Bocconi University and Corriere della Sera in cooperation with University Carlos III de Madrid, Madrid, 25 November 2008. See, Datuk Seri Panglima Andrew Sheng, Islamic finance and financial policy and stability: an institutional perspective, paper delivered at the 1st Islamic Financial Services Board Public lecture on Financial policy and stability, Kuala Lumpur, 26 March 2007, also see, LALDIN AKRAM Mohamad, Fundamentals and practices in Islamic finance, ISRA Series in Contemporary Islamic finance, volume 1, 2008 ; also see, DUSUKI DATO’ WAJDI Asyraf, Islamic Finance: An old skeleton in a modern dress, ISRA Series in Contemporary Islamic finance, volume 2, 2008 ; also see, BAHRAIN MONETARY AGENCY, Islamic Banking & Finance in the Kingdom of Bahrain, 2002. policy is equated with interest rate management by the central banks. In this respect the ECB holds one outstanding instrument for regulating liquidity: determining the key interest rates 20 . In order to preserve the effectiveness of our policy instrument, we have to avoid excessively low levels. On the other hand the core principle of Islamic finance is the prohibition of “Rhiba” meaning the prohibition of interest rates. Banks usually combine in their balance sheets short-term liabilities with long-term assets, resulting in maturity mismatches. Banks try to minimize the potential risks resulting from these mismatches by actively managing their liquidity needs typically through interbank money markets. Given that conventional interbank markets are interest-based markets, Islamic banks cannot use these markets to manage their liquidity positions, and therefore an alternative market design is required 21 . Does this mean that our concepts of financial stability are antagonistic? No certainly not! Interest rates are not the only method to regulate the volume of money. The Malaysian government pioneered the issuance of Islamic sovereign certificates known as Government Investment Issues. These certificates were introduced to provide Islamic banks with a sovereign instrument in which to invest their short-term excess liquidity. Another method for central banks to regulate liquidity is to issue central bank securities 22 . The interest-free Islamic Bonds can be regulated in such a way as to influence the monetary situation by indirectly controlling the availability of funds. The crux is the available market and funding liquidity. Liquidity management as part of their risk management processes is crucial to banking institutions and financial stability. This issue may be even more acute when it comes to Islamic finance products, notably because Sukuk are overall still considered of low liquidity “due to high originator concentration, large diversity of deal structures, and regional fragmentation” 23 . Because there is virtually no global Shariah-compliant short-term money market and no Islamic repo market, Islamic banks face difficulties in managing mismatched asset and liability portfolios 24 . At both extremities of the term structures, the very short term money market and the long maturities in the capital market, Islamic finance products still lack volume. Differences in approaches to liquidity regulation and liquidity risk-management are in theory merely differences in the use of instruments rather than differences in substance. After all the aim is to control the volume of money and thus to protect the economy from systemic risk. Whether this is done through quantitative measures as in a capital control environment or through qualitative price measures like interest rates or through a scaling of risk distribution Article 12.1 of the ESCB Statute states that: “The Governing Council shall adopt the guidelines and take the decisions necessary to ensure the performance of the tasks entrusted to the ESCB under this Treaty and this Statute. The Governing Council shall formulate the monetary policy of the Community including, as appropriate, decisions relating to intermediate monetary objectives, key interest rates and the supply of reserves in the ESCB, and shall establish the necessary guidelines for their implementation. The key ECB interest rates are: the interest rate on the main refinancing operations (the fixed rate in fixed rate tenders and the minimum bid rate in variable rate tenders); the interest rate on the marginal lending facility; and the interest rate on the deposit facility. These rates reflect the stance of the monetary policy of the ECB”; also see, ECB, Glossary, http://www.ecb.eu/home/glossary/html/glossl.en.html. SOLE Juan, Introducing Islamic banks into the conventional banking systems, IMF working paper WP/07/175, p. 20. Idem., p. 21-22. HESSE Heiko, JOBST Andreas, SOLE Juan, Quo vadis Islamic Finance, http://www.voxeu.org/index.php?q=node/2593. EDWARDES Warren, Liquidity Management Issues, Institute of Islamic Banking & Insurance / New Horizon, The Islamic Funds Conference, 18 February 2004, http://www.dc3.co.uk/IslamicLiquidity040218.pdf. is ultimately dependant on policy decisions influenced by market size, instruments availability and global integration capacity or willingness. Liquidity is an elusive concept requiring the supervisor to adopt a dynamic approach. The endogeneity of liquidity calls for a case-bycase approach where the specificities of Islamic finance can be taken into account. With respect to its specificities it is worth investigating how Islamic finance products and institutions are affected by the financial crisis. Islamic finance in the current turmoil - Considerations concerning the impact of the current financial crisis on Islamic finance products and institutions - Highlights of the developments undertaken by Islamic finance stakeholders towards financial stability Considerations concerning the impact of the current financial crisis on Islamic finance products and institutions Analysts and commentators in the financial industry put the blame for the current crisis on the intensive use of structured financial products, on derivatives and other assets whose fundamentals are uncertain. Conversely, Islamic financial institutions and products are singled out for being less impacted directly by the turmoil due to their conformity with the Shariah principles since these principles bring greater discipline to the markets 25 : - by eliminating a large number of derivatives transactions, - by putting a constraint on short sales, - by motivating the creditor in a good evaluation of the credit risk, thereby minimizing the moral hazard risk, - by preventing the amount of debt to be far above the size of the real economy. In effect, these principles are considered as inherent stabilizers. Hence, some observers consider that Islamic financial institutions might rebound faster from this crisis and be in better conditions than the “conventional” banks, thanks to restricted exposure to “toxic” assets. Still, Islamic finance products are not immune to adverse market conditions and could be impacted by the credit crunch or suffer from a property bubble deflation. Islamic finance has overall greatly expanded, and not merely in countries of Muslim obedience. According to different rating agencies, Islamic finance accounts for $800 billions of assets 26 . Gross issuance of sukuk has quadrupled over the past few years, reaching about $30 billion by the end of 2007 27 . CHAPRA Umer, The global financial crisis: can Islamic finance help? Institute of Islamic Banking and Insurance 2009, published by NewHorizon, Global perspective on Islamic banking and insurance; http://www.newhorizonislamicbanking.com/index.cfm?section=academicarticles&action=view&id=10733. HESSE Heiko, JOBST Andreas, http://www.voxeu.org/index.php?q=node/2593. MOODY’S, Global Sukuk Issuance: 2008 slowdown mainly due to credit crisis, but some impact from Shari’ah compliance issues, Global Credit Research Announcement, 22 JAN 2009; SOLE Juan, Quo vadis Islamic Finance, http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20Pages/Products%20and% 20Servi es/Downloadable%20Files/Global%20Sukuk%20Issuance.pdf . In 2008 volumes dropped however to around $15 billion 28 . Several causes are mentioned to explain this severe fall: the global credit crisis, the rising costs of borrowing, the Gulf’s currency risk, the downtrend of oil prices and the diverging assessments of sukuk’s compliance to Shariah. Many observers consider the latter cause as the major reason for the downturn. In November 2007 a Shariah scholar made a statement that 85% of the sukuk issued were not Shariah compliant due to the repurchase agreements they included. In February 2008, the AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) issued new recommendations on the sukuk structure, their issuance and trading. Some market practitioners consider these recommendations as impediments to the issue of sukuk due to the additional constraints and their subsequent impact on their tradability. The judgment by the Kuala Lumpur High Court Justice in July 2008 29 on the validity of some financing schemes also highlights the importance of Shariah compliance and legal certainty for the long-term development of Islamic finance. These examples demonstrate the need to reduce uncertainty with regard to the standards and rules applicable to Islamic finance products and also the need to improve the resilience of Islamic finance and its integration into the international financial system. Not being an expert in Islamic finance, I wish to refer here to a speech made by the Honourable Dr. Zeti Akhtar Aziz a few months ago, when she stated that “There is a need for the Islamic financial system to have the capital requirements, effective risk management and strong governance that are fully equipped to manage the risks that are specific to Islamic financial transactions” 30 . Highlights of the developments undertaken by Islamic finance stakeholders towards financial stability Indeed, despite all the praise accorded to Islamic finance, Islamic finance professionals and stakeholders are looking at the developments that are necessary to ensure further stability and the resilience of Islamic products and institutions. On the issue of capital requirements, I had the opportunity to share my views on the specific question of the appropriate capital regulation for Islamic banks during the IFSB Summit in 2007. Introducing some modifications within the standard framework could enable the adoption of an integrated regulation for both Islamic and conventional banks. The topic is still under discussion, more specifically on the ways to determine its adequacy. The guidance provided by the AAOIFI and by the IFSB brought useful clarification but has not closed the debate, which also remains open as regards conventional banking. The current turmoil prompted the importance of consumers’ confidence in the financial system and more specifically depositors’ trust in their banks to avoid bank runs. This has prompted authorities around the world to further improve existing depositors’ protection schemes, sometimes by incorporating deposits at Islamic banks. Considering that depositors in Islamic banks face the same risks as in conventional banks, depositors’ protection should Idem. Kuala Lumpur High Court Justice Datuk Abdul Wahab Patail’s judgment on the 18th July 2008 ruled that that the application of the Al-Bai' Bithaman Ajil (BBA) contracts were contrary to the Islamic Banking Act 1983 (IBA) and the Banking and Financial Institutions Act 1989 (BAFIA). In another case, he ruled that Istisna contracts are void ab initio (from inception). AKHTAR AZIZ Zeti, Enhancing the Resilience and Stability of the Islamic Financial System, keynote address at the Islamic Financial Services Board and Institute of International Finance Conference: "Enhancing the Resilience and Stability of the Islamic Financial System", Kuala Lumpur, 20 November 2008; http://www.bis.org/review/r081126c.pdf. be protected at the same level. Otherwise, Islamic banks could be tempted to invest in riskier projects 31 and may trigger systemic risk. Closely linked to the issue of depositors’ protection is the topic of the Islamic finance “investment deposit” which provides a good example of disclosure and transparency requirements. Considering that such deposits are based on a risk-sharing agreement and could not be treated as a classical deposit which benefits from a protection scheme, the Hong Kong Monetary Authority recommends improving “financial disclosures on the risk and return profiles of the different categories of deposits, as well as their status under the DPS [Deposit Protection Scheme], will enable depositors, potential or otherwise, to make informed decisions” 32 . Regarding the importance of overall good corporate governance, the IFSB has, in recent months, submitted for public consultation several documents in relation to governance and to the conduct of business for Islamic finance products. With regards to liquidity, constraints are raised by the specificities of Islamic finance. The fact is that the issuer still has to pay a premium over a conventional issue to attract investors particularly risk averse ones at this stage. The insufficient depth of the market could in theory be addressed by the cooperation of different financial centres to create a regional liquidity market, the issue of short-term sukuk or some level of central bank involvement. The same central banks could in theory encourage standardisation of structures and documentation, offer and invest in Islamic interbank securities, support the liquidity of a secondary market in long-term Islamic investments, encourage trading and establish trading infrastructures. Several interesting albeit limited solutions have been launched: In 2007, Kuwait Finance House-Bahrain (KFH-Bahrain) and Fortis Private Real Estate Holding S.A agreed to launch a Shari’a Compliant Overnight Fund (SCOF), as a solution for managing short-term liquidity with the corresponding opportunity to invest on an overnight basis. This fund was incorporated in Luxembourg last year. In a different vein, the Central Bank of Bahrain implemented last year the Islamic Sukuk Liquidity Instrument in order to enable financial institutions to access short term liquidity against Government of Bahrain Islamic leasing bonds (sukuk), issued by the Central Bank of Bahrain. Also of importance in terms of stability, efficiency and market development is the operational link between these new instruments and real-time gross settlement and securities settlement systems. Liquidity management is an important part of the overall risk management for which “conventional” financial institutions may have recourse to derivatives instruments. But the majority of Shariah scholars consider that derivatives instruments contradict Shariah principles. But one can notice an evolution insofar as a number of academics 33 could argue that the admission of such instruments in Islamic finance depends mainly on the type of contract used, their content and their trading format. Contracts on currencies, interest rate and stock indexes are intrinsically barred. Otherwise, forward and swaps contracts on commodities and shares could seamlessly be accommodated in Islamic finance. Even the trading of options is not found incompatible with Shariah principles. However, further work is still necessary to assess the implication for Islamic finance in terms of social welfare, speculation and risk-sharing, and more specifically risk management. ERRICO Luca & FARRAHBAKSH Mitra, “Islamic Banking: Issues in Prudential Regulation and Supervision,” IMF Working Paper 98/30, March 1998; http://www.imf.org/external/pubs/ft/wp/wp9830.pdf; also see, EL HAWARY Dahlia, GRAIS Wafik, IQBAL Zamir, “Regulating Islamic Financial Institutions: The Nature of the Regulated,” World Bank Working Paper 3227. Hong Kong Monetary Authority, Quarterly Bulletin, December 2008. E.g. Muhammad al-Bashir Muhammad al-Amine of the International Islamic University of Malaysia and Manager of the Shariah Compliance Department at Unicorn Investment Bank (2008), Andreas Jobst (IMF, 2008), Obiyathullah Ismath Bacha (International Journal of Islamic Financial Services, 2001). Islamic finance in Luxembourg: opportunities and challenges 34 - Explanation of the business environment - Challenges for further development Explanation of the business environment The development of Luxembourg’s international banking activities started in the late 60’s with the expansion of the euro bond market. The financial centre extended further in the 80’s with private banking services. The other core activity of the Luxembourg financial centre is the investment fund industry. Our practitioners developed acute expertise in the domiciliation, administration and distribution of investment funds with the result that the Luxembourg financial sector is positioned among the world’s leading investment centres together with the US and France. Islamic finance started to operate in Luxembourg as early as in 1983 with the establishment of the first Shariah compliant insurance company in Europe (Takafol S.A.). Year by year, other Islamic financial products developed and there are currently 31 Shariah compliant investment funds (September 2008) domiciled and managed in Luxembourg. Our stock exchange, started listing Islamic funds in 2002 and is thus the first stock exchange in Europe to host sukuk. Its current listing of 14 sukuk with a combined value of $ 5.5 billion put it in a competitive position with London. Several of these sukuk have issuers originating from the Gulf countries, Malaysia or Pakistan. Furthermore, local financial institutions lobby the Treasury to issue Luxembourg sukuk, but the volume would be symbolic in international comparison. On the operational side, Clearstream Banking, the Luxembourg International Central Securities Depository (ICSD) holds under custody and offers the clearing and settlement of a range of Islamic securities. It has slightly adapted its technical processes to sukuk’s requirements as regards the distribution of payments. Earlier this year, Deutsche Bank announced the launch of a new platform "Al Mi'yar" whose aim is to facilitate the issuance of Shariah compliant securities. This platform is domiciled in Luxembourg. It is also worth mentioning that several local market practitioners and support entities (mainly law firms and investment funds service providers) are expanding to the Gulf region. Competition for the global lead in the investment fund industry has attracted expertise in domiciliation, administration and distribution of investment funds to Luxembourg, including Shariah compliant investment funds. Working groups encompassing authorities and market players were set up to find out how to remove barriers to the development of Islamic finance products. Our national agency for the development of the financial centre “Luxembourg for Finance” has issued a leaflet which is used during promotional trips to explain the Islamic finance opportunities in Luxembourg. A 2-day conference is planned for early May to disseminate awareness and knowledge within the banking and funds industry 35 . The BCL participates together with other public authorities in a working group, chaired by the Ministry of Finance, on the promotion of Islamic finance in Luxembourg. The Luxembourg School of Finance and the University of Luxembourg offer modules of Islamic finance in their master programmes. See, BATAINEH Sufian & Carole, La finance islamique: Opportunités et Challenges pour le Grand-duché de Luxembourg, to be published in a forthcoming bulletin of the Association luxembourgeoise des juristes de droit bancaire. See, Islamic Finance awareness days, Agenda 2009, http://www.alfi.lu/. In reality, practitioners in Luxembourg consider that our current legal framework is compatible with Islamic insurance products and Islamic finance products. It already allows the issuance of such products – differences between conventional investment funds and Islamic funds are considered minimal. However, full Islamic banking would request adjustments 36 . The most appropriate structural category for Islamic funds is the “Specialized Investment Fund” (Fonds d’investissement specialisé – SIF) which is targeted at well-informed investors. In addition, this structure is legally easier to establish and it can leverage the possibility of defining its own rules and restrictions applicable to the investments the fund may undertake 37 . When it comes to the listing of sukuk, the Bourse de Luxembourg is pragmatic as it requests only documentation concerning the underlying transactions rather than a comprehensive description of the sukuk’s structure 38 . Challenges for further development Several impediments were identified in the tax framework. To start with, the several double taxation treaties that have been signed with the Gulf countries but none of them is yet in force. The situation is different with Malaysia, Singapore and Indonesia with whom double taxation treaties are already implemented. Currently, the numerous transactions involved in Islamic finance products trigger multiple taxations making them more expensive. Fiscal policy should take the economic finality into account so as to avoid distortion discriminating against Islamic finance products. Dividends are still facing differentiated treatment from investors. Luxembourg should envisage enabling the deduction of remunerations other than interest payments, allowing the amortization of leased goods outside conventional leasing contracts, and recognizing margins made on sukuk transactions as interest payments instead of profits. In addition, market practitioners request the formal recognition of Islamic finance accounting standards. So far, our authorities have proved pragmatic (for instance, tax ruling for special business cases is common practice), innovative and adaptive to the financial landscape. According to discussions currently being held at national level, this will also be the case with regard to Islamic finance. Conclusion Despite the current turbulences, the market practitioners of Islamic finance in Luxembourg remain optimistic that Islamic finance is likely to grow steadily in the next years based on investors’ appetite for financial products based on sound and ethical principles. Numerous challenges remain however, including regulatory changes, legal certainty, illiquidity issues, liquidity risk management concerns, the need for harmonized regulation, regulatory disparity amongst national supervisors and a potentially unlevel playing field. 39 It is BATAINEH Sufian et Carole, La finance islamique: Opportunités et Challenges pour le Grand-duché de Luxembourg, to be published in a forthcoming bulletin of the Association luxembourgeoise des juristes de droit bancaire. Idem. Idem. HESSE Heiko, JOBST Andreas, http://www.voxeu.org/index.php?q=node/2593. SOLE Juan, Quo vadis Islamic Finance, crucial to ensure that Shariah principles are able to accommodate the innovative products which will allow Islamic finance’s integration into the international financial system. Bibliography Books • AL-BASHIR Muhammad & AL-AMINE Muhammad, Risk Management in Islamic Finance – An Analysis of Derivative Instruments in Commodities Markets, Brill Academic Publishers, 2008. • DUSUKI DATO’ WAJDI Asyraf, Islamic Finance: An old skeleton in a modern dress, ISRA Series in Contemporary Islamic finance, volume 2, 2008. • MEGRET J., Le rôle des autorités prudentielles et des banques centrales, in Intégration des marches financiers, dir. Dominique Servais, 3 éd., 2007. • LALDIN AKRAM Mohamad, Fundamentals and practices in Islamic finance, ISRA Series in Contemporary Islamic finance, volume 1, 2008. • BAHRAIN MONETARY AGENCY, Islamic Banking & Finance in the Kingdom of Bahrain, 2002. Articles • ARIFF Mohamed, Monetary Policy in an Interest-Free Islamic Economy Nature and Scope, Monetary and Fiscal Economics of Islam; http://www.financeinislam.com/article/1_36/8/143. • AMEINFO, CBB set to launch key Islamic financial instrument, 9 June 2008; http://www.ameinfo.com/159772.html. • BACHA & OBIYATHULL I.: Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration, International Journal of Islamic Financial Services, 1 1 (1999), p. 9-25. • BATAINEH Sufian & Carole, La finance islamique : Opportunités et Challenges pour le Grand-duché de Luxembourg, to be published in a forthcoming Bulletin of the Association luxembourgeoise des juristes de droit bancaire, 2009. • BURTON John, Issuance of Islamic bonds expected to drop further, Financial Times, 23 January 2009; http://www.ft.com/cms/s/0/d5da10b6-e8a2-11dd-a4d00000779fd2ac.html?nclick_check=1. • CHAN Francis, Islamic banks “largely insulated” from financial crisis, The Straits Times, 12 December 2008; http://www.asianewsnet.net/news.php?id=3081&sec=2. • CHAPRA Umer, The global financial crisis: can Islamic finance help? Institute of Islamic Banking and Insurance 2009, published by NewHorizon, Global perspective on Islamic banking and insurance; http://www.newhorizonislamicbanking.com/index.cfm?section=academicarticles&acti on=view&id=10733. • ČIHÁK Martin & HESSE Heiko, Islamic Banks and Financial Stability: An Empirical Analysis, IMF Working Paper, WP/08/16; http://www.imf.org/external/pubs/ft/wp/2008/wp0816.pdf. • DE LAROSIÈRE, Report by the High-Level Group on Financial Supervision in the EU, 25 February 2009; http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf. • EL-HAWARY Dahlia, GRAIS Wafik, IQBAL Zamir, “Regulating Islamic Financial Institutions: The Nature of the Regulated,” World Bank Working Paper 3227. • ERRICO Luca & FARRAHBAKSH Mitra, “Islamic Banking: Issues in Prudential Regulation and Supervision,” IMF Working Paper,WP/98/30, March 1998; http://www.imf.org/external/pubs/ft/wp/wp9830.pdf. • FLATTER Elie, Développement de l’industrie des fonds Shari’ah et opportunités pour le Luxembourg, D'Wort, 25&26September 2007. • GRAIS Wafik and KULATHUNGA Anoma, Capital Structure and Risk in Islamic Financial Services; in Abdel Karim, R. and Archer, S.: Islamic Finance: The Regulatory Challenge, John Wiley & Sons, 2007; www.erf.org.eg/CMS/getFile.php?id=805. • HESSE Heiko, JOBST Andreas & SOLE Juan, Quo vadis Islamic Finance?, 24 November 2008; http://www.voxeu.org/index.php?q=node/2593. • JOBST Andreas, The Economics of Islamic Finance and Securitization, IMF Working Paper WP/07/117; http://www.imf.org/external/pubs/ft/wp/2007/wp07117.pdf. • KABLAWI Hani, Improving Corporate Governance in Islamic Finance, The Bank of New-York Mellon, Innovation series global corporate trust, 2008; http://www.bankofny.com/CpTrust/data/tl_islamic_finance.pdf. • MENAFN, AAOIFI proposals spark fresh Sukuk debate, 21 April 2008; http://www.menafn.com/qn_news_story_s.asp?StoryId=1093193587. • MOHAMAD Illiayas, High Court Decisions Highlight Islamic Banking Concerns, MIF Monthly; http://www.mifmonthly.com/10_art.php. • MOODY’S, Global Sukuk Issuance: 2008 slowdown mainly due to credit crisis, but some impact from Shari’ah compliance issues, Global Credit Research Announcement, 22 JAN 2009; http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20 Pages/Products%20and%20Services/Downloadable%20Files/Global%20Sukuk%20 Issuance.pdf. • SOLE Juan, Introducing Islamic banks into the conventional banking systems, IMF Working Paper, WP/07/175; http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2007175. • WILSON Rodney, Credit risk management in Islamic Finance, New Horizon, 1 April 2007; http://www.newhorizonislamicbanking.com/index.cfm?section=academicarticles&action=view&id=10484. • ISLAMONLINE.NET & NEWSPAPERS, UK Islamic Banks Brave Economic Crisis, 10 November 2008; http://www.islamonline.net/servlet/Satellite?c=Article_C&cid=1225698052303&page name=Zone-English-News/NWELayout. Speeches • ABBAS ZAIDI Jamal, Overcoming barriers to liquidity; Commoditization, Sukuk, promoting issuance and a secondary market, Islamic Finance and Investment World Europe 2007, June 25th-8th; http://www.iirating.com/presentation/20070625_overcoming_barriers_to_liquidity.pdf . • AKHTAR AZIZ Zeti, Enhancing the Resilience and Stability of the Islamic Financial System, keynote address at the Islamic Financial Services Board and Institute of International Finance Conference: "Enhancing the Resilience and Stability of the Islamic Financial System", Kuala Lumpur, 20 November 2008; http://www.bis.org/review/r081126c.pdf. • AKHTAR AZIZ Zeti, Islamic finance – a global growth opportunity amidst a challenging environment, Keynote address at the State Street Islamic Finance Congress 2008 "Islamic Finance: A Global Growth Opportunity Amidst a Challenging Environment", Boston, 6 October 2008; http://www.bis.org/review/r081009c.pdf. • BEIG Mujeeb, Risk Management in Islamic Finance, Seminar on Risk Management Framework for Islamic Banking Institutions, State Bank of Pakistan 2008; http://www.sbp.org.pk/ibd/IBD_semi2.htm. • DATUK Seri Panglima, SHENG Andrew, Islamic finance and financial policy and stability: an institutional perspective, paper delivered at the 1st Islamic Financial Services Board Public lecture on Financial policy and stability, Kuala Lumpur, 26 March 2007. • EDWARDES Warren, Liquidity Management Issues, Institute of Islamic Banking & Insurance New Horizon, The Islamic Funds Conference, 18 February 2004, http://www.dc3.co.uk/IslamicLiquidity040218.pdf. • HASSAN Najmul, Risk Mitigation through Takaful, Meezan Bank, 14 March 2007. • KHAN Iqbal, Liquidity Management of Islamic Financial Institutions in the UAE, HSBC Amanah Finance, Central Bank of U.A.E., Abu Dhabi, 10 December 2005. • LAMFALUSSY Alexandre (Baron de), Central banks and financial stability, 2nd Pierre Werner Lecture, 26 October 2004, Luxembourg; http://www.bcl.lu/fr/media/discours/2004/20041026/index.ht. • ORCHARD Jamie, Regulatory Treatment of Islamic Finance Firms, International Islamic Finance Forum – Istanbul, 28 September 2005. • PADOA-SCHIOPPA Tommaso, Central Banks and financial stability: Exploring an intermediate land, Second ECB central banking conference, 24 et 25 octobre 2002, Frankfurt am Main. • SMAGHI Bini Lorenzo, Society, State, Market: a European Answer, International Forum Economia e Società Aperta “Uscire della crisi”, organised by Bocconi University and Corriere della Sera in cooperation with University Carlos III de Madrid, Madrid, 25 November 2008. Publications from monetary authorities • ECB, Financial stability review, June 2007; http://www.ecb.eu/pub/pdf/other/financialstabilityreview200706en.pdf. • ECB, Opinion of 10 September 2008 at the request of the Banque centrale du Luxembourg on amendments to the draft law improving the legislative framework for Luxembourg as a financial centre and amending the Law of 23 December 1998 on monetary status and on the Banque centrale du Luxembourg, (CON/2008/42); http://www.ecb.int/ecb/legal/pdf/en_con_2008_42.pdf. • Hong Kong Monetary Authority, Quarterly Bulletin, December 2008; http://www.info.gov.hk/hkma/eng/public/qb200812/qb_all_index_new.htm. • IMF, Global Financial Stability Report, April 2006; http://www.imf.org/External/Pubs/FT/GFSR/2006/01/index.htm.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, on the occasion of the conference "Bank crisis, then and now", organised by the Chamber of Commerce and the Swedish Embassy, Luxembourg, 8 July 2009.
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Yves Mersch: The crisis – point of view of a central banker Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, on the occasion of the conference "Bank crisis, then and now", organised by the Chamber of Commerce and the Swedish Embassy, Luxembourg, 8 July 2009. * * * I will start by drawing parallels between the current recession and the Great Depression of the 1930s. It appears that the world is undergoing an economic and financial shock as big as the shock of 1929-1930. Fortunately, we have benefitted from past experience and lessons since the Great Depression. As a result, the policy response has been much more rapid and effective. In keeping with the principles of crisis management, the goal of aggressive policy decisions is to limit the propagation of the crisis and mitigate its impact on the real economy. I will describe the reaction of the Eurosystem to the crisis. Consequently, I will examine the evolution of output in the euro area and consider the ECB’s macroeconomic projections and recommendations for a successful and efficient resolution of the crisis. Lastly, I will discuss proposals to mitigate and minimize the occurrence of future crises and threats to economic and financial stability. The crisis now and the Great Depression Globally, the current crisis path is tracking the Great Depression’s. Eichengreen and O’Rourke have drawn parallels between the current crisis and the Great Depression from a global perspective. 1 While the evidence suggests that both crises originated in the United States, they were transmitted internationally through mechanisms involving trade and capital flows, financial linkages and commodity prices. Although it was hoped that Europe and Asia could decouple from the spreading economic contagion, this view turned out to be too optimistic. The graphs on the current slide show that, so far, the world industrial production path continues to follow closely that of the 1930s decline, while exhibiting no clear evidence of widespread “green shoots”. Despite early indications that world trade and stock markets appear to have stabilized, for the moment they, are still following paths far below the historical levels of the Great Depression’s. In contrast to the Great Depression, however, the policy response and its impact so far allows for some cautious optimism. Experience with crises since the Great Depression suggests that this crisis, and its subsequent resolution, require measures taken both at the national and international levels. Those measures include a prudent monetary policy and diverse economic policies that target a range of issues, from trend growth to the labour market. This time, interest rates have been cut more rapidly and to a lower level than during the Great Depression. 2 While monetary expansion was more rapid in the run-up to the 2008 crisis than during the 1925-29 period, the global money supply continues to increase rapidly, unlike in 1929 when it leveled off and underwent a subsequent catastrophic decline. 3 Finally, fiscal policy has also been far more aggressive and targeted this time. As a result, it is already possible to witness some signs of stabilization in economic conditions. Response by the Eurosystem The Eurosystem reacted to the crisis promptly and decisively by easing monetary policy and embarking on a range of “non-standard” policy measures. Several exceptional decisions were taken as early as August 9, 2007, long before the true extent of the crisis became apparent. While preserving the overall objective of price stability, the Eurosystem’s operational framework has been modified and an exceptional set of nonstandard policy tools has been adopted. To ease banks’ balance sheet constraints and avoid a “credit crunch” and the emergence of a systemic crisis, the following measures, unprecedented in nature, scope and magnitude, were adopted: • The standard monetary policy tool, the interest rate on the main refinancing operations of the ECB, was lowered 325 basis points since October 2008, which is the largest cut ever implemented over such a short period in Europe. The key interest rate now stands at 1%, the lowest level since the launch of the Euro. • Shortly after the breakout of the crisis in 2007, the Eurosystem provided additional temporary liquidity to banks with immediate liquidity needs. 4 In effect, the ECB was the first central bank to embark on “non-standard” liquidity management. • The Eurosystem also engaged in the provisioning of foreign currency swaps with the United States Federal Reserve System, the Bank of England, the Bank of Japan, the National Bank of Switzerland and the Bank of Canada. Thanks to these agreements, euro area banks were able to obtain foreign exchange liquidity against collateral “A Tale of Two Depressions”, June 2009, http://www.voxeu.org/index.php?q=node/3421. Top right graph: GDP-weighted average of central bank discount rates for 7 countries: US, UK, ECB, Japan, Sweden, Poland. Bottom right graph: Money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. The market was provided with €95 billion within few hours through a fixed rate operation with full allotment. Overnight lending of the same kind continued over the following three days. eligible in Eurosystem operations. The frequency, volume and maturity of these refinancing operations were continuously increased during 2008. • Following the default of Lehman Brothers and a virtual halt of interbank trading, the Eurosystem switched to a new mode of liquidity provision adopting a “fixed-rate full allotment” tender procedure in open market operations. Thus, banks have been granted essentially unlimited liquidity at the key policy interest rate. This is in contrast to the practice in normal times, when a predetermined amount of central bank credit is auctioned in refinancing operations with short maturity. The interest rate would be determined through the competition among bidders. • In May 2009 the Governing Council extended the maturity range of liquidity-providing operations, introducing a new one-year operation. 5 • Before onset of the crisis, the list of assets that the Eurosystem accepted as collateral was relatively large compared to that of other central banks. The Eurosystem now accepts even wider range of securities as collateral. 6 • Unlimited refinancing against a wide range of collateral at longer maturities was coupled with an extended list of counterparties in the Eurosystem's refinancing operations. More than 1700 counterparties were eligible before the crisis and this number rose even further after changes in the operational framework were agreed upon in October 2008. Most recently, the list was extended to include the EIB. • The last unconventional element of monetary policy added in May 2009 was outright purchases of euro-denominated covered bonds issued in the euro area. Before the crisis, banks in the euro area used covered bonds as a major source of funding of a longer-term nature than the ECB's refinancing operations. However, the market was virtually abandoned after the intensification of the crisis last autumn. 7 The positive impact of the measures adopted since the start of the crisis is becoming apparent. Money market rates have fallen to record lows in June, reflecting the first one-year refinancing operation executed by the Eurosystem. Similarly, loan interest rates charged by banks have declined. This suggests that crucial elements of the monetary policy transmission mechanism continue to work. The Eurosystem's balance sheet shrunk to 15% of GDP in May 2009 from its peak of 19% of GDP in December 2008. This appears to be the result of increasing money market activity, at least at short maturities, and a sign of improving confidence. Recovery in the euro area While surrounded by an unusual degree of uncertainty, ECB macroeconomic projections expect a moderate recovery in the euro area in 2010. The accompanying graph shows that during the first quarter of 2009, economic activity in the euro area weakened considerably. The June auction saw a record demand for €442 billion which may suggest the persistence of some funding strains. The total value of these eligible securities is currently about €12 trillion, or 130% of euro area GDP. Already the announcement of the program before any purchases were carried out was positively accepted in the market and lead to a wave of new issuances and lower spreads. However, confidence indicators hint to subtle signs of improvement at very low levels. This suggests that the decline in economic activity over the remainder of this year will decelerate, and after a stabilization phase, moderate positive quarterly growth rates are expected by mid-2010. The recovery will be driven by the macroeconomic stimulus and other measures designed to restore the normal functioning of the financial system. For the moment, the risks to the economic outlook appear balanced. On the positive side, the macroeconomic stimulus might have stronger effect than anticipated and confidence might improve more quickly than expected. On the other hand, a range of adverse factors might flatten the recovery path, e.g. feedback effects from the turmoil in financial markets on the real economy and vice versa; relatively more unfavorable developments in labour markets; the intensification of protectionist pressures or adverse developments in the world economy stemming from a disorderly correction of global imbalances. Past experience shows that financial crises cause deep economic crises that can lower the level and growth rate of potential output for a significant period of time. In some cases, there has been a protracted loss in output in the aftermath of the slump. For example in the case of Finland and Sweden, the recovery of real GDP towards the pre-crisis trend level took more than 8 years. A downward shift in the level of potential output might occur, for instance, through scrapping or stronger discounting of previous investment (e.g. in the automobile and financial sector), or through depreciation of human capital in case of an increase in structural unemployment. In addition, there is no guarantee that the economy will return to its pre-crisis long-run trend potential output growth rate. The experience of Japan suggests that the crisis might have a lasting impact not only on the level of GDP, but also on its potential growth rate. A longer term moderation of the rate of growth of potential output may occur if a deep recession reduces the growth rate of labour in the long run. This can happen if some groups in the labour force are discouraged over time from participating, or if the trends in migration flows are reduced. In addition, more restrictive lending practices and higher risk premia might slow down investment. Finally, there is a risk that protectionist measures could distort the efficient international allocation of capital. The crisis has highlighted the urgency of structural reforms in the labour and product markets to limit the crisis’ negative impact on output and employment. The crisis may become a catalyst for the implementation of structural reforms to increase labour force participation, enhance the flexibility of the labour market, improve human capital, increase competition in goods and services markets and boost investment in R&D. Reforms can affect the level and/or trend growth of the potential output. Without such measures, it might take a politically inacceptable amount of time to return to pre-crisis output levels and trend growth rates. Towards more robust financial framework As stated earlier, from the early stages of the ongoing financial turbulence, public authorities have sought to identify the weaknesses in the financial system and draw lessons to inform policy changes. Policy actions have been geared toward maintaining the effective functioning of intermediation services, and to reinforcing the resilience of the financial system and safeguarding its integrity. In this context, I would like to highlight the crucial role that central banks and governments from around the globe have played since the deepening of the crisis in the autumn of 2008, a period during which the strains in the financial sector started to spillover into the real economy. Unstable financial markets prompted central banks and governments to take a number of exceptional measures beyond guaranteeing continued access to liquidity. Shortand medium-term policy objectives were not only to guarantee continued access to liquidity. In fact, policy measures also swiftly sought to deal with impaired assets as well as recapitalizing viable institutions and swiftly resolving non-viable ones. It is remarkable that this happened despite the absence of a common EU framework for crisis management. Governments, for their part, organized a second line of defense against what was qualified by the ECB as “systemic solvency risk”. The main measures have included recapitalizations, guarantees, and asset support schemes for an estimated total commitment of nearly 24 percent of euro area GDP. 8 Beyond the short- and medium-term issues, the current crisis has highlighted substantial structural weaknesses in many areas of the financial system, both in the micro and the macro domains. Therefore, many issues are currently under consideration at the national and international levels with the objective of putting in place coordinated, focused, and consistent long-term policies to build the foundations of a more resilient global financial system. I would like to concentrate on two dimensions which are very relevant from a central bank’s perspective, namely liquidity supervision and macro-prudential supervision. The crisis has brought to the front the importance of macro-liquidity risk in the global financial system and the need of regulating and supervising it. Any threat to liquidity supply has the potential to create adverse effects that can disrupt both the economy and the smooth operation of the financial system by triggering discreet changes in asset prices, in the capital base of financial institutions, and thus by feedback, onto banks’ funding capacity. As a result, interbank markets can now become a source of turbulences, or even exacerbate a crisis, if fundamental uncertainty makes it too costly for banks to assess counterparty risk. Until recently, public authorities did not pay sufficient attention to liquidity supervision. However, some governments, such as that of Luxembourg, have begun to close this deficiency gap. The law of 24th October 2008 attributes to the Banque centrale du Luxembourg (BCL) the responsibility of monitoring the general liquidity situation of markets as well as evaluating financial market operators’ liquidity risk. In this context, liquidity supervision by the BCL will be complementary to the prudential supervision carried out by the Commission de Surveillance du Secteur Financier (CSSF) and will require a close cooperation with the supervision authority The crisis has also shown the limits of the financial stability paradigm that restricts central banks’ involvement in financial stability to safeguarding the financial system ECB Financial Stability report, June 2009, p. 88. and to acting as ultimate providers of emergency liquidity. There is now an international consensus that a central bank is well placed to contribute to macro-prudential analysis given its inherent function as monetary authority. While micro- and macro-prudential analyses are both tools used to promote financial stability, they differ markedly in approach and methodology. Macro-prudential analysis treats aggregate risk as endogenous and, unlike micro-prudential analysis, is therefore not focused on the analysis and surveillance of individual financial institutions. For this reason, it evaluates systemic risk and considers correlations and common exposures across institutions rather than within institutions. Contributing to financial stability using such an approach is a natural extension of a central bank’s mandate under the EU Treaty. Macro-prudential supervision includes developing early warning systems for the analysis and detection of systemic risk as well as conducting macro stress-testing exercises on the financial sector. This suggests that central banks can readily undertake an active advisory role on financial regulation and supervision issues. Despite a central bank’s natural involvement in macro-prudential supervision there still exists a need for close cooperation with micro-prudential supervisors since effective macrosupervision is effected through micro-supervisor’s actions. In addition, and reminiscent of the argument in favor of a “twin-peaks” supervisory framework as suggested by the de Larosière Group report, central banks’ assessments of macro-prudential risks should be reflected in the actions of micro-prudential supervisors. Macro-prudential supervision will be enhanced by addressing the unintended consequences of pro-cyclicality in financial markets. Pro-cyclicality recognizes several institutional and non-institutional sources. Institutional sources of pro-cyclicality include leverage and the increase in market-sensitive valuation techniques such as value-at-risk, procyclical haircuts, triggers in over-the-counter derivative contracts, use of mark-to-market valuation techniques even in illiquid markets, as well as upfront recognition of profits in structured products even though some risks were retained. During the crisis, pro-cyclicality exacerbated asset price changes as financial institutions attempted to sell-off assets once they had exceeded their leverage ratios, which in turn resulted in lowered market prices. Capitalization requirements and accounting regulations subsequently initiated a negative feed-back loop which was intensified by adverse developments in the credit markets as institutions were required to mark their trading books to market. As a result, it became necessary for them to either sell more assets to maintain adequate capitalization levels or to reduce their loan values. What started as a liquidity problem quickly turned into a solvency problem. In this respect, policy measures require a revision of the pro-cyclical elements of the Basel II guidelines; the use of stress tests in lieu of value-at-risk for new risks or products with a short history; the use of “dynamic provisioning” as introduced by the Bank of Spain, an approach that involves building up anti-cyclical buffers during expansions and offers the possibility of drawing them down during recessions. In fine, the pro-cyclical effects arising from the interplay between leverage and valuation need to be assessed from a financial stability perspective. Common, EU-wide stress testing of the overall banking sector is another area of regulation in which central banks can perform an important role. The objective of stress testing is to assess the resilience of the banking sector along with its ability to absorb shocks. Whereas supervisory authorities remain responsible for stress testing of banks on an individual basis, central banks would conduct analyses in order to determine aggregate need for capital and liquidity requirements. These testing procedures, based on common scenarios, would focus on macroeconomic shocks and the resulting response of the banking sector. The tests would focus on credit risk, equity price risk, foreign exchange risk, interest rate risk and liquidity risk. As an example of the stress testing, the recent ECB exercise shows that euro area 16 Large and Complex Banking Groups (LCBGs) are forecast to lose approximately 200 billion Euros due to credit risk exposures, a figure that illustrates the importance of stress testing national banking sectors (see text chart). Additional simulations performed by the ECB show that to meet a Tier 1 capital ratio of 10 percent, 47 billion Euros in additional capital would be required by the group of 16 LCBGs. If instead of raising capital, the same set of banks reduced risk-weighted assets, simulations show that risk-weighted assets should shrink 469 billion Euros. Shortfalls and deleveraging would be even larger on the basis of leverage ratios, such as the core Tier 1 to tangible assets. Finally, last April, the EFC requested the CEBS to coordinate EU-wide stress testing of the banking sector. These exercises, built on common scenarios derived from the ECB adverse scenario, are designed to assess the resilience of banks and the implications for financial stability of the EU banking system as a whole on a consistent and comparable manner. The regulatory paradigm that relies on self regulation has proven to be insufficient. Recent proposals for a new regulatory framework put forward by the de Larosière Group and the Obama administration are poised, along with the work by central banks and supervisory authorities, to enhance the stability of the international financial system. These proposals offer several important steps towards a more robust financial sector regulation. In June of this year, the European Council voiced its agreement in favor of the creation of a European Systemic Risk Board (ESRB) whose mission will be to monitor and assess risks to financial stability in the EU financial system. This decision followed the publication of the de Larosière Report on 25 February 2009, the Commission Communication of 27 May 2009 and the ECOFIN Council conclusions of 9 June, 2009. The ESRB will deliver quarterly assessments of risks to financial stability and policy recommendations. To carry out this task, the ESRB will require a wide range of information from both macro- and micro-prudential analysis. These data would be obtained from the national supervisory authorities and national central banks. Additionally, impact assessments would draw on information resulting from stresstesting exercises. This new framework poses a strategic challenge for the Eurosystem because of issues pertaining to administrative support, logistical support and support in the form of expertise for the ESRB. Many European central banks and international organizations are about to implement permanent organizational changes as a result of the crisis; enhanced coordination and cooperation will be unavoidable components of the new nascent regulatory and supervisory framework. In combination with more effective and strengthened regulation, central banks need to enhance their mission of ensuring financial stability. Although this will require more resources and the development of expert knowledge, it is necessary to strengthen the financial system. For its success, it will also require support in terms of macroprudential supervision and coordination at both the EU and international levels. At the EU level, financial stability frameworks are largely national with an EU umbrella superstructure to facilitate cooperation, but which has been found wanting in terms of efficiency, of ex-ante compatibility between micro-prudential and financial stability objectives, of a mismatch between responsibilities and accountability in crisis management, of the lack of a crisis resolution framework for systemic banks, and of deposit guarantee schemes not fully consistent with the single financial market. Thus EU financial stability will be enhanced by developing a commonly shared philosophy concentrated not on what the system can deliver, but on what it should deliver within the single market. At the international level, the crisis made clear that there has been a deficit of multilateral surveillance, and thus, the IMF reform and setting up an operational framework for joint work with other international organizations and fora constitute inescapable tasks. I wish to conclude on a positive note: The crisis may be a “welcome” opportunity to gather the political will to put in place long-needed structural reforms in good, service and labour markets with the objective of offsetting the possibly lasting negative impact of the crisis on trend growth. Similarly, the crisis can be a golden opportunity to put in place the foundations of a more robust regulatory and supervisory framework in line with the large number of reform proposals currently discussed.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 5th Economic Forum Belgium-Luxembourg-Arab Countries, Brussels, 17 November 2009.
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Yves Mersch: Islamic finance – partnerships opportunities between Luxembourg and the Arab countries Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 5th Economic Forum Belgium-Luxembourg-Arab Countries, Brussels, 17 November 2009. * * * Excellencies, Governor, ladies and gentlemen, good morning, I am very pleased to be here today, and I would like to thank the Arab-Belgium-Luxembourg Chamber of Commerce for inviting me and especially its general secretary Mr. Hijazin. Based on the agenda of this 5th Economic Forum, I am looking forward to hearing and learning and to explore potential partnerships opportunities between Luxembourg and the Arab countries in the field of Islamic finance, which receives an increasing attention. In this perspective, I welcome and consider as essential such conferences that promote greater awareness of important developments within international banking. Despite its traditional approach, Islamic finance is a key “innovation” in the financial area since the seventies and I expect that today’s conference will provide an excellent opportunity to exchange information and ideas on current issues relating to this important sector. While efficient reactions to the global financial and economic crisis have been taken by government and central banks worldwide to stabilise the financial conditions of banks and reduce funding pressures, this unprecedented turmoil reinforces the need to revisit our economic and financial paradigm. The crisis suggests to some to deviate from markets driven economies and behaviours and to explore more ethical and humanistic values to drive sustainable value creation. One stream in this context is Islamic finance promoting an alignment with the real economy. Based on its prohibition of leverage activities, its principles of justice and participation, Islamic finance is said to contribute to the reduction of the risk perception in the economy and hence its safe recovery. 1 Specialists estimate the volume of Islamic investments to exceed USD 750 billions and the pool of investible assets in the countries of the Persian Gulf and South East Asia to reach USD 5,000 billions. 2 In this part of the world, a non negligible part of the European population has ethical investment and placement needs based on the Shari’ah that have, so far, not yet appropriately been addressed by the conventional banking offering. As of today, more than 38 millions Muslims live in Europe, representing more than 5% of the population. 3 Government and financial institutions alike try to cater for these needs. Intrinsic difficulties for Islamic financial institutions remain however related to the management of their liquidity and I will review how central banks, have engaged into different initiatives to solve these issues so far. I will also share with you some considerations on the challenges that may arise when introducing Islamic financial services into the European framework. Chris Morris (2009) et al., “Has the crisis shown the strengths or the weaknesses of Islamic finance?”, IFM Global Market Monitor, 21 October. Gilles Saint Marc (2008), “Finance islamique et droit français“, presentation to the Finance Commission of the French Senate, 14 May, page 3. Luis Lugo (2009) et al., “Mapping the Global Muslim Population”, Pew Forum on Religion & Public Life, October. As central bankers in Europe, we welcome a wide variety of banking approaches such as the Islamic one. 4 Our purpose is to focus on the implications for safety and soundness of institutions engaging in Islamic finance and ultimately their potential risk for the banking system. As a result, while banking authorities are committed to adapt and to be accommodating for Islamic finance within the European regulatory framework, it is crucial to continuously ensure a level playing field, requiring from Islamic financial institutions the same high licensing and supervision standards to those expected from conventional ones. Although banking authorities in Europe are certainly not competent in religious issues and do not intend to replace the official Muslim scholars to take a position and interpret Shari’ah precepts, it is important that the banking and financial authorities become more familiar with the principles and practices specific to Islamic finance in order to make appropriate supervisory and regulatory judgments. As early as 2005, the Banque centrale du Luxembourg was the host of an awareness programme co-organised in Luxembourg with the Islamic Financial Services Board. This was followed by various efforts, supported notably by the Luxembourg government, the fund administrators, the University in order to identify obstacles to solve and opportunities to enhance for the development of Islamic Finance in Luxembourg. The Government has instructed the tax authorities to come up with proposals in order to have a level playing field and ensure tax neutrality for Shari’ah compliant transactions (essentially Sukuk and Murabaha). I have participated, along with a number of my colleagues of other central banks, in several conferences both in Europe, the Gulf region and South East Asia, in an effort to stay abreast of developments in this market and to emphasize our continuing interest in this. 5 This flexible approach for Islamic investment products and services out of Luxembourg originated in the late seventies, when the Islamic Banking System Holdings Limited Luxembourg was established as first Islamic financial institution in Europe. This was followed by the establishment of Takafol S.A., 6 a life insurance company in December 1982. 7 Those initiatives paved the way for future successful Islamic development which was continuous since then. According to the most recent statistics, there are today 15 Sukuk listed in Luxembourg for a combined value of EUR 5 billions. 8 Luxembourg is the first jurisdiction in a non Muslim country 9 for the domicile of Shari’ah compliant funds with nearly 40 funds managed and promoted by leading global investment companies1. Earlier this year, a major German bank launched its new platform, domiciled in Luxembourg, called Al Mi’yar to facilitate the issuance of Shari’ah compliant securities. Some of the features of Shari’ah-compliant investment are designed to attract Western investors looking for socially responsible investment schemes and who are not only interested in the risk/reward relationship of their investment, but who are also concerned with Christian Noyer (2009), “Global stability, the future of capital markets and Islamic Finance in France”, Euromoney Seminars, Islamic Paris Conference, Paris, 29 September. “3rd Islamic Financial Services Forum: The European Challenge”, jointly organised with the Financial Stability Institute and hosted by Banque de France on Islamic liquidity management, Paris, 3 March 2009. Now denominated Solidarity Takafol S.A, based in Luxembourg. Parker (2009), ”Luxembourg promotes as domicile of choice for funds”, Arab News, 18 May. Amount and number as of 28 October 2009, source Bourse de Luxembourg. For information, on 12 August 2009, the Luxembourg stock exchange has listed a €1.5 billion Sukuk issued by Petroliam Nasional, Malaysian state owned Oil Company. Luxembourg is the 4th domicile for Shari’ah compliant funds in the world with 7% of them following Malaysia (23%), Saudi Arabia (19%) and Kuwait (9%) – see Ernst & Young’s Islamic Funds & Investment Report 2009, page 72. issues of accountability and social responsibility. As you all know, based on the precepts of the Shari’ah, Islamic funds invest in ethical and non leveraged enterprises which for those reasons have a low risk profile. Despite the relative success of Islamic financial services in Luxembourg regarding notably the investment funds and the Sukuk, not all of the regulatory challenges raised by these Islamic institutions have been resolved – challenges that arise from looking to introduce Islamic financial principles into a regulatory framework that was structured without these principles in mind. However, these issues are not specific to Luxembourg only and exist in the whole western countries. 10 One example of issues that precisely fits into the role of a central bank is the absence of an appropriate market of Shari’ah instruments to facilitate the management of the liquidity needs of Islamic banks or Islamic financial institutions and funds. The prohibitions of interest rate as well as the lack of a dedicated infrastructure and adequate instruments prevent the Islamic banks from developing a viable value proposition: rejecting leverage and speculative transactions, Islamic banks need to have greater amount of capital and to sustain a higher liquidity ratio than their conventional counterparts. As a result, their activities turn to be less profitable and less competitive compared to those of their conventional counterpart when addressing the same customer segment. The structural obstacles together with the lack of technical and contract standardization ultimately prohibit Islamic financial institutions from succeeding in the competitive financial landscape where consumers make rational choice not only driven by religious principles. In order to facilitate the emergence of a resilient Islamic financial market in Europe, we have to adapt and shape the infrastructure and supervisory environment to allow efficient and cost effective trading and clearing for a significant number of investment-grade Islamic financial papers across the whole maturity spectrum. In this perspective, it is worth noting that in the current turbulent period, raising finance through Sukuk issuance appears to be cheaper than recurring to conventional bonds due to the burgeoning demand for Islamic instruments. 11 To reflect the specific needs of Shari’ah-compliant finance, the AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) and the IFSB (Islamic Financial Services Board) are working on developing international supervisory standards for instance to improve the corporate governance frameworks or implement capital adequacy and risk management standards for Islamic financial institutions. 12 In closing, let me emphasize that, the Banque centrale du Luxembourg has applied for membership to the Islamic Financial Service Board and would be the first central bank in Europe to participate to this international standard setting organisation. We also second staff to become familiar with Islamic finance and study the before mentioned issues, notably liquidity management. Despite the lack of detailed and scientific studies about the potential effect of Islamic finance on the price and financial stability, the resilience of Islamic banks to the recent crisis 13 Cf. Gilles Saint Marc (2008), “Finance islamique et droit français“, presentation to the Finance Commission of the French Senate, 14 May, page 3. Cf. “3rd Islamic Financial Services Forum: The European Challenge”, jointly organised with the Financial Stability Institute and hosted by Banque de France on Islamic liquidity management, Paris, 3 March 2009. Robin Wigglesworth (2009), “Islamic bonds spark rush of international interest“, Financial Times, 10 November; “Has the crisis shown the strengths or the weaknesses of Islamic finance?”, Global Market Monitor, 21 October. Norbert Hellmann (2009), “Finanzkrise taucht Islamic Banking in ein neues Licht”, Frankfurt Börsen-Zeitung, 10 November. Durmus Yilmaz (2009), “Islamic Finance: During and after the global financial crisis”, Istanbul, 5 October. practically demonstrates the positive diversification effect they could play, contributing therewith to a systemic equilibrium. Moreover, Islamic finance acts as a natural hedging scheme restricting excessive credit boom in so far as it links the supply of financing (what would conventional banks call credit) to the growth rate of the economic activity. Thank you very much.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Gala CFO World 2009, Luxembourg, 25 November 2009.
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Yves Mersch: Credit developments in Luxembourg Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Gala CFO World 2009, Luxembourg, 25 November 2009. * * * Introduction Ladies and Gentlemen, It is a great pleasure for me to be here today and I very much appreciate the opportunity to talk about credit developments in Luxembourg. In times like these the issue could not be more pertinent. Bank lending constitutes one of the most important sources of external financing. To many small- or medium-sized enterprises (SMEs) in particular, bank loans are the only means of external financing available; rather than raising funds directly, for instance through the issuance of bonds or shares, they have to go through a bank to obtain the necessary funds to finance their activities. The importance of credit intermediation cannot be overstated, and a healthy and well-functioning financial sector is therefore part and parcel of a healthy and well-functioning economy. It goes without saying that a central bank, or a system of central banks, has a keen interest in credit developments. Indeed, credit growth is tightly interlinked with economic activity and inflation developments. Before I talk about actual credit developments in Luxembourg, let me say a few words about the main monetary policy transmission channels involving banks. Monetary policy transmission channels involving banks While most monetary policy transmission channels go through the banking sector, either through the price of credit or through credit volumes, central banks can affect the supply of loans as well as the demand side. Take the traditional interest rate channel. Cuts in the policy rate affect the investment and consumption decisions of businesses and households only to the extent that they are actually passed on through the banking sector. Banks determine the extent of the passthrough and their lending rates in turn impinge on the demand for loans from firms and households. Note that it is the real rather than the nominal interest rate which matters in this decision-making process. The underlying assumption is that some prices and wages are inflexible (or “sticky”) in the short run. This implies that the aggregate price level adjusts slowly over time, entailing that falls in the nominal interest rate also lead to falls in the real interest rate. This is an important distinction, as it provides a mechanism that enables monetary policy to stimulate the economy even if nominal interest rates hit their zero lower bound. Indeed, an expansion in the money supply can raise expected inflation, thus lowering the real interest rate and providing further stimulus to the economy through the interest rate channel. Adjustments in short-term interest rates are also transmitted to long-term rates, which ultimately determine investment decisions and decisions about durable consumer expenditure. The expectations hypothesis of the term structure of interest rates is but one mechanism which explains how short-term interest rates may affect long-term rates, namely through an average of expected future short-term rates. While the interest rate channel largely affects loan demand through the price of credit, monetary policy can also influence loan supply through the so-called credit channel. The credit channel proceeds from the assumption that there are frictions in financial markets, such as asymmetric information and moral hazard. A key function of banks is to overcome such information and incentive problems by screening and monitoring borrowers. The credit channel is made up of two sub-channels. The first is the bank lending channel and works through the liability side of banks’ balance sheets, which in turn triggers certain adjustments on the asset side. Thus, an expansionary monetary policy tends to increase loan supply by raising the availability of funds for banks. The empirical evidence on the existence of a bank lending channel in the euro area is rather mixed though. However, the bank lending channel can also work through banks’ capital positions. Cuts to the policy rate and a steepening yield curve can raise banks’ net interest income, which in turn affects profitability and hence bank capital. The available evidence indicates that this only holds for countries where banks lend predominantly at fixed long-term rates, however. In fact, the opposite effect is found in countries where banks lend largely at floating or shortterm rates. In this context, it should be mentioned that corporate loans in Luxembourg are by and large floating rate loans (or loans with an interest fixation period up to one year), as are mortgage loans; only consumer loans are primarily granted at fixed rates. However, asset price rises following a reduction in policy rates may also raise bank capital through positive valuation effects on banks’ trading books. The second sub-channel of the credit channel is called the balance sheet channel and works through changes in the quality of the borrower. Through its impact on cash flows and collateral values, monetary policy can affect borrowers’ net worth, which is inversely related to their external finance premium. Owing to the pro-cyclicality of net worth, the external finance premium is thus counter-cyclical and therefore magnifies the impact of changes in short-term rates on credit availability. This spills over into consumption and investment, and finally into economic growth. This mechanism is also known as the “financial accelerator” A final monetary policy transmission channel involving banks I wish to allude to is the risktaking channel. Low interest rates and abundant liquidity may decrease risk aversion and encourage risky investments, as well as leading to laxer credit standards. This raises the supply of bank loans and can have a significant impact on credit growth. The evolution of credit volumes So much for the theoretical background. Let me now move on to how corporate credit volumes have actually evolved in Luxembourg, and how those developments tie in with those at the euro area level. My intention is not to identify the workings of the different monetary policy transmission channels in Luxembourg – this would be a Herculean undertaking! However, it is helpful to keep the theoretical underpinnings in mind when looking at the actual credit developments and the potential underlying explanatory factors. As you can see in the chart, the underlying trend developments in Luxembourg and at the euro area level coincide, despite the higher volatility in the Luxembourg data. Most notably, corporate credit dynamics rose continuously up until 2008, when they began to unwind rather rapidly, first in the euro area at large and shortly thereafter also in Luxembourg. The pace and magnitude of the decline in the loan dynamics are particularly worrying, with below or near zero growth rates in the third quarter 2009. It is worth emphasising that roughly one year ago, in September 2008, the annual progression of corporate loan volumes in Luxembourg peaked at 54%! As for credit to households, the annual progression of mortgage lending has been on a downward trend since 2006, long before the crisis. However, this downward trend accelerated considerably and the annual growth rate recently stabilised just under 6%. Consumer credit has been progressing steadily since 2008, which represents a trend inversion compared to the preceding years. All in all, household loan dynamics have been much more benign than corporate credit developments. This raises the question as to how and why the corporate credit cycle could take such a rapid U-turn. While the obvious answer is that banks refuse to grant loans in the wake of the financial crisis, this is but one side of the coin. Disentangling demand and supply Indeed, the Bank Lending Survey or BLS – a euro area-wide bank survey on quarterly credit developments – strongly indicates that the sharp slowdown in corporate credit expansion is owing to both supply- and demand-side factors. The graph plots the net unweighted responses provided by the participating banks from the Luxembourg BLS sample. A positive “net percentage” indicates that, relative to the preceding quarter, banks have tightened their credit standards or reported higher loan demand by firms. Conversely, if the respective line is below zero, this points to an easing of banks’ credit standards or a fall in loan demand. As you can see in the chart, the survey results suggest that banks have been tightening credit standards since the onset of the financial crisis, making it more difficult for companies to finance their activities; lending standards have been tightened in particular for large enterprises. At the same time, however, the period of high loan demand ended shortly after the onset of the financial crisis, and net demand even turned negative on several occasions. The slowdown in loan dynamics is therefore owing to the combined impact of tighter credit standards on the one hand and a deceleration or fall in loan demand on the other. You may have noticed that the slowdown in loan dynamics is lagging the tightening cycle: while the progression of loans to companies peaked in the third quarter 2008 before it slowed down rather rapidly, the BLS suggests that banks were already tightening credit standards since the early stage of the crisis in the second half of 2007. In other words, the information on credit standards from the BLS serves as a lead indicator. While the correlation between loan growth and credit standards is not perfect, the available evidence suggests that loan growth will stabilise shortly and subsequently pick up in the course of 2010. This prediction is in line with an ad hoc survey we carried out very recently. The survey questionnaire was sent to four banks with a combined share of roughly 50% of the corporate credit market in Luxembourg. In one of the questions, the four participating banks were asked how they expect corporate lending volumes to evolve. For consistency, the BLS methodology has been used and the results are thus expressed as net percentages. However, the results of the ad hoc survey have been weighted according to the sample shares of the individual banks, while the BLS results are unweighted owing to methodological reasons. As you can see in the chart, the survey results point to a moderate pickup in lending volumes, while lending to SMEs is even likely to accelerate considerably in the second half of 2010. New lending is expected to be the main driver behind the pickup in overall lending volumes, which also encompass loan repayments and write-downs. Banks do not expect a substantial change in loan redemptions over the forecast horizon. As for write-downs on loan portfolios, they do anticipate a rise in write-downs in Q4 2009 and H1 2010, but their mitigating impact on loan dynamics is expected to dissolve entirely in the second half of 2010. Of course, given that banks’ expectations pertain to lending volumes rather than credit standards per se, the expected rise in corporate lending should be seen as the interplay of demand and supply. Some information on the demand side more specifically is also available from this ad hoc survey, though. It should be borne in mind that demand is rather difficult to predict, however; moreover, it is worth emphasising that the survey was addressed to loan officers and therefore naturally reflects the assessment of the lender rather than the borrower’s point of view. Be that as it may, as you can see in that same chart the four sample banks also expect the number of loan applications from new customers to rise, in particular as regards large enterprises. Loan applications from new SME customers, however, are not expected to rise significantly until the second half of 2010. There is little doubt that the corporate credit outlook is improving. Nevertheless, it remains legitimate to ask why banks have tightened their credit standards in the first place. First of all, not all banks have. In the BLS, the highest net percentages recorded in one single quarter have not exceeded 50%, the equivalent of 3 banks. Second, the results from the BLS are not weighted by bank size – in line with the methodology applied at the euro area level – otherwise you would see that the tightening is in fact not nearly as broad-based as it seems. But of course the question remains as to why some banks are tightening their lending standards, thereby reducing the supply of loans to enterprises. It is tempting to blame the tightening entirely on the financial crisis. In a way, this is also correct. However, the impact of “pure” supply-side constraints is not nearly as large as one would think. In other words, while it is true that a number of banks are more reluctant to grant loans to companies, this is not solely attributable to market access or to the cost of funds and balance sheet constraints. Indeed, as the next slide shows, the major reason banks have become more reluctant to grant loans to firms is that their risk perceptions have risen sharply. Since the onset of the financial crisis in 2007, the various explanatory elements pertaining to the banks’ cost of funds and balance sheet constraints (represented by the red, orange and yellow bars in the chart) have indeed contributed to tighter lending standards. However, it is obvious from the chart that the role of these explanatory factors is secondary, while it is banks’ risk perceptions (represented by the blue and green bars) that have played a key role. Risk perceptions pertaining to the industry- or firm-specific outlook in particular have contributed to more stringent lending standards. If banks have chosen to restrict lending, it is therefore largely because of the economic downturn; admittedly, “pure” supply-side elements which constrain banks and thereby leave them no choice but to decrease lending volumes also played a role, but a much smaller one than is commonly believed. This evidence can easily be linked up to the theoretical background on monetary policy transmission channels expounded earlier: “pure” supply-side factors pertain to banks’ availability of funds, i.e. to the bank lending channel, whereas risk perceptions relate to the quality of the borrower, i.e. to the balance sheet channel. How have banks implemented their tighter credit standards? The available evidence indicates that banks have strongly cut their lending rates, seemingly suggesting that tighter credit standards have been implemented through an adjustment of non-price rather than price conditions. The chart plots the evolution of lending rates in Luxembourg, available through the Eurosystem reporting framework since 2003. The data indicate that loans to enterprises are usually floating rate loans (or loans with an interest fixation period up to one year); the chart therefore plots flexible (or short-term) lending rates on new business. Moreover, interest rates may differ substantially depending on the size of the underlying loan granted to the counterparty, which is why the reporting framework requires banks to distinguish between small and large loans. As you can see in the chart, there was a substantial reduction in corporate lending rates – for both small and large loans – in line with the monetary policy easing in the euro area. Peak-to-trough, lending rates on small loans have fallen from 6.24% to 2.42% in the twelve months up to September 2009; lending rates on large loans have fallen from 5.55% in September 2008 to 1.93% in September 2009. However, the reporting framework provides no breakdown by geographical origin of the counterparty; this is unfortunate given that the lending rates are volume-weighted and that about three quarters of outstanding corporate loan amounts granted to companies in the euro area are actually granted to non-domestic enterprises. The available information does suggest, however, that corporate lending rates have come down sharply, while banks have at the same time reported tighter credit standards. How can this information be reconciled? Were the stricter lending standards implemented through non-price factors, such as loan covenants or collateral requirements? Once again, the answer comes from the BLS. The survey does not point to a substantial tightening of nonprice lending conditions, but rather to higher margins. Most notably, banks have signalled higher margins on riskier loans. This scores well with the rise in risk perceptions already noted earlier in the context of explanatory factors underlying the tightening of lending standards. Moreover, it is consistent with non-survey data: margins, as given by the difference between lending rates and three-month EURIBOR rates, have risen since late2008. I have talked extensively about the supply of loans. This is because central banks collect a lot of information from the banking sector, either through statistical reporting requirements or in the framework of voluntary surveys banks participate in. Information on the demand side is sparse, which is why I have only mentioned it cursorily, in the context of the BLS and the ad hoc survey we carried out. The BLS does encompass further demand-side questions which are worth looking at in more detail though. Further to this, the next chart plots the key explanatory factors underlying the evolution of loan demand. You will remember that loan demand began to slow down in 2008. The chart shows that there are various elements pulling loan demand in opposite directions. As shown by the orange and red bars, financing needs pertaining to fixed investment and, most notably, to mergers and acquisitions and corporate restructuring, have exerted strong downward pressure on loan demand. At the same time, financing needs pertaining to inventories and debt restructuring have pulled loan demand in the opposite direction, as shown by the yellow and green bars. Because there are countervailing factors, the evolution of loan demand is somewhat volatile; however, there is no questioning the fact that generally loan demand has come down since the onset of the financial crisis, in spite of some quarter-on-quarter fluctuations. Conclusion To conclude, let me emphasise that the slowdown in corporate loan dynamics is at this stage not fully demystified. What we know for a fact is that loan volumes have ceased to expand at double-digit rates. Although the pace at which loan growth rates have come down is startling, the annual progression of corporate credit has mostly remained positive for now. Moreover, the available information suggests that corporate lending should recover soon and pick up pace in the course of 2010. I have focused on the supply side because, as a matter of fact, central banks have much more information on lenders than on their counterparties. However, I also underscored that the tightening in credit standards is not as broad-based as the underlying data would suggest. This leaves the demand side, but comprehensive and reliable information on the borrower is notoriously difficult to come by. Perhaps this gap can to some extent be filled at today’s conference. Thank you for your attention. Charts Chart 1 The main monetary policy transmission channels involving banks Chart 2 Corporate credit developments in Luxembourg and in the euro area, annual growth rate (in %) Chart 3 Household credit developments in Luxembourg, annual growth rate (in %) Chart 4 The evolution of credit standards and loan demand in Luxembourg (net percentages) Chart 5 Expectations regarding lending volumes and loan applications from new customers (weighted net percentages) Chart 6 Explanatory factors underlying the tightening of credit standards (net percentages) Chart 7 Floating (or short-term) corporate lending rates on new business in Luxembourg Chart 8 Explanatory factors underlying the evolution of loan demand (net percentages)
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Luxembourg School of Finance, Luxembourg, 28 January 2010.
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Yves Mersch: The financial crisis – challenges and new ideas Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Luxembourg School of Finance, Luxembourg, 28 January 2010. * * * I am very pleased to be here tonight and wish to thank the Luxembourg School of Finance for providing me with this opportunity to speak on the recent financial crisis, the policy response, and the challenges ahead. The run-up to the crisis was driven by animal spirits, which encouraged excessive risk-taking by investors and a significant increase in financial sector leverage. Asset price declines triggered an unexpected departure from the normal functioning of the financial system, plunging agents into unquantifiable “Knightian” uncertainty. This unleashed panic, characterised by a “flight to safety” and fire sales of financial assets that amplified the crisis. The risk to systemic stability required intervention by the authorities that was unprecedented both in its extent and in its form. It is important to recall that we have very limited knowledge of many aspects of the crisis. All financial crises share certain phases of market behaviour, but they are all different. In recent years some warnings highlighted existing imbalances and vulnerabilities, but nobody predicted the timing and nature of such a sudden break in market behaviour. As the crisis unfolded, authorities had to take policy decisions rapidly although their effects had become uncertain, as normal market functioning could no longer be expected. What was most surprising in the recent crisis was the role played by liquidity. In retrospect, it is easy to conclude that it should have been monitored more closely and that pro-cyclical behaviour needed to be mitigated more effectively. However, these suggestions only represent “preventative care”. The implementation of such measures could reduce the likelihood, or at least the extent, of future crises. Once a crisis hits, it is too late for “preventative care” and the authorities have to implement “emergency interventions”. These carry significant costs for the taxpayer, so it is natural to ask how the private sector can help share this burden. In my remarks, I will begin with the recent past, reviewing the crisis and the policy responses of both central banks and governments. Then I will turn to the lessons of the crisis and the challenges both in the immediate future and at a longer horizon. I wish to focus on the need to reform the current financial architecture. This process is already underway at the global level as the April meeting of the G20 endorsed Financial Stability Board proposals in this domain. One important objective is to re-align incentives in the financial sector from an excessive focus on short-term profits towards more “socially useful” activities that include reducing systemic risk and encouraging the creation of long-term wealth. Finally, I will comment on some “new ideas” that may contribute to this aim. 1. The policy response to the crisis In the financial crisis, monetary authorities intervened to address liquidity issues and government authorities intervened to address solvency concerns. These complementary roles were clearly established long ago. However, it is generally agreed that the recent crisis somewhat blurred this distinction in practice. As a central banker, I will begin by reviewing the response of the monetary authorities. 1.1 Central bank policy response The financial crisis initially appeared in August 2007 as a sudden shortage of liquidity in the money market. Traditionally, central banks monitor the functioning of this market very carefully, because it is here that monetary policy is implemented through regular refinancing operations. This is why the Eurosystem was the first to respond with massive liquidity injections. The decline of asset prices reduced the value of complex structured finance products, which were widely disseminated across the banking sector. It suddenly became difficult to find a buyer for these instruments. As trading volumes collapsed, it also became difficult to value these assets accurately because prices were no longer observed on the market. Uncertainty increased dramatically and banks began to view each other with suspicion as they realised that individual exposures were not transparent. As the inter-bank market dried up, banks found themselves hoarding cash to rebuild their liquidity buffers. This induced them to tighten credit standards, posing the risk that they might cut back loans to firms and households, transmitting the financial crisis to the real economy. In mid-September 2008 the collapse of a major financial player set off a global financial panic. Given the severe downturn in the euro area economy and receding inflationary pressures, the Governing Council of the European Central Bank responded by rapidly lowering interest rates to 1%, a historical low for the euro area countries in the post-war period. In addition to standard monetary policy measures, the Eurosystem introduced a policy of “enhanced credit support” intended to limit the role of liquidity in the propagation of the crisis, to maintain the transmission of interest rate decisions, and to enhance the flow of credit to the real economy. These extraordinary measures lead to a doubling of the central bank balance sheet in the euro area and an even greater expansion in the US. In effect, the money market ceased to exist and the central bank took over its intermediation role. This emergency intervention contributed to a broad-based improvement in financial markets and a return to a more normal functioning of the money market. According to the most recent figures, the Eurosystem’s balance sheet has already shrunk by 11% from its peak in December 2008, while in the US it has remained stable. Overall, central banks appear to have successfully performed their function as “lender-of-last-resort”. 1.2 Government policy response Turning to the government policy response, this took three forms: (i) the fiscal stimulus, (ii) asset support and (iii) capital injections and guarantees. In October 2008 the intensification of the financial crisis began to affect the real economy and the need for a fiscal stimulus became apparent. In April 2009 the G20 summit in London signed a global plan for recovery and reform. Although justified by the extent of the crisis and varied in extent across countries, this fiscal stimulus caused a substantial deterioration of public deficits and debt-to-GDP ratios. In addition to asset support, governments also intervened on the liabilities side of bank balance sheets, with direct capital injections and with state guarantees. Since these measures are the subject of tonight’s conference, I will discuss them in more detail in the second part of my speech. For now, let me just recall that so far euro area governments have committed 26% of GDP to supporting the financial sector (although the sum actually drawn is only about 10% of GDP). This support was necessary, not for the banks’ sake, but for the sake of the central role they play in the market economy. This is particularly true in the euro area, where banks are firms’ main source of external funding, as opposed to other economies whose financial system is sometimes considered more “market based”. These differences across economies also determined different policy responses. The US and the UK initially focussed on asset support that was intended to return markets to proper functioning. Eventually, they turned to their second line of defence, with direct capital injections to support the banks. In the euro area, this order was reversed, with authorities more focussed on the banking sector and turning to asset support as a second line of defence. 2. Preparing for the future Having described the recent policy response to the crisis, I turn now to the challenges that remain for the future. I will divide my remarks in three parts. First, the immediate challenge is to implement exit strategies from the current extraordinary monetary and fiscal measures. Second, a longer term challenge is to design and implement financial reform that effectively mitigates systemic risk. Finally, I will discuss some new ideas advanced within this process of reform. 2.1 Immediate challenge: monetary and fiscal exit strategies First, let me consider the exit strategy from current extraordinary monetary measures. As I mentioned before, there are signs of substantial improvement both in financial markets and in the real economy. These suggest that the Eurosystem extraordinary liquidity measures are not all needed to the same extent as in the past. However, unwinding of enhanced credit support must be both timely and gradual. It must be timely because there are risks associated with acting either too early or too late and it must be gradual because the situation is only improving progressively. The process of withdrawal is facilitated by the fact that many of the non-standard measures were designed to phase out naturally over time unless renewed by explicit policy decisions. For other measures, the situation has improved sufficiently for Governing Council to initiate the gradual process of withdrawal. The cornerstone of the exit strategy is the ECB primary objective of price stability in the medium term. This has guided the introduction of enhanced credit support and will govern the process of withdrawal. As with the monetary policy strategy, the exit strategy cannot precommit Governing Council to a given timing or sequence of actions. These must be decided with reference to changing economic and financial circumstances. Now I wish to briefly address the exit strategy from the current fiscal stimulus. In addition to government measures supporting the financial sector, the extraordinary fiscal stimulus and the so-called automatic stabilisers have substantially deteriorated public finances during the current economic crisis. According to autumn 2009 forecast of the European Commission, the deficit ratio in the euro area should reach 6.9% of GDP in 2010, while government debt is expected to reach 84% of GDP in 2010. These significant fiscal imbalances undermine public confidence in the sustainability of public finances, which may place an additional burden on monetary policy in maintaining price stability. As stressed by the ECB Governing Council, national governments must abide with the EcoFin Council agreement to communicate timely, ambitious and credible fiscal exit strategies as soon as possible. The fiscal consolidation process should be transparent and should be guided by the rules of the Stability and Growth Pact (SGP). Current government commitments to start consolidation in 2011 at the latest represent a minimum requirement for all euro area countries. Furthermore, given the future challenges raised by ageing populations, fiscal consolidation efforts should provide a strong focus on expenditure reforms. Developing and communicating fiscal exit strategies is an urgent policy priority. 2.2 Financial reform process to mitigate systemic risk Beyond the immediate challenges, I wish to focus on the ongoing programme of wideranging financial reform. The objective of this process is to counter systemic risk and enhance the future resilience of the financial system. The recent crisis provided us with three important lessons that could guide this process of financial reform • First, systemic risk needs to be monitored by an operational macro-prudential framework, extending the perimeter of regulation and mitigating the pro-cyclicality of the financial system • Second, incentives need to be aligned on creating long-term value and not shortterm profits • Third, cooperation in surveillance and oversight needs to be improved Let me expand on the first lesson, the need for an operational macro-prudential framework. The analysis and control of systemic risk was a key missing ingredient in the run-up to the crisis. The problem is that although banks may seem resilient when considered individually, the banking system as a whole may still be vulnerable. This paradox can be explained through the two key dimensions of the macro-prudential framework. First, the cross-sectional dimension focuses on the risk of joint failures that reflects similar exposures or interconnectedness. Second, the time dimension focuses on interactions within the financial system, as well as feedback between the financial system and the real economy. These links account for the pro-cyclical behaviour of the financial system, which can aggravate systemic risk by amplifying the effects of the business cycle. The Basel Committee on Banking Supervision has already agreed on a set of proposals aimed at improving the resilience of the system. These focus on raising the quality and quantity of bank capital in order to better absorb future shocks. They also suggest introducing a bank leverage ratio, although this will have different effects in the US and the EU unless there is convergence in accounting standards. More generally, there is agreement on the need to require banks to build-up countercyclical buffers in good times that can be drawn down during bad times. In addition, the Basel Committee and the CEBS (Committee of European Banking Supervisors) are developing new standards for liquidity. The European Union has also enhanced its macro-prudential framework by creating the European Systemic Risk Board, with responsibility for issuing early warnings and recommendations. The second lesson was that incentives need to be aligned on creating long-term value rather than short-term profits. The final lesson of the crisis was that it clearly revealed the need to improve cooperation in surveillance and oversight. This requires better links between the two pillars of financial supervision: the micro approach, which focuses on individual institutions, and the macro approach, which focuses on systemic risk. 2.3 New ideas to prepare for the future I have described the immediate challenges linked to exit strategies and the longer-term process of financial reform that is already underway. Let me now comment on some new ideas advanced in the wake of the crisis to prepare for the future. In a Financial Times column entitled “how to save banks without using taxpayers’ money” Professors Wolff and Vermaelen describe a financial instrument called Contingent Convertibles (also known as CoCo bonds). In the recent crisis, these could have helped distressed institutions to convert debt to equity, reducing the need for capital injections from the state. The advantage of Contingent Convertibles is that they would not require a negotiated decision by the firm or an intervention by the authorities, but would convert debt to equity automatically when the value of equity falls below a level specified in advance. The process appears to be transparent, predictable and dictated by market developments. Professors Wolff and Vermaelen add a twist by providing the original shareholders with a call option to buy back the converted debt. This serves to smooth the conversion process and avoids an incentive problem that can create so-called “death spirals.” I expect Professor Vermaelen, who will speak next, will provide more details. Turning to other “new ideas,” the “Tobin” tax on financial transactions reappeared in the recent policy debate to finance the cost of future bailouts. This is an old idea dressed up in new clothes. The Tobin Tax appears to be a solution in search of a problem, as it has already been suggested to finance developing countries, offset the cost of global warming, prepare for population ageing, etc. Even in the present case, a transaction tax would still not address the underlying problem. In fact, it may actually aggravate it, acting as an additional source of moral hazard. By raising costs, this tax could actually encourage higher risk taking, preparing the ground for the next systemic crisis. The Jackson Hole Conferences in 2008 and 2009, in which I participated, presented several additional “new ideas” in this context. Most recently the discussion focussed on Ricardo Caballero’s analysis of the “surprising” nature of the recent crisis. He stressed that the “surprise” was not the decline in property prices, but the repercussions this had in the financial sector. The unexpected departure from the normal functioning of the financial system plunged agents into unquantifiable uncertainty. This unleashed panic, characterised by a “flight to safety” and fire asset sales that amplified the crisis. At this point, the role of the authorities is to fight the panic, which involves providing some form of insurance. In the 2008 Conference, Anil Kashyap and his co-authors suggested that capital insurance could be provided by the private sector, while in 2009 Caballero argued that only the state can insure against systemic risk. Necessarily, any insurance arrangement is contingent, so it may share some of the features of Contingent Convertible bonds. However, if all banks were required to contribute to a common insurance pool, the risk coverage would be spread more broadly than if the scheme is limited to the “too-big-to-fail” banks. Caballero proposed Tradable Insurance Credits (TICs) that institutions could attach to individual assets or liabilities on their balance sheets. Since TICs could be traded between banks, they would allow insurance coverage to flow to where it is needed in a crisis, without the authorities needing to specify in advance the nature of the contingent event to be covered. Banks that find themselves less exposed in a crisis could choose to sell their insurance to distressed banks at a premium, a reward for prudence that most insurance schemes do not offer. I find some of these features attractive, but any insurance scheme is also subject to important limitations. Private insurance schemes require freezing huge amounts of resources to cover the insurance promises. The failure of some mono-line insurers in the recent crisis indicates that private sector resources can turn out to be insufficient, aggravating financial instability. On the other hand, public sector insurance schemes jeopardise the sustainability of public finances as they transfer the risks to the taxpayer and distort incentives as mentioned above. 3. Conclusion Let me conclude. Financial crises are an inevitable part of the business cycle. It would be misguided to expect to eliminate them completely. However, we do have a responsibility to learn from them in order to reduce the inefficiencies in the financial system and improve its resilience in future episodes of turbulence. I wish to stress that there is no “silver bullet” solution just as there was no single error behind the financial crisis. If we are to improve on the current situation, there are many changes that need to be implemented. Some critics have argued that the response of governments and central banks raised moral hazard problems that sow the seeds of the next crisis. However, it is important to recognise that moral hazard also appears within the crisis. This was spread over many months, allowing agents to adapt their short-term behaviour to authorities’ decision whether or not to intervene. The policy response had to simultaneously stabilise the short-term situation while accounting for long-term costs. Today it is generally accepted that the extraordinary policy measures taken were necessary to prevent a collapse of the financial system with even worse economic consequences. Let us hope that the ongoing process of financial reform will enhance the resilience of the financial system, reducing the need for extraordinary interventions in the future and their associated costs.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 5th High-level Seminar of Central Banks in the East Asia-Pacific Region and the Euro Area, Sydney, 10 February 2010.
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Yves Mersch: The framework for short-term provision of international reserve currencies to sovereign states and their central banks Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 5th Highlevel Seminar of Central Banks in the East Asia-Pacific Region and the Euro Area, Sydney, 10 February 2010. * * * Good afternoon, ladies and gentlemen! Today, I would like to discuss “the framework for short-term provision of international reserve currencies to sovereign states and their central banks”. Let me begin by reviewing the recent evolution of global liquidity. Then, I will discuss different concepts of supplying foreign reserves and consider their recent developments. In the third part of my speech, the pros and cons of these concepts will be explored. Finally, I will point out certain trade-offs with other economic objectives and draw conclusions on the evolution of the global framework. Let me start by highlighting current developments in global liquidity. For this purpose, I define global liquidity as the sum of monetary aggregates of the major advanced economies. Global excess liquidity may be understood as monetary liquidity that is not needed by economic agents to finance real economic transactions. In theory, excess liquidity may be measured by comparing long-run developments in money supply and GDP. Assuming the trend of velocity of money remains stable over time, nominal GDP is a proxy for the transactions demand for money. In practice, recent disruptions in the money market substantially complicate the assessment of excess liquidity in the short to medium term. In this context, the ECB monetary policy strategy proved appropriate in taking a broad based perspective focussing on threats to price stability in the long term. This makes it possible to cross-check the results of the monetary analysis with the results of the economic analysis focussed on short to medium term developments in inflation and growth. In recent past, the injection of liquidity by central banks was higher than at any time in the last 15 years. Its stocks remain large and continue to build up. Of course, the fast pace of excess liquidity creation reflects not only growth in money aggregates but also shrinking nominal GDP. Before the crisis, global excess liquidity was often ascribed to global imbalances reflecting on one hand large current account deficits in countries like the US and the UK and on the other hand substantially increased savings and sizeable current account surpluses in some advanced, emerging and oil-producing economies, which accelerated the accumulation of their foreign exchange reserves. Another source of global liquidity consisted of large interest rate differentials between major economies, which encouraged investors to engage in carry trade transactions in foreign exchange. Short-term risks to consumer price stability are currently dampened by a drop below potential in most economies and rising unemployment. However, the situation can change abruptly. One should not underestimate the risk of prolonged excess liquidity on unwelcomed developments in specific asset classes. Global excess liquidity also reduces investors’ willingness to hold liquidity at the current low level of returns and might fuel their risk appetite. This could provide a renewed chase for performance. Recent experience indicates that even in a situation of abundant global liquidity, local markets in foreign currencies can seize up and currency shortages swiftly propagate across currencies, international markets and time zones. This highlights the importance of the global liquidity provisioning concepts to counter illiquidity of particular markets. In a liquidity crisis, monetary authorities can engage in foreign currency liquidity-providing operations which can be classified into the following four major concepts: national foreign exchange reserves, pooling of reserves, inter-central bank swap lines or repos and monetary units or loan facilities by supra-national monetary authorities. Central banks maintain foreign reserves mainly in key currencies but also in high-value liquid assets like gold. They may redirect the investments of such foreign reserves towards bank deposits, in an endeavor to offset the withdrawal of bank deposits in foreign currency by investors. At the outset of the crisis, global foreign exchange reserves had reached an unprecedented Euro 3.5 trillion (USD 5 trillion) compared to only Euro 2.3 trillion (USD 2 trillion) in 2001. The share of Asian countries more than tripled during that period and China alone now holds reserves worth about Euro 1.7 trillion (USD 2.4 trillion). Another possible strategy to ward off potential future currency crises (proper exchange rate regimes and exchange rate management notwithstanding) consists of schemes that pool foreign reserves of several central banks. This concept generally requires a binding arrangement between sovereign states specifying the pooling mechanism and its management. In May 2009 the Chiang Mai Initiative of the ASEAN+3 group agreed to transform its network of bilateral currency swap agreements into a multilateral facility that would pool together Euro 85 billion (USD 120 billion) of reserves. So far, these arrangements have never been called upon. An additional source of reserve currency can be inter-central bank swap lines and repos. These involve two transactions. First, foreign currency is delivered against collateral in form of assets or domestic currency. Second, on a specified date in the future, accrued interests are paid and transactions are unwound, which implies that currency positions or repoed assets are retransferred. Since December 2007 certain central banks around the globe have been participating in a temporary network of inter-central bank swap lines and repo agreements. In particular, this included the US Fed supplying unlimited liquidity in US dollars to the ECB, the Bank of Japan, the Bank of England and the Swiss National Bank. Other swap lines have also been put in place, for example the ECB provides Euros to the Fed. At the peak of the crisis in December 2008, the US Fed provided globally Euro 432 billion (USD 583 billion). Since then, demand has receded continuously and the swap lines have been discontinued. Lastly, monetary units or loan facilities created by supra-national monetary authorities can grant liquidity to their member states. In response to the crisis, IMF member states agreed a Euro 175 billion (USD 250 billion) general allocation of Special Drawing Rights (SDR). In times of need, members can exchange SDRs for key currencies through voluntary trading arrangements with other IMF member countries; otherwise SDRs count as part of the official international reserves. The discussion whether SDRs could play a greater role as an international reserve currency has been re-opened during the crisis. In addition, the “New Arrangements to Borrow” boosted IMF facilities by Euro 345 billion (USD 500 billion). The IMF redesigned its lending framework with the introduction of a “Flexible Credit Line” for countries with a sustainable strong economy and enhanced “Stand-by Arrangements” that are more widely accessible. Let me now suggest some criteria to evaluate the alternatives that I have just mentioned. These criteria include effectiveness, costs, efficiency and moral hazard. First, effectiveness in alleviating liquidity shortages in foreign currency depends on the speed and size with which foreign reserves can be mobilized. The discretionary nature of national reserves in foreign currency means that in principle they are available at short notice. In turn, this might have a reassuring effect on market confidence. The same also applies to other sources, such as standing swap lines, pooled reserves or IMF facilities that can be accessed unconditionally. In addition, foreign exchange reserves should be available in a size sufficient to match outstanding demand. This can require very large volumes in a systemic crisis. While national foreign exchange reserves might alleviate temporary shortages in an individual institution or economy, their limited quantity might reduce their effectiveness during large systemic events. This suggests a need for additional sources involving cross-border cooperation. However, measures that are provided at the discretion of monetary authorities are based on a case-by-case assessment and a decision by the respective lender. These will reflect several factors, including the objectives of the creditor, whether the crisis is systemic, country-specific or institution-specific and also the form of the measure: For instance the lending authorities might favor a secured repo agreement, although this removes collateral from the borrowing central bank. Compared to repo agreements, lending in the form of a currency swap preserves the potential to add new liquidity. Second, the effectiveness of liquidity provision in foreign currency has to be judged against its economic costs. Every time a country receives foreign currency support from an external creditor, the costs depend on the respective agreement. Foreign exchange reserves, on the other hand, bear an opportunity cost representing foregone alternative investments. An efficient international currency system based on pooling or similar concepts will require a lower overall amount of reserves. Of course, such an international system requires political agreement and additional administrative costs associated with managing the reserve pool. A further cost is associated with risk. Credit risk arises whenever a national central bank provides liquidity to domestic counterparties. However, it will also arise when one central bank furnishes liquidity to another central bank, or when the IMF provides liquidity to a national government. Besides, foreign currency reserves fluctuate in value and are therefore also subject to foreign exchange risk. A priori exchange rate volatility increases the required volume of reserves as well as its opportunity costs. A third criterion to judge liquidity provisioning in foreign currency is linked to moral hazard. This arises whenever individuals, institutions or countries expect that they will not have to bear the consequences of their actions. This will incite them to act less prudently than they would otherwise, leaving third parties to bear some of the consequences of their behaviour. For financial institutions, the prospect of emergency provision of foreign currency liquidity may encourage excessive risk-taking in carry trades or in foreign currency lending. This potentially increases the likelihood of a systemic crisis. For national authorities, the prospect of emergency liquidity provision from abroad might reduce the incentive to conduct sound economic policies and accumulate adequate reserves. This leads to the paradoxical situation that unconventional measures applied in a crisis might lower the incentive to maintain preventive measures during normal times. In turn this increases the likelihood that unconventional measures will be needed again in the future, i.e. crisis resolution might tradeoff with crisis prevention. These moral hazard considerations are a well-known problem whenever insurance is provided in a context of asymmetric information. Their negative effects can be mitigated to a certain extent. For instance, appropriate pricing of foreign currency liquidity provision can limit its function to that of an emergency backstop facility which is costly for banks to use. Additionally, the framework has to be in line with global economic objectives, such as price stability, balanced growth and efficient international allocation of resources. • Policies that preserve price stability in the long term should also ensure stability of the financial system. However, in short term these two objectives might appear to conflict. Even when liquidity in domestic currency is provided to another country, it might find its way back to the domestic economy and contribute to inflationary pressure, if not sterilised. • A buildup of national reserves might itself contribute to systemic instability. A reserve framework requires stability of the reserve currency in order to act as a global store of value and an anchor for price stability. However, the Triffin-dilemma notes that the accumulation of reserves implies persistent current account deficits of the reserve-issuing country. This potentially creates instability and fuels global imbalances. Moreover, such a reserve system aggravates interdependence between the reserve accumulating countries and the reserve-issuing country. For instance, the US Treasury market relies largely on demand from emerging market central banks. This dependence is likely to increase as the Federal Reserve phases out its asset purchase program, reducing US demand. • This is connected to potential negative side effects of reserve accumulation or intervention in foreign exchange markets. In consequence, it can distort exchange rates and prices of other assets and might be difficult if not impossible to disentangle from its benefits. • Finally, an acceptable solution from the country perspective might not appear desirable from the global perspective. For instance, excessive accumulation of foreign exchange reserves might distort international capital allocation. This leads me to the general conclusion that there are many practical obstacles to a first-best solution for foreign exchange reserve provisioning. Ultimately, I will conclude with some considerations on the challenges facing the global framework for short term international reserve provisioning. • In general, the discussion requires a common understanding of international liquidity and its economic interlinkages with credit markets and the real economy. • The immediate challenges we are facing include the implementation of exit strategies from exceptional measures of support. In terms of evolution of new concepts, it has been discussed whether it would be desirable to develop a network of standing inter-central bank swap lines. It was also proposed that central banks should consider extending their collateral requirements to accept foreign currency denominated assets or obligations booked abroad during emergency operations. • Constitutive elements of an international crisis prevention setup have to be defined and the different objectives of involved parties taken into account. Thus an element of political coordination will be inevitable to set the trade-offs and accommodate different national interests. More automatic mechanisms can help reduce the need for repeated negotiations to obtain political consensus. • Moreover, crisis resolution requires a provisioning framework with sufficient flexibility to respond adequately rapidly to a variety of possible shocks. This suggests relying on different sources, while preferring market solutions and turning to national foreign exchange reserves as the first line of defence. Thank you very much for your attention!
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Speech by Mr Yves Mersch, President of the Central Bank of Luxembourg, at the Luxembourg Financial Centre Conference, Shanghai, 28 September 2010.
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Yves Mersch: The euro – a credible currency? Speech by Mr Yves Mersch, President of the Central Bank of Luxembourg, at the Luxembourg Financial Centre Conference, Shanghai, 28 September 2010. * * * Excellences, Ladies and Gentlemen, It is my pleasure and honor to talk to such a distinguished audience this afternoon. I am very grateful to for this opportunity to exchange views on the credibility of the Euro and on the role of our respective currency areas for a more balanced global economy. Let me start with the credibility of the Euro. If you ask me, who has been a member of the Governing Council of the European Central Bank (ECB) since its establishment in 1998, if the Euro was a credible currency, you will not be surprised that my answer is “Yes”. The statement the Euro being a credible currency might be more surprising against the backdrop of the current economic and financial crisis. Especially, as it has doubtlessly affected not only the (global) economy but also the major institutions of the Euro area. Some outside observers even have prematurely forecasted its demise. Let me explain why these predictions are wrong. Currently ongoing recovery in the Euro area In the short term, the economic situation is improving. The Euro area and its single currency are recovering from the most severe recession since World War II at a pace which takes laymen and experts by surprise. Since mid-2009 economic activity has been expanding. Recently the recovery has gained momentum. Euro area real GDP increased, on a quarterly basis, by 1% in the second quarter of 2010. Clearly, the Euro zone was hit hard by the Great Recession. In 2009, i.e. in the aftermath of the near meltdown of financial markets in September 2008, real GDP fell by 4.1% in the Euro area. As a consequence unemployment rates soared to beyond 9% the same year. Correspondingly, the free fall of energy prices and the decrease of economic activity slashed down inflation significantly in 2009, pushing the inflation rate even into negative territory for a couple of months. More recently, price developments have somewhat normalized, staying in line with the ECB’s aim of keeping inflation rates below, but close to, 2% over the medium term. Although, in line with the ECB’s projections recent data and surveys indicate a moderation of growth in the second half of this year in the Euro area as well as on the global level, I am confident that the positive underlying momentum is increasingly broader based and signals a self-sustaining recovery in the Euro area. In my view, therefore inside the Euro area the gradual pace of adjustment of the monetary policy stance, of the overall provision of liquidity and of its allotment modes can continue. The Euro: sound track record in the first decade In a longer perspective the performance of the currency union is far more flattering. Between 1999 and 2009 real per capita output in the Euro zone grew on average by 1.5% per year. This is a comparable order of magnitude to that in the US, despite higher overall growth rates in the US. Consumer prices developed in line with the ECB’s definition of price stability. In the eleven and a half years after the creation of the single currency the Harmonized Index of Consumer Prices (HICP) has risen on average by exactly 1.97% per year. The performance of the ECB in delivering price stability has beaten that of the former benchmark currencies, the Deutsche Mark and the Dutch Guilder. High cost of fighting the crisis Still, there is no scope for complacency. In recent months, Europe has demonstrated unwavering commitment to the unity and integrity of the single currency area. However, the fight against the financial crisis and the deep recession has not only been successful, but also very costly. Moreover, it has uncovered institutional weaknesses as has been the case in the history of most currency unions. In particular, it poses challenges to the sustainability of public finances. In the Euro area the government deficit climbed to 6.3% of GDP in 2009. This year the Euro area government deficit will peak at 6.6%, before declining only to 6.1% in 2011. The overall government debt is expected to amount to 88.5% of GDP next year. This is still below the level prior to the introduction of the Euro. But it is also an increase of more than 20% from the level before the crisis. Although, it is not too comforting that other major currency areas are facing even more severe deteriorations of public finances, it is a matter of fact: In the US fiscal stimuli and rescue packages have resulted in the federal budget deficit widening to around 10% of GDP for the fiscal year 2009 – and it will probably stay at that level in 2010 and 2011. By consequence the government debt-to-GDP ratio in the US was about 84% in 2009. It is expected to rise to 102.5% by 2011. In the UK, the general government deficit widened to 11.5% of GDP in 2009, and it is expected to decline to only about 10% by 2011. Gross government debt-to-GDP ratio is expected to increase from 68.1% in 2009 to around 87% in 2011. In Japan, the general government fiscal deficit is projected to be between 6% and 7% of GDP in 2009, 2010 and 2011, respectively. The government debt ratio was about 189% of GDP in 2009, and is expected to increase to about 195% of GDP by 2011. Restoring fiscal sustainability is key Given the deterioration of public finance in the industrialized world in general and in the Euro zone in particular, it is of the essence to correct fiscal imbalances in many Euro area countries. Responsible fiscal management is the basis for balanced and sustainable growth. Stability-orientated fiscal policies will stimulate confidence of households, firms and investors. This confidence is the pre-condition for economic growth and job creation. Governments must therefore send a clear message to markets – a message of determination and commitment to sound macroeconomic policies and fiscal sustainability. Budget plans for 2011 and beyond should reflect the urgent need for credible consolidation strategies. Remember the words of John Maynard Keynes in 1937, in the aftermath of the Great Depression: “Just as it was advisable for the government to incur debt during the slump, so for the same reasons it is now advisable that they should incline to the opposite policy”. Strengthening of the institutional framework What is economically reasonable needs an appropriate institutional framework. Neither markets nor the Stability and Growth Pact (SGP) succeeded in ensuring fiscal discipline in a sufficient manner. Therefore, the spirit of the SGP needs to be strengthened. Promising steps have been undertaken so far. The task force under the chairmanship of the President of the European Council, Herman Van Rompuy, proposed, first, a streamlining of national budgetary calendars in order to improve monitoring and correction at an earlier stage of decision making. The so called European semester will stress economic surveillance: the fiscal discipline of the SGP, the structural reforms in the long term vision program “Europe 2020”, and a new mechanism to prevent macro-imbalances which will be fully embedded in the surveillance cycle. The European semester aims at prior policy guidance and preventive budgetary surveillance, in time when these really matter and allow discussing common policy before the budgets are agreed at the national level. The European Semester cycle will start in January with an “Annual Growth Survey” prepared by the Commission, reviewing economic challenges. Second, the task force discusses a system of “smart sanctions” against countries in breach of the debt and deficit limits, in order to strengthen the SGP in a preventive phase. The commission will tackle its proposals tomorrow. These plans aim at imposing more automatic sanctions in a gradual way. In order to prevent the built-up of imbalances leading to pressures on the fiscal stance and diverging situations weakening the effect of a single monetary policy, surveillance at the macro-economic level needs to be strengthened, especially as far as competitiveness is concerned. Within a single currency union, the relative competitiveness of economies mirrors the sustainability of national price and cost developments, the compatibility of national nominal trends with those that are appropriate for the monetary union as a whole. Proposals are due to October. This institutional deepening in crisis prevention is completed by crisis management decisions. The set up of the European Financial Stability Facility (EFSF), a rescue fund which achieved “AAA” status by all major rating agencies, intended to this. The European System of Central Banks (ESCB) together with the Commission call for renewed efforts for more integrated financial and capital markets. The regulatory reform for banking should spur these efforts leading to a new European banking landscape. Luxembourg with its experience will assume its share and responsibility in this evolution. Another institutional deepening has been approved by the European parliament last week. In the micro-prudential area three European risk agencies will be set up for supervision in banking, securities markets and insurance. They will be completed by a European Systemic Risk Board strongly supporting Central Banks in the area of macro-prudential surveillance, hitherto neglected. Rebalancing and global cooperation China has been affected by the global crisis, too, though in a more subtle way. The challenges are manifold. First, China’s impressive growth story of the previous decade was mainly export driven. This approach led to the inflow of foreign capital, a huge current account surplus and a massive accumulation of foreign exchange reserves. Different from what could be observed in the past, China as a dynamic Newly Industrialized Country became the biggest net creditor to the rest of the world in general, and to the US in particular. The economic rise of China and other Emerging Market countries has gone along with increased political presence and responsibility at the global level. China in this respect reassumes the role it had in the world economy throughout most of history. Second, although the fiscal position of China was sound, other vulnerabilities have been disclosed. A growth model that is highly concentrated on exports is at risk when external demand drops sharply. A broadening of the macro economic policies would reduce this exposure. The growth model, thus, would become more sustainable. Tackling this issue would also be a contribution to deal with global imbalances. One step on this way for sustainable growth and an orderly rebalanced global economy could be the enhancement of social safety nets. A coherent system of reforms of social security, health care and pension schemes would reduce the need for precautionary savings of private households and could thus stimulate private spending. This holds in particular for the challenge of an ageing society. A shift from economic activity from the public to the private sector would be helpful in this respect, just like corporate governance and financial sector reforms, or a reflection on local government finance. There are some encouraging indications that measures to increase household income, notably in rural areas, expected to feature prominently the new five-year plan starting in January 2010. This could be an important contribution to a broadening the Chinese economic approach, and to move to a more quality oriented growth. Concluding remarks I am convinced that cooperation between the major players in the world economy is crucial. To tackle global imbalances, each continent has to do its homework. For China, continuing the rebalancing process from external to domestic demand, from huge public enterprises to private enterprises, demographic ageing and dispersion are no less challenging. In such an environment the increased role of the Renminbi will be one part. The European Union must resume the path of institutional deepening. It needs less divergence and more structural reforms to enhance growth and employment. Also, enhanced stability in the financial sector is of the essence. We must furthermore strengthen the economic governance of the European Union with reforms designed to a stable Euro and strengthen the foundations for sustainable public finances. In such a surrounding the Euro can and will stay a credible currency. To sum up, both economic areas have – to use the word of Premier Wen Jiabao who spoke recently in Tianjin – to undertake efforts to ensure, first, better balance, second, coordination and, third, sustainability of economic development.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a lecture in memory of Mr Pierre Werner, organised by the Official Monetary and Financial Institutions Forum OMFIF, London, 14 October 2010.
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Yves Mersch: After the EMU rescue – which way for Europe? Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a lecture in memory of Mr Pierre Werner, organised by the Official Monetary and Financial Institutions Forum (OMFIF), London, 14 October 2010. * * * Your Excellencies, Ladies and Gentlemen, Neither the European Coal and Steel Community Treaty of 1950, nor the 1957 Treaty of Rome dealt extensively with currency. This might have been because convertibility after World War II was not very wide-spread and capital controls were the norm. Belgium was one of the first countries to establish free movement of capital but only within a dual exchange rate regime. This particularity had been one of the reasons for Luxembourg to emerge as a financial activities center for Europe. The principle of fixed exchange rates had been a feature of the international framework for currency stability after World War II for the economies of Europe, North America and Japan. The Bretton Woods System was based on gold and the US dollar as the predominant monetary standard and worked for several years with almost no frictions. By 1968 a new era of currency instability threatened when market turbulence forced the revaluation of the German Mark and the devaluation of the French Franc. These developments clearly revealed the weaknesses of the Bretton Woods System as well as the threats to the common market and specifically the common agricultural policy. Ideas of a new European currency framework gained momentum and Luxembourg’s Prime Minister Werner, also Minister of Finance, was asked to steer a Committee mandated to design the path to an increased economic and monetary integration of the six then members of the European Economic Community. That report, finished on the 8 October 1970 and sent to the Ministers of Finance in the first instance, laid down the achievement of Economic and Monetary Union by 1980. The youngest member of the Committee and the only one still alive is Prof. Dr. Hans Tietmeyer. It was he who at the first meeting of the Governing Council of the ECB insisted on the seating arrangements to be changed from countries in alphabetical order to members’ family name in alphabetical order. In doing so, he was truly loyal to the spirit of the Werner plan. In deed, if it took another 20 years after the Werner plan deadline before a single currency was established –, for reasons that would take another conference to explain – it is worth revisiting the Werner report finalized 40 years ago. We can call it truly visionary. Although many of the proposals of the original Werner plan have been realized, some of the original thoughts were ignored or diluted and we might with the benefit of hindsight, ask ourselves whether this has not been a mistake. Of course, the Werner report originated in a different environment when the Union with its original six members still was aiming at a final goal of something like a federal Europe. When, after several run-ups, turbulences and tensions, the goal of a single currency was eventually achieved with the introduction of the Euro in 1999, not only had the number of member states increased, but it had become clear that despite the single currency, there would not be a political union to accompany that currency. National sovereignty in the economic policy-making area would be preserved. Nonetheless, recent turbulences highlight the inherent tensions of European integration, especially those between a monetary policy in which sovereignty is pooled while economic policy remains under national sovereignty. Tensions translate into dynamics either for progress or for regression. True enough, even during the intergovernmental conference that was to lead to the Maastricht Treaty, there were parallel negotiations for the development of a political union. The political union made only limited progress, while the detailed draft for EMU was hailed as a breakthrough for European integration. In truth, it was once again a compromise between the pooling of sovereign competences at the European level in the monetary area – with optin and opt-out clauses for some countries – and the economic union where ultimate responsibilities remained at the national level. Many features were similar to the Werner report like a three stage approach with a warming up period (ten years in the Werner plan, eight years in the Maastricht Treaty) or the abolition of all capital controls. Inside the Werner Committee, the discussions had centered on the sequence of transfer of powers to the European level. Foremost Germany argued that monetary union should follow political union. This so-called crowning theory was inspired by historic developments in other countries. The others on the contrary considered monetary policy union as a powerful catalyst for deeper integration in other policy fields that must follow. Today, I want to focus on another feature. The Werner report supported the idea of an independent institution for fiscal monitoring and coordination. This thought clearly reflected the concept that a single monetary policy would be supported by sound public finances. More concretely, the report called for ever closer economic policy coordination with an agreed framework for national budgetary policies. At the institutional level, it suggested a “centre of decision for economic policy”. This coordination body for economic policies should have been established alongside the European system of central banks, i.e. the monetary authority. Both institutions were to be independent from the national governments, being politically accountable only to a European Parliament. This independent economic authority should have influenced the national budgets with a focus on the level and the direction of the balances as well as the financing of deficits and the use of surpluses, respectively. The Werner report also advocated a certain degree of tax approximation especially for cross border activities. When the Intergovernmental Conference on EMU started, Europe had endowed itself with a Parliament, but with limited powers and no capacity to levy taxes and to control centralized policy making at European level. Most European resources were transfers from national budgets. Tax sovereignty was left untouched after a timid attempt to change tack in the socalled Guigou group set up by President Mitterrand to prepare the Conference. During the Conference an attempt by Belgium and Italy to move into the tax area ran into massive resistance. Political union was off the agenda and loose coordination of economic policies was deemed sufficient. It was believed that market discipline would install responsible behavior in the fiscal and competitive position of countries. The land grabbing attitude of the European Commission pretending to be the economic and fiscal authority in the event of more integration indirectly strengthened the case for the intergovernmental approach and the socalled own responsibility of each individual country in this respect. It can seem surprising that governments were so confident about market discipline and reactive national policies when one major factor of self-correction within a currency union was by design rather weak in Europe, namely labour mobility. True, progress has been made in language knowledge, university students exchange, diploma recognition and access to professions. Mobility is good at the lower and higher skill ends, but the high share of closed public service in Europe, non-portability of pension rights, rigid labour laws and cultural differences make labour mobility a slow process. Therefore in 1997 the Treaty was complemented by the Stability and Growth Pact which has mostly focused on fiscal deficits. The result proved insufficiently coercive and was even further weakened when Germany and France failed to abide by the rules in 2003. The absence of a meaningful macro-economic surveillance led to heterogeneity which was further accommodated by the absence of expected market reactions. Today we have to acknowledge that market reactions often come with delays and then tend to overreact. But let me be clear: Forty years after the Werner report and eleven and a half years after the introduction of the single currency, for me, the verdict is unambiguous: Monetary policy within the Euro area has been a success. It is widely accepted that the best a central bank can do in supporting economic growth is delivering price stability. The ECB has delivered price stability. Even though real GDP in the Euro zone has grown by only 1.5 % per year in the first decade since its establishment, while the US economy expanded by 2.2 %, this difference can to a large extent be explained by the greater population growth on the other side of the Atlantic. On a per capita basis annual real GDP growth rates are very similar, 1.2 % in the US versus 1.0 % in the Euro area. The Euro area’s economic growth rebounded strongly in the second quarter of 2010, driven by higher investment and replenishment of inventories. Last week the IMF revised its figures for growth in the Euro area upwards in line with earlier ECB projections. Incoming hard and soft data for the second half of the year do not warrant increased pessimism. In the course of the crisis of the past three years the ECB and the Eurosystem were forced to act very fast, boldly and innovatively in order to ensure their long term goal of price stability and the functioning of the transmission mechanism. Their monetary policy interventions were successful. The recovery of the European economy is ongoing and the tensions in the financial systems have eased somewhat, although it is still too early to claim victory. But we have to draw the lessons from the recent experience. With the eruption of the crisis in September 2008 the accumulation of private debt was suddenly stopped. The problem of excessive indebtedness was not solved, however. Fiscal rescue packages, the impact of automatic stabilizers, and the support of the financial system including guarantees to the banking sector led to a significant increase in public leverage to levels unprecedented in peacetime. In other words, parts of the excessive private debt load were shifted to the public sector. The crisis exposed institutional weaknesses. Some had their source inside the financial system. Despite some initial temptations for re-segmentation of prudential competences, the response will be at the European and at the EU27 level. It will consist of the implementation of new concepts and institutions aiming at de-risking the financial industry. Liquidity monitoring through a monthly liquidity coverage ratio and a yearly net stable funding ratio will be complemented by macro prudential surveillance in a European System Risk Board closely associated with the General Council of the European Central Bank. The US equivalent to this Systemic risk Board held its inaugural meeting at the beginning of this month. Three European Agencies for banking, securities markets and insurance start with a mostly coordination function, but have certain evolutionist competence clauses in their statutes. They have to walk the narrow line between cross border activities of banks and integration of markets on the one hand and competences remaining at national levels like deposit guarantee schemes, resolution procedures, insolvency legislation, i.e. everything that pertains to the tax payer who remains fiercely protected by national governments despite the spill-over effects of cross border activities, on the other hand. To tackle these effects through a potential 351 bilateral Treaties in so many areas among 27 member states, can hardly be seen as a stable equilibrium in decision making nor a level playing field for economic activities in a single area. The new institutional set-ups at EU level therefore face some of the same problems we experience within the Euro-area. The ultimate goal will however be the same: foster economic welfare through integration of markets and market players. This obviously will also be beneficial for the optimal functioning of a single monetary policy at Euro area level. The transfer of private debt into public debt as such was similar to what was observed in the whole industrialized world. But the weak institutional framework for fiscal discipline at national and at Euro area level as well as the absence of control by financial markets was emphasized in some countries by three developments: 1. an overextended national financial system 2. an insufficiently strong starting position in the cyclical downturn in terms of deficit and debt 3. a rapidly deteriorating competitive position as shown for example in unit labour costs or current account balances Suddenly markets reacted and overreacted while Governments excelled in denial and cloak and dagger stories. This slow reaction forced the ECB into action as a back-stop exposing the unfinished work of the institutional set-up of EMU just as the financial crisis had exposed failures in the macroprudential area throughout the industrial world. In both cases, the welfare price of overly relying on market reaction only has become clear. Now credible deleveraging has been implemented in many countries. This action should allow those countries to be back on a sustainable trajectory of growth in the medium term. A crisis management facility, the EFSF, has been set up as a symbol for the existence of a “community of destiny” that is a monetary union. A common destiny engulfs solidarity. But solidarity presupposes responsibility. This means that crisis prevention mechanisms are even more important than crisis management facilities. And we have to recognize that before a fiscal deterioration occurs and needs corrective actions, we ought to detect early signals in the macro economic imbalances of economies that share a single currency. To overcome the macro-economic heterogeneity within the Euro area, an explicit and clear framework for the surveillance of competitiveness is needed with the aim of correcting large imbalances. Despite having a single currency and central bank, national economic policies remain insufficiently aligned. Forty years ago (!) the Werner plan was very outspoken on this issue: “Having regard to the marked differences between the member countries in the realization of the objectives of growth and stability, there is a grave danger of disequilibria arising if economic policy cannot be harmonized effectively”. The needed framework is not aimed at increasing the power of the Commission in macroeconomic surveillance in the EU but at highlighting the Euro area dimensions of surveillance and policy adjustments. This dimension requires more automaticity with a focus on countries with vulnerabilities, competitiveness deterioration and high debt levels. It should foresee graduated sanctions at a sufficiently early stage to reinforce compliance. It should take aim at national rigidities that are incompatible with a currency union, like automatic indexation mechanisms of wages and pensions. On the fiscal side, it is also worth remembering the emphasis that the Werner report put on an independent fiscal authority. The quality and independence of economic analysis is crucial. Several suggestions could be made in this respect, for instance increasing the role of the Commissioner in charge of Economic and Financial Affairs akin to the role of the Commissioner in charge of competition. External assessment could also be provided by a Committee of “wise persons”. Quality and reliability of statistics need to be reinforced, deadlines in procedures reduced, scope of discretion of exceptional circumstances curtailed and more automaticity introduced. I hope that the Van Rompuy Task Force is bolder on those issues than were the Commission’s proposals. To conclude: In line with the vision of the Werner Plan, the integration of Europe as an evolutionary process has to continue. The financial crisis of the last three years has uncovered the institutional shortcomings of the current framework and exposed gaps in the existing economic governance regime. To make sure that the Euro will continue to be a stable and credible currency, monetary policy has to be supported by sound public finances and balanced and sustainable economic growth in the member states of the Euro area. A strengthening of the Stability and Growth Pact, preventing and correcting macroeconomic imbalances at an early stage, and more effective enforcement via gradual sanctions for non-compliant euro-area countries will help to achieve this goal. An independent fiscal authority would help to advance the institutional deepening of the Euro zone and, in this respect, reflect the spirit of Pierre Werner.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 54th Congress of the International Association of Lawyers Union Internationale des Avocat, UIA, Istanbul, 31 October 2010.
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Yves Mersch: European lessons to be drawn from the crisis to improve global financial stability Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the 54th Congress of the International Association of Lawyers (Union Internationale des Avocat, UIA), Istanbul, 31 October 2010. * * * Excellences, Ladies and Gentlemen, Three years after the first turbulences occurred on the interbank markets, it is apparent that they marked the beginning of the most severe crisis since the end of World War II. As the crisis is not yet over, we still lack the perspective of setting up a comprehensive list of lessons from the crisis. Nonetheless, I thank the International Association of Lawyers for inviting me to share my views on this issue. In my speech, I will highlight the causes of the financial crisis, the political responses, and the likely consequences. In particular I will make clear, that policy responses cannot be applied globally but need to take into account the structure and special features of an economic area. As a member of the Governing Council of the European Central Bank (ECB) I will elaborate on the European experiences and challenges and the role of monetary policy in particular. However, what I will say should not be interpreted in the context of the future monetary policy decision of the Governing Council next Thursday. You might recall that my colleagues and I are in our purdah period. Causes of the crisis Let me start with an overview of the causes of the financial crisis, giving examples of market and government failures, referring to an excellent analysis by Guillermo de la Dehesa, Chairman of the Centre for Economic Policy Research (bold mine): “The first failure appeared when the U.S. government tried to encourage wider homeownership by households, allowing every American family to be entitled to mortgage loans, regardless of their income level or their ability to pay, thus creating a problem of “adverse selection”. […] The second failure occurred in the originated and securitized subprime mortgages market, both in terms of government regulation and supervision. On the one hand, the majority of mortgages were not originated by the banks but by agents and brokers working on commission, who were not regulated and who were only required to obtain an administrative local state permit to sell financial products. Therefore, their main objective was to sell a mortgage to a family and charge a commission without much effort to verify whether the mortgage holder could pay it. […] The third major failure was that many banks that were securitizing mortgages and selling them believed that they had removed their risk burden – an idea that ultimately proved not always to be right. […] In other words, the banks were creating a parallel, off-balance-sheet banking system that would take short-term resources and invest them in long-term risky assets that were neither regulated nor subject to supervision. The managers of many of these special vehicles were buying the same structured products based on subprime mortgages. Through this vehicles, they were taking on the same risk that bank had intended to transfer by securitizing and selling them to a third party. If the Federal Reserve and the European Central Bank had forced the banks to reintroduce the securities into their balance sheets (which they never should have removed in the first place), the banks would have consumed regulatory capital that they did not have. This would have resulted in an even greater credit crunch that what ultimately occurred. What is most significant is that, were it not for these vehicles and the parallel banking system created, there would be no other reasons to explain why a problem that originated in the U.S. mortgage securitization system was able to spread in such a way to the European banks. The fourth incomprehensible failure needs to be attributed to the way investors themselves have behaved. These investors were managing very large bank, pension, and insurance asset portfolios or hedge funds and were supposed to have accumulated a high degree of expertise in investing (as high as the fees they charged). […] How was it possible that so many of theses sophisticated investors were buying these structured products with a AAA or AA rating without being able to understand their content due to the huge mathematical complexity of their structures? The only explanation is that they bought these products because they were more profitable than the traditional AAA- or AA-rated assets, which is in itself an oxymoron in terms of finance theory. The fifth failure both in market and governments was associated with the credit rating agencies that assess the default risks associated with financial assets that are issued, bought and sold in the markets. […] These credit agencies are also privileged in that they cannot be legally prosecuted. That is, they have no legal or administrative responsibility (like auditors have) over the ratings they give because of the protections they enjoy under the first amendment of the U.S. Constitution; their employees are considered to be merely “financial reporters” that are exercising their “freedom of expression”. After 1970, the agencies were funded by the issuers and sellers of bonds or structured products who they are supposed to monitor and rate, thus creating a large conflict of interest: On the one hand, the bond issuers can decide not to contract an agency if they get a provisional rating that they consider to be low, and can attempt to contract with another that will give a higher rating, since they know what rating they will receive before they make a decision. The sixth major failure during the 2008–09 financial crisis was committed by the banks themselves and other financial entities when they failed to effectively carry out their main responsibility of serving as an intermediary between the savings of depositors and the investments of investors in an economic system. […]The reason the financial system exists is based exclusively on its capacity to compile and analyze information. For both depositors and investors, this kind of activity demands a very high level of trust in the accuracy and quality of the information and advice provided by the financial intermediaries. If this level of trust is broken, as was the case during the 2008–09 financial crisis, it can ultimately paralyze the activities of the financial intermediaries and the markets, generate uncertainty, and eventually cause panic, producing a run on the banks and paralyzing markets, leading to serious negative consequences for the overall economy. Four characteristics make banks key players in a market economy: First: billions of payments requiring transfers of funds are carried out by the banks every day. They run the payment systems that underpin economies transactions. The second characteristic is that banks and other financial intermediaries borrow short from depositors or other savers and lend long to investors, subsequently incurring interest rate, term mismatching, and counterparty risks that make them highly vulnerable to any abrupt change in economic conditions. Therefore, they are a public service that takes important risks. The third is that these entities undertake very important and necessary tasks for the success of the economy by channelling resources from the savers to the investors and by transferring the risk from those who cannot afford to take them to those who are willing to assume them. The fourth is that banks are needed to ensure effective implementation of monetary policy. Monetary policy is the most relevant economic policy for softening the impact of economic fluctuations and cycles and for maintaining price stability. The seventh serious failure was in economic banking: A new economic theory surged based on two hypotheses: “rational expectations” and “efficient and complete markets”. Theses new theoretical developments were the intellectual basis of the rise of a new political trend toward financial deregulation. Also in some area monetary policies were aimed at maintaining low interest rates, resulting in two huge bubbles in a single decade, the 2000 dot-com and 2007 financial and real estate bubbles. The eighth failure relates to banking supervision. On most cases, the largest bank failures and the most expensive bail outs have coincided with countries where the supervisor was not the central bank, but the governments. […] The ninth significant problem, associated with market failure is that many banks failed to manage their risk appropriately and sufficiently. Sometimes, as mentioned, it is because of pressures from the shareholders to get a higher return on equity; and sometimes it is because of the executive remuneration system which encourages greater risk taking. Other times it is because the executives believed that their long term financing would remain cheap since basic interest rates would continue to be low. […] Good risk management begins with the basic rules of common sense and caution, not with complex models taken from physics. The tenth market and regulatory related failure has been the enormous development of bilateral or over-the-counter derivatives markets, for both foreign exchange and loan interest rates, that have reached never-before-seen historic levels. […] The eleventh failure was the shortcomings of the Basel II Accord allowing increased leverage in larger banks. The twelfth and final failure detected in the 2008–09 financial crisis is the moral hazard created by the prominence of banking systems that are “too big and too interconnected too fail” or “too big to be saved” because they can create a systemic crisis in national and global banking networks with very serious economic consequences for the entire world economy. The large banks and their networks that know they will be bailed out by governments if ever faced with solvency issues have an incentive to take on greater risk than a bank or intermediary that fails with no entity to save it.” 1 In a nut shell: these shortcomings jointly allowed the entire financial industry to book profits too early, too easily and without proper risk adjustment. At the same time they covered a process of excessive indebtedness in the private and financial sector. The tensions increased and erupted in the financial crisis that started in the summer of 2007, deteriorating severely in September 2008 when the former US investment bank Lehman Brothers collapsed pushing the global economy to the edge of the abyss. Political responses The financial crisis and the subsequent economic downturn have called for unprecedented policy responses by both fiscal and monetary authorities worldwide. See de la Dehesa, Guillermo (2010): Twelve Market and Government Failures Leading to 2008–09 Financial Crisis, Occasional Paper No 80, Group of Thirty, Washington DC. Differences in the economic and financial structures and the political set up of the Euro area compared to the United States led to different specific measures – aiming at achieving the same goals, however. Let me elaborate on these structural differences: – First, the economic structures of the Euro area and the United States differ a lot. Small and medium-sized enterprises, for example, play a dominant role in the European economy. Moreover, the public sector represents bigger parts of the European economy, and is a major player in the ownership structure of certain banks. Overall, the economy in the Euro zone is less flexible than in the US. Wages and prices are slower to adjust. Let me provide an example from my “home turf”. Prices change rather infrequently in the Euro area. On average it takes retailers 13 months to reprice their products. According to surveys, it is 11 months for producers. In the United States, comparable figures indicate durations of less than 7 months and slightly more than 8 months respectively. Whereas this lower flexibility might be a disadvantage to benefit from positive supply side shocks like technical innovations, during the time of a crisis this European “sluggishness” offered some protection against an overshooting of negative expectations leading to a deflationary spiral. – Second, there are also profound differences in their financial structures. The differences in the composition of funding sources for non-financial corporations are striking. Europe’s small and medium-sized firms have no direct access to capital markets but need loans to finance their activities. In the Euro area bank financing accounts for roughly 70 % of firm’s total external financing. In the United States, by contrast, firms rely to a much larger extent on market-based sources, which represent 80 % of total external financing. Also, universal banking is the predominant business model in continental European banking compared to the US which – before the outbreak of the crisis – were characterized by specialised investment banks. In its fight against the crisis the ECB always has taken account of this particular structure of the euro area economy. To be effective, the applied measures of the ECB concentrated on the banking sector and the provision of liquidity. In the US, by contrast, the Fed focused on capital markets and bought assets outright on debt capital markets – an appropriate strategy given the reliance on capital markets of US companies rather than on bank loans. The ECB’s focus on the banking sector applied to all three stages of the crisis from the European perspective – Abundant liquidity provision when tensions in the money market first occurred in August 2007. – Unprecedented rate cuts from October 2008 on, when the economy slipped into a deep recession. To support the supply of credit to the real economy the ECB additionally employed some unconventional measures to alleviate the funding pressures in the banking sector. – Intervening in certain market segments to ensure the functioning of the transmission mechanism of monetary policy when sovereign debts markets came under severe pressure in Mai 2010. These bold and innovative measures helped to sustain financial intermediation in the euro area. Moreover, it maintained the availability of credit for households and companies. At the same time they have been compatible with the ECB’s primary mandate of maintaining price stability over the medium term. Longer term objectives Sound financial sector Beyond the crisis, the financial sector must become more resilient, the massive debt burden has to be eroded and new excesses in indebtedness must be prevented the financial, the private and public sector. The de-risking of the financial industry and the deleveraging of excessively indebted private households and countries are the long term objectives for a sustainable financial and economic system. Regulation and supervision of the financial sector have to reduce the probability of institution failure. Higher quantity and quality of capital, minimum liquidity requirements and leverage limits, as demanded by the Basel Committee on Banking Supervision, aim to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, independent of the source. However, the current proposals for new capital and liquidity rules ignore the importance of bank credit as the dominant means of finance in the Euro area, the basically well functioning system of universal banks on this side of the Atlantic. Although it is important to call for sound liquidity risk management and robust capital buffers, it seems awkward to target deposits and loans of banks as major threats to financial stability given the experience of the crisis. The universal banks in continental Europe, which rely on deposits as a major source of finance, were more diversified with retail and corporate lending operations and fund management than their US counterparts. Their solid deposit base provided stability to the system as a whole. By contrast, the “originate-to-distribute model” pushed forward risky and opaque products, which were at the epicentre of the subprime crisis. Only those European banks got into trouble that embarked into investment banking activities or had bought toxic assets on a large scale. But the crisis also revealed weaknesses of business models based on public sector support or public financing. The additional ratio for systemically important financial institutions (SIFIs) can be questioned in so far as it sanctions the traditionally larger banks of continental Europe. Such large banks are unpopular in the US – without being necessarily more risky. The negative consequences of Basel III, that sanctions bank loans as relatively risky and illiquid, imposing higher capital requirements and haircuts, are threefold: – The formerly stable universal banks of continental Europe would be pushed into riskier activities when the margins of lending to smaller and medium sized firms were diminishing due to regulatory requirements. – The new rules lead to comparative disadvantages to the European banking system. The US banks rely more on fees than on deposits. The global playing field will be tilt. – As the real economy is mainly financed by the banking system, financing conditions for companies without access to the capital markets would tighten and trigger a negative impact on economic growth. As the former IMF head and Governor of the French Central Bank, Jacques de Larosière, put it recently: “The cruel irony is that the banking system model that most favours financial stability and economic growth could be the chief victim of the new framework.” A remaining challenge is to regulate and supervise the shadow banking system. Moreover, it has to be made sure, that Basel III will be implemented at the time in all jurisdictions to guarantee a level playing field. As we know, this was not the case for the Basel II rules. Institutional reform Also, on the institutional level reform is necessary. Here again, a one-fits-all-answer will not be appropriate. The US did consolidate its highly fragmented regulation regime. Banking there is regulated at both the federal and state level. Depending on a banking organization’s charter-type and organizational structure, it may be subject to numerous federal and state banking regulators. Europe also has to overcome national fragmentation in this respect. Despite some initial temptations for re-segmentation of prudential competences, the response will be at the European and at the EU27 level. It will consist of the implementation of new concepts and institutions aiming at de-risking the financial industry. Liquidity monitoring through a monthly liquidity coverage ratio and a yearly net stable funding ratio will be complemented by macro prudential surveillance in a European System Risk Board closely associated with the General Council of the European Central Bank. The US equivalent to this Systemic risk Board recently held its inaugural meeting. Three European Agencies for banking, securities markets and insurance start with a mostly coordination function, but have certain evolutionist competence clauses in their statutes. They have to walk the narrow line between cross border activities of banks and integration of markets on the one hand and competences remaining at national levels like deposit guarantee schemes, resolution procedures, and insolvency legislation, i.e. everything that pertains to the tax payer who remains fiercely protected by national governments despite the spill-over effects of cross border activities, on the other hand. To tackle these effects through a potential 351 bilateral Treaties in so many areas among 27 member states, can hardly be seen as a stable equilibrium in decision making nor a level playing field for economic activities in a single area. The new institutional set-ups at EU level therefore face some of the same problems we experience within the Euro-area. The ultimate goal will however be the same: foster economic welfare through integration of markets and market players. Fiscal challenges Learning from recent experience, we have to examine carefully the role of excessive debt. After collapse of Lehman brothers in September 2008 the accumulation of private debt was suddenly stopped, but the problem of excessive indebtedness was not solved. Fiscal rescue packages, the impact of automatic stabilizers, and the necessary support of the financial system led to a significant increase in public leverage to levels unprecedented in peacetime. Government debt in the euro area will have grown by more than 20 percentage points from 2007 to 2011. The equivalent figures for the US and Japan are between 35 and 45 percentage points. Debt-to-GDP-ratios are approaching 90% in Europe, 100% in the US and the UK, and 200% in Japan. The debt burden must be eroded and new excesses in indebtedness have to be prevented. This holds particular for the Euro zone because a single monetary policy needs to be supported by sound public finances. Fiscal and macroeconomic surveillance need to be empowered. The recent discussions within the European Council show a lack of ambition compared to the already timid proposals of the Commission; although the designed new fiscal framework might speed up a faster and broader-based imposition of sanctions on countries that do not comply with the SGP rules. It is to be hoped that the European Parliament will revert to an automatic sanction mechanism. Indeed, it should be possible to start with some sanctions even before a country breaches the 3%-of-GDP rule, thus strengthening the preemptive side of the framework. Concluding remarks Having stabilized the global economy over the last three years, the current challenge is to return on a path of increased stability. This will have distinct consequences for the global economy. Given the massive debt burden that has to be eroded, the industrialized world will experience lower growth potentials. On top, the necessary reduction of debt will lead to slower growth rates in the short term as the unavoidable consequence of the deleveraging process. Sustainable, longer-term growth, however, can only be reached when fundamental economic imbalances are tackled and structural reforms are initiated. In Europe, more ambitions and commitment by political leaders are needed. Stricter rules and higher capital requirements for the financial industry will make the system stronger and healthier. But effective regulation also requires on-the-ground supervision based on competence and proximity. Rules appropriate for the marked based model should not be applied to the heterogeneity of the European system. As the economy in the Euro area is largely based on the availability of bank loans any regulatory change must take account of that. Otherwise, continental banks might suffer from competitive disadvantages. As a consequence financing conditions for the real economy might deteriorate, dampening growth and job creation.
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the conference "The Emerging Framework to Strengthen Banking Regulation and Financial Stability", organised by the Financial Stability Institute, BIS, and hosted by the Arab Monetary Fund, Abu Dhabi, 8 November 2010.
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Yves Mersch: Shaping a new regulatory framework – international banking at the crossroads Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the conference “The Emerging Framework to Strengthen Banking Regulation and Financial Stability”, organised by the Financial Stability Institute, BIS, and hosted by the Arab Monetary Fund, Abu Dhabi, 8 November 2010. * * * Let me start by thanking the Arab Monetary Fund and the FSI of the BIS for providing the opportunity to present my views on financial sector reform in the post crisis era from the perspective of international banking. The topic is vast, and I shall not attempt to deal exhaustively with its numerous dimensions, but rather concentrate myself on one key component, namely cross-border banking flows. I will describe their main drivers, explore their impact on financial stability, and review major reforms currently discussed and aimed at maximizing the benefits of international banking. International banking: drivers, effects and impact on financial stability Cross-border flows have expanded enormously in the last three decades. Since the second half of the 19th century, the internationalization of banking has proceeded in several waves. The most recent waves followed the liberalization of the early 1980s and the expansion of subsidiaries and branches in emerging and developing economies since the second half of the 1990s. Measured by the expansion of cross-border lending and the local claims of foreign banks, the scale of international banking increased dramatically since the beginning of 1980s, also in the Gulf States (Figure 1). While international claims vis-à-vis developing countries are less than 20 percent of claims to developed countries, there has been a recent acceleration of the former. In the last half of this decade, the increase in the share of loans to non-banks in the Gulf States is noticeable, and it reflects the internationalization strategy of banks which have favored extending credit by local affiliates to cross-border lending. Until the beginning of this decade, international banking growth tracked well the increasing world integration as measured by international trade growth. More recently, however, cross-border flows have grown faster than international trade reflecting the emergence of risk transfer and securitization thus making international banking an important component of a broader process of globalization and integration. Capital flows have not been uniformly distributed across countries, and a crosscountry analysis of net international positions show large imbalances and persistent net creditor and debtor positions (Figure 2). The most important ultimate macroeconomic drivers of international banking are the regulatory environment and technological developments. While maximizing shareholders’ value is banks’ objective, the ultimate drivers of international banking are macro drivers in home and host countries, and micro drivers related to bank-level efficiency. A 2008 survey of internationally active banks in Europe conducted by the ECB indicates that the international expansion of banks is driven primarily by the pursuit of new business opportunities and by incentives to follow their non-financial customers abroad. Consistent with the results of the empirical literature, economies of scale and scope play a relatively minor role. The liberalization of international trade and capital markets has increased economic integration and interdependence. Restrictions to foreign bank entry have been gradually eased by bilateral and regional trade and investment agreements as well as by multilateral liberalization efforts under the umbrella of the World Trade Organization. During the last quarter of a century, deregulation and a trend toward the international harmonization of banking supervision and market infrastructure have enhanced economic integration and international banking activities. By reducing the costs of foreign operations, deregulation has fostered M&A, greenfield investment and the provision of cross-border financial services and new products. This was clear in the EU with the “single banking license” of 1989 and the 27 directives implemented by member states under the Financial Services Plan. This has also been the case with innovation through Islamic banking financial products (e.g., sukuk) which have increased integration and interconnectedness of monetary and capital markets and is further pursued by recent initiatives like International Islamic Liquidity Management Corporation (IILM). Traditional banks have opened affiliates in Islamic countries and banks from these countries have entered traditional markets. These developments have led several EU countries, including Luxembourg, to modify their legal frameworks to facilitate these transactions by reducing instances of double taxation. In addition, wholesale activities were boosted in the Euro area by the creation of TARGET, a platform for an efficient cross-border payment system, TARGET 2, a completely integrated IT platform for cross-border payments, and starting in 2013, T2S, a single IT platform for cross-border security settlement. Finally, technological advances have boosted the effects of economic integration on international banking by improving access to information on borrowers and on collateral, and by facilitating the development of models to value credit risk, price new securities, and manage risks more efficiently. The macroeconomic conditions in home and host countries also drive international financial flows. First, regulatory and economic developments in home countries affect the international activities of banks. For instance, the development of the Eurodollar market resulted from U.S restrictions on interest paid on deposits within the U.S., and the U.K. government restrictions on sterling lending by U.K. banks. Similarly, prior to 1999, U.S. banks established subsidiaries abroad to undertake investment activities that restrictions on universal banking made impossible at home. Second, there exists ample evidence of a positive correlation between economic development and financial sophistication. Third, increases in domestic market competition are behind the international expansion of banks faced with the decline in their margins. All that said, in deciding on their internationalization strategy, banks also take into account the growth prospects and the state of economic, political, and legal development of the potential host country. First, macroeconomic and financial stability in host countries are important drivers of foreign bank lending. It is estimated that the elimination of currency risk increased banking activity in the Euro area 25 percent. Second, banks prefer countries that have a low cost of information gathering; the existence of credit bureaus has been found significant in making a country more attractive to international banks. Third, international banks tend to prefer countries with attractive deposit insurance regimes otherwise they operate through non bank vehicles for market sensitive funding sources. Finally, banks that are successful in incorporating host country’s characteristics can boost their comparative advantage vis-à-vis other banks. These factors may be cultural or geographical proximity, for example. As an illustration of some of these factors as well as of the interconnectedness of world capital markets, Figure 3 displays nodes to describe countries/regions of banks’ location with the size of the nodes proportional to the size of the share of banks’ cross-border assets and liabilities, and the thickness of the lines as a measure of the amount of finance across nodes, both in U.S. dollars and in Euros. In the lower panel, cumulative net capital flows are depicted by the thickness and direction of the arrows. Up to mid-2007, capital flew out of Japan, the Euro area, Asian financial centers and oil-exporting countries (via offices in the U.K. and the Caribbean) toward the U.S. and emerging markets. After the crisis, the direction of most capital flows was reversed. In particular, funds flew out of the U.S. and back toward the U.K. Luxembourg is not on the picture, not because of non availability of data as a recent IMF paper wrongly states, but because the IMF has neither consulted the ECB, or the BCL, its website, or its publications. International banking has enhanced economic growth and efficiency, but has affected the distribution of risks as well. Cross-border flows have facilitated the transfer of financial innovations and increased income in recipient countries; have improved allocative efficiency by making it possible for host borrowers to tap international funding sources and by reducing their costs of funding owing to increased competition. Finally, international banking has been a catalyst of financial sector reforms in host countries, which have in turn increased potential growth. On the other hand, reliance in foreign lending, as exemplified in recent times of stress, can be riskier than reliance on purely domestic lending sources. During times of turmoil, overseas funding may dry up for financial and non-financial firms, while banks supplying funding overseas may experience credit losses and liquidity hardships. During the last quarter of 2008, for instance, cross-border lending fell by nearly two trillion U.S. dollars (at constant exchange rates) against a drop of 0.5 trillion U.S. dollars of foreign banks’ local claims in local currencies. From the banks’ viewpoint, the risk profile and resilience of banks is also affected. Diversification of a bank’s counterparties does reduce its risk profile; it has been observed that during the crisis more diversified banks suffered lower losses (this despite that research has found that more diversified banks tend to hold riskier portfolios). Similarly, although cross-border banking induces banks to exploit the riskreturn frontier along its international dimension, the ensuing efficiency increase has not always been associated with better risk measurement and management practices. The profile of systemic risk has been also affected by the increase in the financial system interconnectivity inherent in international banking. The international activities of banks allow risk sharing, reducing thereby the probability of financial crises, and according to the literature, also the procyclicality of lending. Parent-subsidiary relations make it possible, as exemplified during the last crisis, that whether due to reputation or other considerations, parent companies support their affiliates in times of duress. However, as experienced in my own country, it would not be wise to expect that behavior consistently at all times. The health of the parent company may not allow it to support its affiliates, and even force it to rely on its affiliates for funding. In Luxembourg, a traditional net provider of liquidity to banks’ parent companies, this risk is less serious, but cases of sudden stoppages of cross-border funding are too numerous to be ignored. They offer clear lessons as to the potentially very damaging impact of sudden halts in cross-border capital flows on countries’ credit supply and growth. By its own nature, international banking increases the degree of interconnectivity of the financial system and may exacerbate contagion risk, and increase the speed with which shocks are transmitted. In addition, a current concern is the fluidity and comprehensiveness of information flows among national supervisors, between supervisors and financial institutions, and among financial institutions. This aspect of cross-border banking increases systemic risk. As documented by a recent CGFS study on funding patterns and liquidity management of internationally active banks, information frictions were at the origin of large currency mismatches of international banks which complicated the crisis management. Information issues also plague crises resolution and, especially, burden-sharing arrangements. So, I turn now to what is being done to design a new, more robust, regulatory framework for international banking. International banking and the emerging regulatory framework The crisis highlighted deficiencies in the way certain international banks conducted their business and managed financial risks, but also disclosed regulatory failures. The interconnectedness of the global financial system became evident during the crisis as the geographically diversified portfolios of certain internationally active banks became channels of transmission of distress across borders; cross-currency mismatches put severe pressure on some banks’ capital and transmitted liquidity shocks across markets; underpricing of risk led to unsustainable leverage levels; opaque and complex asset positions plagued certain large international banks’ balance sheets; reliance on international capital markets for funding grew enormously in the run up to the crisis so that capital markets and banks became inextricably linked well beyond their usual complementarities; international trade flows suffered from sudden reversals of capital flows as banks took remedial actions, including by curtailing credit. National supervisory frameworks and pre-crisis world capital and liquidity standards were insufficient for preventing the crisis; were revealed to be inefficient and costly for managing it and; offer no clear way out of the current situation due to the lack of a harmonized set of rules for crisis resolution and burden sharing. Despite the fact that the new Basel proposals aim to improve the regulatory framework on for instance capital, liquidity and leverage requirements and are expected to increase the resilience of banking systems in the near future, this new regulatory regime contains some questionable elements. In this regard, it is worth recalling that the leverage ratio does not account for the real risk of assets in addition to ignoring bank-specific business models – even if universal banks have been proven to be more resilient than investment banks (see figure 4) Indeed, diversified banks were not the main channel underlying the spread of the subprime crisis that originated in the United States. Rather it was the investment financial institutions, including the shadow banking system, that seemed to be the main vehicle of contagion. Recent IMF figures displayed at the last IMFC meeting, usefully underpinned by 2 documents “Understanding Financial Interconnectedness”, (see figure 5) provide evidence that the level of financial interconnectedness of the shadow banking system, in contrast with banking system linkages, might explain the rapid process of crisis transmission. The crisis occurred against a background of EU financial stability frameworks built on a national basis. In the EU, each country’s supervisory authorities derive their legitimacy from national parliaments, are subject to national accountability mechanisms, and are financed nationally. A set of MOUs make each country’s authority responsible for the consolidated supervision of financial institutions domiciled in that country, the home supervisor, while host supervisors are responsible for subsidiaries of institutions from other countries operating in their territories. Each national central bank is responsible for providing ELA to financial institutions domiciled in its territory with the obligation of informing the ECB. The EU had concluded two MOUs to deal with crossborder issues in crisis management: the 2003 MOU on high-level principles of cooperation between banking supervisors and central banks, and the 2005 MOU on cooperation between banking supervisors, central banks and finance ministries. MOUs have been signed to deal with banks of regional systemic importance as well. In turn, colleges of supervisors are responsible for monitoring insurance groups and some banks. Committees in charge of developing guidelines for the functioning of supervisory colleges and the assessment of financial sector vulnerabilities report to the Financial Stability Table of ECOFIN. EU regulations are applicable to all EU countries (e.g., CRD, MiFID, and Solvency II), but countries can choose the form and methods by which to implement those regulations nationally. The EU Commission has enforcement powers in matters related to the completion of the common market, and thus on mergers and acquisitions of financial institutions and injections of state capital. Finally, international organizations and international standard setters such as the BIS, the IMF, the FSB, IAIS and IOSCO also affect EU legislation. But the crisis made it clear that in the EU as well as in an increasingly integrated world, uncoordinated national policies and highly disparate regulatory regimes are inconsistent with the objective of preserving financial stability. The crisis exposed the costs of the national model of crisis prevention, management and resolution prevailing in the integrated EU market. When the crisis hit, crisis prevention was underdeveloped in the EU. While there had been significant progress in setting standards (e.g., via the CRD), there was no agreement on a common set of procedures for early action or for remedial action; it existed in various different degrees of discretion in the use of sanctions across member countries as well as a wide degree of central banks’ involvement in national liquidity surveillance. Regarding crisis management, the CRD, the FCD, and the 2005 MOU had set the trend toward more information sharing and improved allocation of responsibilities in case of crisis. However, a harmonization of rules for remedial action based on early intervention and rapid, low cost, decision-making was missing. In the case of existing ELA arrangements, host countries, while responsible for ELA for subsidiaries and branches, did not have access to supervisory information about branches, and had some difficulty in assessing the risks involved in their ELA operations. Costs of intervention remained opaque; host country authorities did not have the incentive to provide liquidity support because of EU ring-fencing prohibitions; home-country authorities delayed provision of information or taking crisis-management actions to avoid capital losses, reputational effects or political backlashes; the home authority did not always have the incentive to keep host authorities reasonably informed. Finally, given that crisis resolution is fundamentally national, countries’ approaches to financial institutions’ failure vary. Most countries have only a few bank-specific regulations; instead, general commerce bankruptcy laws often apply which delays the process of dealing with insolvent banks, even prohibiting in some cases their recapitalization. In the case of a large and complex financial institution (LCFI), the focus of bankruptcy law is in some countries on the right of claimholders and in others on the right of debtors, often incompatible with a cost-efficient solution. In addition, there were differences across countries regarding deposit insurance (e.g., definition of deposits, co-insurance, risk-based premia, and funding). 1 This state of affairs increases the regulatory burden, provides incentives for regulatory arbitrage, hinders competition, exacerbates moral hazard, uses taxpayer money to save inefficient firms, endangers the EU integration process, and is inconsistent with financial stability. World and EU financial stability frameworks are evolving with the aim to enhance crisis prevention, management and resolution for cross-border financial institutions. In 2008, given the costs of the crisis and the Nordic experience, the EU proposed an MOU on cooperation among supervisors, central banks and ministers of finance on cross-border financial stability. This was a key step in establishing a series not only of principles, but also procedures to exchange information and cooperation among countries in normal times in order to prevent, as well as to manage and resolve, cross-border crises. The 2008 MOU includes prescriptions for coordinating public information, conducting stress-testing exercises and establishing contingency plans. It remained, however, a voluntary framework which does not fully solve the tension between home country lead responsibility for integrated supervision and the host country responsibility for financial stability. In 2009, the Larosière Report and the European Council agreed on the need to build a comprehensive cross-border framework for the prevention, management and resolution of financial crises in the EU. The Financial Stability Board (FSB) published principles for cross-border cooperation on crisis management stressing the role of supervisory colleges. These principles enhance incentives for financial institutions to behave prudently; promote private sector solutions and limit public intervention only when necessary to preserve financial stability and; keep a level playing field. Supervisory cooperation took a big step forward with amendments to the CRD as a 2009 EC Directive made compulsory the colleges of supervisors for banks with significant subsidiaries and branches in the EU. Chaired by the consolidating supervisor, the colleges have the objective of exchanging information; determining risk assessment programs of the banking groups; leveling the playing field in terms of application of the Directive in the concerned Member States. Finally, last May, the Council of the EU decided the establishment of Cross Border Stability Groups for all large EU cross-border groups by mid 2011 accompanied by the signature of Cross-Border Cooperation Agreements. Recognizing the insufficiency of the microprudential approach to deal with systemic risks, the European Parliament approved a new crisis prevention framework which also considers the systemic risks posed by international banks. It is now generally accepted that microprudential regulation and supervision of individual institutions and A 2009 EC Directive increased the coverage of deposit protection to 100.000 Euros starting end-2010. A July 2010 EC proposal of Directive seeks a further harmonization of EU deposit insurance schemes and a reduction of the reimbursement period, as well as mechanisms to guarantee the financing of the schemes. markets, while necessary, is not sufficient because it does not take into account the interactions among financial institutions and between financial institutions and the real sector. The European Systemic Risk Board (ESRB), a key component of an integrated micro-macro European System of Financial Supervisors (ESFS), will be operational at the beginning of 2011. It will be responsible for macro-prudential oversight to prevent or mitigate systemic risks, enhance early warning mechanisms and facilitate the translation of risk assessments into action so as to avoid episodes of widespread financial distress, to enhance the smooth functioning of the internal market, and ensure a sustainable contribution of the financial sector to economic growth. The ESRB can issue warnings and recommendations for action, which while not binding for the addressee, inaction by the addressee will have to be explained. The three microprudential components of the ESFS will start their supervisory activities at the beginning of next year. These new authorities will be born from the transformation of the existing 3L3 committees into a European Banking Authority (EBA), a European Securities and Markets Authority (ESMA), and a European Insurance and Occupational Pensions Authority (EIOPA). The network of national financial supervisors will work together with the new European Supervisory Authorities (ESAs). The new bodies will be built on shared and mutually-reinforcing responsibilities, combining nationally-based supervision of financial institutions with specific tasks at the European level; will foster harmonized rules and coherent supervisory practice and their enforcement. Other initiatives at the world level are intended to promote sound practices for colleges of supervision. The EU supervisory framework addresses cooperation in supervision in general and also by colleges. The Committee on European Banking Supervisors (CEBS) is currently developing guidelines for their operational functioning. The CEBS has also developed an MOU template to be signed at the end of 2010 not only by EU supervisors, but also by EEA relevant authorities. However, many EU financial institutions are truly global, and thus it is important to mention that also the Basel Committee on Banking Supervision (BCBS) has put out a set of eight good practice principles on supervisory colleges. The objective of supervisory colleges is to enhance information exchange and cooperation among supervisors in order to support the effective supervision of international banks. In the EU, a framework for cross-border crisis management in the banking sector is just in its gestation period. Research unequivocally shows that coordination failure is a distinct possibility in a cross-border setting. Therefore, ex-post negotiations on burden sharing lead to under-provision of recapitalization; in contrast, an ex-ante burden-sharing mechanism might encourage moral hazard. In this vein, measures have been taken to upgrade deposit insurance, as I said earlier, to strengthen capital requirements and to reform the EU infrastructure to prevent crises. Yet, a framework to enable authorities to control the impact of a failing cross-border financial institution is still missing. Therefore, mindful that the costs of uncoordinated national resolution increases with the degree of interconnectedness and integration of financial institutions, last month, the EC issued a communication proposing the building blocks of an EU framework for cross-border crisis management in the banking sector. According to this communication, the objectives of the framework are twofold: first, to ensure that national supervisors have tools to identify problems in banks at an early stage so as to be able to intervene to restore the institution’s health or to prevent its deterioration; second, to make crossborder banks’ failure possible without contagion and without disruption of banking activities. The framework is very ambitious as it covers early preparedness, preventive as well as intervention measures, resolution and insolvency principles. The full implementation of the framework would pose significant challenges under the present state of European integration, in particular with regard to issues related to burden sharing, intragroup asset transfers during periods of crisis and heterogeneity of insolvency laws within the EU. In this context, it may be more realistic to pave the way for a second best approach i.e. a nationally based framework for cross-border crisis management associated with a binding process for cooperation and information exchange. The establishment of ex-ante bank resolution funds may also contribute to the reduction of moral hazard and increase financial stability. The EC communication to the EU bodies proposes the establishment of national bank resolution funds. These would be funded by a levy on banks so as to facilitate the resolution of failing banks avoiding thereby contagion and sales of bank assets under stress. Bank resolution funds should not be viewed, however, as insurance against failure or to bail out failing banks. Funds are part of the set of tools of a financial stability framework that includes crisis management, and are intended to palliate, at least partly, the stability implications of the failure of LCFIs. In Luxembourg, the Central Bank has suggested an innovative framework for an ex-ante bank resolution fund through the establishment of a privately pre-funded structure covering both issues of an orderly resolution, i.e Deposit guarantee scheme (DGS) and Bank resolution fund. In order to avoid any conflict of interest or misallocation of DGS reserves, this shall be an earmarked component of the fund. In addition, this framework is designed such that liquidity constraints taking effect during a transitional period would be minimized in order to safeguard the flow of capital into the bank resolution fund. This can be ensured via a dual mechanism which allows for the substitution of loans granted to the fund by the purchasing of an equivalent amount of bonds issued by contributing credit institutions. At the global level, the Cross-border Bank Resolution Group of the BCBS issued last March ten recommendations for addressing the challenges posed by cross-border bank resolution. Concluding remarks I remain confident that the new macroprudential architecture will contribute to a more stable financial system that will permit maximizing the benefits of capital flows. Let me finish with a pragmatic quotation from Goethe: “Knowing is not enough; we must apply. Willing is not enough; we must do.” I believe we are applying what we learnt; I also believe we are establishing a new foundation for safeguarding financial stability. However, it should be noted though, that the views on the new micro-prudential regulation framework are still diverging. Questions are still under discussion especially in view of global standards applied to heterogeneous financial systems. Level playing fields considerations loom not least in accounting rules. And the European authorities have made it clear that this time around geographical implementation has to be done time congruently. Cross border financial activities have played a positive role in the process of globalization. At the same time they have enhanced the need for ever closer cooperation among competent authorities. Bodies for international standard setting therefore ought to include representatives from international financial centers. Systemically important financial centers should clearly play a distinguished role in the international post crisis architecture. In this respect, I fully concur with the suggestions for the way forward in the latest IMF paper. Thank you for your attention.
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Closing keynote address by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Islamic Finance Conference, Frankfurt am Main, 18 November 2010.
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Yves Mersch: Prospects of Islamic finance – the view of a central bank in Europe Closing keynote address by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Islamic Finance Conference, Frankfurt am Main, 18 November 2010. * * * Ladies and Gentlemen, It is my pleasure to talk to an audience of such distinguished financial specialists. Before I embark on what Islamic finance means for central banking in Europe, I will have a look at the growing importance of the phenomenon, its characteristics in the context of financial stability in general and its performance during the financial crisis in particular. Finally, I will present the achievements within my own constituency to overcome the obstacles for an accelerated and safe spreading of Islamic finance in Europe. Islamic finance: growing importance The development of modern Islamic finance roughly started more than four decades ago. At the very beginning it occupied a small niche visible in Islamic countries. In Malaysia the Pilgrim Fund (Tabung Haji) was established in 1969 as an Islamic savings institution. More recently Islamic finance has expanded out of this niche. Worldwide, the assets of Islamic finance institution have grown at double-digit rates for a decade. Even some conventional banks have embarked into the provision of Shari’ah compliant financial assets reaching an estimated 509 billion USD at the end of 2007 according to Moody’s 1 . Today, there are at least 70 countries that have some sort of Islamic financial services. Almost without exception, the major multinational banks offer some kind of these services. With the rise of the importance of Sovereign Wealth Funds (SWF), Islamic finance was pushed further. About a decade ago, many emerging countries started to accumulate huge foreign exchange reserves, most of them benefiting from rising oil, gas and other natural resources’ prices, being supported by favorable macroeconomic policies. With assets under management of an estimated 3,000 bn USD in 2009, SWF represent twice the wealth of hedged funds. Muslim countries, oil exporters in particular, account for more than 50% of all SWF’s assets – not all of which are Islamic finance products, though. While Islamic banking remains the main form of Islamic finance, Islamic Insurance companies (Takaful), mutual funds and Islamic bonds (Sukuk) have witnessed strong global growth. The Sukuk markets in particular have gained importance. In recent years, the issuance rose from less than 8 bn USD in 2003 to 50 bn USD by mid-2007. 2 After a sharp decline during the financial crisis, private sector estimates see global sukuk markets rebounding, expecting the total volume to surpass 20 bn USD in 2010. 3 Moody’s, Islamic Finance Explores New Horizons in Africa, 2008, http://www.moody’s.com. Cakir, Selim / Raei, Faezeh: Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?, IMF Working Paper, WP/07/237, Washington, 2007. Chua, Tony: CIMB Islamic optimistic on sukuk issuance, in: Asian Banking and Finance, August 2010. This development might well continue. As Muslim populations are under-banked, and there is an increased financial need for infrastructure projects like roads and housing in many Muslim countries, the demand for Shari’ah compliant financing is still growing. The International Organization of Securities Commissions predicts that as much as half of the savings of the world’s estimated 1.2–1.6 bn Muslims will be in Islamic financial institutions by 2015. The business model indeed could also be attractive outside the traditional Islamic territory, e.g. in Western countries with large Muslim populations, such as the UK, France or Germany. 4 According to estimates, the Muslim population in Europe currently adds up to almost 40 million 5 . Additionally, Islamic finance provides an alternative for ethical investment and can help investors independent of their religious orientation to diversify their portfolios and funding sources. Ethical foundations of Islamic finance: neither new nor exclusive The obvious growing importance of Islamic finance calls for a deeper understanding of its underlying principles. The main feature of Islamic finance is the idea of justice. This is mainly achieved by four principles. To a European observer the link between ethics or religion and finance seems awkward at first glance. This connection however is neither new nor exclusive to Islamic countries. It has a long tradition in economic thinking in the occidental world, too. Remember the reasoning of the German sociologist Max Weber. He argued that capitalism in northern Europe evolved when the Protestant ethic motivated people to engage in business and trade in the secular world, and to this end accumulated wealth for investment. In his view, the Calvinist ethic in particular was an unplanned driver behind capitalism. Similarly, the founding father of modern economics, Adam Smith, stressed the importance of ethical foundations of markets. Prior to the “Wealth of nations” (1776), he published “The Theory of Moral Sentiments” in 1759 – a work, Smith himself considered to be a superior work to his magnum opus. To sum up: Islamic Banks seek to maximize their profits just like other banks. They have to comply, however, with Shari’ah law – without being religious institutions. Making the financial system more resilient For a central bank financial stability is a prerequisite for achieving its goal of a stable currency. The interplay between Islamic finance and financial stability is therefore of particular interest. Generally, an increasing number of approaches in banking and finance should make the system safer overall because it reduces the concentration of funding sources on the macro level. On one hand, the particular character of Islamic finance could make banking more resilient to potential financial shocks. The lack of exposure of opaque and complex assets and the absence of excessive leverage should protect Islamic banks from the impact of financial crises. Reliance on deposits rather than wholesale funding adds another layer of stability. On the other hand, the asset-based and risk-sharing nature of Islamic finance can make the business model more vulnerable to second round effects of a financial crisis, i.e. Islamic Imam, Patrick; Kpodar, Kangni: Islamic Banking: How has it diffused?, IMF Working Paper, WP/10/195, Washington, 2010. Lugos, Luis et al.: Finance islamique et droit français, in: Mapping the Global Muslim Population, Pew Forum on Religion & Public Life, 2009. banks may suffer more from the real economic downturn that normally follows financial turbulences as the losses of the customers are partly shared. Moreover, the lack of product standardization and the missing harmonization of Islamic standards in general pose risks to the management of liquidity. The judgment on the contribution of Islamic finance to financial stability is therefore ambiguous. In principle, Islamic finance can make the financial system more resilient, although it is more vulnerable towards negative spillover effects from the real economic sector. However, this potential can only be realized, when the regulatory and supervisory regime, the legal framework and payment and settlement systems are robust and current shortcomings in liquidity management are overcome. Experience during the current crisis Although we still lack comprehensive and detailed research on the performance of Islamic finance during the financial crisis those pieces of empirical evidence that are available support the former reasoning. According to a recent IMF study Islamic banks fared indeed better than conventional ones in 2008. 6 This result was however reversed in 2009 when the financial crisis hit the real economy. Overall, Islamic banks performed better within the last three years than their conventional counterparts. Thanks to higher solvency and lower leverage Islamic banks succeeded in matching relatively higher demand for credit at a time when Europe and the US dealt with the threat of a credit crunch. Moreover, according to various credit rating agencies, the change in Islamic Banks’ risk assessment has been better than that of conventional banks (with the exception of banks in the United Arab Emirates (UAE)). Ensuring a level playing field As long as financial stability and the functioning of the transmission mechanism of monetary policy are not at risk, central banks should not interfere with the structure of finance. Ensuring a level playing field can be seen as a prerequisite for functioning financial markets. If the demand for Islamic compliant financial products is rising, obstacles for its further development should be abolished without contradicting the principles of appropriate supervision and regulation nor the prevalent operational framework of central banks. Therefore, the infrastructure and supervisory environment should be provided to allow efficient clearing of a sufficient number of investment-grade Islamic finance papers across the whole maturity spectrum. While banking authorities are committed to adapt and to be accommodating for Islamic finance within the European regulatory framework, it is crucial to require the same licensing and supervision standards from Islamic financial institutions as expected from conventional banks. 7 Real challenges however remain on the legal side for example asset transferability. But these complications are to a large extent shared with the conventional banking system. Keeping that balance will be beneficial to both Islamic investors and the European financial system. Hasan, Maher; Dridi, Jemma: The Effects of the Global Crisis on Islamic and Conventional Banks: A Compartive Study, IMF Working Paper WP/10/201, Washington, 2010. Mersch, Yves: Speech at the 5th Economic Forum Belgium-Luxembourg-Arab Counties, in Brussels, 17th November 2009. Luxembourg’s pro active approach In Luxembourg, private and public decision makers of the financial industry are motivated to establish a regional hub for Islamic finance, making use of Luxembourg’s expertise in cross border finance. Major steps have been taken already. The Central Bank of Luxembourg is a member of the Islamic Financial Services Board (IFSB), a standard setter for financial stability. Addressing shortcomings in the Sukuk market such as lack of liquidity and international recognition, small size of issuances, insufficient number of high quality issuers and focus on domestic markets, the IFSB coordinated the establishment of an International Islamic Liquidity Management Corporation (IILM) in October 2010 with the Banque centrale du Luxembourg as a founding member. This new corporation will issue investment grade Sukuk across the whole maturity spectrum in order to facilitate liquidity management for institutions offering Islamic Financial services (IIFS) and cross border investment flows. In 2002, the Luxembourg stock exchange was the first in Europe to receive a Sukuk listing. The number of Sukuk listed today on the Luxembourg stock exchange compares well with the leading stock exchanges in Europe. Luxembourg provides the infrastructure for the post trade related aspects of Shari’ah compliant securities transactions, namely in settlement and custody services. In May 2010, the Banque centrale du Luxembourg and Clearstream launched LuxCSD, a new Central Securities Depository for Luxembourg, which will enable the settlement of securities transactions in central bank money and thus be compliant with the highest standards of safety for market participants, providing at the same time a connection to the Euro system project Target2-Securities. The international expansion of Sukuk presupposes a higher degree of standardization, reliability in terms of Shari’ah compliance as well as robust accounting, legal, tax and regulatory frameworks. The adoption of best practice regulation and supervision requires sufficient differentiation among Sukuk types. Challenges for the expanding market are posed by sector risk due to an overreliance on real estate and construction, the involvement of different laws and jurisdictions together with enforceability issues. Luxembourg is the leading location for Shari’ah compliant investment funds in Europe. In 2008 the Grand Duchy set up a task force to identify possible hindrances to the local development of Islamic finance. Tax treatment for common Islamic finance transactions has been adjusted to ensure tax neutrality compared to conventional transactions. Skilled staff is essential to any provider of financial services. Dedicated training courses have been set up by the Luxembourg Institute for Training in Banking (IFBL), the Luxembourg School of Finance (LSF) and the university to meet the growing demand for education in Islamic finance. Next year in May, the Banque centrale du Luxembourg will host, for the first time in the Euro area, the Islamic Financial Services Board annual summit, a major fourday-conference. Concluding remarks Islamic finance provides opportunities and challenges in the context of the agreed goal of enhancing global financial stability. From the perspective of a European central banker, Islamic finance should be a complement to conventional banking and capital markets, not a substitute. Due to their characteristics, Shari’ah compliant financial products can enhance the stability of the financial system. Shortcomings in standardization and liquidity management must be tackled, however. Cooperation between investors, issuers and regulatory and supervisory authorities is a prerequisite for a successful integration beneficial to all stake holders. Luxembourg with its tradition as a specialized financial center will continue its endeavors to establish an international hub for Islamic finance.
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Keynote address by Mr Yves Mersch, President of the Central Bank of Luxembourg and Member of the Governing Council of the European Central Bank, at the Bank Finance 2011 Conference, Frankfurt am Main, 3 March 2011.
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Yves Mersch: Is inflation back? Keynote address by Mr Yves Mersch, President of the Central Bank of Luxembourg and Member of the Governing Council of the European Central Bank, at the Bank Finance 2011 Conference, Frankfurt am Main, 3 March 2011. * * * Headline inflation in the euro area is on the rise. According to Eurostat’s flash estimate euro area annual HICP inflation increased by 0.1 percentage points to 2.4% in February. This figure is more a snapshot than an incipient violation of the ECB’s medium- termoriented definition of price stability, – namely of inflation below but close to 2% –, but there is no room for complacency. The key question is whether we are facing a “hump” – in other words, is this acceleration in headline inflation temporary –, or is it the edge of a plateau, where the pressure on prices is more persistent than currently assumed. The judgment on this is three-forked: we envisage a good, a bad and an ugly scenario. The good scenario, i.e. the good news, is that we have been here before. Temporary increases in headline inflation have not prevented the ECB from managing to keep the average annual inflation rate in the euro area at 1.97 over the past 12 years. The bad news is that things might be slightly different this time, as forecasting inflation is, indeed, a complex task. The really ugly news is that there may be even drivers at work that could lead to errors in forecasting inflation significantly, especially in underestimating future price levels. Let me discuss this in more detail. The good scenario: the hump scenario is the most benign Annual headline inflation in the euro area increased steadily in the course of 2010, from 1.0% in January to 2.2% (in December, an increase of 1.2 percentage points within one year. This 11-month increase in headline inflation is due) almost entirely to the food and energy components of the HICP. Crude oil prices, for example, have surged by around 35% over the last half year, peaking above 120 Dollar very recently, and pushing up import prices. Recent political turmoil in some oil exporting countries in the Arabian world may lead to further price increases. The contribution from the other components of the HICP basket was relatively stable, though mildly accelerating. According to the consensus among monetary authorities, these sources of price pressure can and should be ignored by central banks, as long as the increases are truly temporary and inflationary expectations stay anchored at levels consistent with price stability: One-off and unpredictable price shocks cannot be tackled by the traditional instruments of monetary policy. Nevertheless, second-round effects must be avoided by all means. They materialize when a one-time shock, e.g. a transitory price hike, becomes entrenched in other prices, particularly through a wage-price spiral. Has this happened in 2010? Labour cost indicators were subdued in the third quarter of 2010 and data on euro area negotiated wages for the fourth quarter suggest an ongoing moderate growth in wages. But industrial producer prices (construction excluded) increased significantly in the course of 2010 and reached the level of 5.3 % in December. Today we have published the ECB’s staff projections on growth and inflation in the euro area. The time horizon of these staff projections is similar to that in which monetary policy has its effects, namely 18–24 months. According to the staff figures that have been significantly revised upwards from earlier projections, overall HICP inflation is projected to BIS central bankers’ speeches stay above 2% for the rest of this year, with annual inflation averaging 2.3% in 2011. Thereafter, average inflation is projected to decline to 1.7% in 2012. The growth projection has also been revised upwards compared to December. Real GDP is expected to grow by 1.7% and 1.8%, respectively, in 2011 and 2012. According to this scenario, one might expect a “hump” in inflation, i.e. suggesting the observed increase in the inflation rate is only temporary. The bad scenario: the complexity of inflation forecast The problem is that one cannot be sure that this benign scenario will come true. Forecasting inflation is a difficult task – this holds in particular for times of increased uncertainty like in the aftermath of a financial crisis and, more recently, political exceptionality. Even in normal times, the models may be wrong. Let me mention only some potential sources of error. Firstly, although there are sound reasons generally to treat shocks to the economy as one-time events, the cumulative effect of a series of shocks, and thus on the development of the price level, cannot be excluded. The standard macroeconomic models also widely used in central banks tend to underestimate headline inflation. In the first 12 years since the introduction of the Euro, the staff projections performed well as far as core inflation was concerned. The projection of the head line inflation, however, was systematically too low, because – among other reasons – the scale of the pass-through of past energy or commodity price shocks into output prices has been underestimated. Secondly, upward risks to headline inflation stem from pronounced base effects. Base effects occur when variations in the annual growth rate of the HICP are the result of an atypical movement in the index in the base period. They tend to be particularly influential during periods when inflation volatility 12 months earlier was high, for example as a result of sharp movements in commodity prices. It is expected that 2011 will benefit from negative cumulative base effects from energy and food in 2010 of up to 0.7 percentage points. Thirdly, the choice of leading sub-indicators is a tricky one. Let me give an example. In recent years energy prices, namely for crude oil, contributed to an increasing extent to the volatility of headline inflation. There is, in fact, not just one price for “oil”. Traditionally West Texas Intermediate (WTI) commands a higher price than Brent crude. Most recently the price differences between the two benchmark sorts of crude oil showed anomalies: on 1 March, WTI was trading around 100 US Dollar per barrel, while Brent was at 114 US Dollar per barrel. While this huge difference could be partially explained by regional factors like the cold winter in Europe and the large stock of WTI oil in the US, the reliability of these prices to signal global scarcity can be questioned. Fourthly, one major driver of inflation is the dynamics of the economy. To measure the slack in the economy, the deviation of aggregate demand from the economy’s potential supply – the so-called “output gap” – is often seen as a helpful guide for policymakers. On this logic, inflation rises, when aggregate demand exceeds potential output. However, the concept of a stable relationship between output gap and inflation is not only frequently challenged in theory but also hard to apply in practice. The operational appropriateness of the output gap as a guide to policy is limited by the availability of reliable real-time estimates. For example, estimates of the euro area output gap, as published by international organizations from 1999 to 2004, underwent significant revision. Some revisions matched or even exceeded the original estimate of the gap itself. BIS central bankers’ speeches Complexity has increased further because of the financial crisis: In this context, the crisis has had two effects: In the first place, the crisis triggered a probable one-off permanent loss in the level of potential output, in particular because of the downsizing of the financial and construction sectors. Whether the longer-term growth rate of potential output will also be affected, remains to be seen. In any case, the reliability of output-gap measures as real-time clues to future inflation is weakened. In the second place, the financial crisis has impacted the effectiveness of monetary policy. The exceptional liquidity requirements of banks after the dryingup of the money market in the summer of 2007, as well as the severe tensions in some segments of the market for euro-area government bonds, have affected the transmission channels of monetary policy in the euro area. To restore the effectiveness of monetary policy, the authorities have had to adopt several unconventional measures of temporary nature. The general complexity of the art of forecasting inflation, coupled with heightened uncertainty in the aftermath of the financial crisis, calls for prudence and humility. Policy makers have to be wary when deducing real-time policy implications from inflation forecasts. For the euro area, a thorough exchange of views between all members of the governing council of the ECB is of utmost importance in bringing to bear a great wealth of experience. The ugly scenario: the threat of a plateau At the current juncture, new sources of inflationary pressure may emerge. Below the surface may lie new potential threats to price stability. Let me highlight three of them. Firstly, the combination of dynamic economic growth, accompanied by accelerated inflation in emerging markets, and an intensification of world-wide linkages bears the risk that imported inflation will come to play a larger role in domestic price levels in the industrialized world. For instance, the current increases in prices of certain agricultural products and raw materials may be more persistent than currently assumed. In other words: The disinflationary impact of globalization, from which the industrialized world has benefited in the last 20 years, could turn into an imported inflationary impact. The lagged effect of food prices could still add a layer of headline inflation. Secondly, in several countries of the euro area, the diminishing labour force presents a demographic challenge kicking in 2013. There is anecdotal evidence that, in countries characterized by a dynamic recovery, there is already a shortage of skilled workers such as electricians. With resistance to adjust pension ages or to extend participation rates among age or gender cohorts with low employment, this all in all may cause an upward pressure on wages, bearing the risk of a wage-price spiral. Informal contacts with NFC point to expectations of wages rising in 2011 in line with inflation. Thirdly, the output gap may be closing faster than anticipated – not to mention the measurement problems attached to that leading indicator of inflation. As the economic recovery continues, there are new indices, which we will have to follow closely. For example, capacity utilization is coming back very rapidly to normal. In accordance, the European Commission’s February 2011 surveys in the manufacturing sector have shown a particularly steep rise in selling price expectations to a level even surpassing the 2008 peak. Spillovers to producer prices and producer prices of consumer goods are only a question of time. Moreover, the momentum for structural reform to lift potential growth is still a bit lackluster. A raised potential for growth could somewhat ease inflationary pressures. BIS central bankers’ speeches Concluding remarks: credible and effective alertness The scenarios I mentioned should not be interpreted as predictions. Nor can one attach precise probabilities to any of them. They indicate, however, that our assessment of risk to the medium-term outlook for the price level in the euro area needed to be adjusted upwards. The Governing Council of the ECB will make sure that the uncomfortable scenario will not materialize, and that the assumed temporary increase in the inflation rate will not prevail over the medium term. If indirect and second-round effects were to materialize on large scale, monetary policy would be reactive instead of being ahead of the curve. Once the genie of inflation is out of the bottle it might be too late. In order to avoid these effects, we will exert strong vigilance. Therefore, be assured that any threat to price stability in the medium term will be combated preemptively and vigorously. We will not let the genie out of the bottle. BIS central bankers’ speeches
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the General Assembly of "The Luxembourg Bankers' Association", Luxembourg, 27 April 2011.
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Yves Mersch: Basel III and liquidity surveillance in Luxembourg – building an operational systemic and micro-prudential framework Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the General Assembly of “The Luxembourg Bankers’ Association”, Luxembourg, 27 April 2011. * * * Ladies and Gentlemen, I would like to thank the ABBL General Assembly organizers’ for inviting me to share with you some thoughts on the challenging question regarding the recent Basel III liquidity regulation proposals, their potential impact for the Luxembourg banking system, and how those changes are integrated by the BCL within its mandate for liquidity surveillance. Let me say upfront that liquidity surveillance has to be put in the broader perspective of the increasing key role of central banks in financial stability and macroprudential policymaking. The recent financial crisis has highlighted the need to go beyond a purely micro approach to financial regulation and supervision. The policy debate and proposed changes in regulation and supervision are focusing in particular on developing a macroprudential framework, on constructing macroprudential tools and on reflecting upon their usage, their relationship with other policy areas such as monetary policy, microprudential, fiscal to competition, their implementation and their effectiveness. In Europe, beyond changes in the architecture, there is a number of major planned reforms in financial regulation; as you can see on the slide in front of you (taken from the eighth Financial Stability Review of the BCL to be presented tomorrow) the spectrum of those changes is vast. It covers capital and liquidity regulatory frameworks, financial institutions, as well as markets and markets infrastructures. Our task today refers to the important pillar of liquidity surveillance. Note, however, that all these prospective changes are taking place within the context of evolving national supervisory frameworks. I am convinced that no matter how those mandates finish being structured across countries, central banks, by their unique role in monetary policy and settlement and payment systems oversight, ought to have a clear mandate in financial stability and a key role in macroprudential policy. One of the alleged strengths of our country has been its capacity to rapidly adapt, and often even lead, key policy and structural developments around the world. Given the large proportion of countries that have already given their central banks a clear mandate in financial stability and in macroprudential policy formulation, implementation and coordination, our challenge is clear. Already in 2010, the BCL has provided legislative proposals to the Executive branch in this respect as well as what concerns a regulative regime. BIS central bankers’ speeches Current main reforms in financial regulation Capital and liquidity Individual financial institutions Markets Capital Capital ratio Conservation buffer Countercyclical buffer Leverage ratio Central counterparties – OTC markets Crisis management and resolution Rating agencies Liquidity LCR NSFR Initiatives from the Basel Committee Corporate governance Alternative investment funds Systemically important financial institutions Initiatives from the European Commission Given the role of liquidity in the recent crisis, an international consensus on liquidity regulation is emerging and has been assigned high priority among regulators and supervisors. Let me start by making some remarks on the background of ongoing efforts directed towards forging a consensus view for the future Basel III framework. As you know, Governors of national central banks (NCBs) along with Heads of Supervision authorities, albeit without Luxembourg given the country’s current institutional framework, have been working in order to finalize a definition of liquidity that will permit regulators to minimize system-level distortions through the penalization of those banks holding assets with poorly structured liquidity profiles. As observed during the crisis, illiquid assets played a central and significant role in the aggravation of the turmoil. In fact, the “illiquidity” phase of the crisis was particularly acute as the speed with which assets became illiquid lead to a significant negative impact on the ability of banks to have access to funding. Now, one naive way of addressing such systemic liquidity problems would be through the imposition of elevated liquidity requirements – spread equally – across all institutions with the central bank playing the essential role of liquidity provider. However, a model such as this one runs the risk that all institutions may, during a crisis, exhaust their liquidity requirements simultaneously leading to a systemic crisis. This is not an effective approach to regulation. So what is the alternative? To date, policy-makers have not yet reached a final consensus on a suitable macro-prudential framework able to safeguard against systemic liquidity risk. This is why work on liquidity regulation is viewed by the Basel Committee in Basel (CGFS, FSB) as being of central importance going forward. So, today I shall discuss the proposed Basel III liquidity ratios and their impact on our country, while taking advantage of this opportunity to let you know how we envision liquidity surveillance, what we have done, and what we plan to do in the near future. BIS central bankers’ speeches The Basel III regulations will provide regulators with standard empirical measures of liquidity risk providing them with a toolkit that can help to mitigate funding and market liquidity risk. Central banks are deeply involved with liquidity management at the macroeconomic level and are recognized as the de facto emergency liquidity providers during times of crisis. In its current form, the Basel III definition of liquidity relies on two particular measures that have been proposed in the context of adopting a new global liquidity standard. As you surely know by now, these are the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). It is broadly recognized that these measures of liquidity should be designed so that, from a macro-prudential perspective, they can be used as possible tools to help alleviating and mitigating a rise in systemic liquidity risk. They should help increase the banks’ liquidity buffers and lower maturity risk transformation, which in turn should make them more resistant against the transmission and amplification of liquidity shocks. In particular, there are two types of risk that need to be targeted. These are market liquidity risk and funding liquidity risk. Market liquidity risk results from firms being unable to engage in quick and efficient sales of assets, a desirable property of efficiently functioning financial markets. In an illiquid market, asset sales may be hindered thereby adversely impacting the price of the asset. Funding liquidity risk, on the other hand, may result in firms being unable to meet their expected cash flow requirements over the long or short-term. This can adversely impact a firm’s ability to access funding, particularly on short notice. Regulators recognized that both types of risk lead to market inefficiencies and thus result in undesirable implications for financial firms and, ultimately, the real economy. You can therefore see that quantitative liquidity measures such as the LCR and the NSFR, while based on a well established tradition on liquidity risk management theory, are a welcome innovation from a regulatory perspective given that – for the first time – they provide regulators with the capacity to introduce and harmonize standard measures in liquidity risk management practice. Since these empirical measures will be central to the new Basel liquidity standards, I believe it would be advisable for me to spend some time discussing each indicator in turn. The LCR will be used to help mitigating short-term liquidity stress thereby allowing financial institutions to maintain smooth access to short-term funding requirements. Let me begin with the LCR. It is the current consensus of the Basel Committee that the LCR should be introduced after an observation or trial period thereby providing a window of opportunity during which any refinements to the measure could be introduced. From a technical perspective, the LCR is a short-term measure of liquidity which is specifically intended to ensure that financial firms can continue to access near-term liquidity needs in an efficient manner. In principle, this should make certain that banks have a sufficient quantity of liquid assets so as to be able to withstand up to a month-long period of sustained and severe liquidity stress. For illustrative purposes, let us consider what would have been the evolution of the LCR in the context of Luxembourg’s financial sector. While the Banque centrale du Luxembourg (BCL) has not yet formally adopted this measure in its role as a liquidity supervisor of the Luxembourg financial system, it is developing the framework necessary for the implementation of Basel III. I will describe its main components later. In an internal study conducted by the BCL, the evolution of the LCR was evaluated based on a sample of banks that excludes less-relevant branches and covers the period spanning from 2003:Q1 until 2010:Q4. BIS central bankers’ speeches Figure 1 The evolution of the LCR for Luxembourg’s banks, 2003q1 – 2010q4 Source: BCL calculations. You can observe the evolution of the LCR for this period in the accompanying figure. It was found that the median of the LCR decreased from roughly 82% in 2003:Q1 to a minimum of 52% in 2009:Q1. Since then it has been increasing almost consistently until the present time. One possible interpretation of this behavior for the period until 2009:Q1 is that banks were reducing their holdings of liquid assets. However, since the end of the crisis, financial institutions have been holding increasing amounts of liquid assets which represents the beginning of the re-stabilization of the liquidity conditions in the domestic financial markets. The NSFR will help to enhance the medium to long-term funding needs of banks thereby mitigating liquidity runs. Let me now turn to the second of the two proposed liquidity measures, the NSFR. In contrast to the LCR, the NSFR is designed as a medium- to long-term measure of liquidity intended to mitigate any future liquidity runs and, subsequently avoid any possible knock-on effects of a systemic liquidity crisis; like firms’ default, for example. In fact, the NSFR addresses the issue of maturity mismatch between a bank’s assets and liabilities. It is important to make clear that the NSFR has not been designed to play the role of an early warning indicator (EWI) of liquidity difficulties. Indeed, if one were to apply the NSFR to the period leading up to the recent crisis, the NSFR would have revealed to be an inconsistent indicator of future liquidity stress. This results from the inherent difficulties of attempting to separate liquidity from solvency. BIS central bankers’ speeches Figure 2 The evolution of the NSFR for Luxembourg’s banks, 2003q1 – 2010q4 Source: BCL calculations. As part of the same internal study I alluded to earlier, the NSFR was evaluated over the period from 2003:Q1 to 2010:Q4 using the same sample of banks as for the LCR. If you look at the figure displaying the evolution of the NSFR before you, you can see that, on average, the NSFR declined continuously from a median of 90% in the first quarter of 2003 to a median of 67% at the end of 2008. Since that time, the NSFR has slowly started to recover. Its decline until 2008 can be mainly attributed to a faster increase in total assets in comparison to capital as well as to an increase in wholesale funding from banks and nonfinancial corporations (NFCs). These results for the NSFR in Luxembourg are broadly similar to the results calculated by the International Monetary Fund (IMF) for Europe. For the NSFR, I should also mention that this ratio has been the subject of a study conducted by the Bank for International Settlements (BIS) and entitled “BASEL III: Long-term impact on economic performance and fluctuations”1. While a slight negative effect on output is not disputed, the authors – in fact, Mr. L. Clerc form the Banque de France will actually participate in our Financial Stability Review presentation tomorrow – conclude that the adoption of tighter liquidity requirements leads to an approximate reduction in output volatility by 1 percent. Overall this suggests that prudent liquidity controls would have a beneficial effect for the real economy. P. Angelini, L. Clerc, V. Curdia, L. Gambacorta, A. Gerali, A. Locarno, R. Motto, W. Roeger, S. Van den Heuvel and J. Vlcek. “BASEL III: Long-term impact on economic performance and fluctuations”. Bank for International Settlements, BIS Working Papers No. 338, February 2011. BIS central bankers’ speeches The calibration of the LCR and the NSFR will be critical to ensuring the liquidity and funding stability of banks, but further research will be required. Although the members of the Basel Committee have not yet achieved a final consensus on the exact structure of an operational liquidity management framework, the proposed new standards for liquidity risk management are a welcome development. In combination with a more robust and efficient supervisory landscape, the proposed Basel III recommendations should help to bolster liquidity risk management practices in the financial sector. This will have an overall welfare-enhancing effect on the real economy and will help to ensure the stable provision and access to liquidity and funding between financial institutions. In addition to reducing the risk of a rapid drying up of liquidity, this will aid considerably in mitigating the risk of excessive interconnectedness in the financial system by encouraging banks to reduce their common exposures. As we have seen, these are important ways in which well-calibrated LCR and NSFR can serve to enhance liquidity and preserve access to stable sources of funding. However, despite some initial empirical work and theoretical studies, neither the LCR nor NSFR has been implemented within the context of an operational supervisory framework yet. This both highlights and elevates the need for further quantitative impact analyses and related studies in order to ensure that, from a financial stability perspective, there is a reasonable and justifiable calibration underlying the LCR and NSFR for supervisory frameworks. In this context, policy-makers can be confident that any calibration is accurate and will not result in banks being restricted either in their ability to manage short and long-term liquidity or in their ability to undertake the maturity transformation activities which are vital to their financial intermediary’s role in the economy. This will also lead to a reduction in the cost of financial intermediation. It is for these reasons that regulators must strive towards striking a balance between efficient – but not overly restrictive – regulation and a set of rules that do not result in negative consequences for financial stability. We intend to maintain our dialogue with assertiveness in this respect and hope that Luxembourg’s representation at international level can be improved through a clear assignment of representatives. Part II How the BCL envisions and implements liquidity surveillance The 2008 BCL mandate to monitor the liquidity of markets and market operators recognizes central banks’ unique role in the surveillance of systemic liquidity risk. The crisis demonstrated that liquidity risk can emerge quickly. The manner in which liquidity risk materializes and is transmitted is determined by the nature of funding instruments and linkages among financial institutions, the degree of leverage of market operators, as well as their reactions to emerging stresses. Policy responses to the crisis must, at a minimum, enhance institutions’ liquidity risk management and information available to measure and track systemic liquidity risk. The task is complicated because the assessment of liquidity risk at the systemic level is often susceptible of a fallacy of composition given that the viability of banks’ individual approaches to liquidity risk will depend upon the strategies being pursued by other market operators. For instance, if banks have a great deal of interconnectedness via the interbank market, a liquidity shock impact will be relatively larger than if their interconnectedness was lower. In addition, if banks’ business models were diverse, the impact of a liquidity shock would be relatively smaller than if banks’ activities were concentrated on just one business line. The 2008 Law, in giving to the BCL the mandate to monitor markets and market operators’ liquidity, acknowledged the necessity of liquidity surveillance in Luxembourg. On this capacity, the BCL has issued regulations, such as the BIS central bankers’ speeches BCL regulation 2009/4 requesting banks to apply the BCBS “Principles for Sound Liquidity Risk Management and Supervision”. The Bank actively participates in the shaping of the Basel III framework for liquidity risk measurement, standards and monitoring. Taking due account of current regulatory developments, the BCL intends to publish further instructions to market participants on liquidity management before the end of this year. In the same way the BCL changed its architecture to comply with its liquidity surveillance mandate, it will also adapt to its unavoidable role in macroprudential policymaking in Luxembourg. Following the 2008 new mandate on liquidity surveillance, the BCL adapted its internal structure and resources so as to ensure that the Luxembourg market and its financial actors are constantly subject to analytical and quantitative scrutiny so as minimize systemic liquidity risk in the Luxembourg financial industry. The BCL has increased technical cooperation with regulators at the national and international level and is active in committees and working groups that develop regulations, practices, standards, as well as measures and monitoring tools to improve the financial sector’s ability to absorb liquidity shocks arising from financial and economic stress of various sources. This encompasses not only Luxembourg recent participation in its second IMF FSAP exercise, but also in EBA-led stress tests and BIS study groups. But this is only one leg, albeit crucial, of the unavoidable role of the BCL in macroprudential policymaking in Luxembourg. As the contours of a macroprudential policy framework take shape, the BCL will need a clear mandate on financial stability and a prominent role in macroprudential policymaking, whatever shape the framework ends up taking. But this is just the beginning of major changes to come in the near future. Given their role in monetary policy, central banks monitor markets and economic and financial developments that have a bearing on policies designed to reduce procyclical risks, a key objective of macroprudential policies. Similarly, given their role in settlement and payment systems oversight, central banks have developed a unique expertise in systemic risk analysis, inescapable element of macroprudential measures to reduce the probability of default of individual financial institutions. From a governance viewpoint, central banks have the right type of incentives to contribute to the effectiveness of macroprudential policies because failure in this area is costly for them, and eventually, for their hard-earned independence. Liquidity risk surveillance requires monitoring liquidity risk pricing both at the macroand at the micro-level. Observers (e.g., Borio and Drehmann) have shown that financial markets have a tendency to misprice risk over time. This was certainly the case in the run-up to the crisis. However, it is less widely recognized that banks also had severe pitfalls in their models for pricing liquidity internally, which resulted in an under-pricing of liquidity risk and compounded the gravity of the crisis. There is no single best indicator that captures systemic liquidity risk. This fact stresses the need to monitor a wide range of indicators and, unavoidably, to use informed judgment to assess liquidity risk. It is necessary to complement analysis such as the one described above with information on factors that history tells us that are, in one way or another, associated with liquidity stress and that inextricably link systemic with firm-level liquidity risk. I think in particular about high leverage levels and degrees of maturity transformation that rely heavily on short-term funding. A difficulty is that the crisis highlighted that some of those standard indicators tend to perform poorly or to suggest a lower level of vulnerability than it is actually the case. For example, when risk premium is low, financial institutions are encouraged to increase their leverage as their bets tend to look relatively less risky. In addition, haircuts on collateral tend to fall consistently with this view. This way, liquidity risk accumulates, and a change in market sentiment suffices to lead to forced asset sales on banks’ leveraged positions. Also, observing changes in collateralized lending practices and haircut levels are crucial indicators for assessing liquidity risk pricing, but this information tends to be viewed as proprietary by major market operators. At the BIS central bankers’ speeches micro-level, financial institutions are being required to enhance their funds-transfer pricing processes, which will be part of the liquidity management requirements I alluded earlier and that the BCL will announce in the coming months. The BCL is developing an operational framework for systemic and micro-prudential liquidity surveillance. As I have just illustrated, traditional tools for monitoring liquidity risk, while necessary, proved to be insufficient in the run-up to the crisis. The task of a liquidity risk supervisor is therefore not simple. The approach taken at the BCL strives to integrate the multiple facets of liquidity risk. However, to avoid the temptation to “look at everything”, the BCL approach is risk based. There is already convincing theoretical and empirical evidence that not only size, but also the degree of interconnectedness of banks via the interbank market, for example or the evolution of non-core liabilities constitutes good proxies for institutions’ systemic risk. These characteristics, as well as the relevance of a given institution for the key role of the Central Bank in preserving financial stability, determine the set of financial institutions that are more often and more intensely monitored – classified in terms of their degree of systemic importance. A key qualitative component of liquidity surveillance in the BCL is the assessment of banks’ liquidity risk management frameworks. As painfully learned from the crisis, this should be the first-line bulwark to defend an institution against liquidity risk. Particular emphasis is being laid on issues such as sound governance both at the banking group and at the local level; the definition of management risk tolerance level; the set of monitoring tools institutions use for assessing their liquidity risk; the robustness of stress tests scenarios and the extent to which they reflect Luxembourg idiosyncrasies; the size and composition of local liquidity buffers; the internal consistency of banks’ contingency funding plans and where applicable; intra-day liquidity management. In addition, the BCL also pays attention to the soundness of the business model and the balance sheet structure of local credit institutions and in particular to possible liquidity risks that are being transferred from foreign-based banking groups to local subsidiaries. In this regard, some degree of liquidity management at the local level plays a significant role in the BCL liquidity risk assessment of banks, and it must be subject to its approval. Finally, the BCL pays particular importance at assessing whether banks’ internal pricing of liquidity within the institution and among group member duly reflects liquidity risk. But even these tools and procedures are not enough. The BCL liquidity surveillance framework includes a combination of qualitative and quantitative elements. On-site visits are an important component of the BCL monitoring framework in order to assess business models and the liquidity situation and the risk management framework of credit institutions. In the absence of a formal MoU, the BCL surveillance visits are nevertheless coordinated and conducted with the Commission de surveillance du secteur financier. Since 2009, 14 on-site visits have been performed, and a similar number is expected to take place over the coming year. Another pillar of the BCL liquidity framework is off-site surveillance. While structural liquidity risk may be monitored and analyzed through information provided by financial institutions (prudential and statistical reporting requirements), by the micro-prudential approach or even by market intelligence, the BCL endeavors to have timely cash-flow based liquidity projections from market participants on a short-term basis. At the moment, 45 financial institutions which are important from a financial stability and a monetary policy perspective, provide a forward-looking daily liquidity reporting that includes a five-day forecast. The forward-looking nature of indicators is at a premium given the sudden realization of liquidity risk. This is the reason for the Bank’s analysis and close interaction with the industry in all aspects regarding the two liquidity ratios of Basel III and the monitoring tools proposed such as maturity ladder reporting, funding concentration, and the availability of unencumbered assets. Another key in-house liquidity monitoring tool compares every bank’s liquidity position using two different scores: one that BIS central bankers’ speeches compares a bank’s liquidity position across peer banks and another that compares a bank’s liquidity over time based on 21 different risk factors. The tool mainly helps identifying banks with weaker liquidity positions and streamlining monitoring tasks. The framework is also useful to draw inferences about the general liquidity trends within the Luxembourg banking sector for the purpose of ensuring financial stability. The framework integrates on- and offbalance sheet data and market and macroeconomic information. Finally, the BCL uses other indicators for analyzing the liquidity situation of banks at a micro-level. They include microand macro-prudential indicators, albeit of a backward- or coincident-nature, such as loan-todeposit ratios, liquidity ratios, banks’ data on funding structure by maturity and geographical distribution, portfolio analysis, inter-bank and intra-group activity information, and data on banks’ participation in payment systems. Liquidity surveillance and EU financial stability frameworks are still built on a national basis, but surveillance frameworks are evolving. Each EU national central bank is the LLR to financial institutions domiciled in its territory with the obligation of informing the ECB. This situation implies that host countries are in theory the providers of ELA to subsidiaries and branches, but do not have access to supervisory information about branches, and thus, have no way of assessing the risks involved in the ELA operations they undertake. Basel III still proposes the application of regulations on a consolidated basis. This means that branches located in Luxembourg should be supervised by the home supervisor. This is clearly problematic for Luxembourg since some branches are relatively large and systemically-relevant, and have to be monitored. Also there is a tendency for groups to run their subsidiaries like branches which inevitably leads to conflicts of jurisdictions. The challenge for BCL risk-based liquidity surveillance is to take account of the activities and the liquidity risk profile at the group level. A major consequence of this state of affairs is that the distinction between liquidity and solvency, and the ensuing impact on the sharing of the costs of the operation, remain opaque. On the other hand, home-country authorities may delay providing information or taking crisis-management actions to avoid capital losses, reputational effects or political backlashes. So the home authority does not always have the incentive to keep small-country host authorities informed in an acceptable way. In turn, host country authorities may seek to retain as much intervention authority as possible. The EU level MoUs signed in 2005 and 2008, being voluntary in nature, did not help much. As a result, several Colleges of Supervisors and Cross-border Stability Groups are being put in place to alleviate the remaining tension between home-country lead responsibility for integrated supervision of LCBGs and the host country responsibility for financial stability. The BCL currently participates in several Colleges of Supervisors and Cross-border Financial Stability Groups. Additionally, bilateral arrangements with other home supervisory authorities and/or regular exchanges of views with representatives from banks’ head offices take place in order to keep abreast of developments at the group level and to raise potential concerns with regards to the situation at the domestic level. Basel III is work in progress, and one-size-fits-all is incompatible with the richness of Luxembourg business models. The final contours of the Basel III framework are still to be made precise. It is already clear, however, that the framework is not yet well suited to cover the diversity of banks’ business models that characterize the industry in Luxembourg. The BCL is involved in technical discussions to strike the right balance between efficient liquidity surveillance and competitive and robust banks. Discussions cover, for example, the possibility of recognizing some stable funding in the period over the one month to which the proposed LCR applies and the period over one year to which the proposed NSFR applies. Investment funds’ deposits are so far not considered as a reliable funding source within the LCR – except those having a proven operational relationship – and are not considered as available source of funding in the NSFR. Another feature under discussion is the asymmetric BIS central bankers’ speeches treatment of the loss of funding in covered bonds, and the covered pool inflow which is not considered as unencumbered, and thus cannot be included within the stock of highly liquid assets. This situation makes it quite difficult to respect the LCR for certain business models. These two issues are particularly relevant for custodian banks and banks mostly involved in covered bonds issuance, respectively, but they are not the only ones under consideration. The road map is complex, but the way is clear. I have already alluded to the results of the top-down analysis conducted by the BCL on the new liquidity standards in the first part of my talk. This analysis is currently being complemented through a bottom-up approach instrumented by means of a joint survey of the BCL and the CSSF with a representative sample of domestic credit institutions covering a large share of total assets. Without going into the details of this survey, the results of which will be presented and discussed at the occasion of an ABBL conference scheduled to take place on 24th May, it is already clear that Luxembourg banking sector does on aggregate fall short of the required standards at the current juncture. I draw five preliminary lessons from these results: first, the BCL working at home with the industry and abroad with standard-setting entities, needs monitoring the implementation of the upcoming liquidity standards during the observation period, and especially the LCR. Second, it seems almost unavoidable that the new standards will induce certain banks to adjust their business models in order to comply with the new agreed pricing of liquidity risk components and offer products with more stable or more fee-based income. Third, as mentioned above, the BCL will use the survey and its internal studies during the upcoming review and calibration process at the international level in order to flag those issues that are considered to unduly penalize sound business models. Fourth, contrasting and comparing the top-down and the bottom-up approach is a rich source of information that the BCL intends to use for refining national regulation taking into account current and future qualitative and quantitative liquidity requirements and for designing reporting requirements. Finally, the BCL foresees a continued and increased focus on on-site visits and complementing the daily liquidity reporting in the near future by other requirements following the implementation of Basel III as a clear way of strengthening liquidity surveillance and boosting the robustness of Luxembourg banks. Concluding remarks Let me conclude with a few final remarks. When times are good, there is tendency to feel that there is too much regulation. When times turn bad, everyone wonders why there was not enough regulation in place to prevent bad states of the world to materialize. Regulators and supervisors experience thus a perennial need to justify their role and actions. Certainly, no regulation is perfect. It is especially difficult to develop a regulation that is conceptually broad enough to generate a level playing field, and it is at the same time flexible enough to take national specificities into account and to dampen potential negative effects on the real economy. Basel III regulations strive to fulfill these requirements but, as I reflected during this talk, more work is still needed. The BCL is actively contributing to this task through its participation all along the development of the Basel III liquidity standards. From the banking industry perspective, the crisis and the ongoing regulatory changes are an opportunity to enhance liquidity management and the pricing of liquidity risk and take up new challenges within the boundaries of the new regulations. In particular, the paramount role of high quality liquid assets within Basel III are a call to market operators to review their business models, their products and funding sources with the aim of building even stronger institutions. Thank you for your attention. BIS central bankers’ speeches
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a Lunch-Conference of the BLC (Business Club Belgo-Luxembourgeois en Suisse), Zurich, 23 May 2011.
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Yves Mersch: International financial centers after the crisis Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a LunchConference of the BLC (Business Club Belgo-Luxembourgeois en Suisse), Zurich, 23 May 2011. * * * Ladies and Gentlemen, It is my pleasure to talk in front of this distinguished audience about the challenges of international financial centers after the crisis. I would therefore like to thank Business Club Belgo-Luxembourgeois en Suisse for inviting me to this conference breakfast. The worldwide scenery of international financial centers is in transition. The respective locations face massive upheaval as global competition and the post-crisis reforms in regulation and supervision begin to bite. In order to overcome the challenges of a changing environment and to identify the potential opportunities, it is important to distinguish between the different drivers. A large part of the challenges financial centers are facing, are due to regulatory changes, which result from the reform in the aftermath of the financial crisis. In addition there are global trends that have been going on already before the outbreak of the financial crisis and which continue to have an impact. I will refer to these major sources of change in more detail in the course of my talk, provide some experience from Luxembourg, and will discuss the shortcomings and remaining challenges of the new regulatory framework. International financial centers – hit hard by the global crisis The high degree of integration and interconnectedness of financial markets contributed to the amplification and spread of the financial crisis around the world. The crisis had devastating effects on both the banking sector and the real economy, in particular in international financial centers with a high concentration of activities in banking, trading etc. They are the nodes of a global network. By consequence, the global financial crisis hit Luxembourg’s open economy and internationally-integrated financial center – although relatively less than the neighboring countries, such as Germany and France. Luxembourg is the world’s second largest investment fund center in terms of size (after the United States) and the largest in terms of interconnectedness, the most important private banking center in the euro zone and Europe’s leading center for reinsurance companies. Moreover, Luxembourg is among the 25 most systemically important financial centers in the world. At the height of the crisis, Luxembourg’s sizeable investment fund industry endured substantial redemptions and its foreign-subsidiary dominated banking system experienced a sharp drop in the aggregate balance sheet as well as in the off-balance sheet positions. This led to a 20 percent contraction in the aggregate balance sheet of the foreign-subsidiary dominated banking system in Luxembourg. Banks have also seen a 30 percent drop in their off-balance sheet positions as assets under management dwindled. About 8 percent of the financial sector’s work force lost their jobs, only a part of which could be re-employed by other institutes. Still, Luxemburg was less scathed by the financial crisis than countries with a highly leveraged home banking sector that sometimes had expanded excessively abroad. BIS central bankers’ speeches Moreover, the overall situation has since stabilized. No bank rescues were required since 2009 and investment fund assets have rebounded beyond pre-crisis peaks. In 2010, the number of investment funds that have been registered in Luxembourg increased by 5.9 percent to 3,463. The net asset value in turn rose by around 20 percent to 2.2 billion Euros. Thanks also to the global recovery and developments in neighboring countries, growth resumed early in the second half of 2009 and labor markets showed initial signs of recovery. Last year, Luxemburg’s Gross Domestic Product expanded by 3½ percent – compared to an average of 1.7 percent in the European Union. The global financial crisis, nonetheless, will leave a lasting imprint on the Luxembourg economy. Global trends increase competition Even before the outbreak of the crisis in the summer of 2007 the worldwide scenery of international financial centers was in motion. At first glance, however, the picture looked rather static. While the traditional financial centers in the industrialized world were prospering in an overall growing environment, and managed to defend their relative positions, emerging financial centers, particularly from Asia, were able to improve their competitiveness dramatically. It was therefore apparent that the top dogs would be facing increasing pressures to maintain their dominant positions. As financial centers emerge and develop over long periods of time, they are not too easily shaken. Most of the described trends therefore will continue after the recovery from the crisis. By consequence, traditional financial centers from the US and EU continue to represent the lions share of the global market. Although, in absolute terms, in many market segments overall levels of market activity have diminished, financial centers from the US and Europe provide around three-quarters of global financial services. Let me be more precise: – More than two thirds of global banking assets remain concentrated in financial centers in the US and Europe. – The US and Europe capture more than three quarters of the global revenue pool in investment banking. – Over two-thirds of all private and public debt securities and almost four-fifth of all interest-rates derivatives outstanding are registered in financial centers from the US and Europe. – Foreign exchange trading still is highly concentrated in London and Chicago, with the UK and the US capturing together some 50 percent share in global trading. 70 percent of all foreign exchange derivatives transactions are undertaken in the US and the EU. Emerging financial markets, especially in Asia, have grown strongly in past years. But they, too, have been hit hard by the crisis. After they will have recovered from the setback of the crisis, experts expect that they will speed up again their catch-up process. Concentration is ongoing as size still matters. Most experts predict that London, New York, Hong Kong, and Singapore are set to remain strongholds of global finance. Their major advantage is that they can build on existing market strength and favorable economic conditions. BIS central bankers’ speeches In the long-run, emerging financial centers are likely to succeed in establishing the scale and scope in their market environment that will help them advance into the top group of global locations. The crisis may have accelerated this trend. The foreseeable increasing global competition will put even more pressure on financial centers to defend or improve their respective positions. This holds in particular for those in Europe which is far from being a homogeneous jurisdiction. Indeed, European financial market places are at risk to fall behind in the global race for markets shares. The main European financial centers in Paris, Zurich, Madrid, Milan, Frankfurt, Amsterdam, Luxembourg, and even London, have clearly lost ground compared to other advanced and emerging locations.1 Changing environment trough new rules The financial crisis triggered a fundamental reassessment of the financial industry. Until four years ago, it was widely understood that financial markets were inherently self-correcting and therefore best left to their own devices. This prevailing paradigm has been sacrificed. After more than two decades of deregulation in the majority of the industrialized countries, finance has entered a new era: various initiatives have been undertaken to reform and strengthen the global framework for financial stability and reduce the probability of such a devastating global crisis occurring again. Major steps have been taken in the area of regulation, most notably in the “Basel III” capital accord. The Basel III rules stand on two pillars: – First, they focus on strengthening micro-prudential regulations, aiming to bolster the resilience of individual banks during periods of stress. In particular, Basel III calls for more and better capital of financial institutions and also introduces leverage ratios and stresses the role of liquidity risk. – Second, they also include macro-prudential regulations, aiming to mitigate systemic risks across the banking system. Better and more capital buffers are supposed to make the banking sector more resilient in the case of another crisis. The increased capital requirement may come at high cost, though. If banks hold too little capital, they are left crisis-prone and in the potential need of bail-outs. Too much capital, however, could lead to huge swathes of the banking business becoming unprofitable. This might cause higher borrowing cost which could affect economic growth negatively. By consequence, riskier assets but more profitable activities might be driven into the shadow-banking sector. But the regulation of the shadow banking system is still an unsolved issue. These entities are no banks in the legal sense, although they take – and generate – similar risks. If there is a strict silo-regulation of the formal banking sector, the actual risky business does not disappear, but moves on in the non-regulated sector. An important issue is the problems of banks that have become too big or too interconnected to fail. The idea that a “Systemically Important Financial institution”, SIFI, will be saved in a crisis because of its systemic importance is not compatible with the core principles of a market economy. Those who fail in the market have to bear the ultimate consequence of leaving the market. But if the maxim is “too big to fail”, then the state and the taxpayers are vulnerable to blackmail. Compare Kern, Steffen: Global financial centres after the crisis, DB Research, August 2010. BIS central bankers’ speeches The financial crisis has exacerbated the problem in so far as some of the surviving banks have become even bigger or more interconnected. Moreover, the government guarantees which were appropriate in the crisis now encourage banks to grow, to connect and to take even bigger risks. To repair this clearly flawed incentive structure, the G20 endorsed the Financial Stability Board’s (FSB) policy framework to address the moral hazard risks and externalities posed by SIFIs. The key policy objectives of the FSB SIFI framework are to (i) increase their loss absorption capacity to reduce the likelihood of their failure, (ii) to facilitate the orderly restructuring or unwinding of a failing SIFI to reduce the impact of its failure on the financial system (“living will”); (iii) to intensify supervisory oversight for SIFIs; (iv) to strengthen core financial market infrastructures to reduce contagion risk from failure.2 Challenges imposed by liquidity rules Though it is highly welcome that the new rules tackle liquidity risks, the new requirements for liquidity management could themselves become a source of instability. One reason is that the regulators’ definition of liquidity is highly concentrated on government bonds. As the current environment shows, some market segments of government bonds can eventually dry up. Another reason is the respective definitions of the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR). – The LCR is the main component of Basel III’s liquidity regime. It is also known as the “Bear Stearns rule”. It requires banks to maintain a stock of “high-quality liquid assets” that is sufficient to cover net cash outflows for a 30-day period under financial stress. – The NSFR seeks to counter maturity mismatches in the balance sheet of financial institutions. It calculates the proportion of long-term assets, which need to be funded by longer term stable funding. While the LCR stresses the liquidity situation up to 30 days, the NSFR focuses on the situation beyond one year. Assets which are liquid for more than 30 days and less than one year are not taken into account, not even on a weighted basis. However, the Basel Committee on Banking Supervision (BCBS) has recognized this shortcoming and is investigating the issue. In addition, there is the risk that the reformed banking regulation has damaging impact on the European model. The treatment of covered bonds, mutual funds, deposits etc. in the liquidity ratios affect the business model oft many continental European banks. One can also question whether the main victims of the new rules will not be the European universal banking model which was certainly not at the origin of the crisis but constituted an anchor of stability. Finally, the lack of a resolution framework for cross-border financial institutions remains on the agenda. In spite of the insight, that the reform of regulation and supervision cannot be successful at the national level alone, it is still unclear how the costs would be distributed if a cross-border institution would get into difficulty and should need to be saved. Financial Stability Board, Macroprudential policy tools and frameworks: Update to G20 Finance Ministers and Central Bank Governors, February 2011. BIS central bankers’ speeches Shortcomings in macro prudential supervision … As the importance of systemic financial stability has become apparent, questions on macroprudential policies have become highly topical. Unfortunately good answers are outnumbered by open questions. There are few purely macroprudential policy tools, and in many cases policy makers need to rely on micro prudential instruments. The financial sector is constantly changing, and the level of risk does not remain the same. Systemic risk is difficult to measure and define. The credit to GDP ratio for example is not a particularly good indicator of risks. Financial cycles often last longer than business cycles. The probability of different shocks may be difficult to estimate. Their impact, however, is even more difficult to assess e.g. because of nonlinearity. The application of the classical Tinbergen rule (“one tool – one objective”) is not possible. In short: the understanding of how to use which instrument in which situation remains at a very early stage. Three layers of shortages can be identified: 1. The analytical framework is short of data; 2. The instrumental framework is short of experience 3. The institutional framework is short of resources We therefore need to recognize the limits of our understanding; these difficult questions must be approached with a certain degree of humility. … in spite of progress in the institutional set-up Although the toolkits are still in their infancy, institutional progress has been made in macro prudential supervision. In the EU, the European Systemic Risk Board (ESRB) was established in January 2011. Its mission is to contribute to prevent or mitigate systemic risk to the financial stability in the Union. The ESRB comprises the ECB, the national central banks of the EU, the three new European authorities on banking, insurance and securities, the European Commission, and the Economic and Financial Committee (representing national treasuries). Its role will be to conduct macroprudential surveillance across the EU, to issue risk warnings and recommendations, so as to contribute to the prevention and mitigation of systemic risks. Recommendations can be issued to any national or supranational authority.3 Macro prudential policy is viewed as having a wide range of tools from monetary, fiscal and competition policies. But these instruments are under the responsibility of others. In the light of the above-mentioned shortcomings, however, there is the risk that macro prudential becomes policy making with other peoples instruments. The potential fight for competencies among different institutional bodies might undermine the effectiveness of the macro prudential approach. Concluding remarks: Challenges remain, opportunities emerge The financial crisis has traumatized the global financial system. The huge losses of many major financial institutions and negative feedback loops from the real economy in the aftermath of the financial crisis have triggered changing market structures. In addition, global competition between financial centers has intensified. IMF: Macroprudential Policy: An Organizing Framework, March 2011. BIS central bankers’ speeches In response to the crisis, the world has moved into a new stage of international regulation and supervision of financial markets. The new rules – many of which have not been implemented yet – start to bite already, due to the tightening of capital requirements and a more homogeneous regulatory framework which pose challenges in particular to smaller financial centers. But this changing environment implies also opportunities to improve their relative positions. In order to do so the provision of convincing conditions is of the essence. Local factors gain weight, e.g. a well-educated workforce in an open and flexible labour market and excellent infrastructure. The respective governments should comply with robust public finance in line with a stability-oriented monetary policy. Smart regulation – at national, regional and global level – and a stable legal and institutional framework are a prerequisite for success. Global standards are needed to ensure a level playing field. At the same time, it is crucial that international financial centers of systemic importance have a voice in the international standard setting, so these can benefit from their wealth of experience and competence in supervision based on the proximity and high interaction with the supervised entities. BIS central bankers’ speeches
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Welcome address by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ESE (European Supervisor Education Initiative) Conference 2011: "Financial crisis and the challenge of supervision", Luxembourg, 28 September 2011.
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Yves Mersch: Financial crisis and the challenge of supervision Welcome address by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ESE (European Supervisor Education Initiative) Conference 2011: “Financial crisis and the challenge of supervision”, Luxembourg, 28 September 2011. * * * Ladies and Gentlemen, It is a great pleasure and an honor to host the 2011 European Supervisor Education Initiative conference on Financial Crises and the Challenge of Supervision here in Luxembourg. I am pleased to note that so many participants from the supervisory and central banking community are attending. I am convinced, that stimulating input by the distinguished discussants will be beneficial to all participants. The Banque centrale du Luxembourg, given its mandate of prudential liquidity supervision and its role in macro-prudential policies, has joined the European Supervisor Education Initiative in 2010. Against the background of renewed vulnerabilities and turbulences in markets, the subject of the conference is indeed very timely. Liquidity risk, together with sovereign and funding risk constitute for the time being the main threats to the EU-banking system. The recent intensification of tensions in the sovereign debt market has led to contagion risk of systemic nature. From a supervisory perspective, let me redraw that the past financial crisis have evidenced the fact that micro-prudential supervisory instruments and tools alone, if used in an isolated way, may no longer be sufficient to address the challenges posed by financial instability. The need has been highlighted to restructure regulation and supervision and to go beyond a purely micro-prudential approach in this regard. Focussing on the development of a macroprudential framework should better position authorities to contribute to reducing pro-cyclicality and improving the financial sector’s resilience to adverse shocks. In response to the regulatory challenges, the European System of Financial Supervision (ESFS) has been established, under which the European Systemic Risk Board (ESRB) has been made responsible for the macro-prudential oversight of the financial system as a whole. The work of the ESRB, which is founded on close cooperation between central banks, national supervisory authorities, the European Supervisory Authorities (ESAs) and policy makers, will contribute to the mitigation of systemic risk within the financial system. However, despite the significant progress in institutional architecture at the European level, crucial areas within global and national financial systems remain fragile and vulnerable to unexpected shocks. All countries face a varying degree of challenges. In Luxembourg we still have significant gaps, particularly with respect to institutional reforms and the adjustment of our model of supervision. In this regard, I am aware that there is no perfect supervisory model, nevertheless, we must try to profit from the recent experiences of other neighbour countries in order to mitigate systemic vulnerabilities and enhance financial stability. As you know, different countries; U.K., Belgium, France and recently Switzerland, have adjusted their model to be more integrated. So it would appear self-evident that central banks, given their role as lenders of last resort and their responsibilities in monetary policy and liquidity management, should play a key role in safeguarding financial stability. However, the lender of last resort might be the most important backstop during periods of financial turbulences, nevertheless this should not be a “free lunch”. In order to fulfill their responsibilities effectively, central banks should be equipped with a clear and independent macro-prudential mandate and toolbox to assess and mitigate macro-prudential risks at the systemic level. This proposal is coherent with the BIS central bankers’ speeches recommendations of the de Larosière report which attributed an umbrella role to central banks in the supervisory framework. In this regard, it must be assured that national macro-prudential authorities have the flexibility to adjust regulatory requirements over the business cycle. Thus, I welcome the Commission’s proposal regarding CRD IV in particular, the countercyclical capital buffer. However, the macro-prudential regime must find a balance between preserving national flexibility – as the business cycle varies between European countries – and maintaining a level playing field so as not to distort competition within the Single Market. As I mentioned, aside from the institutional arrangements, many challenges remain to be resolved. The G-20 and the European Commission have taken some initiatives in addressing the regulatory deficiencies highlighted by the crisis. These include Basel III, OTC derivatives, the shadow banking system, high frequency trading, central counterparties (CCPs) and crisis resolution mechanisms, etc... Such proposals remain at an early stage and still face the challenges of jurisdictional realities. Let me now focus on some specific issues that may arise under the new regulatory regime. With respect to liquidity, two new instruments have been proposed i.e. the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These quantities are intended to improve financial institutions’ liquidity risk profiles and the resulting increase in resilience should help to mitigate funding and market liquidity risk. In combination with a more robust and efficient supervisory landscape, the new liquidity standards should also help to bolster internal liquidity risk management practices. This issue remains crucial as the recent sovereign debt turbulences have increased the level of liquidity pressure experienced by banks. At the same time, tensions in foreign currency funding for financial institutions have become acute and it seems to be important that these concerns be addressed within the context of the new regulation. Going forward at the national level, the BCL has seen the need to incorporate these ratios into its current risk-based liquidity surveillance framework which relies on a combination of qualitative and quantitative elements. In addition, regular on-site visits and continuous off-site monitoring are currently combined with a five day forward-looking liquidity reporting by banks. The BCL also sees the need to conduct surveys and studies in order to assess the liquidity situation of financial institutions. Indeed, with regard to the new liquidity ratios, an empirical analysis was performed in Luxembourg. The results revealed that a one-size fits all approach to liquidity supervision might not be appropriate given the diversity of banks’ business models. Thus I wonder if it would more useful to complement the focus on financial institutions by taking into account their activities. Therefore, a maximum harmonized rulebook, disallowing flexibility on a national level, does not strike the right balance between efficient liquidity surveillance and increased resilience of banks. The issue of the maintenance of liquidity buffers at national level for host entities of cross-border banking groups shall deserve particular attention in this regard. It is profoundly in the interest of all actors that these new requirements be implemented in a consistent and timely manner. During the transitional period however, further analysis is required in order to ensure an appropriate calibration. Unintended consequences due to restricting the ability of banks to manage their short and long-term liquidity or to undertake the maturity transformation process which represent the core of financial intermediary activities need to be weighed against the intended benefits. Furthermore, care should also be taken to avoid incentivising banks to shift some of their activities to the non-regulated banking system; the so-called “parallel” or ”shadow” banking sector. Currently, only preliminary information on the level of interconnectedness between regulated and non-regulated entities is available to supervisors. Additional work is needed in this regard, in order to improve the efficiency of financial regulation across markets and jurisdictions. Looking forward potential new risks stemming from micro-structural issues such BIS central bankers’ speeches as UCITS exchange-traded funds and high frequency trading, which I mentioned before, need to be properly addressed. Regarding the access of credit institutions to central bank funding, their eligibility should be based on their financial soundness, as assessed through their solvency and liquidity robustness. It is therefore of crucial importance for central banks to have access to relevant and detailed micro-prudential information and assessments on their monetary policy counterparts. Moreover, this assessment cannot be dissociated from prudential information on the banking group to which the respective counterpart belongs. This calls for an enhanced participation by central banks and their involvement both in the EU College of Supervisors and cross border stability groups. Before I conclude, I think it would be appropriate to point out that the increased level of interconnectedness of financial systems and banking groups highlights the need for improved cross-border cooperation and crisis management. Finally, let me mention human capital requirements as another key area which often goes, unmentioned yet is important for improving the quality and efficacy of supervision. By combining the competencies and skills of supervisors and central banks, the ESE initiative certainly contributes to enhancing the convergence of practices. Under this welcome initiative, the efforts of the Banque centrale du Luxembourg will continue to enhance the approach adopted by the ESE initiative. Ladies and Gentlemen, I wish you a pleasant stay in Luxembourg, and an interesting and successful conference. I am sure the presentations as well as the panel discussions will include interesting and fresh ideas and insights from which all participants can benefit in their ongoing tasks, be it at local or cross-border level. BIS central bankers’ speeches
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Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the SWF (Sovereign Wealth Fund) Forum, Montreux, Switzerland, 24 October 2011.
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Yves Mersch: Current challenges in the sovereign debt crisis Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the SWF (Sovereign Wealth Fund) Forum, Montreux, Switzerland, 24 October 2011. * * * Ladies and Gentlemen, It is my pleasure and privilege to talk in front of this audience of experts and practitioners. I do thank the SWF Forum for this opportunity to share my thoughts on the current challenges of the sovereign debt crisis in Europe. Montreux seems to be the perfect setting for a central banker to speak. Is there a better symbol for stability and long-term nature than the surrounding Alps? And Lake Geneva represents a perfectly balanced level of liquidity – while central bankers have to deal with the contradiction of abundant global monetary liquidity and a shortage of market liquidity in certain asset classes. But without further ado, let me embark in today’s topic. Need for clarification: the often forgotten strengths of the euro area Some countries in the euro area face a combination of high levels of indebtedness, budget deficits and weak or absent growth. Amid growing market turmoil and the risk of contagion an increasing number of economists call for debt restructuring in the affected countries. These proposals often share an anti-Euro sentiment and seem to be in accordance with the naysayers who were taking potshots at the Euro even before its inception in 1999. However, many critics ignore the euro area’s strengths. There is a need for clarification. Let me start by stressing some facts: 1. Since its inception almost 13 years ago, the euro area has experienced an unprecedented level of price stability. 2. The euro area has logged real per-capita income growth of around 1 percent a year since 1999, just below the U.S.’s 1.1 percent. Observers often look only at headline growth figures, where the difference is bigger. But the figures match once adjusted for population growth. 3. During the same period of time, the euro area has created 14 million jobs, six million more than the USA. 4. Contrary to common belief, the heterogeneity within the euro area is not significantly bigger than between U.S. states. 5. On a consolidated base public finances are in a much better shape than those of other major currency areas. The euro area as a whole will run a budget deficit of about 4.5 percent of gross domestic product this year. The International Monetary Fund (IMF) expects a U.S. budget shortfall of about 10 percent this year. 6. According to the IMF the aggregate debt-to-GDP for the euro area stands at 87 percent. For the US the debt-to-GDP ratio in 2011 is expected to be 100 percent. 7. The current account is broadly in balance, different from other advanced economies of similar size. For this year the IMF forecasts a current account deficit of 3 percent for the U.S. Still, there is no room for complacency. The sovereign debt crisis in several Member States of the euro area and financial markets turmoil indicate that we are facing very challenging times. BIS central bankers’ speeches Currency without a state The above mentioned figures are publicly available and communicated by the ECB and the national central banks of the Euro system on a regular basis. Why then, one may ask, are markets still so suspicious? The main reasons lie in the specific set-up of a currency regime without a government in general and the euro area in particular. Although the euro area has a centralized monetary policy, fiscal policy is still in the hands of national authorities. Several problems arise in this context. Let me highlight just one of them: There can be the case for moral hazard in so far as fiscal profligacy of one single member state could be averaged out by the virtuous behavior of the majority of the other countries. The incentive structure is flawed because it can lead to unsustainable fiscal policies of individual member states which in turn would generate negative spill over effects to the monetary union as a whole. The founding fathers of the euro area were aware that the management of a single currency in a union of sovereign states would be challenging and that effective rules were required to safeguard the credibility of the currency. At the very core of that framework the no-bail-out clause and the Stability and Growth Pact were installed. The first should have excluded free rider incentives and the second should have aligned national fiscal policies to prevent negative spill over effects to the currency union as a whole. But the global financial crisis with its consecutive phases has disclosed the weaknesses of that institutional set up. The financial crisis with the epicenter at the US subprime mortgages markets erupted in August 2007. After its dramatic deterioration in September 2008 it turned into a sovereign debt crisis in spring 2010. The pre-crisis situation of public finances differed in the various countries of the euro zone, sometimes significantly. Regardless of whether private debt has been socialized or the problem was from the beginning in public finances itself, the outcome was a drastic increase in the public debt burden. The financial aid packages for stressed banks and fiscal and social stimulus programs to combat the recession disclosed painfully the limits of the financial capacity in some countries. With hindsight we have to acknowledge that some countries allowed fiscal profligacy, weaknesses in the banking sector and deteriorating competitiveness. The institutional setup could neither prevent nor resolve a severe crisis of the magnitude that we are currently experiencing. Although, the instruments and procedures were available, they were not implemented, ignored, or watered down. In a nutshell: the euro area suffered from serious weaknesses in the fields of financial, fiscal and economic governance on the preventive side and had lacked a crisis resolution mechanism. Sovereign default is no panacea The current situation is characterized by widespread instabilities, the contagion of stress from smaller to larger countries threatening the financial system as a whole. To solve the problem, a number of voices call for debt restructuring in the affected countries. These calls for default tend to ignore some severe obstacles. Let me mention some of these. The default of a company or even a private household cannot be compared to a sovereign default. As Governments have to discharge duties of public interest they cannot be dissolved via an insolvency process as how it is practiced with a distressed corporation. The demand for public goods will remain; the need to provide them likewise. Moreover, for firms in severe financial distress it is common practice to pass some of the burden from the debtor to the creditor to arrange a settlement among the parties involved. Both, debtors and creditors alike share an incentive to do so. The liabilities of the debtor BIS central bankers’ speeches decrease and the creditor – compared to a fully fledged insolvency – reduces losses. The private creditor might benefit in relative terms from a bail-in. He therefore can agree upon rescheduling a loan or converting debt into equity. The problem with the sovereign case starts with the blurred distinction between solvency and liquidity of a country. The question whether a company faces the threat of insolvency can be answered relatively clearly. Its assets and cash flow can be compared to its liabilities and the chances of cost containment and generating additional funds to tackle the threat of insolvency. For a government things are more complex. Like a private firm a state can reduce its costs and spur revenues when liabilities exceed assets and revenues. But governments can do more. On top of the privatization of publicly owned assets, public expenditures can for instance be diminished by cutting the salaries of civil servants and public employees – a far more difficult task for a private company. Beyond the public budget and the value of marketable assets a government can increase revenues by levying taxes. The entitlement to tax is unique to the state and grants access funds and means from an owner without the duty of compensation. By consequence, a government with liquidity problems has much more leeway to avoid default. All this, of course, relies heavily on the political will of the government and capability of the administration. The feasibility of such measures in turn depends to a huge extent on the people’s attitude, i.e. in particular the willingness of the social and economic elites to pay for the state. Cultural and social issues clearly play an important role here. To sum up, the concept of insolvency as an objective inability to pay is not an operational concept for sovereign debt.1 Still, for a highly indebted country it apparently seems attractive to lower the debt burden by default. Such a political decision is based on the assessment of the balance of benefits and costs. To make it clear: the disadvantages outweigh the advantages of that sweet-seeming but poisoned temptation. – The defaulted sovereign will lose access to international capital markets as a consequence of the ultimate loss of credibility. – The assumption that a sovereign default would abolish the need for austerity measures is misleading. At least countries with a primary deficit – the rather normal case for a country in financial distress – will still have to consolidate its budget. – Strong repercussions on national income are to be expected due to the negative wealth effects, capital outflows and trade disruption. – The domestic banking sector will suffer due to necessary write-offs on the affected government bonds. Domestic banks tend to hold those as major creditors. Financially stricken banks might cause a credit crunch, restricting the access of the real economy to funding. A negative feedback loop might be generated. – The international financial system will be jeopardized, in particular in times of increased insecurity and market volatility. International market turmoil might trigger a negative loop affecting the domestic economy of the debtor country. Legal considerations and empirical evidence On top of these economic arguments, legal aspects have to be taken into account. Different from individuals and firms, in the absence of war a sovereign country cannot be forced to See Hellwig, Martin (2011), p. 63. BIS central bankers’ speeches fulfill its financial duties. Given that restriction, a global consensus has build that contracts and obligations between nations have to be binding although they are merely based on trust. The sovereign signature is the supreme symbol of a countries legal system. To breach an international agreement puts the credibility of the whole country in question, including its legal and economic system. These legal issues might not matter in the ivory towers of contemporary economists. In reality, however, markets can only function properly when they are embedded in a sound legal framework. During the 1980s and ‘90s parts of Latin America and several countries of the former Soviet Union experienced severe social frictions when they were exposed to the dynamics of pedigreed free markets without the prior set-up and implementation of a sound legal system. Beyond this theoretical reasoning there is empirical evidence a sovereign default is no panacea for heavily indebted countries. Although there are individual cases in which restructuring was manageable and to that extent successful, these cases are rare. By contrast, most of the times restructuring of sovereign debt was disorderly, devastating and time consuming. The average length of the negotiations was 2½ years with the durations varying greatly. While sometimes negotiations have taken just a few months like in Uruguay in 2003, in Pakistan in 1999, in Chile in 1990 or in Romania in 1983. In other occasions it took many years to return into calmer waters, for example in Vietnam from 1982 until 1998, Jordan from 1989 to 1993, Peru from 1983 to 1997 and Argentina more recently.2 All these reasons represent the foundation why Governments try to avoid a default by all means. By consequence sovereign bonds – in particular in industrialized countries – are generally regarded as a largely risk-free investment. They form the basis for the risk free rate not being backed by equity. As such they are also the anchor for many transactions and valuations in the financial sector. The particular case of a monetary union The above mentioned arguments also apply to a monetary union like the euro area. But there are additional particularities. 1. Due to the high level of integration in financial markets and trade, there is an elevated risk of contagion in case of a sovereign default in the euro area. The potential consequences for banks that would need to write off parts of their assets would be severe. Negative feedback loops to the real economy were likely. 2. The incentive structure might become flawed. Moral hazard could be aggravated with regard to the borrower. If a Member Country knows that it does not have to fully service its contractual liabilities obligations but instead restructure its debt, it may be tempted to accumulate excess levels of debt.3 3. The credibility of the monetary union as a whole could be scratched. If investors paint the solvent member states with the same brush, risk premia on sovereign bonds would rise sharply affecting the whole specter of credit. 4. Last but not least, there are legal considerations. Generally, if a government does not service its financial obligations it breaches its legal obligations (independent of the effective lack of enforceability by the creditors already mentioned). In the case of the euro area there is an additional trait. Article 126 paragraph 1 of the treaty (which is binding for all EU countries not only those whose currency is the Euro) clearly See Bini Smaghi (2011); Reinhard et al. (2003); Ozler (1993). See ECB Monthly Bulletin (10:2011). BIS central bankers’ speeches states that a Member State “shall avoid excessive government deficits”. Although there is some scope for interpretation what “excessive” means it can hardly be doubted that a deficit that leads to a sovereign default was ultimately excessive.4 Working for the better: Closing the implementation gap … These sound arguments call for the avoidance of a sovereign default by all means. But what is to be done instead? The superior avenue is a combination of crisis resolution to curtail the panic and prevention measures to regain confidence. In more detail this means: 1. Those countries under the rescue umbrella have to fully implement the conditions of the respective programs in order to return to a sustainable level of debt and regain competitiveness. During the adjustment process they receive financial aid from the Luxembourg based European Financial Stability Facility (EFSF). In order to eliminate any doubts on the sufficient fire power of the EFSF, governments of the euro area Member States should provide appropriate leveraging of the fund – not to be confounded with monetization. It is also important that the EFSF operationally can intervene in the secondary markets as soon as possible to tackle fundamentally unfounded distortions in the sovereign bonds markets. These distortions hamper the smooth functioning of the single monetary policy stance. 2. Macroeconomic imbalances and unsustainable fiscal policies must be avoided in the future. Prevention is key. The recent agreement reached by the European Parliament and the Council on the “Six Pack” is a step in the right direction. The Stability and Growth Pact has been strengthened; imbalances and competitiveness will be monitored at an early stage. But this economic governance package falls short of greater automaticity in decision-making that the ECB has long advocated for. For the time being, the implementation gap must be closed. Most of the above mentioned proposals are mirrored by decisions that have been taken already. As soon as possible the new governance rules must be applied completely and rigorously. Moreover, the governments of the euro area member states must implement all the decisions of the EU summit of 21 July. Swift implementation is a necessary condition to resolve the confidence crisis the euro area currently faces. … but being prepared for the worst: increasing resilience and ring fencing Nevertheless, if a countries debt burden becomes unsustainable, a restructuring of sovereign debt cannot be excluded as ultimate resort. To be prepared for the worst, several lines of defense have to be strengthened: 1. In order to mitigate foreseeable tensions in the financial industry, banks have to clean their balance sheets as quickly as possible. They need to build up a stronger equity position by retaining profits and moderation in remunerations, bonus payments in particular. Preferably they can search for recapitalization via capital markets. If this is not feasible, Government must step in to recapitalize solvent banks. Where it would be necessary, the EFSF can be approached to recapitalize banks. See Siekmann, Helmut (2011). BIS central bankers’ speeches 2. It must be crystal clear that in the unlikely case of a restructuring of one country, this would be a unique case. The impression that restructuring was a standard instrument of the crisis management tool kit must be avoided by all means. In order to do so, countries with elevated debt levels would have to speed up their consolidation efforts to send out signals of credibility to the markets. Sound and credible public finances are the best way to ring fence from markets suspicion. In any case it is advisable to avoid any restructuring that is not purely voluntary or that shows elements of compulsion, and to avoid any credit events and selective default or default. Rather, the Member States of the euro area need to demonstrate their determination to their own individual sovereign signature, in order to ensure financial stability in the currency union a whole.5 Concluding remarks The epicenter of the global financial crisis has shifted from the US to the euro area. The rapid spreading of the crisis is reducing the options at hand to tackle the crisis. Europe has already taken important decisions to improve its crisis resolution mechanism and to strengthen preventive measures to avoid macroeconomic imbalances and unsustainable fiscal policies. It is important to implement these rules now and make the institutions operational, as markets tend to lose patience. There is a strong appetite for a comprehensive solution. The banking sector must increase its resilience against sudden, external shock. This is particularly important in times of high market volatility and elevated uncertainty. Quick action is needed to clean up banks’ balance sheets and recapitalize them, where it is deemed necessary. On top, countries with elevated debt levels and augmented budget deficits have to put public finances on a more sustainable path and spur growth by structural reform. Sovereign defaults should be avoided as the cost most likely would outbalance the benefits by far. The ECB has repeatedly objected to all concepts of debt restructuring that are not purely voluntary or that have elements of compulsion; any credit events and selective default or default should be avoided. A strong and transparent commitment to sound public finances is the best weapon to combat market attacks. *** Thank you for your attention. See ECB Monthly Bulletin (10:2011). BIS central bankers’ speeches
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Text of the Pierre Werner Lecture by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the European Institute, Florence, 26 October 2011.
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Yves Mersch: Optimal currency area revisited Text of the Pierre Werner Lecture by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the European Institute, Florence, 26 October 2011. * * * “It is necessary that even those born well after the 1950s and 1960s realize that the European Union has not come about by chance, but that it is based on the fundamental necessities of life amongst the peoples of Europe.” 1 Pierre Werner Ladies and Gentlemen, It is my pleasure and privilege to talk here at the European Institute. I thank in particular Professor Marcellino for this opportunity to share my thoughts on Optimal Currency Areas (OCA) in general and the challenges of European Monetary Union (EMU) in particular. Some countries in the euro area face a combination of high levels of indebtedness, budget deficits and weak or absent growth. Amid market attacks and the risk of contagion an increasing number of economists have already announced the unavoidable break-up of the euro area. These predictions often share an anti-Euro sentiment and seem to be in accordance with the naysayers who were taking potshots at the Euro even before its inception in 1999. But they are wrong – as I intend to prove in the rest of my talk. Comparison of two currency areas of similar size Since the introduction of the Euro in 1999 the currency area has been regularly compared to the US. Although, there are many arguments why such comparisons are difficult, they can indeed yield useful insights. I will therefore start by looking at the facts, comparing basic features, price stability, output growth, employment, heterogeneity within the respective currency areas, public finance, private savings and trade in the US and the euro area. Basic features The US is a fully fledged political federation with 52 states. Over 312 million people live in the US. The US economy is the world’s largest national economy, with an estimated GDP of 12 trillion Euros in 2010 at purchasing-power parity, i.e. roughly 20 percent of global Gross Domestic Product (GDP). The euro area, by comparison, is a community of seventeen sovereign member states which have introduced the euro as their common currency and sole legal tender. They are embedded in the 27 nation European Union (EU). 332 million live in the countries of EMU. In 2010, the euro area generated a GDP of 9.2 trillion Euros. The economy of the euro area accounts for roughly 15 percent of world GDP. Pierre Werner, 11 December 1997, on the eve of the Luxembourg European Council [“Il est nécessaire que même ceux qui sont nés bien après les années 50 et 60 se rendent compte que l’Union européenne n’est pas un coup du hasard, qu’elle se fonde sur des nécessités fondamentales de la vie entre les peuples de l’Europe.”] BIS central bankers’ speeches Price stability The primary mandate of the ECB as the central bank of the euro area is to safeguard the purchasing power of the citizens. Price stability in the understanding of the ECB is an inflation rate below but close to 2 percent in the medium term. Since its inception almost 13 years ago, the euro area has experienced an unprecedented level of price stability: 2.0 percent average annual inflation. In the US, during the same period of time, the annual inflation averaged at around 2.5 percent. Output growth The euro area has logged real per-capita income growth of around 1 percent a year since 1999, just below the US’s 1.1 percent. International comparisons often look only at headline growth figures; overlooking demographic developments. Looking closer at the contributing elements in both currency areas some interesting aspects are revealed. The standard growth accounting distinguishes mainly between employment and labour productivity. Labour productivity itself can be further decomposed into changes in labour composition, Information and Communication technologies (ICT) and non-ICT usage per hour and (residual) Total Factor Productivity (TFP) growth. TFP accounts for effects in total output not caused by inputs. If all inputs are accounted for, TFP measures an economy’s long-term technological progress. The distinction between ICT and non-ICT reflects that the ICT sector is presumably one of the major drivers in growth across the world. Comparing the contributions of labour productivity to growth between 1995 and 2007, a significant difference becomes apparent: 1.7 for the euro area vs. 2.9 for the US. By adding the contribution of hours worked (0.5 vs. 0.6) one gets the growth rate of output (2.2 vs. 3.5). The main explanations for this difference are ICT capital services per hour (0.4 in the euro area vs. 1.0 in the US) and economy-wide TFP (0.5 vs. 1.1). Analyzing the sectoral decomposition of TFP growth, it can be stated that TFP in the production of goods is slightly larger in the euro area than in the US. Rather, the higher overall TFP growth in the US is driven by stronger TFP growth in services, in particular in distributive trade (0.2 vs. 0.5). For good order, one should not forget that productivity and technical progress in general and in Services in particular are subject to measurement difficulties. TFP figures – being a residual – can only represent a rough metric. Thus, the TFP contribution can be plagued by measurement errors, erroneous assumptions about market structure, or the nature and existence of the aggregative production function. The residual will also be a catch-all of neglected factor utilization, factor quality improvements over time, statistical complications associated in calculating factor rewards (appropriate tax and depreciation allowance for capital income etc).2 In a nut shell: the main difference between the measured growth differences in the euro area and the US are attributed to the difficulties to assess differences in the technological progress of ICT services. See Trichet, Jean-Claude (2011), Speech at the Jackson Hole Economic Symposium Panel: Setting priorities for long-term growth Jackson Hole, U.S.A., 27 August. BIS central bankers’ speeches Employment Having identified the limited explanatory power of growth statistics to compare mature economies with rather similar per capita growth rates, one might preferably rather look at the development in labor markets to gain some information about the economic dynamism. Between 1999 and 2011, the euro area has created 14 million jobs. During the same period of time, 8 million jobs have been created in the US. Heterogeneity within the currency area Contrary to common belief, the heterogeneity within the euro area is not significantly bigger than between US states. Although it is very common to distinguish between the countries of the euro area and focus on the diversity among individual member states, this exercise is rarely done for the US. In fact, however, the dispersion of many key economic indicators is very similar. Let me provide some detail on the heterogeneity within the respective currency areas. Before the crisis, the dispersion of inflation in euro area countries had remained broadly stable since the late 1990s. The level was similar to the 14 US Metropolitan Statistical Areas. During the crisis a temporary increase in inflation dispersion in the euro area was observed. This development has been reversed over the past 12 months, however. In the same vein, the dispersion of GDP growth is quite similar on either side of the Atlantic. Before the crisis the dispersion of growth rates was around 2 percent, in both the euro area and the US. Dispersion increased somewhat during the crisis in both currency areas but remained broadly in line with pre-crisis patterns. Moreover, in both currency areas there are comparable patterns in the dispersion and developments of competitiveness. In the US as well as in the euro area, regions can be found with persistently above or below average unit labour cost growth – a good measure of competitiveness. In the euro area, Greece, Portugal and Ireland, in particular, had progressively lost competitiveness. They are now trying to catch-up by implementing adjustment strategies. Germany, by contrast, had lost competitiveness in the reunification process but has managed to regain competitiveness over the same period of time. Looking at the most and least competitive states in the US states over the same period of time, we see that some states have suffered from large or persistent increases in unit labour costs. Some still exceed the national average by 20 percent. Other US states have been improving their competitiveness compared to the national average over the past decade. Public finance, household savings and trade On a consolidated base public finances in the Euro are in a much better shape than in the US. The euro area as a whole will run a budget deficit of about 4.5 percent of gross domestic product this year. The International Monetary Fund (IMF) expects a US budget shortfall of about 10 percent of GDP this year. The UK government expects for this fiscal year to meet its deficit target of 7.9 percent of GDP, down from 9.3 percent of GDP in the previous one ending in April 2011. The budget forecasts however are based on the assumption that the economy will grow 1.7 percent in 2011 – in spite of economists’ recent forecasts of around 1.0 percent. According to the IMF the aggregate debt-to-GDP for the euro area stands at 87 percent. Figures for the UK are similar. For the US the debt-to-GDP ratio in 2011 is expected to be 100 percent. In Japan debt-to-GDP exceeds 200 percent. As far as private households’ financial positions are concerned the euro area is in the best position of all major currency areas. In 2010 gross savings as a fraction of households’ BIS central bankers’ speeches disposable income stood at roughly 14 percent in the euro area, 8.6 percent in the US, and 5.4 percent in the UK. Trade within the euro area and the EU is flourishing as well as the exchange of goods and services with the rest of the world. The euro area is the most open major economy in the world. In 2011, exports of goods and services from the euro area stood at 22.7 percent of GDP compared to 12.6 percent of GDP in the US. The current account in the euro area is broadly in balance (-0.4 percent of GDP in 2010). For this year the IMF forecasts a current account deficit of 3 percent for the US. Optimum currency areas: basic considerations The above mentioned figures are publicly available. They are well known to scholars and market participants. Why then, one may ask, are markets still so suspicious against the euro area? Why is there a talk of a sovereign debt crisis in the euro area rather than in the US or the UK? And why has the epicenter of financial markets turmoil moved from the US to the euro area. Before I try to answer these questions in greater detail, let us recall some of the basic considerations of optimal currency areas. When countries or states participate in a currency union they abolish their nominal exchange rate. By doing so they sacrifice a hitherto important means of adjustment vis-à-vis the other countries or states participating in the currency area. 50 years ago Nobel Prize laureate Robert Mundell argued that adjustment to economic shocks has to occur via other channels. Mundell and other protagonists of the Optimum Currency Area theory highlighted three major channels for adjustment in a monetary union in the absence of internal nominal exchange rate flexibility: – First, price flexibility can help countries or states to overcome economic shocks by adjusting wages and reducing relative prices in order to rebuild competitiveness. – Second, cross-border factor mobility – in particular on labour markets – can foster adjustments to shocks as employees from anemic economies move to the healthier ones until the former regain competitiveness and growth. – Third, funds may flow from the more prosperous countries or states to the weaker ones via fiscal transfers. 3 While the first two adjustments channels clearly help to approach a new equilibrium in the aftermath of an asymmetric shock, the third one could only temporarily dampen the burden of adjustment and play a stabilizing role. In the long run, however, fiscal transfers would set the wrong incentives insofar as internal pressure for adjustment would be weakened and free rider behavior encouraged. By consequence, in a currency area it is essential that the participating members have sound public finances beforehand to reduce the vulnerability against asymmetric shocks and the need for temporary financial aid. From theory to practice: a currency without a state Let me move from the conceptual considerations of the theory of Optimum Currency Area back to reality. The key challenge for a currency area is how to organize the incentive Mundell, Robert (1961), “A Theory of Optimum Currency Areas”, American Economic Review, 51, pp. 657–665. BIS central bankers’ speeches structure and the adjustment channels of a currency union which lacks the flexibility of nominal exchange rates. Comparing the two major currency areas – the euro area and the US – the major difference is clear: The US, being a fully fledged sovereign state has a central government. The organizations of relevant policies and decisions are to a large extent federal and, therefore, uniform at the central level of the federation. The euro area by contrast is an alliance of sovereign countries with most of the relevant political decisions – including public finance – being taken by national governments. There is a risk embedded in the constellation of the euro area: moral hazard can arise when fiscal profligacy of one single member state is averaged out by the virtuous behavior of the majority of the other countries. Such an incentive structure would be flawed because it could lead to unsustainable fiscal policies of individual member states which in turn would generate negative spill over effects to the monetary union as a whole. The run-up to the single currency The intellectual architects of the single currency were aware that the management of a single currency in a union of sovereign states would be challenging. Instead of a single government effective rules were required to safeguard the credibility of the currency. Although the vision of a single European currency is an ancient idea going back as far as to the Roman Empire, the idea of a common European currency in recent history gained momentum in the late 1960s. Luxembourg’s Prime Minister Pierre Werner, also Minister of Finance, was asked to steer a Committee mandated to design the path to an increased economic and monetary integration of the six then members of the European Economic Community. That report, finished on the 8 October 1970, was sent to the Ministers of Finance in the first instance, laid down the achievement of Economic and Monetary Union by 1980. The Werner report proposed the inception of an independent institution for fiscal monitoring and coordination. This idea clearly reflected that a single monetary policy would need support from sound public finances. More concretely, the Werner report called for closer economic policy coordination with an agreed framework for national budgetary policies. At the institutional level, it suggested a “centre of decision for economic policy”. This coordination body for economic policies should have been established alongside the European system of central banks, i.e. the monetary authority. Both institutions were to be independent from the national governments, being politically accountable only to a European Parliament. This independent economic authority should have influenced the national budgets with a focus on the level and the direction of the balances as well as the financing of deficits and the use of surpluses, respectively. In the next major attempt to design a single European currency, the Delors report in 1989, the insight that sound fiscal policies would be necessary to safeguard the credibility of the common money was still vivid. That blueprint named after the President of the European Commission at that time, Jacques Delors, stated that “an Economic and Monetary Union could only operate on the basis of mutually consistent and sound behaviour by governments and other economic agents in all member countries. (…) Uncoordinated and divergent national budgetary policies would undermine monetary stability and generate imbalances in the real and financial sectors of the community.” Almost exactly 20 years ago, the Maastricht Treaty was drafted by the European Council on 9/10 December 1991 in the Dutch city of Maastricht. It founded the European Union and led to the creation of the single European currency and to provide a framework of lose policy coordination. BIS central bankers’ speeches At the very core of that framework the no-bail-out clause and the Stability and Growth Pact (SGP) were installed. The first should have excluded free rider incentives and the second should have aligned national fiscal policies to prevent negative spill over effects to the currency union as a whole. The SGP was a compromise of quantifying fiscal soundness without interfering with the budgetary and fiscal policies of sovereign states. It aimed to maintain fiscal discipline within EMU. Member states adopting the euro had to meet the Maastricht convergence criteria, and the SGP should make sure that they continue to observe them. The compromise was also characterized by the strong belief that governments would be reactive to market discipline. However there was a lack of political will to commit to sustained stability-oriented fiscal policy. The weak commitment was evident when the Stability and Growth Pact was watered down under the pressure of France and Germany in 2003. Moreover, the rule book failed to consider the possibility of a financial crisis in the euro area leaving an institutional vacuum for crisis resolution. Painful lessons from the Great Financial Crisis The global financial crisis with its consecutive phases has disclosed the weaknesses of that institutional set up and the overestimated belief in market discipline. Originally, the financial crisis erupted in August 2007with the epicenter at the US subprime mortgages markets. It deteriorated dramatically in September 2008 when the US investment bank Lehman Brothers collapsed. And it triggered the sovereign debt crisis in the euro area in spring 2010. The pre-crisis situation of public finances differed in the various countries of the euro zone, sometimes significantly. Regardless of whether private debt has been socialized or the problem was from the beginning in public finances itself, the outcome was a drastic increase in the public debt burden. The financial aid packages for stressed banks and fiscal and social stimulus programs to combat the recession disclosed painfully the limits of the financial capacity in some countries. With hindsight we have to acknowledge that in some countries fiscal profligacy, weaknesses in the banking sector and deteriorating competitiveness have been observed. The institutional setup could neither prevent nor resolve a severe crisis of the magnitude that we are currently experiencing. Where the instruments and procedures were available, they were not implemented, ignored, or watered down. Flaws in the Maastricht Treaty With today’s knowledge and experience let me highlight just two major weaknesses in the Maastricht Treaty: It was based on a flawed economic paradigm and it did not foresee geopolitical developments before and after the introduction of the single currency. 1. Overestimation of free markets The spirit of the Stability and Growth Pact was also characterized by a strong belief in the power of free markets to discipline governments. This belief reflected the prevailing paradigm in economics at that time. But the global financial crisis has undoubtedly marked a turning point also in that context. The financial crisis has put the legitimacy of absolutely free financial markets into question. At the same time, the concept of market economies is challenged in many places, and the voices calling for the state are getting louder. The pendulum strikes back. There is a clear risk that the well founded desire for improved regulation leads to a too tight corset that ultimately might strangulate market dynamics. It would be misleading to assume BIS central bankers’ speeches that partial market or regulatory failure in the past means that the government would always provide superior solutions by governments. Excessive faith in the state as well as a sprawling public sector lead in the long run into servitude, as argued by the Austrian economist Friedrich August von Hayek and proved by the communist movements of the previous century. Only in the market economy, freedom and wealth come together. However, also those err who rely alone on the self-regulation of markets. The challenge is to find the right balance between market and state, to define reasonable rules set by the state to generate the greatest possible freedom for sustained prosperity to the benefit of the society. In less general terms it is worth recalling how financial markets have been assessing the creditworthiness of sovereigns within the euro area. Countries with weaker positions which introduced the Euro could refinance themselves roughly at the same cost as the most solvent states. Spreads, if existing, were very narrow, even between Greece and Germany. Financial markets were irrationally optimistic. Today, markets seem to be irrationally pessimistic. Even wealthy states with sound economic fundamentals are in trouble to refinance themselves at reasonable conditions. Recently, for instance, Italian sovereign funding costs were driven above 5 percent. The UK by contrast funds itself at 1.6 per cent – although Italy and the UK are two countries of roughly the same size, wealth and income. While the Italian public debt with some 119 percent of GDP is larger than that of the UK (80 percent of GDP), the Italian private sector has much stronger balance sheets than the UK private sector. This means that the Italian government has stronger private wealth for potential future taxation than the UK. Moreover, the consolidation plans of the Italian government are far more ambitious that the British ones. Some argue that growth prospects for the UK are more promising as its central bank could depreciate its own currency by a very lax monetary policy. By doing so, future growth and tax revenues would be boosted. The problem is, however, that the UK economy heavily relies on a huge non-exporting service sector (while in Italy manufacturing plays a bigger role), which does not profit from a weaker currency. Indeed, exports in the UK have failed to recover in spite of the great sterling depreciation. By contrast, since the end of 2007, the British GDP has contracted cumulatively by 3.4 per cent. Moreover, depreciation comes at huge costs: The weaker sterling has made the UK’s people poorer in real terms through higher inflation. In 2007, the average UK citizen was 30 percent richer than the average Italian; now they are just 5 percent richer.4 2. Geopolitical changes The Maastricht Treaty was signed on 7 February 1992 by the members of the European Community by the six original members of the community – Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany – and those six countries who had joined the EC later, namely Denmark, Ireland, the UK, Greece, Portugal and Spain. Amid the various enlargement steps of the EU and the euro area several problems have emerged, some of which are interrelated. First, economically, the situation of those countries that joined the EU later differed sometimes greatly from the original core. That holds particularly true for those countries that entered the EU after the breakdown of the Berlin Wall and the communist bloc. Laggard countries while catching up in their productivities in traded goods’ sectors tend to suffer from See Nielsen, Erik (2011), Italy’s debt a better bet than “triple A” UK, Financial Times, Oct 10th 2011. BIS central bankers’ speeches higher inflation rates because within the service sector productivity growth rates are restricted but wages still catch up (Balassa–Samuelson hypothesis)5. This, of course, poses a potential threat to a currency union with the aim of a stable price level. Second, an institutional problem is the indirect result of these developments. The intellectual architects of the euro area assumed the member states of the currency area were basically the same who constituted the European Union. Only one institution on the union level – the Commission – would then have been necessary to represent the EU and to be in charge of the currency area’s rule book. Today, the EU comprises 27 countries, the euro area only 17. However, with the exception of the field of monetary policy the euro area still lacks a true institution on its own with competencies on the community level. A lot has been achieved – responses within the existing Treaty The sovereign debt crisis has revealed that the euro area suffered from serious weaknesses in the fields of financial, fiscal and economic governance on the preventive side and had lacked a crisis resolution mechanism. But the current crisis has also been recognized as an opportunity to repair the institutional shortcomings of the “currency without a state”. Europe has always made its greatest steps forward in times of crisis mirroring the words of Jean Monnet: “People may accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them.” And indeed, Europe has already undertaken major steps to tackle the identified weaknesses within the existing Treaty. 1. In the absence of a nominal exchange rate the alignment of national fiscal policies and the prevention of imbalances via rules is a necessary condition to support the credibility of the single currency. The recent agreement reached by the European Parliament and the Council on the “Six Pack” is a step in the right direction. The Stability and Growth Pact has been strengthened; imbalances and competitiveness will be monitored at an earlier stage. 2. Since the beginning of this year, the European Systemic Risk Board and the European Supervisory Authorities are operationally. These truly European bodies are responsible for providing the incentives to avoid excessive risk taking in the financial industry and to promote a level playing field in support of beneficial financial integration within the euro area. 3. A crisis mechanism has been set up and is still being improved. Countries with stressed liquidity positions which are subject to market attacks receive financial aid from the Luxembourg based European Financial Stability Facility (EFSF). This support should allow them to return to a sustainable level of debt and regain competiveness as soon as possible. 4. In order to eliminate any doubts on the sufficient fire power of the EFSF, governments of the euro area Member States plan to provide appropriate leveraging of the fund. The EFSF will operationally be allowed to intervene in the primary and secondary markets as soon as possible to tackle fundamentally unfounded distortions in the sovereign bonds markets. These distortions hamper the smooth functioning of the single monetary policy stance. Samuelson, P. A. (1994), Facets of Balassa-Samuelson Thirty Years Later, Review of International Economics 2 (3): 201–226. BIS central bankers’ speeches Within the given framework, the implementation gap must be closed to resolve the confidence crisis that the euro area currently faces. Most of the above mentioned proposals have been decided already. As soon as possible the new governance rules must be applied completely and rigorously. Moreover, as stated earlier, factor mobility in particular on labour markets is an important adjustment mechanism. Labour mobility within the euro area works rather smoothly at the lower and higher skill ends. But the high share of closed public service in Europe, nonportability of pension rights, rigid labour laws and cultural differences make labour mobility a slow process. Additionally a further improvement of the Single Market – including markets for products and services – is important for fast and market-based adjustment in case of shocks. … but challenges remain beyond today’s Treaty Challenges remain, however. They refer to the institutional framework of the euro area to safeguard the own life of a currency union within a common market to further proceed in the direction of an Optimum Currency Area. In the medium to long run, we will need an institution that is solely responsible for the euro zone. Remembering core elements of the Werner Plan, a single monetary policy needs support from sound public finances and closer economic policy coordination with an agreed framework for national budgetary policies. This could be realized by either be a European Commissioner with special authority or a finance minister (not necessarily with a huge budget), as it has been suggested by outgoing ECB President Jean-Claude Trichet, or another, ideally independent body that makes sure that national policies do not generate negative spill over effects which jeopardize the currency union as a whole. But in any case, the institutional vacuum that currently exists must be filled. I am confident that Europe can also overcome these challenges. There can be no doubt, however, that current and future steps for further European integration will be accompanied by a credible and stable Euro that deserves the faith of financial markets, international investors and – last but not least – the more than 320 million citizens of the euro area. Ladies and gentlemen, thank you for your attention. BIS central bankers’ speeches
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Keynote lecture by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Euro Finance Week, Frankfurt am Main, 15 November 2011.
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Yves Mersch: Challenges of excessive indebtedness Keynote lecture by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Euro Finance Week, Frankfurt am Main, 15 November 2011. * * * Ladies and Gentlemen, It is my pleasure and privilege to contribute to the Euro Finance Week. This conference has a long tradition of bringing together experts in finance, economics and politics. In recent years it has become a distinguished forum to discuss ways to get out of the financial crisis we are still facing. The global rise in debt levels The financial crisis weighs heavy on the global economy for more than four years. It erupted in August 2007with the epicentre at the US subprime mortgages markets and deteriorated dramatically in September 2008 when the US investment bank Lehman Brothers collapsed. And it triggered the sovereign debt crisis in the euro area in spring 2010 that has not been resolved until today. The debt crisis has deeper roots. And indebtedness has not been only a feature of the financial industry and public finances. According to figures of the Bank of International Settlement (BIS) the aggregate gross financial liabilities of industrial country governments, households and non-financial corporations (represented by 18 countries) have grown from about 165% of gross domestic product (GDP) in 1980 to a record 320% of GDP by 2010. By contrast, most emerging market (EME) countries have been doing better. BIS data since the mid-1990s suggest that EME debt levels have remained relatively modest and stable. Their debt stands now at about 110% of GDP on average, i.e. – a little more than one third of that in advanced countries. The indebtedness of industrial countries is not only high. It is still rising. The average debt levels of industrial countries have risen to reach 320% of GDP by 2010, starting from a modest level of 165% of GDP in 1980. This is an annual average increase of more than 5 percentage points. Both private and public sector debt levels have risen dramatically. Adjusted for inflation, corporate debt has risen by three times, government debt by 4½ times and household debt by six times. This dramatic rise is widespread across advanced countries. Total non-financial sector debt now exceeds 450% of GDP in Japan, 350% in Belgium, Portugal and Spain, and 300% in two thirds of the countries. But also other major industrial countries have also experienced a substantial increase in their debt ratios. Household and non-financial corporate indebtedness in the United Kingdom began to rise rapidly in the early 2000s. In Germany and France, the aggregate debt ratio started to increase rapidly beginning in the mid-1990s, led by the growing indebtedness of both the government and the private sector. These high levels of indebtedness imply serious risks. Borrowers’ ability to service their debt becomes progressively more difficult due to the sensitivity to decreases in income and increases in interest rates. For any external event, the likelihood of default rises together with the level of debt. Even for a mild shock, highly indebted borrowers may suddenly no longer be regarded as creditworthy. BIS central bankers’ speeches Highly indebted governments may be constrained both in their scope for engaging in traditional countercyclical stabilisation policies and in their role as lenders of last resort during an economic or financial crisis. Moreover, growth might be hampered by excessive debt levels. Following the empirical findings of Kenneth Rogoff and Carmen Reinhart, who concentrated on the impacts of public debt on growth, recent BIS research also looked at corporate and household debt. The main finding is that there is a threshold of about 85% of GDP beyond which an additional 10 percentage points of debt reduces average per-capita growth by 13–14 basis points. What has caused this trend of accelerated borrowing? The main reasons were the liberalisation of credit markets since the late 1970s and the introduction of (complex) financial innovations which made it easier to borrow. In several countries the accumulation of debt was financed by property investment, which could be used as collateral for even more borrowing. Moreover, since the mid-1980s until the current crisis, the economic environment has been more stable, a period that has been coined the Great Moderation. Lower unemployment and inflation rates and less uncertainty made investors more optimistic. Borrowers borrowed more and lenders lent more – while inflation remained low. In addition financial innovation stabilized the credit supply. This allowed risks to move away from the banking system. General economic stability was improved, risk primea compressed, and future income prospects were boosted. On the political level a persistent deficit bias in fiscal policy has been en vogue which additionally pushed debt levels upwards. The lack of fiscal discipline was accompanied by households’ and firms’ behaviour that did not properly discount a higher future tax liability in their spending decisions but instead increased their own liabilities. Last but not least, tax incentives distorted financing choices. Preferential tax treatment of interest expenses may have played a major role in boosting corporate borrowing to finance ever larger mergers and acquisitions as well as leveraged buy-outs. Likewise, generous tax deductions for mortgage interest payments, combined with public policy intervention to boost home ownership, may have contributed to a sharp growth in household debt in some countries. Global economic challenges To tackle the threat of a debt trap three main approaches are generally discussed: fiscal consolidation to reduce the public fraction of debt, economic growth to increase the affordability of given liabilities, and inflation to lower the debt burden in real terms. Fiscal consolidation decreases the vulnerability of public finance. And public finance is the water mouth of debt from all sectors in an economy in times of crisis. Regardless of whether private debt has been socialized or the problem was from the beginning in public finances itself, the outcome was a drastic increase in the public debt burden. Even John Maynard Keynes was aware of the limits of public expenditure based on borrowing has to its limits. After the Great Depression, Keynes acknowledged: “Just as it was advisable for the government to incur debt during the slump, so for the same reasons it is now advisable that they should incline to the opposite policy.” To bring public finances in order is of additional importance in mature economies where the demographic challenge kicks already in and might challenge the sustainability of established pension systems. Growth should be stimulated. To this goal, structural reforms can strengthen confidence, market dynamics and job creation. Higher competitiveness will increase the flexibility of the economy and lift the longer-term growth potential. In particular, rigidities on labour market should be removed to increase wage flexibility. Structural reforms to increase competition in BIS central bankers’ speeches product markets, particularly in services and the privatisation of services currently provided by the public sector might further accelerate growth. To improve supply side conditions will also help to dampen the negative short term impacts on aggregate demand that kick it when the necessary fiscal consolidation measures are implemented. Inflation, by contrast, is not a feasible option. This statement might not come as a surprise from a central banker. But there are sound reasons behind: 1. Accelerated inflation would raise the risks of even higher future inflation and greater output volatility. Uncontrollable wage-price spirals would be likely. 2. It would reduce incentives for governments to lower their public debt levels. 3. Financial markets would probably not buy the story of, for instance, a temporary modest increase in the inflation target. Rather they would add an inflation risk premium when public debt is rolled over. Real refinancing costs of governments could become even higher once the genie of higher inflation rates was out of the bottle. 4. It is a myth that accelerated inflation can be a substitute for economic adjustment. Remember that the necessary disinflation policies of the late 1970 and early 1980 came along with high costs including severe recessions and sharp increases in unemployment. The case of the euro area Although elevated debt levels are a common feature of advanced economies the euro area has been at the epicentre of the current public debt crisis since spring 2010. Strangely enough, on a consolidated base public finances in the euro are in a more favourable position than for example in the US. The euro area as a whole will run a budget deficit of about 4.5% of GDP this year. The International Monetary Fund (IMF) expects a US budget shortfall of about 10 percent of GDP this year. According to the Commission’s spring forecast, the euro area deficit ratio is projected to decline to 3.5% of GDP by 2012. By comparison, in the US and Japan fiscal deficits are expected to be at 8.6% and 9.8%, respectively, in 2012. On the other side of the channel, the UK expects for this fiscal year to meet its deficit target of 7.9% of GDP, down from 9.3% of GDP in the previous one ending in April 2011. The budget forecasts however are based on the assumption that the economy will grow 1.7% in 2011 – a euphemistic view compared to private sector economists’ recent forecasts of 1.0 to 1.3%. According to the IMF the aggregate public debt-to-GDP for the euro area stands at 87 percent. Figures for the UK are similar. For the US the debt-to-GDP ratio in 2011 is expected to be 100 percent. In Japan public debt-to-GDP exceeds 200 percent. Under market scrutiny Still, it is the euro area that is under particular market scrutiny. Market judgement can sometimes deviate from economic fundamentals. Even wealthy states with sound economic fundamentals are in trouble to refinance themselves at reasonable conditions. Comparing for instance Britain and Spain based on debts, deficits and inflation, Britain should be the riskier credit. But British bonds yield around 2.3% while Spain’s yield around 5.5%. Moreover, market sentiments can deteriorate dramatically within days – although economic fundamentals might not have changed. In mid October Italian one year bonds yielded around 3.5%. Last week they yielded around 7%. BIS central bankers’ speeches Main differences to other countries Although financial markets might temporarily be irrationally pessimistic there is no room for complacency and the challenges must still be addressed. In order to do so, it seems reasonable to recall what makes the euro area different from other currency areas. The euro area is an alliance of sovereign countries without a central government or budget. Most of the relevant political decisions – including public finance – are taken by national governments. In this constellation member states share a common monetary policy and lack the instrument of the nominal exchange rate to react to internal or external imbalances. In this institutional environment there has always been a risk embedded: moral hazard could arise when fiscal profligacy of one single member state can be compensated on average by the sound economic behaviour and stable public finances of the majority of the other countries. Such an incentive structure is flawed in so far as it can lead to unsustainable fiscal policies of individual member states which in turn would generate negative spill over effects to the monetary union as a whole and make financial markets to paint other members states with the same brush. With hindsight, the original attempt to substitute a single government by rules, market and peer pressure has not been sufficient. Although the no-bail-out clause and the Stability and Growth Pact (SGP) were installed to exclude free rider incentives and to ensure the alignment of national fiscal policies, imbalances have emerged and the current crisis has not been prevented. Particularly, there was a lack of political will to commit to sustained stability-oriented fiscal policy. The weak commitment was evident when the Stability and Growth Pact was watered down under the pressure of France and Germany in 2003. Moreover, a crisis was not included in the scenarios to be prepared for. No crisis resolution mechanism for the euro area was foreseen. Political and institutional challenges Crises always must be seen as opportunities. As the Swiss writer Max Frisch once said: “A crisis is a productive time. It just has to be cleansed of the taint of a catastrophe.” All advanced economies have to take swift, decisive and credible action to tackle the challenges that go along with the global debt crisis. This clearly includes the euro area. Having discussed the feasible options to overcome the debt challenge and the particularities of the euro area it is important that the consolidation of national budgets and the strengthening of the growth potential have to be put in place in a more coordinated way. Important decisions have already been taken. In late September the European Parliament approved new legislation to tackle the shortcomings in the existing economic governance framework for co-ordinating fiscal and structural policies. The so-called “Six Pack” is a step in the right direction as the Stability and Growth Pact will be strengthened; imbalances and competitiveness will be monitored at an earlier stage. In addition to the “Six-pack” the Heads of State or government of the euro area agreed in March 2011 on a “Euro Plus Pact” with the aim to strengthen policy coordination in the areas of competitiveness and convergence. A set of common indicators will be used to monitor the progress of labour-market reforms, reforms to wage-setting arrangements and reforms addressing the sustainability of pension, health care and social benefit systems. Regarding the most urgent current challenges the Heads of State and Government of the euro area agreed on 26 October on a set of measures to restore confidence and address the current tensions in financial markets. These include a significant leveraging of the European Financial Stability Facility (EFSF) resources which shall increase the fund’s ability to extend loans, finance bank recapitalisations and conduct bond purchases in the primary and BIS central bankers’ speeches secondary markets. The crisis mechanism based in Luxembourg had been set up to help countries with stressed liquidity positions. This support should allow them to return to a sustainable level of debt and regain competitiveness as soon as possible. As stated earlier, accelerated inflation is not a feasible option. Therefore, monetary policy in the euro area must remain focussed on delivering price stability. By doing so, the ECB can also best contribute to financial stability, by including a firm anchoring of inflation expectations and supplying the financial system with the necessary liquidity. Monetary policy, however, cannot replace governments which have to live up to their own responsibilities. But challenges remain beyond today’s institutional framework to safeguard the own life of a currency union within a common market to further proceed. In the medium to long run, we will need an institution that is solely responsible for the euro zone. A single monetary policy needs support from sound public finances and closer economic policy coordination with an agreed framework for national budgetary policies. This could be monitored ideally by an independent body be it a European Commissioner with special authority or a finance minister (not necessarily with a huge budget), as it has been suggested by former ECB President Jean-Claude Trichet. But in any case, the institutional vacuum that currently exists must be filled in the long term. Ladies and gentlemen, thank you for your attention. BIS central bankers’ speeches
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Opening remarks by Mr Gaston Reinesch, Governor of the Central Bank of Luxembourg, at the Eurofi Financial Forum 2015, Luxembourg, 9 September 2015.
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Gaston Reinesch: How to achieve stronger growth in the EU? Opening remarks by Mr Gaston Reinesch, Governor of the Central Bank of Luxembourg, at the Eurofi Financial Forum 2015, Luxembourg, 9 September 2015. * * * Ladies and gentlemen, Distinguished guests, At the outset, I would like to thank Eurofi and its President Jacques de Larosière for inviting me to make the opening remarks to this afternoon’s debates on “How to achieve stronger growth in the European Union”, a highly topical subject, to say the least. I will focus on the euro area and structure my remarks in two parts. First, I will touch upon the economic outlook in the euro area. I will do so in light of the European Central Bank’s (ECB) staff euro-area macroeconomic projections, which have been published last week, referred to hereafter as the “staff projections”. Second, I will proceed with a broad overview of the issues and challenges of longer term growth in the euro-area and put forward some avenues for reflection and discussion. The information available from the staff projections indicate a continued though somewhat weaker economic recovery and a slower increase in inflation rates compared with previous expectations. As far as inflation is concerned, the staff projections foresee an annual Harmonized Index of Consumer Price Inflation (HICP) of 0.1% in 2015, 1.1% in 2016 and 1.7% in 2017. 1 In comparison with the June projections, 2 the outlook for inflation has been revised down, largely owing to lower oil prices and, to a much lesser extent, a slower closing of the negative output gap. Furthermore, taking account of the most recent developments in oil prices and recent exchange rates, there are downside risks to the September staff inflation projections. Concerning the economic situation, recovery is expected to continue, albeit at a somewhat weaker pace than earlier expected, reflecting in particular the slowdown in emerging market economies, which is weighting on global growth and foreign demand for euro area exports. Domestic demand should be further supported by the monetary policy measures of the ECB and their favorable impact on financial conditions as well as by the progress made in fiscal consolidation. Moreover, the decline in oil prices should provide support for household real disposable income and corporate profitability and, thereby, enhance private consumption and investment. Overall, this assessment is broadly reflected in the staff projections which foresee an annual real GDP growth of 1.4% in 2015, 1.7% in 2016 and 1.8% in 2017. Again compared with the projections in June, the outlook for real GDP growth has been revised downwards. This is due primarily to lower external demand owing to weaker growth in the emerging markets. The risks to this outlook are tilted to the downside, reflecting in particular the increased uncertainties related to the external environment. Notably, current developments in emerging market economies have the potential to further affect global growth adversely via trade and confidence effects. Before addressing the second part of my remarks, let me revert to the evolution of the output gap, i.e. the difference between actual and potential output. The negative output gap is expected to narrow gradually over the projection horizon, which is encouraging news. ECB Staff Macroeconomic Projections for the Euro Area, September 2015. Eurosystem Staff Macroeconomic Projections for the Euro Area, June 2015. BIS central bankers’ speeches However, it is also necessary to stress that while the output gap is narrowing, it is occurring against a background of weak potential output growth, which is estimated to be around 1% over the projection horizon. This is below its pre-crisis level. In noting this, we should, moreover, not overlook the fact that since the late 1990s the euro area experienced a steady decline of potential output growth: from about 2% in 2000, it declined continuously to about 1.5% before the crisis. There is indeed a problem in long-term growth dynamics. This problem is not new but has deepened over time. With this in mind, let us consider very briefly fiscal and monetary policy before focusing later on structural reforms. Starting with fiscal policy, it should support the economic recovery, particularly through growth-enhancing public investment, material and immaterial, while remaining fully compliant with the Stability and Growth Pact. A full and consistent implementation of the Pact is crucial to maintain confidence in the euro area’s framework. This, in turn, would have positive implications for future growth prospects, which should help ensure debt sustainability and be conductive to future fiscal space. With regard to monetary policy, which has to be focused on the primary objective of maintaining price stability over the medium term, its highly accommodative stance has contributed and continues to contribute to support economic activity and investment, narrow the negative output gap and foster economic growth. Let us also bear in mind the important fact that price stability, as well as financial stability, is a conditio sine qua non for a stable and growing economy. The monetary policy stance currently provides a window of opportunity to implement reforms. This brings me to the third crucial policy area, which can and should contribute decisively to future growth, namely structural reforms. There exists a large consensus that structural reforms are needed to boost potential output and productivity growth in the euro area and to reduce unemployment which is much too high, especially, but not only, among the youth. Incidentally, let me say that I prefer speaking more generally of increased productivity rather than increased competitiveness, the latter being a more elusive and relative concept. The world as a whole can become more productive, but it cannot gain in competitiveness. Structural reforms, notably in product and labour markets, but also through actions improving the business environment, can have two key effects and here I refer to ECB President Draghi’s speech this year at the ECB Forum on Central Banking, which took place in Sintra earlier this year. 3 First, they lift the path of potential output, either by raising the inputs to production – the supply and quality of labor and the amount of capital per worker – and by ensuring that those inputs are used more efficiently, that is to say by raising total factor productivity. Second, they make economies more resilient to economic shocks by facilitating price and wage adjustments as well as a swift reallocation of resources within and across sectors. These two effects are complementary. An economy that rebounds faster after a negative shock is an economy that grows more over time and it suffers lower hysteresis effects. And the same structural reforms will often increase both short-term flexibility and long-term growth. A comprehensive and credible package of structural reforms will therefore help increase resilience and growth and reduce unemployment. Structural reforms are often considered with a critical eye, if not fiercely opposed. Three considerations are mainly mentioned in this context: the “ugly” argument, which has to be resisted; the “bad” argument, which calls for careful refutation; and the “well meant” argument, which raises an issue that needs to be addressed. “Structural reforms, inflation and monetary policy”, Introductory speech by Mario Draghi, President of the ECB, ECB Forum on Central Banking Sintra, 22 May 2015. BIS central bankers’ speeches The ugly argument can be considered as a problem of collective action and rent-seeking. Structural reforms touch vested interests. The benefits of such reforms are large, but spread among the whole economy and are partly backloaded. Disadvantages, albeit globally low, are concentrated in relatively small groups, who are highly motivated to oppose them. This kind of opposition should be resisted and these arguments discarded. The bad argument has some intellectual merits. It states that in a situation of significant economic shock, structural reforms may have a negative effect on short-term demand. Such a conclusion, implying that structural reforms should be postponed – and here again I refer to President Draghi’s speech 4 – has nevertheless to be rejected. The reason for such a rejection is that the short-term impact of structural reforms does not simply depend on when they are implemented but how, the credibility of reforms and their interactions with other policy measures. And if structural reforms are well designed along such parameters, they can in fact have a largely neutral, if not positive, impact on short-term demand even in adverse cyclical conditions. 5 Then, there is a line of argumentation stemming from the more general concern of increasing inequality in our economies. In the context of structural reforms, this issue has to be taken seriously. European citizens are sensitive to the problem of increased inequality. Or, successful reforms require the acceptance of citizens and their conviction that such reforms will eventually increase per capita income without adverse inequality effects. Structural reforms have therefore to be designed in such a way as to avoid increased inequality and, if needed, accompanied by budgetary redistributive measures. For example, and this is also relevant in the more general context of growth, it seems that there is scope in a lot of countries for tax reforms, which could be both efficiency and equality enhancing, whilst being revenue neutral. All this being said, structural reforms in the euro area are necessary and should be seen beyond the confines of national economies. This is important in order to enhance all possible mutually reinforcing effects and positive spillovers. Further, it would also be helpful to strengthen coordination, minimize national discretion and think of the euro area as being one economy and not the simple addition of 19 economies. The implementation of measures should be enforced and national parliaments should be involved to ensure democratic accountability and local ownership. So far, I used the term “structural reforms”. However, the term “structural policies” might be a more appropriate and all-encompassing terminology. In that sense, let me very broadly mention how other policy areas or initiatives can through different channels contribute to enhance medium and long-term growth: first, innovation; second, the transition to a low carbon economy; third, the completion of the Financial Union; and fourth, institutional reforms in the governance of the economic pillar of the Economic and Monetary Union. Technological progress, product and process innovations are key drivers to long-term growth as recalled by Professor Christopher Pissarides in his presentation at the Sintra ECB Forum on Central Banking, 6 who stated that Europe as a whole was not doing very well in this field, although there were exceptions. Ibid. Let us note that the current accommodative monetary policy and its effectiveness should not be used as an excuse to delay necessary structural reforms. “Structural Perspectives on European Employment: The Role of Innovation and Growth”, Sir Christopher Pissarides, Professor, London School of Economics and University of Cyprus, Paper presented at the ECB Forum on Central Banking, Sintra, 22 May 2015. BIS central bankers’ speeches This points to the need to improve the ecosystem of innovation throughout the different stages, from basic research to successful market applications. There is still a too broad and deep Death Valley along this process. Second, the transition to a low carbon and more resilient economy represents another key challenge in this respect. This is a global problem. Europe is, however, a key player in this field, as the forthcoming United Nations climate change conference in Paris demonstrates. Climate preservation is not only a necessity but also, as continuously stressed for example by Nicholas Stern, 7 an opportunity for the enhancement of the co-evolution of growth and structural change. Third, the Financial Union has also a strong potential to support future growth. The Banking Union has to be completed and the Capital Markets Union has to be launched successfully. You will discuss that in detail over the next days. Allow me only to touch on one specific element, which by the way was considered important enough by “The Economist” for a cover story some months ago, with the title “The Great Distortion – A Dangerous Flaw at the Heart of the World Economy”, 8 namely the difference in taxation between debt and equity. This point has also briefly been touched upon in the comprehensive Eurosystem contribution to the Commission’s Green Paper on Building a Capital Markets Union. Let me quote part of the relevant paragraph: “Initiatives in taxation should aim to reduce the preferential treatment of debt financing as opposed to equity financing… This can facilitate a greater reliance by firms on equity and have a positive impact on their access to other forms of finance. It could also be important to rebalance the financial structure of firms, especially in those countries where the level of indebtedness in the non-financial corporation sector is still significant.” 9 Fourth, and last but not least, there is also a case to contemplate institutional innovation and governance change in the Economic pillar of the Economic and Monetary Union. Let me on this point quote Mario Draghi’s response during last week’s monetary policy press conference to a question by a journalist. “If I look at the ECB – now, of course I am a biased observer here – you would judge that the integration of monetary policy has been pretty successful. Why that? Because we moved from a rules-based system that we had in the 1980s and 1990s to an institution-based system where you have co-decision. Co-decision in our sense, not co-decision in the way it’s been used in Brussels between Parliament and different institutions. So it’s a sharing of responsibility and a sharing of sovereignty, within the same institution. And what I have been arguing is that the same path ought to be adopted in other areas, one of which is the budgetary area, where we now coordinate our actions based on a set of rules, one of which is the Stability and Growth Pact. Another one is the six-pack and so on. Now, we think, and I certainly think, that this system is not completely satisfactory, for a variety of reasons that you’ve seen in the last few years, and so it would be a good thing if we were to move to a common institution also in the budgetary See for instance: “Economic development, climate and values: making policy”, paper by Nicholas Stern, Chair of the Grantham Research Institute on Climate Change and the Environment, July 2015. “The Great Distortion – A Dangerous Flaw at the Heart of the World Economy”, The Economist, 16 May 2016. Eurosystem contribution to the European Commission’s Green Paper on Building a Capital Markets Union, 2015. BIS central bankers’ speeches area. And this is a point that’s been made in the Five Presidents’ report so it’s not only my own view.” 10 Ladies and Gentlemen, I hope that some of these inevitably piecemeal and largely incomplete remarks offer some food for discussion for the upcoming debates. Thank you very much for your attention. “Introductory statement to the press conference (with Q&A)”, 3 September 2015. BIS central bankers’ speeches
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Speech by Mr Gaston Reinesch, Governor of the Central Bank of Luxembourg, at the National Bank of Poland's Biannual EU Presidency Lecture, Warsaw, 27 October 2015.
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Gaston Reinesch: Beyond the horizon of the Luxembourg presidency – a central banker’s perspective Speech by Mr Gaston Reinesch, Governor of the Central Bank of Luxembourg, at the National Bank of Poland’s Biannual EU Presidency Lecture, Warsaw, 27 October 2015. * * * Ladies and Gentlemen, Dear Marek, At the outset, I would like to extend my sincere gratitude to the National Bank of Poland and in particular to Governor Belka for inviting me to give the National Bank of Poland’s Biannual Presidency Lecture, which has already earned an excellent reputation and become a wellestablished tradition. It allows to take stock of ongoing developments in the European Union (EU) and to ponder how it could evolve in the future. I am very pleased to be given the opportunity to address such a distinguished audience here in Warsaw today. I. Introduction Ladies and Gentlemen, His Royal Highness, the Grand-Duc of Luxembourg, during his state visit to Poland in May last year, introduced his speech on the occasion of the dinner offered by the President of the Republic of Poland by stating that he was touched by an invitation to Poland’s Public Radio to pay tribute to Radio Luxembourg, formerly called “Luxy” by the Polish people, and that he particularly appreciated the symbolism of this gesture. He stressed that existing ties between nations may not necessarily be material but very often had immaterial aspects. The fact that the Grand-Duchy of Luxembourg became associated with values of liberty and a certain “joie de vivre” by the Polish people was for him a source of pride. Such reminiscence living in the memories and in the heart of people is priceless. The paths of our two countries did not often cross directly, but we certainly have something in common, notwithstanding our different size and history. To some extent, we share a similar past in the sense that given our geographically strategic location, we too, in a more remote past, have been the target of neighbouring countries that had expansionary ambitions. But our two countries have succeeded in overcoming the greatest challenges, including historical tragedy. The ties between Luxembourg and Poland have strengthened over time. Today, about 5,000 Polish citizens contribute to Luxembourg’s multicultural landscape. I am also very glad to say that I recently appointed a Polish national who will soon join our legal department. The Central Bank of Luxembourg’s staff is representing 20 different citizenships and more than 50% of its staff do not have Luxembourg citizenship. Poland is a large country, but above all, it is a great one. It is a proud country and rightly so. Last year was a year of commemoration and celebration of several important events. You commemorated the 70th anniversary of the Warsaw Uprising. You celebrated the 15th anniversary of NATO membership, the 25th anniversary of Polish freedom and the emergence of a fully sovereign Poland, a solid parliamentary democracy and a dynamic social market economy, with an overall remarkable macroeconomic performance. Last but not least, and this brings me to our topic of today, last year you also celebrated the 10th anniversary of Poland’s accession to the EU. The fact that the current President of the European Council, Donald Tusk, is a Polish national and the President of the European BIS central bankers’ speeches Commission, Jean-Claude Juncker, is a Luxembourg national, might be considered a coincidence of European history. At any rate, it fills our two countries with a certain pride. Allow me at this point of my speech a brief digression to share with you a few memories of my last visit to Poland, which unfortunately dates back to as far as 2001. I accompanied the then Luxembourg Prime Minister Jean-Claude Juncker on a state visit. I have fond memories of that visit, not only of the ceremony at the Tomb of the Unknown Soldier and of the very interesting formal discussions, which included an important European component, but also of a delightful lunch hosted by a Polish peasant family at their farm house in Lublin Province. Lunch was followed by a no less emotional visit to a primary and middle school, during which pupils who welcomed us very warmly showed a particular interest in the EU enlargement process and the expected accession of Poland to the EU. Throughout our stay, we were impressed by the courage and determination of the Polish people and by their eagerness to join the EU. If anything, this experience strengthened my conviction that one of the basic tenets of the European construction is unity in diversity. It is my firm belief that the enhancement and deepening of unity has to go hand in hand with a good understanding of every current and future member State’s characteristics and specificities, in all their dimensions, notably political, economic, and cultural. To be successful, Europe must continue to be perceived by its citizens as an enriching project, economically, socially and politically, a community of basic common values in which people can prosper in peace. Without a continued broad acceptance by European citizens of the European project, the necessary future steps of integration will prove difficult, if not impossible. In this spirit and before I get to the core of my speech, allow me to say some words about Luxembourg. After all, I just stressed the need to understand our respective historic, economic and political backgrounds. Most of you know of Luxembourg as a financial centre, which emerged some fifty years ago. But I presume that most of you only have a vague idea of the economic development of the Grand-Duchy of Luxembourg since its independence in 1839 and up to the middle of the 20th century. So allow me to take a longer historical perspective to give you a very succinct overview of its economic development since the middle of the 19th century, an economic development, which from the middle of the 20th century, was closely co-determined by the European integration process. Around 1850, Luxembourg was one of the poorest regions in Europe, an unproductive agricultural economy. The Luxembourg economy then experienced a takeoff, which can be described by using, on the one hand, the traditional economic concepts of supply and demand and, on the other hand, the concept of economic integration. On the supply side, it all started with the geological discovery of a natural resource in the south of the country, namely iron ore. While the phosphorus content of the iron ore was too high to allow for the production of quality pig iron, this problem was solved by the technological import of an innovation by a British engineer, the Thomas Gilchrist process, a perfect example of cross-border technical dissemination in the 19th century. As far as labour was concerned, labour supply was relatively elastic and this for two reasons. First, there was immigration of both a qualified labour force, such as engineers, and less qualified workers coming mainly, but not exclusively, from neighbouring countries. Second, domestic migration from the poor agricultural North to the South took place. Thus, farmers were leaving agricultural businesses to become predominantly, in the first instance, miners. Later on, through learning by doing and educational efforts, the average level of qualification of Luxembourg nationals and of the descendants of immigrants increased. Hence, Luxembourg nationals also gradually became engineers, accountants, managers etc. Let me also mention that most of the descendants of first generation immigrants acquired BIS central bankers’ speeches Luxembourg nationality. This explains why so many Luxembourgers have for example Italian family names or even Polish ones, given the immigration of Polish citizens to Luxembourg, particularly in the interwar period. Furthermore, the scoriae, a fallout or byproduct of the Thomas Gilchrist process, provided an excellent fertilizer for the poor agricultural soil. Thus, the industrial steel revolution boosted productivity in the agricultural sector. The large industrial investments that were needed were financed with capital that mainly came from Belgium and Germany. There was also an institutional or sovereign dimension in the sense that a law voted by Parliament conditioned the granting of concessions of iron ore exploitation to an obligation of on-site transformation of iron ore to a final product, thus laying the foundations for the development of a value added chain on Luxembourg territory. On the demand side, there was no significant demand in Luxembourg for the products of the steel industry, which, moreover, was characterized by economies of scale. However, at that time, Luxembourg was a member of the Zollverein, a German customs union. The Zollverein offered a large free-trade area for steel made in Luxembourg and facilitated the supply of coal, a key input to steel production. Without such economic integration, the steel industry would not have been at the origin of the economic upswing and, later on, the engine of growth of the Luxembourg economy, and this for more than a century. As a Luxembourg economist1 once said: “Just as Egypt is a gift of the Nile, Luxembourg is a gift of iron”. Some fifty years ago, in the 1960s, the steel industry, directly or indirectly, accounted for nearly 50% of Luxembourg’s GDP; it was the most important employer and constituted the key source of tax revenue for the Luxembourg State. But, as history consistently shows, there is no sustained growth without structural change and without shocks. In the aftermath of the 1974 oil shock, the steel industry throughout Europe suffered a structural crisis of unprecedented magnitude. Luxembourg, depending very much on the exports of steel, was very seriously impacted. It was confronted with an economic crisis of national dimension with tremendous potential consequences in macroeconomic terms, and which could have entailed the country’s downfall. But, around that time, an exceptional and lucky historical coincidence occurred in a country that in the 1960s only had around half a dozen commercial banks, a number that was largely sufficient to cover the needs of the small domestic market. When the steel industry declined, Luxembourg experienced the birth and development of a financial centre, without there being any direct causal relationship between the decline of the steel production and the expansion of financial services. The initial development and the expansion of the financial sector had multiple causes and most of these were of an external origin. This said, let me take a step backwards to the period after World War I. After World War I, the German Zollverein was dissolved and Luxembourg had to look for a new economic partnership. In a referendum organized in 1919, a large majority of the Luxembourg population expressed a preference to enter into an economic union with France. However, such an interest was not reciprocal and Luxembourg finally turned to Belgium, which led to the establishment of the Belgo-Luxembourg Economic Union. The economic union, mainly based on a customs union, became effective in 1922. It included elements of monetary cooperation, which led to the establishment of a monetary association between Belgium and Luxembourg in 1935. The monetary association was highly asymmetric. Luxembourg was not granted a central bank and was not directly involved in monetary policy decisions. In a nutshell, it had no monetary sovereignty. Carlo Hemmer. BIS central bankers’ speeches With the introduction of the euro, the monetary association was dissolved. As requested by the Maastricht Treaty, Luxembourg established a national central bank in June 1998, before the introduction of the euro. This very succinct overview shows that economic and political integration have throughout Luxembourg’s history been a key factor for the development of the Luxembourg economy, a very small open economy, which is export-led and partly import-driven. I mentioned the Zollverein, followed by the creation of the Belgo-Luxembourg Economic Union2 and monetary association. That process was followed by European integration, starting with the European Coal and Steel Community (ECSC), and followed later by the creation of the European Economic Union and the European Union. The symbiotic relationship with Europe has served the country well and the pro-European public opinion in Luxembourg towards Europe has remained unscathed despite the challenges the country, the European Union, and, more specifically and recently, the euro area have been facing over the years, especially the global financial crisis that started unfolding some eight years ago. This brings me to the Luxembourg Presidency’s programme, which is ambitious and based on seven pillars: – Stimulating investment to boost growth and employment, – Deepening the European Union’s social dimension, – Managing migration, combining freedom, justice and security, – Revitalising the single market by focusing on its digital dimension, – Placing European competitiveness in a global and transparent framework, – Promoting sustainable development, – Strengthening the EU’s presence on the global stage. I hope you do not expect me to cover all these items. Besides, since an EU Presidency is a government-driven process, and since central banks are independent off political processes, I will try to confine my remarks to topics that are of a more direct interest to central banks. I will also seize this opportunity to share a few personal thoughts on how the EMU’s governance could be further improved over the years. These reflections will be structured in two parts. In the first part, I will briefly highlight the ongoing challenges for the single monetary policy, and touch upon the macroeconomic outlook for the euro area. I will then take stock of key measures that have been taken to strengthen European economic governance, and point out some possible improvements and avenues that could be explored to further enhance the EMU’s framework over the medium term, before concluding. II. The global financial crisis and ongoing challenges from a monetary policy perspective The global financial crisis that started to unfold in 2007, by any historical standard, gave rise to very challenging economic and financial conditions. Between 2007 and 2013, facing elevated pressures in several financial market segments as well as contracting economic activity, the ECB’s Governing Council adopted forceful and timely standard and non-standard measures. Against the backdrop of the wealth of the Eurosystem measures taken in There also was the Benelux Union signed in 1949 between Belgium, the Netherlands and Luxembourg. BIS central bankers’ speeches response to the financial crisis, I will focus on the current euro area challenges from a monetary policy perspective and the measures taken by the Eurosystem since 2014. An overview of the measures taken in response to the financial crisis covering, among others, liquidity management actions, changes to the collateral framework, supplementary longer-term refinancing operations, asset purchase programmes, and forward guidance, will be included as an annexe to the written version of this speech. Importantly, it is because of the forceful measures taken between 2007 and 2013 that the ECB’s Governing Council consistently provided an anchor of stability and confidence throughout the financial and sovereign debt crisis. As a matter of fact, despite the severe tensions during the financial and sovereign debt crisis and the resulting volatility in economic activity and headline inflation3 inflation expectations remained firmly anchored at levels consistent with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term. Throughout 2014, however, additional contingencies materialized, with risks extending to a worsening of the medium-term outlook for inflation and a loosening in the anchoring of inflation expectations. While standing at elevated levels above 2% in 2011 and 2012, annual HICP inflation declined throughout 20134 and – in a context of already low inflationary pressures – continued its downward trend in 2014. Moreover, survey and market-based inflation expectations reacted to low actual inflation. While the impact focused on short-term inflation expectations, from mid-2014 medium to long-term inflation expectations also tended to decline. The risk of inflation remaining low for too long a period of time thus became a key concern. In the course of 2014, therefore, the Governing Council lowered key policy interest rates further and introduced a negative interest rate on the deposit facility in June 2014 (–0.1%, further lowered to –0.2% in September 2014). Since September 2014, the main refinancing rate stands at 0.05%. With key policy interest rates in the vicinity of a lower bound, the Governing Council adopted further non-standard monetary policy measures in 2014, not only in order to address impairments in the transmission of monetary policy, but also with a view to initiating a monetary accommodation beyond what could be achieved through reductions in policy interest rates, thereby supporting the anchoring of medium to longer-term inflation expectations in line with the Governing Council’s price stability objective. In June 2014, the Governing Council announced a series of targeted longer-term refinancing operations (so-called “TLTROs”). TLTROs provide long-term funding over a period of up to 4 years. The exact borrowing terms depend on the volume of a borrower’s lending to the real economy (relative to a benchmark that is specific to each credit institution). By combining low long-term refinancing rates and positive incentives to lend, TLTROs aim at enhancing loan supply and lowering lending rates. Unlike the longer-term refinancing operations introduced earlier in response to the financial crisis, TLTROs are specifically designed to provide incentives for lending to the real economy, one of the key factors holding back the recovery. While annual HICP inflation stood at 3.3% in 2008, the annual rate of change in the HICP declined to 0.3% in 2009. On a monthly basis, annual HICP inflation varied between –0.6% in July 2009 and 4.0% in June and July 2008. Real GDP growth dropped from 3.2% in 2006 to –4.5% in 2009. While the euro area returned to positive growth in 2010 and 2011 (2.1% and 1.6%, respectively), the euro area economy contracted by 0.8% and 0.3% in 2012 and 2013, respectively. HICP inflation declined from 2.2% in December 2012 to 0.8% 12 months later. HICP inflation dropped – and remained since – below 1% in October 2013. BIS central bankers’ speeches Then, in September 2014, the Governing Council announced an asset-backed securities purchase programme (“ABSPP”) and a new covered bond purchase programme (“CBPP3”). The Governing Council stated that it expected these two asset purchase programmes to last for at least two years. Both programmes are tailored to the financial structure of the euro area economy. The covered bond market represents a primary source of financing for euro area banks and the link to the underlying loans is fairly close. ABS interest rate spreads, too, are closely linked to the lending rates banks apply on the underlying loans. Therefore, both purchase programmes complement the TLTROs in strengthening the transmission of monetary policy to the borrowing conditions of the non-financial private sector in the euro area and in supporting credit conditions for businesses and households in the euro area. At the end of 2014, the Governing Council communicated its intention to increase the Eurosystem’s balance sheet towards the level that existed at the beginning of 2012 in order to provide a sufficient degree of monetary stimulus to raise the inflation rate to levels below, but close to, 2%. Thus, in early 2015, it conducted a thorough reassessment of the outlook for price developments and of the monetary stimulus achieved. Back then, it concluded that the medium-term inflation outlook had weakened. While the monetary policy measures adopted since June 2014 permitted a satisfactory pass-through of the liquidity injected to private sector borrowing costs, the prevailing degree of monetary accommodation was not sufficient to adequately address heightened risks of too prolonged a period of low inflation. Against this background, the Governing Council decided to expand asset purchases to encompass euro-denominated investment grade securities issued by euro area governments as well as agencies and European institutions (the so-called Public Sector Purchase Programme, “PSPP”). The combined monthly purchases of public and private sector assets under all three pillars, together called the Expanded Asset Purchase Programme (i.e. the ABSPP, the CBPP3 and the PSPP), amount to €60 billion. They are intended to run until the end of September 2016, or beyond if necessary, and, in any case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term. Given the various channels through which each of the monetary policy measures taken since June 2014 operate, and due to the well-known lags of monetary transmission and the uncertainty with regard to the counterfactual, it is too early, at the current juncture, for a final assessment of the final impacts of these measures. There is, however, ample evidence that the monetary policy measures in place since June 2014 have been conducive to an easing in borrowing conditions and have supported credit flows in the euro area. Since last year, interest rates for bank loans declined by much more than the concomitant reduction in policy rates.5 In the October 2015 Bank Lending Survey, euro area banks reported a stronger than expected net easing of credit standards on loans to businesses in the third quarter of 2015. Moreover, net demand for loans to businesses and for housing loans strengthened. Regarding euro area banks’ access to retail and wholesale funding, the October 2015 Bank Lending Survey suggests improved access to funding for all main market instruments (retail deposit funding, however, deteriorated slightly). Banks continue to report that the additional liquidity generated by the expanded asset purchase programme is being used for lending. Between May 2014 and August 2015, the composite cost-of-borrowing indicator for euro area non-financial corporations and households declined by 75 basis points and 67 basis points, respectively. Over the same period, policy interest rates declined by 20 basis points (main refinancing operations and deposit facility) and 45 basis points (marginal lending facility). BIS central bankers’ speeches Finally, banks report that the expanded asset purchase programme has had a net easing impact on credit standards, in particular for loans to businesses. With regard now to inflation and growth, the September 2015 ECB staff macroeconomic projections show a more mixed result. They indicate a continued, though somewhat weaker, recovery and a slower increase in inflation rates compared with earlier projections.6 More recently, renewed downside risks have emerged to the outlook for growth and inflation. At the same time, the 2015Q3 and the 2015Q4 Surveys of professional forecasters7 suggest that the 2014/2015 package of measures led to a stabilisation of longer-term inflation expectations. It is important to underline that these projections on inflation and on output are based on, and are conditional on, a full implementation of the Expanded Asset Purchase Programme announced in January and on the full implementation of the credit easing measures decided in the course of 2014. This monetary policy stance is considered essential for a continued recovery and a convergence of inflation towards our price stability objective. It has to be stressed that these projections were also based on a set of technical assumptions (e.g. in relation to international factors, including exchange rates, oil price, and commodity prices). To the extent that these factors could change, and could possibly worsen, thereby entailing increased downside risks, the current monetary policy stance would have to be revisited. In light of the renewed risks that have emerged on the back of recent developments in global economic, financial and currency markets, the Governing Council will continue to monitor very closely the risks to the outlook for price developments over the medium term. It is ready to use all the instruments available in its mandate to act, if so warranted. While our monetary policy measures have contributed to the euro area recovery and to a gradual improvement in the inflation outlook for price stability, monetary policy is not a panacea and not the only game in town. Our measures should be supported by action in other policy domains to support economic recovery and to ensure debt sustainability. Let me mention two of them: structural reforms and fiscal policy. First, a continuation of structural reforms is necessary and they should be seen beyond the confines of national economies. They could, inter alia, increase the growth potential of the euro area and make it more resistant to shocks. In this context, one should keep in mind that already before the crisis the level of unemployment was too high and the growth of potential output too low. One of the most important economic challenges, next to a greater economic convergence, is an increase in potential growth with an increase in productivity; this should also be seen against the background of demographic challenges. I have elaborated on this point in a speech I recently gave at the EurofiFinancial Forum. Second, while having to stay fully compliant with the EU fiscal rules of the Stability and Growth Pact, fiscal policy can also contribute to supporting the economic recovery, particularly through growth-enhancing public investments, material and immaterial, which have a demand and a supply effect. It also seems that in some countries, including Luxembourg, there is scope for tax reforms that could both enhance efficiency and reduce inequality, while being revenue neutral. The September 2015 ECB staff (June 2015 Eurosystem) macroeconomic projections foresee annual HICP inflation at 0.1% (0.3%) in 2015, 1.1% (1.5%) in 2016 and 1.7% (1.8%) in 2017. Compared with the June 2015 BMPE, the outlook for HICP inflation has been revised down largely due to lower oil prices. The September 2015 ECB staff (June 2015 Eurosystem) macroeconomic projections foresee real GDP growing by 1.4% (1.5%) in 2015, by 1.7% (1.9%) in 2016 and by 1.8% (2.0%) in 2017. The slightly weaker outlook for activity than the June 2015 BMPE largely reflects a less favourable external environment. According to the 2015Q3 and the 2015Q4 Surveys of professional forecasters, longer-term inflation expectations stood at 1.9% (up from 1.8% according to the 2014Q4, 2015Q1 and 2015Q2 survey rounds). BIS central bankers’ speeches Furthermore, against the background of weak investment, the Investment Plan for Europe – also referred to as Juncker Plan –, is a welcome initiative and a priority of the Luxembourg Presidency. It aims to unlock additional investment of at least €315 billion over the next three years by addressing market gaps and by mobilising private capital. Beyond the immediate objective to boost investment, the Investment Plan for Europe strives to improve long-term competitiveness, human capital and physical infrastructure. Let me now come to the governance of the Economic and Monetary Union (EMU). III. EMU governance: progress achieved and room for further improvement The Economic and Monetary Union (EMU) involves the coordination of economic and fiscal policies, a single monetary policy and a single currency, the euro. While the single monetary policy and the single currency were established with the inception of the euro (“monetary union”), the financial crisis revealed a clear need for a strengthening of the coordination of economic and fiscal policies (the “economic pillar” of the union). And, indeed, we have witnessed significant progress, notably with regard to the Economic and Governance framework, the Banking Union, the strengthening of the macro-prudential framework, and the establishment of financial backstops. I will touch briefly on those domains. Economic and fiscal governance Following the financial and sovereign debt crisis, a number of important initiatives were taken with a view to avoiding unsustainable developments in individual countries that were jeopardising the smooth functioning of the Economic and Monetary Union. The preventive and corrective arms of the Stability and Growth Pact have been strengthened and complemented by, among others, a macroeconomic monitoring exercise to address macroeconomic imbalances (“Macroeconomic Imbalance Procedure”) before they could become systemic and spill over to other Member States. The new rules introduced by a set of legislative initiatives, known as “Six Pack” [effective in 2011] and “Two Pack” [effective in 2013] and the Treaty on Stability, Coordination and Governance in Economic and Monetary Union, with its Fiscal Compact [also effective in 2013], undoubtedly brought about important changes to the Stability and Growth Pact like the operationalization of the debt rule, a stronger focus on expenditures, as well as automatic correction mechanisms that are to be monitored and assessed by national bodies that have to be independent. At the same time, the new framework allows for more flexibility, depending in particular on a Member State’s underlying budgetary position over the medium term. The new rules aim to better prevent deviations from set budgetary objectives and to enforce potential sanctions more effectively. Under the current framework, surveillance has been extended to macroeconomic policies through the Macroeconomic Imbalance Procedure and can even be strengthened for euro area Member States with high fiscal deficits or public debt, or facing challenges pertaining to financial stability. Annual assessments are conducted in the context of the “European Semester”. However, despite the substantial progress that has been made so far, there is room for further improvement, both in terms of form and substance. First, the economic and fiscal governance framework has become very complex, to say the least. Clarification and simplification of that framework could lower the risk of misinterpretations and misperceptions. Second, for a rule-based framework to be credible it is imperative to apply the rules effectively. Recent reforms endowed the Stability and Growth Pact with some degree of BIS central bankers’ speeches flexibility.8 However, when interpreted too widely, the flexibility of the Stability and Growth Pact could increase risks related to debt sustainability. The Banking Union The Banking Union, based on three pillars (i.e. the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the single Deposit Guarantee Scheme) constitutes a major step in addressing some of the major weaknesses uncovered by the crisis. Since 4 November 2014, the ECB is at the helm of the Single Supervisory Mechanism (SSM), which will help harmonize banking standards across the euro area and help reduce the fragmentation, along national lines, of the banking landscape. One might argue that the Banking Union is a corroboration of Jean Monnet’s famous statement, according to which “Europe will be forged in crisis and will be the sum of the solutions adopted for those crises”.9 Indeed, after the financial crisis and, even more, after the sovereign debt crisis in the euro area, there was an acute awareness of the incompleteness of the Economic and Monetary Union. All of a sudden, European integration received a boost, this time with the inception of a banking union, which took shape very rapidly. The work on the single rulebook started as early as 2009, and, by the end of 2013, there was the Capital Requirement Regulation (CRR), the Capital Requirement Directive (CRD IV) and the founding act of the SSM regulation.10 The establishment of the SSM, which has been a major undertaking, not only in terms of staff and resources, was well managed by the ECB. In full separation between monetary policy and banking supervision, it ensures independent banking supervision of the highest quality, without interference of other, non-prudential, considerations. Significant progress also has been achieved with regard to the establishment of a framework for the resolution and restructuring of banks, the second pillar of the Banking Union. The Single Resolution Mechanism (SRM), established by way of an EU Regulation that entered into force in August 2014, introduces a European framework to ensure the orderly resolution of banks covered by the SSM. Within this framework, a resolution procedure is triggered by the ECB which, in its capacity as supervisor, expresses an opinion on a bank’s solvency. The Single Resolution Board, which will be fully operational as from 1st of January 2016, is at the core of the SRM. It is responsible for preparing and implementing the effective resolution of insolvent banks, especially significant and cross-border banks, in cooperation with the national resolution authorities. The EU Bank Recovery and Resolution Directive (BRRD), adopted in May 2014, introduced a single rulebook for the resolution of banks. With the transposition of this directive into the national laws of the Member States, national authorities are endowed with the tools required to restructure or unwind banks in a timely and orderly manner, minimizing the costs of bank failures. Another fundamental measure introduced by the BRRD is the “bail-in” tool. In future resolutions and restructurings of banks, shareholders and creditors will have to contribute to the absorption of losses and capital recovery of the failed banks. In addition, banks themselves will finance the national resolution funds introduced by the BRRD. From 2016, the Single Resolution Fund, which will be built up over a period of eight years, will replace these national funds in Member States participating in the SSM and the SRM. See also the Communication “Making the best use of the flexibility within the existing rules of the Stability and Growth Pact” issued by the European Commission in January 2015. Jean Monnet (1976), Memories, Paris Fayard. Danièle Nouy, Chair of the Supervisory Board of the SSM. “The banking union, one year on”, Center for European Reform, London, 21 October 2015. BIS central bankers’ speeches Further progress is required in relation to the third pillar of the Banking Union, a single Deposit Guarantee Scheme. Admittedly, a new EU Directive on deposit guarantee schemes, which aims to address the current weaknesses by ensuring a uniform level of protection of depositors throughout the European Union and to eliminate market distortions, was adopted in April 2014. Nonetheless, an effective crisis management framework should include a credible single deposit guarantee scheme. In light of the pan-European solutions that have been adopted for the SSM and the SRM, it would be consistent to take a similar approach for the third pillar of the Banking Union. As announced some days ago, the Commission will make a legislative proposal on the first steps towards a common European Deposit Insurance Scheme by the end of this year. Strengthening of the macro-prudential framework While it is important to supervise individual institutions, it is equally important to safeguard the stability of financial systems as a whole by containing systemic risks. Back in 2010, the European Parliament and the European Council agreed on the EU regulations establishing the European Systemic Risk Board (ESRB), which is responsible for the macro-prudential oversight of the financial system within the European Union. Since then, the macro-prudential framework in Europe has been strengthened. The CRD IV and CRR, for instance, introduce macro-prudential instruments that can be applied by designated national macro-prudential authorities. In each Member State, National Central Banks play a key role in macro-prudential oversight. In this regard, but also more generally, their independence is key. The SSM Regulation requires that national authorities notify the ECB when applying macroprudential measures embedded in the CRD IV and CRR and take into consideration the ECB’s views if the latter objects to such measures. The SSM Regulation also allows the ECB, in cooperation with the national authorities, to adopt, if deemed necessary, higher buffer requirements or take stricter measures than those adopted by the national authorities. Despite the progress already made, further advances in the macro-prudential framework are necessary. First, the macro-prudential framework embedded in the CRD IV and CRR applies to credit institutions only, leaving aside less-regulated institutions. While the optimal degree of regulation imposed on less-regulated entities remains the subject of intense discussions, more regulation is justified where such entities carry out activities that are close substitutes to banking intermediation (in particular institutions lending to households). Macro-prudential authorities should also assess exposures that exist between credit institutions and less regulated credit institutions. Second, under the current framework, macro-prudential instruments not included in the CRD IV and the CRR, such as loan-to-value and loan-to-income ratios, remain in the exclusive remit of national authorities. Discretionary power of national authorities can potentially lead to unequal governance structures and/or an unequal application of macro-prudential rules or instruments. Having said that, it has to be recognized that macro-prudential frameworks and policies are still in their infancy. The deeper nature of systemic instability remains to be fully understood. The development of tools to detect and assess risk is work in progress. It remains the subject of comprehensive research, both in central banks and academia. In order to deepen, inter alia, our understanding of macro-prudential tools, the Banque centrale du Luxembourg recently signed a cooperation agreement with the Toulouse School of Economics (TSE), which is led by professor Jean Tirole who was awarded the Nobel prize in economics in 2014. BIS central bankers’ speeches Financial backstops Finally, let me briefly mention another major contribution to the strengthening of the Economic and Monetary Union following the financial crisis, namely the establishment of financial backstops for the euro area. The European Financial Stability Facility (EFSF) was introduced as a temporary mechanism in 2010. Two years later, the European Stability Mechanism (ESM), a permanent mechanism that may funnel, under effective strict conditionality, financial assistance to euro area Member States experiencing financing difficulties was established under an intergovernmental agreement. The EFSF and the ESM, which together have a combined lending capacity of €700 billion have, so far, disbursed about €250 billion of financial assistance to five Member States. In December 2014, the ESM Board adopted the Direct Recapitalization Instrument (DRI), which provides the ESM with the capacity to directly recapitalize banks in the euro area under certain conditions, thereby contributing to severing the link between banks and public finances. IV. The way forward: a longer-term view Let me now briefly highlight two areas that could be of overriding importance for the more longer-term future design and functioning of the European Union and the euro area, i.e. the capital markets union and the way towards a type of “fiscal union”. The Capital Markets Union The Capital Markets Union (CMU), which is high on the agenda of the Luxembourg Presidency, is a major undertaking, a genuine European-wide project. The CMU is welcomed by the Eurosystem, which delivered its opinion several months ago. On 30 September 2015, the European Commission issued its Action Plan on Building a Capital Markets Union.11 It aims to put in place the building blocks of a well regulated and fully functioning CMU in the EU by 2019. While the details of the design of the CMU remain to be defined, given the complexity of the undertaking and the potentially far-reaching implications, a thorough stock-taking of the issues at stake should be followed by prioritized and targeted outcomes. The CMU is intended to deepen the integration of capital markets in the European Union. Deeper integration would foster the efficiency of capital markets by providing businesses with access to a wide range of sources of capital from all over the European Union and by offering investors and savers additional investment opportunities, thereby enhancing economic growth and job creation. In this context, let me recall that the Eurosystem is particularly supportive of measures aimed at reviving securitization. It welcomed the Draft EU Regulation introducing criteria for simpler, more transparent and standardized Asset Backed Securities (ABS), which allows such securities to be acceptable as collateral and to be purchased by the Eurosystem. Financing through the markets and financing through banks should not be seen as a tradeoff, but as substitutes. Banks will remain key players in capital markets, and will continue to play a major role in credit intermediation through their role in funding and provision of information, especially to SME’s. Europe needs a network of strong and efficient retail banks offering good service in a competitive context. Europe also needs strong players in financial markets, not in the sense of national champions, but in the sense of genuine European financial actors. Building a Capital Markets Union – Eurosystem contribution to the European Commission’s Green Paper. BIS central bankers’ speeches To bring about its expected benefits, the CMU should foster and result in a high level of financial integration in capital markets across the European Union, based on an adequate legal and regulatory framework. This framework should be cast wider in order to cover also less regulated and more opaque activities, such as shadow banking. CMU could imply, inter alia, more ambitious steps towards a greater convergence of: – Bankruptcy laws, – Company laws, and – Taxation of financial products, including reflections on how to reduce or even eliminate the current taxation bias in favour of debt financing and against equity. Although there are complaints about the over-reliance on debt and the fact that leveraging is too high, debt is favoured over equity through taxation. It seems to me that there is some inconsistency here. Towards a type of “Fiscal Union” Imperfect labour mobility as well as price and wage rigidities within the euro area do not fulfil the conditions of an optimal currency area. Against this background, Heads of Governments established facilities aimed at increasing economic and social convergence via (limited) fiscal transfers. Some progress has also been made in the field of tax harmonisation and tax transparency; other initiatives are under preparation. Absent the determination among policy makers to share sovereignty in the fiscal domain, the economic and fiscal governance of EMU aimed to foster a high degree of coordination between national economic policies. Notwithstanding the various efforts undertaken since the financial crisis, over the long-term, economic and fiscal governance in the euro area could benefit from being strengthened more fundamentally. The Five Presidents’ Report, for instance, concludes that “all mature Monetary Unions have put in place a common macroeconomic stabilisation function to better deal with shocks that cannot be managed at the national level alone”. This Report provides a comprehensive study of the key elements of such a potential common macroeconomic stabilisation function for the euro area, including – among others – a (sufficiently large) central fiscal capacity, an EMU Treasury, the issuance of bonds guaranteed by all euro area Member States and a system of transfers (with gradually increasing coverage) conditional on fiscal discipline and reform processes owned by the beneficiaries. Such a move towards a type of “fiscal union” would certainly raise complex economic and legal questions and would have far-reaching implications. Accordingly, the exact design of an effective fiscal stabilisation mechanism for the euro area will and should continue to be the subject of extensive, yet inspiring, analysis and of constructive discussions. Such a reform process requires the acceptance of citizens and must be appropriated by national actors. Reforms without citizens’ acceptance and without ownership cannot succeed. Participatory processes and good communication are key. It would also be an illusion to think that more solidarity, notably through more transfers, could be agreed upon without strengthened institutionalized discipline, inter alia in the fiscal field, as well as without any additional structural reforms.12 I elaborated on the latter point in my opening remarks at the October 2015 Eurofi conference in Luxembourg. BIS central bankers’ speeches Conclusion Ladies and Gentlemen, Let me conclude. From the day the six founding members of the ECSC decided to establish a common market for coal and steel to the day eleven countries adopted a single currency, nearly 50 years went by. Starting with selective sectoral integration, Europe gradually moved to an economic and monetary integration, a truly inspiring achievement. Meanwhile, the euro has become the currency of almost 340 million people residing in 19 European countries. Concerning the adoption by Poland of the euro, the future will tell us when Poland will join the euro area. Let me only add on a very personal note that when that happens, I will not be discontent. The global financial crisis has shown the imperative need to bring EMU to the next level by making it more resilient, more integrated and more inclusive. The crisis revealed the inherent weaknesses of EU’s economic governance, both in terms of crisis prevention and crisis management, and significantly accelerated the necessary reform process. Ladies and Gentlemen, the European institutional architecture will need to be enhanced further. My conviction is that Europe needs more, not less, integration, more, not less, solidarity and more, not less, mutually shared discipline. We should always keep in mind that the European project emanated after World War II. It is a project of trust and peace, and peace should never be taken for granted, as exemplified by recurrent geopolitical turbulences, including close to our borders, and resurgent nationalism. However, enhanced solidarity and sharing of sovereignty will only be possible if Member States that decided to become part of a community of shared destiny show rigor and abide by the rules they established and will have to establish in the future. The current dramatic refugee and immigrant crisis, which is also a humanitarian one, furthermore highlights the need not only for short term coordination action but also the need for a longer term institutional response. Thank you for your attention. BIS central bankers’ speeches Annexe The recent financial crisis unfolded in three main episodes: 1. Increased delinquency and foreclosure rates for US sub-prime mortgages in the second half of 2007 led to acute pressures and elevated volatility in short-term funding markets. The Eurosystem swiftly reacted by conducting supplementary longer-term refinancing operations, taking joint action with the Federal Reserve by offering US dollar funding to Eurosystem counterparties and by “frontloading” the liquidity provision to the banking sector within reserve maintenance periods. 2. Following the collapse of the US financial institution Lehman Brothers in midSeptember 2008 financial tensions intensified considerably across all money market segments and maturities and increasingly spread to the real economy throughout the world. In a coordinated move, the ECB and six other major central banks announced reductions in their policy interest rates in October 2008.13 In addition, with a view to ensure the continued ability of banks to refinance themselves and to support credit flows above and beyond what could be achieved through reductions in key interest rates, the Eurosystem took further liquidity management measures. The measures were tailored to the financial structure of the euro area economy and the specific circumstances of the crisis. They focused on a significantly increased liquidity provision to euro area banks as they are the primary source of financing for the real economy in the euro area. In particular, a fixed rate tender procedure with full allotment was adopted for main refinancing operations and longer-term refinancing operations. In addition, the Eurosystem conducted supplementary longer-term refinancing operations (maturities of six months and 1 year) with a view to enhance the provision of longer-term refinancing and temporarily widened the set of eligible collateral accepted in refinancing operations. As part of its “enhanced credit support”, in 2009, the Eurosystem also launched a programme of outright purchases, for an amount of €60 billion, in the covered bond market, a very important market in Europe and a primary source of financing for banks. 3. As a result of these enhanced credit support measures – in combination with the Governing Council’s considerable reduction in key policy rates14 – banks generally continued to have broad access to euro liquidity and money market interest rates declined significantly. With financial market conditions having improved in the course of 2009 and early 2010, the Governing Council gradually scaled back some of the non-standard measures while continuing to provide liquidity support to the banking system at very favourable conditions with a view to facilitate the provision of credit. 4. Another episode of the crisis started to unfold in May 2010 when market concerns about the sustainability of public finances in some euro area countries grew in view of rapidly rising government debt-to-GDP ratios and increasing contingent liabilities. Bond markets in these euro area countries became severely dysfunctional. Given the importance of government bond markets for the transmission of monetary policy, there was a risk of serious impairments in the On October 8, 2008, the Governing Council decided to lower all three policy interest rates by 50 basis points (minimum bid rate on the main refinancing operations lowered to 3.75%; interest rate on the deposit facility rate lowered to 2.75%; interest rate on the marginal lending facility lowered to 4.75%). In the context of subdued inflationary pressures and a severe downturn in the euro area economy, between October 2008 and May 2009, the Governing Council lowered the main refinancing rate from 4.25% to 1%. BIS central bankers’ speeches ability of banks to provide credit to the real economy. Against this background, in May 2010, the Governing Council launched the Securities Markets Programme (SMP)15 with the aim to ensure depth and liquidity in dysfunctional market segments and to safeguard the proper functioning of the monetary policy transmission mechanism. Since the aim of the programme was not to inject additional liquidity into the banking system, until June 2014, SMP interventions were fully sterilised. 5. Having temporarily improved after the announcement of the SMP (and following the commitments taken by some euro area governments to ensure the sustainability of public finances), conditions in several financial market segments in the euro area deteriorated significantly in the second half of 2011. The Governing Council swiftly took bold measures encompassing two longer term refinancing operations (with a maturity of up to 3 years), US dollar liquidity providing operations and liquidity swap operations (coordinated action with other central banks). The two 3-year longer-term refinancing operations announced conducted in December 2011 and February 2012 led to a considerable increase in excess liquidity, thereby contributing to a significant easing of financing strains. In addition, the Governing Council announced a new covered bond purchase programme, for an intended nominal amount of €40 billion (November 2011), co-announced coordinated central bank action to enhance the capacity to provide liquidity support to the global financial system (November 2011) and introduced comprehensive measures to increase collateral availability (December 2011). 6. The sovereign debt crisis continued to have an adverse impact on economic confidence and financing conditions in 2012, also reflecting a perceived lack of determination of governments to tackle the root causes. In mid-2012, funding stress in the banking sector was aggravated by a severe malfunctioning in some euro area sovereign bond markets, partly related to unfounded fears of reversibility of the euro. Very high risk premia in some government bonds and financial fragmentation hindered the effective working of monetary policy. With a view to safeguard monetary policy transmission, the singleness of monetary policy and integrity of the euro area, in August/September 2012, the Governing Council announced the concept of outright monetary transactions in secondary sovereign bond markets in accordance with the monetary policy mandate (“OMTs”). OMTs are subject to strict effective conditionality attached to an appropriate EFSF/ESM programme as a necessary condition. While OMTs are not subject to ex-ante quantitative limits, liquidity injected through OMTs will be fully sterilised. While OMTs have not been activated to date, their mere announcement contributed to addressing risk premia related to self-fulfilling expectations of highly disruptive scenarios. While OMTs themselves cannot remove the root causes of severe impairments, strict effective conditionality ensures that root causes are tackled (a mechanism much stronger than in the case of the SMP which was terminated in September 2012). 7. While financial fragmentation moderated in 2013, inflationary pressures receded. The annual rate of inflation declined from 2.7%/2.5% in 2011/2012 to 1.3% in 2013, on average. With a view to ensure price stability in the context of low underlying price pressures and to foster the economic recovery, the Governing Council lowered policy rates further (from 1.5% in July 2011 to 0.25% in November 2013). In the first half of 2013, also reflecting spillovers from developments outside the euro area, both the level and the volatility of euro money market interest rates increased, thereby reducing the monetary accommodation introduced by the Governing In addition, the Governing Council reintroduced some of the non-standard measures phased out earlier (e.g. reactivation of temporary liquidity swap lines with the Federal Reserve System and a new six-month refinancing operation). BIS central bankers’ speeches Council. In order to anchor market expectations of future policy rates more firmly around a path warranted by its assessment of the outlook for price stability over the medium term, in July 2013, the Governing Council decided to provide forward guidance. The Governing Council stated that it expected the key ECB interest rates to remain at their prevailing or lower levels for an extended period of time. Importantly, despite the severe tensions during the financial and sovereign debt crisis and the observed volatility in economic activity and headline inflation, inflation expectations remained firmly anchored at levels consistent with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term. BIS central bankers’ speeches
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Statement by Mrs Linah K Mohohlo, Governor of the Bank of Botswana, Gaborone, 25 February 2003.
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Linah K Mohohlo: 2003 Monetary Policy Statement Statement by Mrs Linah K Mohohlo, Governor of the Bank of Botswana, Gaborone, 25 February 2003. * * * Introduction I am privileged and honoured to welcome you to this important event in the calendar of the Bank - the presentation of the Monetary Policy Statement for 2003. Let me begin by refreshing memories on the objective and content of the Monetary Policy Statement, which the Bank of Botswana issues every year. The Statement serves several purposes. First, it provides an opportunity for the Bank to report on inflation and monetary policy developments in the previous year, and to present its assessment of the outlook for inflation in the current year. Second, it enables the Bank to outline policy issues and the approach that will be taken in formulating its policy stance in response to inflation-related developments throughout the year. Third, the Monetary Policy Statement contains, certainly since last year, the Bank’s annual objectives for inflation and credit growth, and an explanation of how these are derived. The Statement, therefore, plays an important role in conveying to stakeholders and the public at large a range of information relating to one of the Bank’s core functions - the formulation and implementation of monetary policy. While the transparency entailed in the presentation of the Monetary Policy Statement is important in its own right, it is also important in influencing economic and financial expectations, as well as the behaviour of economic agents. The Bank’s aim is to engender a public expectation of sustainable low inflation consistent with the broad objective of macroeconomic balance as a basis for sustainable growth. In addition, the Statement serves as a vehicle for enhancing the accountability of the Bank to its stakeholders. In my remarks this evening, I will present only the main highlights of the full text of the 2003 Monetary Policy Statement. It is important, therefore, that you take the time to read the full text of the Statement, so you can obtain a more detailed analysis of monetary policy developments. I will briefly review the behaviour of inflation in 2002 and its underlying causes, before assessing the extent to which monetary policy succeeded in achieving its objectives in 2002. I will then outline the Bank’s view of prospective economic and financial developments in 2003 and, on the basis of that assessment, the policy outlook for the current year. The Bank’s Monetary Policy Framework and Objectives I believe you are aware that the principal objective of monetary policy in Botswana, as it is for most central banks around the world, is to control inflation; in particular, it is to ensure that inflation is predictable and maintained at low levels. By carrying out this responsibility of controlling inflation, the Bank contributes, along with other Government policies, to the ultimate objective of promoting a stable macroeconomic environment. This supports rising incomes and living standards for Batswana, along with other national objectives, especially economic diversification which, in turn, depends on export competitiveness. You will agree that export competitiveness cannot be achieved unless Botswana’s inflation is low and comparable to the average of trading partner countries, such as South Africa, the United Kingdom, the United States of America and mainland Europe. This requirement is the basis for determining the desired range of inflation. The framework within which policy is determined identifies the key relationships of the inflationary process. It is a well-known fact that excessive expenditure in relation to available goods and services in any given period pushes up prices - this is the concept referred to as demand-pull inflation. It is also well known that much expenditure, especially by the private sector, is financed through borrowing from the banking system. Hence the Bank determines the growth rate in bank credit that would be consistent with a low and sustainable level of inflation. The framework also identifies the tool used in controlling inflation, and as is the case with most central banks, the tool used by the Bank is interest rates. Obviously in deploying the interest rate instrument, the Bank strikes a careful balance between the need to discourage excess credit growth, and the need to encourage productive investment as well as financial savings. In formulating the monetary policy stance, the Bank closely examines the factors that influence inflation. This analysis is necessary because the Bank is only equipped to deal with changes in inflation which are primarily due to domestic demand pressures. Furthermore, such pressures tend to have persistent, rather than erratic effects, such as those that may be due to transitory developments or supply fluctuations. That is why, in addition to the headline inflation data published by the Central Statistics Office, the Bank examines the underlying inflation trend, or core inflation. This is a measure of inflation which excludes the impact of factors which are transient in nature; it also excludes exceptional changes in administered prices and/or indirect taxes, and is a more precise measure of price developments in any economy. The Bank recognises the need, however, to respond to any impact that the transitory developments may have on underlying inflation, particularly their effect on inflation expectations and second-round influences on price changes. In a market-based economy such as Botswana’s, monetary policy influences inflation indirectly through its effect on interest rate changes, which then influence credit as a key means of financing expenditure on both consumption and investment. The effectiveness of interest rates in controlling credit is monitored closely. The Bank also recognises that the rate of growth of government spending is an important component of domestic demand, since the Government allocates large amounts of funds to finance public consumption and investment. The fact that the Government plays a large role in the economy underscores the need for complementarity between fiscal and monetary policies in achieving the inflation objective. This is the policy framework that provides a backdrop to the Bank’s assessment of the economic and financial environment over the past year, in which inflation or price developments took place. Developments in Inflation in 2002 As you will no doubt recall, the Monetary Policy Statement for 2002 set an inflation objective range of 4 - 6 percent. In setting this objective, the Bank was aware that headline inflation would be influenced by a number of transitory factors, especially the introduction of the 10 percent Value Added Tax (VAT) in July 2002. Before the introduction of VAT, annual headline inflation stabilised at around 6 percent during most of the first half of 2002. However, following the introduction of VAT, and as you will recall, inflation started rising, and increased from 5.9 percent in June 2002 to just over 11 percent by the end of the year. The Bank had anticipated a temporary increase in headline inflation arising from the introduction of VAT, of between 4 percent and 6 percent over and above underlying inflation. This prospect was conveyed in a press release in June 2002. It was pointed out, at the time, that the VAT-related price increases would be a one-off temporary adjustment and that, in the absence of any significant second-round price effects, due for instance to compensatory wage increases, the impact of VAT would not result in a sustained rise in inflation. In the event, and in line with the Bank’s expectations, the effect of VAT was that the month-on-month rate of change in prices rose from an average of 0.5 percent over the twelve months to June 2002, to 3.2 percent a month later in July 2002. Thereafter, the monthly rate of price increases progressively slowed down to reach 0.4 percent in October. The monthly price increase was then higher in November, primarily due to technical adjustments to some components of the Consumer Price Index (CPI) basket, particularly the adoption of a new billing system by the Botswana Telecommunications Corporation. Although overall inflation increased sharply in the second half of the year, an analysis of the inflation trend that discounts the impact of VAT and other technical adjustments to data suggests that underlying inflation was around 6 - 7 percent for 2002, which was a little above the upper end of the Bank’s policy objective for that year. A closer look at the sources of inflation in 2002 provides further support to the conclusion that, while headline inflation was influenced by VAT and other price adjustments, the underlying rate was mostly contained. Prices of almost all categories of commodities rose at a higher rate in 2002 compared to 2001 as had been expected, given the wide-ranging impact of VAT. Food prices, however, rose at a much faster rate than the average, due in part to drought conditions in the region. Food price inflation rose from approximately 4 percent in December 2001 to over 14 percent by the end of 2002. This accounted for almost half of the rise in overall inflation during the year, and reinforces the view that, after taking account of the impact of VAT and other exceptional factors, such as volatile food prices, underlying inflation was largely contained during 2002. The relatively moderate rise in underlying inflation was to some extent supported by a fairly benign inflationary environment in the world’s major economies. Although all major economies experienced moderately higher inflation, mainly as a result of rising energy prices, especially oil, average inflation rose by less than 1 percentage point, from 1.2 percent in 2001 to 2 percent in 2002. The inflation trend in South Africa was somewhat different; price increases were sharp, mostly due to the effects of the depreciation of the rand that had occurred towards the end of 2001. Inflation in South Africa was also affected by increases in food prices and labour costs. Core inflation in South Africa was 12.2 percent in December 2002 compared to 5.8 percent at the end of 2001. The combined effect of all these developments was that average inflation of Botswana’s trading partners rose from 4.2 percent at the end of 2001 to 8.4 percent at the end of 2002, and was reflected in a rise in the cost of imports. In this connection, it should be pointed out that Botswana’s inflation briefly fell below that of trading partner countries in the middle of the year, although it was subsequently higher due to the impact of VAT. In light of the moderate upward trend in underlying inflation, the Bank continued to restrain the growth rate of commercial bank credit to the private sector. After an adjustment to take account of the extension and subsequent early repayment of loans by certain large borrowers, using offshore funds, credit rose by 21.4 percent over the year, compared to 18.1 percent in 2001. This growth rate was well above the Bank’s target range of 12.5 - 14.5 percent, which had been judged to be consistent with the economy’s underlying growth potential and the inflation objective. Moreover, the high rate of growth of Government spending, estimated at 18 percent during 2002, albeit below the 20 percent growth rate recorded in 2001, also continued to exert pressure on inflation, thereby placing a heavier burden on monetary policy. The expansionary fiscal policy implied an undesirable imbalance between fiscal and monetary policies in dealing with inflation. Monetary Policy Implementation During 2002 In light of the high growth rate of credit and the need to contain inflationary expectations following the introduction of VAT, the Bank tightened monetary policy towards the end of the year by raising interest rates by a total of 1 percent in October and November 2002 - half a percent at each time. Consistent with past practice, the two changes in interest rates were immediately followed by press releases, which emphasised that the increase in interest rates was not a response to the rise in inflation resulting from the introduction of VAT, because the Bank considers the VAT-induced impact on inflation as a transitory event, which did not directly justify a monetary policy response. The Bank’s focus was on the impact that VAT may have on inflationary expectations. Hence it was important to forestall the development of expectations of higher inflation by pointing out the dangers of accommodating second-round effects of VAT-related price increases and advising against possible compensatory wage increases. Higher interest rates were, therefore, aimed partly at ensuring that such expectations do not develop. This was done in order to demonstrate the Bank’s commitment to containing inflation arising from any temporary VAT-related price increases, and in order that expectations of rising prices do not become entrenched. There was also a need for a tighter monetary policy given that credit growth was still higher than desired. The effect of the exchange rate on inflation was benign during 2002. While the Pula appreciated in nominal terms against major international currencies, it depreciated by 8 percent against the rand, resulting in an overall stable nominal effective exchange rate of the Pula. However, as inflation was higher in Botswana than in trading partner countries, largely due to the impact of VAT, the real effective exchange rate of the Pula appreciated by 2.6 percent in the year to December 2002; and to that extent, Botswana’s trade competitiveness was eroded. The Outlook for Inflation in 2003 The performance of the global economy is expected to improve further in the course of 2003, with world output currently forecast to grow by 2.5 percent, up from an estimated 1.7 percent for 2002. Despite the forecast improvement in growth, inflation is expected to remain low and stable since the growth in world output will still be below trend. There is, however, considerable uncertainty with respect to oil prices due to the situation in the Middle East and Venezuela, as well as an imminent war in Iraq. Nevertheless, as inflation continues to be largely under control, it is anticipated that major world economies will maintain stimulative monetary policy which, in some instances, will be supported by expansionary fiscal policy. Inflation in South Africa, which is the most important external influence on inflation in Botswana, rose sharply during 2002. It is, however, expected to slow down in 2003, reflecting the recent strengthening of the rand, the tight monetary policy stance and supportive fiscal policy. Despite these favourable developments, it is unlikely that South Africa’s inflation target of 3 - 6 percent will be met during 2003. Forecasts of core inflation in South Africa for the year put it at between 7 percent and 8 percent, from just over 12 percent in 2002. For the other key trading partners, inflation is expected to remain around its current rate of 2 percent. Therefore, if the nominal effective exchange rate of the Pula is unchanged, Botswana’s imported inflation is likely to be lower in 2003 than it was last year. Demand in Botswana, as reflected by the growth in commercial bank credit and government expenditure, was still undesirably high by the end of 2002. However, it is expected that the increase in interest rates in the last quarter of 2002 will, in due course, moderate the growth in bank lending. Furthermore, the recently released 2003/04 Government Budget indicates that expenditure will grow at a much slower rate of around 4 percent. This laudable fiscal restraint, together with the expected reduction in credit growth, should help to moderate inflationary pressures. The Government’s decision not to award a public sector pay rise in 2003 should contribute further towards restraining demand pressures. It is hoped that this favourable scenario will not be undermined by the findings of the ongoing Salary Structure Review Commission. Be that as it may, prospects for 2003 are generally of a better balance between monetary and fiscal policies, and this augurs well for a sustainable lower inflation in 2003. Against this background, it is the Bank’s view that inflation in the first half of 2003 will be around the present level of 10 to 12 percent, before falling by the middle of the year and during the remaining months of 2003. This projection is based on the fact that most of the year-on-year effect of VAT on the Consumer Price Index will drop out after July 2003. The outlook is also predicated on the success of monetary policy in restraining credit growth, and the fact that government spending will indeed slow down. It is also expected that there will be no further undue external inflationary pressures generated by further large increases in prices of food and/or oil, or import prices more generally. Bank’s Monetary Policy Stance in 2003 As highIighted earlier, the Bank seeks to achieve a rate of inflation that, at a minimum, will maintain relative stability in the real exchange rate and avoid the need for a devaluation of the Pula. The annual inflation objective is based on an assessment of forecast inflation for trading partner countries. Although the forecast for Botswana’s trading partners’ inflation for 2003 is slightly higher than the initial forecasts for 2002, which were used in the calculations of last year’s inflation objective, there are strong reasons for maintaining the inflation objective range of 4 - 6 percent for 2003. First, by reducing Botswana’s inflation to below the forecast average of trading partner countries, the range of 4 - 6 percent will provide an opportunity to regain some of the competitiveness lost last year as a result of a relatively higher level of inflation in Botswana. Second, underlying inflation remains close to the upper end of this inflation objective, which means that the 4 - 6 percent range remains both a desirable and feasible objective for 2003. Third, there remain concerns about the risks of further VAT-induced increases in inflationary expectations. Hence it is important for the Bank to promote expectations of a sustainable low inflation. The range for the growth rate of private credit that is considered to be compatible with achieving this inflation outcome is 12 - 14 percent. As in the past, this range is calculated from the expected annual capacity for growth of the non-mining sector of the economy, as contained in the ninth National Development Plan (NDP 9); it is also based on the desired level of inflation for the year, with an allowance for the process of financial deepening as the economy develops. Conclusion I wish to conclude by underscoring the main message of this year’s Monetary Policy Statement - that inflation should continue to be restrained during 2003. This effort will be supported by an expected favourable external and domestic developments, although there are uncertainties about the price of oil. In major industrial countries, output growth is expected to improve, while inflation is forecast to remain under control. Except for the threat of a possible oil price increase and the lagged impact of last year’s inflation increase in South Africa, there is minimal risk of external pressures on inflation. Here at home, it is anticipated that credit demand will slow down in response to the increase in interest rates in late 2002; this should ease demand pressures and curtail higher inflationary expectations. Moreover, fiscal restraint, as underscored by the much reduced growth rate of government spending for the ensuing fiscal year, is expected to contribute towards reducing inflationary pressures this year. In light of these prospects, the task for monetary policy in 2003 will be to ensure that underlying inflation does not increase; the objective is also to reverse the upward trend in overall inflation that was experienced in 2002 to a downward path of the Bank’s desired range of 4 - 6 percent by the end of this year. While the Bank will continue to respond appropriately to monetary and inflation developments, the fiscal restraint that characterises the 2003/04 government budget should contribute to a balanced sharing of the burden of containing inflation as between monetary and fiscal policies during 2003. I thank you for having joined us this evening and for your kind attention. Thank you Director of Ceremonies.
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Speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, to the Nigerian Economic Summit Group, Lagos, 22 March 2004.
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Linah K Mohohlo: The role of the central bank in economic transformation sharing experiences Speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, to the Nigerian Economic Summit Group, Lagos, 22 March 2004. * * * I am most grateful to you, Mr Chairman, and through you, the Nigerian Economic Summit Group, for inviting me to join you on this important occasion. This event and other similar activities hosted by many countries in our continent, provide meaning and substance to the objectives of the African Union. This gathering is consistent with the many contributions that the people of this country have made towards the realisation of the African Union and all that it entails. Of particular significance to me is that this event has been put together in collaboration with the Nigerian Women in Business. I have no doubt that this is as it should be, particularly during this month when the “United Nations Women’s Week” has been celebrated. In Botswana, we have followed with admiration the strides made by women in Nigeria. The initiatives and achievements of the women of Nigeria are examples of what is possible in, not only achieving equality and fundamental human rights for more than half a country’s citizens, but in advancing the economic well-being of the populace as well. Removing the many social, political and cultural barriers to the full participation of women in any economy, at all levels, will go a long way towards ensuring the success of efforts as we bring about the much needed transformation, be it social, political or economic. What is an undeniable fact is that whatever barriers there are to women’s advancement, they will not remove themselves. Women must take the initiative and avoid being tentative in their approach and apologetic in their demands. A good number of women in Nigeria, as in other parts of the world, have the requisite credentials to unlock the doors to responsible positions in all areas and sectors of the economy. You have a shining example, right here in Nigeria, in the Minister of Finance, the Honourable Okonjo Iweala, whose steadfast determination and exemplary efficiency in discharging the responsibilities of her Ministry are already evident. I want to believe that the authorities do not have to look too far for leadership at the apex of the banking field as well. This brings me to the main theme - “The Role of the Central Bank in Economic Transformation”. You will agree, Mr Chairman, that the degree to which a central bank can effectively assist in the economic transformation of any developing country depends not only on its degree of professional competence with which it carries out its mandate, but also on the environment in which it operates. It is this latter point that marks the contours of my remarks on the theme; it is the same point that anchors the success of Botswana’s socio-economic progress since Independence, which in large part enabled the Bank of Botswana to play a constructive role in the economic transformation of the country over the years, and continues to do so to this day. The rest of my remarks will be organised to provide a brief background on Botswana’s economic development, especially its transformation from a poor rural economy to a fast growing mineral-led economy. This brief survey will serve as a backdrop to the contribution of the Bank of Botswana towards realising the country’s full potential in achieving sustainable economic growth and development. As many of you know, Botswana is a landlocked country situated in the centre of Southern Africa, covering an area more or less the size of Kenya. Most of the country is not suitable for crop farming as it is semi-desert, with cattle rearing generally the only viable form of farming. Diamonds were discovered in 1967, soon after Independence (1966) and, currently, Botswana is the world’s largest producer of diamonds in value terms. The mining sector contributes approximately one third to GDP and accounts for about 80 percent of exports. The revenue from diamonds and the Government’s prudent fiscal policies have generally resulted in budget surpluses and a sizeable level of foreign exchange reserves, currently equivalent to 24 months’ import cover of goods, services and factor payments. Despite the dominance of the diamond sector, other sectors of the economy, including tourism and financial services, have grown in importance over the years.1 Several indicators suggest that the development process pursued by Botswana has been very successful. For instance, per capita income grew at an average annual rate of 8.4 percent between 1966 and 1990. Despite a slowdown in the 1990s, Botswana has registered annual GDP growth rates which few other countries have matched, particularly in the past 20 years. As a result of the good economic performance, the country has graduated from being very poor at Independence to one of the relatively rich in the region, and has achieved middle-income status. Diamond revenues have helped the Government to generate savings, hence there is no need for government borrowing. This has two implications for the business environment. First, the lack of government borrowing means that the private sector is not “crowded out” for investment resources. Second, the usually buoyant revenues have enabled the Government to reduce taxes to very low rates. Notwithstanding these achievements, problems remain. The level of poverty is at an unacceptable level, too many of our people remain unemployed, and the HIV/AIDS pandemic is raising many new social and economic problems. Fortunately, the outside world has recognised Botswana’s efforts in economic development, and this has resulted in the country acquiring an international reputation for good governance, transparency and negligible corruption. Consequently, Botswana has attained and maintained the highest sovereign credit rating in Africa, awarded by both Moody’s Investors Service and Standard and Poors.2 The rating compares favourably with several middle-income countries elsewhere in the world. The country has also scored highly in the Global Competitiveness Report for the period 2003-20043, and Transparency International has recently ranked Botswana 30 out of 133 countries in its Corruption Perception Index.4 All of these scores are the highest among surveyed African countries and are higher than those of several European countries. Those of you who are familiar with the credit rating procedures are aware that they are based on a wide cross section of the institutional, political, social and policy characteristics of the country being rated and, therefore, the process of assessment is very intrusive. I hasten to add that the central bank played a pivotal role in facilitating the rating exercise. Botswana’s experience provides considerable lessons for the process of economic transformation, given that the country has successfully completed one transformation and is in the process of another. The first transformation involved managing the impact of mineral exploitation on a poor subsistence agricultural economy. The second involves managing the transition from a rapidly growing, mineral-led economy to one which is more diversified and broadly based. Let me comment on these two transformation experiences, and draw some lessons that may be useful for other countries and will no doubt be of interest to this gathering. When diamonds were discovered in Botswana, the country had little in the way of human or physical resources. In deciding how the newly-discovered mineral resource was to be managed, the Government focused on a few principles that, with hindsight, have proved to be extremely important. These principles included securing a fair deal for the nation in terms of the income generated from mineral exploitation; ensuring the efficient exploitation of minerals and not overstretching the nation’s limited resources; and sharing the revenue from minerals nationwide and not concentrating the benefits in particular areas. Interestingly, the diamond mines were never nationalised and were left to be run by a private sector company that was, and continues to be, in partnership with the Government in the project. The Government’s main concern was deciding how to best use the revenues generated by diamond exports. In doing so, it was guided by the desire to improve living standards as equitably as possible. Most of the mineral revenues were invested in physical and human infrastructure, such as roads, water supplies, telecommunications, education and health facilities. By and large, the Government avoided spending mineral revenues on what could be considered wasteful grandiose projects. Perhaps most importantly, the Government acknowledged the need to save some of the revenues and accumulate financial assets in the form of foreign exchange reserves. With these reserves, and National Development Plan 9, 2003-2009, Republic of Botswana, Gaborone. www.moodys.com and www.standardandpoors.com, respectively. World Economic Forum, Geneva, October 2003. See www.transparency.org/cpi/cpi2003. generally prudent budgeting, Botswana has been able to avoid the volatility and disruption that typically afflicts mineral producers who are vulnerable to fluctuations in mineral prices, output and revenues. The result has been rapid economic growth, generally rising per capita incomes and, at least until HIV/AIDS came along, there were major improvements in “quality of life” indicators such as life expectancy and literacy. Although some development experts attribute Botswana’s relative success to the exploitation of diamond deposits, this is only part of the story. Natural resources, no matter how endowed and lucrative, cannot, on their own, develop a country. What is important is the quality of economic policy making, and it is in this sphere that Botswana is distinguished from many other developing countries, certainly not the good fortune of having diamonds. There are several dimensions to what I have just referred to as the “quality of economic policy making”. The first key element is complementarity so far as fiscal, monetary and exchange rate policies are concerned. The second is policy consistency and achieving stability in the policy environment, given their particular importance to both domestic and foreign investors. The third element is coherence and creation of synergies in policy implementation. It is in this policy environment that the Bank of Botswana has contributed to the development of the country. While the challenges are different, I believe that the same principles of stable, consistent and transparent macroeconomic policies, derived through a transparent process of consultation, analysis and discussion, with a leadership that is honest and unselfish, should help the second transformation to be completed as relatively successfully as the first. Mr Chairman, with this background, it is now time that I focus on the central point of my remarks - that is, the role of the central bank, in this case the Bank of Botswana, in the achievement of Botswana’s economic transformation. The Bank’s contribution to the policy environment, and the role it plays in achieving the broader national goals, is spelled out in the mandate given to it by Parliament.5 In general terms, it is a supportive role, as it is for almost all central banks in the world. Specifically, the Bank has, as its primary responsibility, to promote, and when achieved, to maintain monetary and financial stability. While the Bank has many tasks to perform, such as, to issue the national currency, to assist the development and functioning of an efficient payments mechanism, to implement the Government’s exchange rate policy, to manage the country’s foreign exchange reserves, and to provide advice and banking services to the Government, all of which are important in themselves, what is of paramount importance is the achievement of monetary and financial stability goals. This is a supportive role because none of these objectives are ends in themselves; the Bank pursues them as means towards the greater end of sustainable national economic growth and development. As I noted earlier, one of the most important elements of a successful economy is a stable macroeconomic environment, which can only be achieved by pursuing sound and consistent economic policies. It is not something the Bank can do alone; every organ of the economy has a role to play. The Bank’s part is to foster monetary and financial conditions that are conducive to an orderly, balanced and sustained development or - in the language of this event - to engage in the transformation of the economy through the combined efforts of government, private individuals and businesses, both domestic and foreign. Little of what I have alluded to should be new to this well-informed group. Not only are these underlying principles and objectives of a central bank embodied in the NEPAD initiative, it is also a message I believe you will have heard many times from your own central bank, under the able leadership of my counterpart and friend, Governor Sanusi, and most likely from every other central bank Governor who takes the time to discuss these issues in public - which these days seems to be a regular and frequent occurrence. You will agree that it is far better to hear from central bank Governors periodically, if not frequently, on these important issues rather than have the uncertainty that comes from a lack of information on what central banks do and why they do it. It is with this thought in mind that I want to share with you how we go about these specific central bank tasks at the Bank of Botswana. Monetary stability in Botswana is pursued through a monetary policy that aims to achieve a sustainable low and predictable level of inflation. Precisely how low it should be is a subject of ongoing Bank of Botswana Act, 1996. debate, not only in Botswana but elsewhere where monetary or price stability has been recognised and accepted as the primary goal of monetary policy. Experience has taught us that high and volatile inflation works against the efficient allocation of scarce resources by creating an environment that inhibits businesses and consumers from making sound investment and saving decisions, and sustainable growth is impossible without productive investment supported by adequate long term savings. In pursuing its inflation objective, the Bank of Botswana is mindful of this fact, by setting domestic interest rates high enough to provide a positive return to savers but not so high that they discourage private sector investment. The Bank’s monetary policy must also be mindful of the international dimension in which it operates. As I pointed out earlier, Botswana is a small open economy and, like all such economies, the country is dependent on trade and foreign investment to complement its own efforts to grow and prosper. This means that there is a need to remain and, where possible, to improve Botswana’s international competitiveness, but also, in Botswana’s case, to diversify the economy away from its current dependence on relatively few products, especially diamonds, as the principal source of growth. Many different policies, focusing for the most part on trade and investment, contribute to these efforts. The Bank for its part contributes by pursuing a monetary policy that, in the short run, seeks a rate of inflation that is no higher than the average of its major trading partners which, if successful, implies a relatively stable real effective exchange rate, given that Botswana has pegged the nominal exchange rate of its currency, the Pula, to a basket of currencies comprising the South African rand and the IMF’s Special Drawing Right (SDR). In the longer run, however, real and durable international competitiveness and export diversification must ultimately come from improvements in productivity. The Bank’s focus on bringing inflation down to low and sustainable levels reflects both this fundamental national objective as well as its own statutory objective of achieving and maintaining monetary stability.6 The second main responsibility of the Bank is to promote and maintain financial stability through the regulation and supervision of domestic banks, by assisting in the development and operation of an efficient payments mechanism, and by maintaining confidence in the currency. These functions constitute the bulk of the Bank’s activities, and they involve the licensing of commercial banks and other deposit-taking institutions, continuous monitoring of their solvency and liquidity, daily processing of cheques and other means of payment used in the hundreds of thousands of financial transactions that occur each day, and designing, printing and minting as well as distributing good quality bank notes and coin to the public.7 It is important to point out that the overall credibility of the Bank, and hence its effectiveness in achieving its fundamental objectives, is critically dependent on how well it performs these operational tasks. Competent and well-trained staff, high standards of efficiency and accuracy, up-to-date equipment and facilities, are required and must have the full attention of management to ensure that they are the best available for the job to be performed. Experience has shown that financial stability and monetary stability are inextricably linked. This means that regulation and supervision of financial institutions will be most effective in an environment of macroeconomic stability. A consistent and sound macroeconomic policy environment, with complementary monetary, fiscal and exchange rate policies, is essential. Major inconsistencies inevitably lead to an increase in economic and financial risks, to the point where the financial system itself becomes vulnerable. At the same time, the absence of a well-functioning financial system will make the achievement of monetary stability more difficult. There is one other element of a sound and efficient financial system that must be taken into account by the Bank. It is that corporate governance for financial institutions be of the highest standards, and that specialist service providers, such as accountants, auditors and lawyers, adhere to equally high professional standards and code of business ethics. You will agree that if accounting and auditing standards are weak or perverted, effective banking regulation and supervision will be seriously compromised. That is why in addition to on-site and off-site supervision, the Bank of Botswana regularly meets commercial banks bilaterally and as a group, to ensure that good corporate governance is the order of Monetary Policy Statements 2003 and 2004, Bank of Botswana, Gaborone (see www.bankofbotswana.bw). Annual Report 2002, Bank of Botswana, Gaborone (see www.bankofbotswana.bw). the day, and that the quality of customer service is constantly improved in line with international best practice. This level of attention to high standards of corporate governance and professional conduct has meant that there has been no bank failure in Botswana. The closure of the Bank of Credit and Commerce International (BCCI) in 1991, was due to its global problems and not its domestic operations.8 Mr Chairman, earlier in my remarks, I highlighted that the success of a central bank in fulfilling its mandate depends on two factors - the environment in which it operates, and its own competence in carrying out its duties. It goes without saying that there has to be a favourable and supportive environment which should facilitate the carrying out of the mandate. After all the central bank, related institutions and agencies are a means of implementing the strategies aimed at attaining an overall shared vision or goal for the country as a whole. These institutions serve a larger national goal; hence there is need to generate synergies in their activities if the overall national objective is to be achieved. One of the synergies that crucially influences the effectiveness of a central bank’s role in macroeconomic management is its relationship with government. Of necessity, this relationship must be close. The central bank is “the government’s bank”; the government is typically the largest or only shareholder of the central bank; and central bank functions typically involve providing a range of services to government. What is important, however, is that the relationship is clearly defined; the central bank should be independent of the Government particularly with respect to the important central banking function of maintaining monetary and financial stability. Central bank independence has several dimensions. First, there must be a clear specification of objectives and allocation of unambiguous policy responsibilities. Second, there should be a prohibition on government intervention or interference in the formulation or implementation of policy decisions relating to the responsibilities allocated to the central bank. Third, there should be restrictions on government actions, such as borrowing from the central bank, that might compromise the Bank’s ability to formulate and execute policy. Fourth, there should be a prohibition on government interference in the execution of duties by officers of the Bank. It should be noted, however, that central bank independence is not absolute. Many central banks that have independence in the formulation and implementation of monetary policy are subject to objectives, such as inflation targets, that are specified by their respective governments. Furthermore, governments have a legitimate role in determining the broad components of the macroeconomic policy framework, such as the nature of monetary policy and exchange rate regimes. More generally, the need for central banks to be ultimately accountable to an elected authority such as Parliament, whether directly or indirectly, means that there has to be some element of constraint on independence. Operationally, however, it is important that central banks should have policy independence if they are to be effective in achieving their objectives. In the case of the Bank of Botswana, there is a reasonable degree of independence. The Government plays no direct role in the formulation and implementation of monetary policy, and the Bank is left to set interest rates and determine other parameters of monetary policy implementation without interference. This allows the Bank to focus squarely on its objective of achieving low and sustainable inflation. The Bank is also independent with regard to the licensing and supervision of banks. Furthermore, while the Governor, Deputy Governors and Board Members are government appointees, they cannot be removed from office by the Government, except where they are incapable of performing their duties. Public officers have to be in a minority on the Bank’s Board. In addition, there is no provision in the Bank of Botswana Act for the Minister of Finance to issue instructions of any kind to the Bank. The only direct way for the Government to intervene in the Bank’s policy decisions is through instructions issued by the President, and it is clear from the way in which this provision is framed in legislation that it is intended to be used only in exceptional circumstances. There are, however, indirect channels where the Government can influence the Bank’s decisions. The most senior official in the Ministry of Finance is an ex-officio member of the Board, and as the representative of the shareholder, he puts the Government’s views forward. And in certain areas, such as exchange rate policy, the Bank of Botswana Act specifies that the Government makes decisions and the Bank’s role is advisory.9 Banking Supervision Annual Reports, Bank of Botswana, Gaborone. Bank of Botswana Act, 1996. As you can appreciate, the Bank of Botswana enjoys a relatively high degree of independence from the Government. While there are undoubtedly areas where that independence can be strengthened, key areas of policy formulation and implementation are left to the Bank to pursue in accordance with the best professional judgment of Bank staff, and this has led to high quality policy making that has contributed to Botswana’s economic success. Partly for these reasons, major policy disagreements between the Bank and the Government are very rare. Besides its main policy responsibilities, the Bank also has a number of important statutory roles to play in providing financial services to the Government, as its financial advisor. As well as being banker to the Government, the Bank advises on any borrowing the Government may contemplate. It also carries out various ad hoc agency functions. For instance, when the Government decided to obtain a sovereign credit rating in 2001, the Bank managed the process, by selecting an advisor, hosting the rating agencies, and acting as a clearing house for data and information. More recently, the Bank handled the Government’s first domestic bond issue, and this was very successful and is making an important contribution towards the development of the domestic capital markets. I have been associated with the Bank of Botswana since its inception, and it is with pride that I am able to say it is one of the most respected institutions in Botswana; it is also an exemplar for public institutions, as appropriate. In terms of corporate governance, transparency and accountability, the Bank aspires to conduct its business in accordance with best international practice. The fact that the Bank has a high level of credibility, both domestically and internationally, is not just an achievement of which to be proud; it also makes the Bank’s policy implementation more effective, as its pronouncements are acted upon and are effective in shaping expectations. As I conclude, Mr Chairman, I wish to suggest that the success achieved by Botswana in its macroeconomic development has been shaped by a set of mutually supportive policies motivated by a common vision. The role of the Bank of Botswana in this context was to participate and contribute its part to the larger scheme of national goals. The Bank’s activities have been assisted by the mutually supportive synergies generated by the national effort at all levels. Needless to say, all the organs of any government, including the central bank, must pull together if development endeavours of bringing about appreciable socio-economic transformation are to be achieved. With these remarks, it only remains that I commend the organisers of this Economic Summit for the initiative undertaken, and to express my heartfelt appreciation for the excellent arrangements made to facilitate my presence at this occasion in such distinguished company. For me, it will remain a memorable experience. I wish you, individually and collectively as a nation, success now and in all your future endeavours. I thank you for your attention.
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Speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, at the 2007 Executive Directors' Retreat, International Monetary Fund, Washington DC, 20 June 2007.
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Linah K Mohohlo: The challenges faced by developing countries in the current global environment, and how the IMF could be reformed to meet these countries' needs Speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, at the 2007 Executive Directors’ Retreat, International Monetary Fund, Washington DC, 20 June 2007. * * * Managing Director, Mr de Rato Deputy Managing Directors, Mr Kato & Mr Portugal Distinguished Executive Directors, ladies and gentlemen, It is an honour and privilege that I am in your company this evening. Equally important, I am most grateful that I have the opportunity to share some thoughts with you on the challenges faced by developing countries in the current global environment, and on how the International Monetary Fund could be reformed to meet these countries’ needs. These subject matters are the core dimensions of your Retreat discussions and there should be consensus building emerging at the end of the Retreat. Since these are broad topics, I can only briefly highlight a few points in view of the time constraint. I should also admit that although the topics have a global perspective, it is inevitable for me to draw on my African and Botswana’s experience, where I continue to serve in a number of capacities. In sharing my views with you on these matters, I can assure you that none of my remarks are intended to be provocative. However, I am convinced that it is in the best interest of your deliberations that I express my perspective on the issues as candidly as possible. Global economic trends I consider the hallmark of my remarks to be opportune for several reasons. This is a time of almost unprecedented increase in global prosperity. World economic growth is not only rapid (estimated at 5.4 percent in 2006); it is also broad-based. In Sub-Saharan Africa, economic growth in 2006 was 5.5 percent, a trend which is forecast to continue through 2007 and 2008, and has, accordingly, given rise to optimism which borders on euphoria. In fact, some commentators (non-economists presumably) have gone as far as to describe the current situation as a “perfect calm”. While this expression or description may be more poetic than accurate, it, nevertheless, helps to draw attention to an important point, and that is, if “perfect calm” is a correct analogy for “anti-storm”, then the favourable current conditions should be regarded as exceptional, which means that they will not continue indefinitely. For this reason, the International Monetary Fund and other concerned parties cannot afford to be complacent, for to do so is to ask for trouble. To paraphrase a recent piece by Larry Summers, this is a time when a lack of fear would be cause for concern. 1 This is not the time, therefore, to argue that the international financial institutions have become obsolete. On the contrary; given what are commonly referred to as “global imbalances”, global monetary stability has become even more uncertain, a situation which calls for the Fund to safeguard global stability now and into the future. Moreover, the seemingly increased prosperity of many developing countries, although typically from very low levels, may tempt the advanced economies to drag their feet in implementing important previously promised initiatives, including the increase in aid to Africa L. Summers “A lack of fear is cause for concern”. Financial Times 27 December, 2006. by the G8 and pushing for a successful conclusion to the Doha Round of trade negotiations. Failure to fulfil these commitments energetically, and now, risks missing the opportunity afforded by the current favourable global economic conditions to sustain global prosperity. Worse still, it would undermine the very dynamic that underpins the current rapid pace of economic growth. In fact, a well known economist, Joseph Stiglitz, may have exaggerated the current global economic situation, when he described it as being close to having conditions where all countries, including the poorest, can benefit. It is my belief, however, that we are still far from achieving that desirable goal, despite the undeniable rapid speed of globalisation. Globalisation and world trade Speaking of globalisation, we are aware that, for the most part, it is driven by technological advances that have made diverse means of transport and communication increasingly cheaper. As a national of a developing country, I firmly believe that we should seek to take advantage of the many opportunities offered by globalisation rather than seek to avoid the accompanying challenges. I am convinced that the challenge is to improve levels of productivity as the key to rising living standards; this is a fundamental truth which I never tire to raise. But how can we maintain this positive approach when so many larger and more developed economies are so wary of some of the effects of globalisation? The scope for avoiding the challenges of globalisation is almost non existent. Even bilateral and regional trade agreements may not be favourable to small developing countries such as Botswana with a population of only 1.8 million, given the world trading system that is increasingly becoming complex and competitive. Globalisation also affects international financial markets, where the amounts traded are becoming larger and more diverse. You will recall that the Managing Director, Mr de Rato, underscored the point when he characterised these developments in his recent speech to the Bretton Woods Committee, as a “torrent of change” 2 . Faced with this torrent of change, the alternatives are either swimming or sinking, as drifting is not an option. Changing balance of economic power Related to the globalization process is the fact that, in recent times, the world has witnessed a change in the balance of economic power. Observers suggest that 50 years ago, 60 percent of global GDP had come from within the original G7 countries and the balance from the rest of the world; but now the situation has reversed. There is no doubt that this change is a challenge to the Bretton Woods institutions. For instance, it so happens that no advanced industrialised country has borrowed from the Fund for more than 20 years, and yet these countries tend to dominate decision-making. On the other hand, other members of the Fund expect the institution to deliver on its mandate fairly and equally to all the 185 members. It is in this context that there remains the legitimate expectation that, in time, there will be a reform of the voting system so that developing countries, a large number of which are in Africa, can be in a position to influence policy in a meaningful manner, both in the Fund and World Bank. Indeed the role of China and other countries in its league, as major economic players in the world, has made it imperative and urgent to change the quota system. Hence the decision of the Fund’s Board of Governors to increase the voting power of China, Korea, Mexico and R. de Rato, “Steering a Course Through the Torrent of Change: Principles for Reform of the International Monetary Fund”. Speech to the Bretton Woods Committee, 12 June 2007. Turkey. While this is a laudable decision, a lot more needs to be done on the Fund’s quota system and, therefore, voting power, so that it can be reflective of the member countries’ economic weight, while ensuring that the voice of low income countries can have a meaningful impact in decision-making. Quota reform While the Fund’s Medium Term Strategy has several complementary elements, the centre piece is still the issue of quota and voice reform. It was heartening to see that some progress is being made as reported in the communiqué of the International Monetary and Financial Committee (IMFC) following the 2007 Spring meetings. Nevertheless, we have only heard fine statements of principle, and hardly any reports on concrete agreements. For instance, the quota and voice reform brief on the IMF website, currently states that “Following the endorsement received in Singapore last September, IMF staff and the IMF Executive Board have looked at several of the key issues, many of which are complex and require careful deliberation and broad consultation”. This may be true, but it is hardly informative. Of course, it is true that collective action requires consensus building and a “give and take” approach in order to make progress. But for quota reform, two salient points stand out. First, a situation where we rely on the current voting system to produce reform of itself in a manner that would be acceptable to all members, inevitably requires more giving than taking by those wielding more voting power due to their economic weight. Second, the basic issues of quota reform, and the basis of their resolution, appear very straightforward to many of us. Continued delay can only risk a wider malaise. If I may quote again, a recent IMF working paper entitled “Rethinking The Governance of the International Monetary Fund” submitted that: “a major revision of the quota formulas is long overdue, and leaving this unaddressed raises serious questions regarding the IMF’s governance which could develop into a core mission risk and jeopardize the relevance of the institution” 3 . For this reason, observers have called for meaningful progress such that the quota review can be completed in time for the 2007 Annual Meetings 4 . It is encouraging that the Fund’s Managing Director has recently indicated that the Executive Board is earnestly working towards accelerating the quota review timetable. In this endeavour, it is legitimate to expect that the views of a diverse spectrum of interested parties will continue to be canvassed in order that an amicable consensus can be reached. Role of the international financial institutions I thought I should also comment on the role of the international financial institutions. Admittedly, there have been benefits derived from these institutions since the end of the Second World War. In particular, the contributions of the Fund, World Bank, World Trade Organisation and the OECD have been remarkable. It was inevitable that, over time, the Fund would change in many ways from its original role of policing a fixed exchange rate system among the major economies. In this regard, only a few weeks ago, the Independent Evaluation Office reported on Exchange Rate Surveillance for the period 1999-2005 and concluded, among others, that “the IMF was simply not as effective as it needs to be in both its analysis and advice, and its dialogue with member countries” 5 . This shows that, in this case, there is unanimity that there is need for change. A. Mirakhor & I Zaidi (2006) “Rethinking the Governance of the International Monetary Fund” IMF Working Paper WP/06/273. R. Cooper & E. Truman E. (2007) “The IMF Quota Formula: Linchpin of Fund Reform”. Independent Evaluation Office (2007), “IMF Exchange Rate Policy Advice, 1999-2005: An IEO Evaluation”. On a related matter, the Policy Support Instrument (PSI), which was introduced in October 2005, was in recognition of the fact that fewer countries need to borrow from the Fund. While it is acknowledged that one contributing factor to the reduced need for Fund lending is the extent of success of IMF programme implementation in the past, this reduced recourse to Fund resources should not lead to member countries ignoring the Fund’s reform programmes and policy advice, because doing so would be counter-productive. I hasten to add that, although not a borrower of Fund resources for programme assistance, Botswana values her long-term partnership with the Fund. There is absolutely no doubt that Fund advice has largely been beneficial; so too has technical assistance. However, in the advent of the PSI, we should ask whether it has moved far enough from the Poverty Reduction and Growth Facility (PRGF). Is there still too much prescription and not enough discussion? Is the Fund’s endorsement of policies still so important for member countries, given the increased opportunities for funding provided by financial globalisation? And what are members to do when the assessments by the Fund and World Bank differ radically? It will be interesting to see the number of countries, if any, that have so far taken advantage of the programme, now that the PSI Fact Sheet is published on the IMF website. Furthermore, the Fund needs to change its approach to surveillance and, accordingly, some important structures of the Fund, such as the IMFC, have suggested that surveillance needs to become more advisory than prescriptive. It is felt that such an approach would encourage country ownership of decisions resulting from IMF advice, and facilitate more timely publication of surveillance Reports, instead of the current protracted exchanges, in some cases, on the findings of Fund surveillance missions. This is not to suggest that there should be no scope for a more constructive dialogue, especially in areas where the difference between fact and perception is negligible. As it should be, the Managing Director espouses the view that the Fund must be trusted to give even-handed advice and fair representation to all its members. I need not emphasise that the role of the Executive Board is to ensure that this trust is earned and then maintained. Governance As I come to the end of my remarks, I would like to devote a few minutes to the related and equally important topical issue of governance, which is one of the principal themes of your Retreat. You may be interested to note that, earlier this year, the Bank of Botswana hosted a two-day workshop for SADC Central Banks on Trends in Central Bank Governance, with technical input and assistance from the Central Bank of Sweden, Bank for International Settlements and the Fund. Unsurprisingly, it was found that there is diversity in the internal governance structures and procedures required to ensure good governance of an autonomous central bank, and it was further noted that consensus is yet to emerge regarding best practice in the conduct of a central bank in its relations with various stakeholders. Diversity was due to several factors, among which are historical and socio-political characteristics of a country. Nevertheless, there were common pillars that are a basis of good governance, namely, accountability, transparency and avoidance of conflict of interests by Boards and management. Evidently, governance issues in the Fund are similar and equally challenging. It follows, therefore, that despite the diversity of the 185 member countries, the governance of the Fund must, of necessity, be based on these principles. You will agree that unless the Fund is seen to be managed according to the highest standards of good governance, which enshrine widely accepted notions of fairness and accountability in its operations and decision-making, including in staff appointments, then its relevance and objectivity will continue to be questioned. The Executive Directors themselves do, of course, strive to be above reproach on this matter, and it is important to stress that, from the member countries’ point of view, the buck of accountability stops with you, as you are effectively the guardians of this institution. Unfortunately, recent events at the World Bank are not encouraging. While almost every independent commentator saw an excellent opportunity to reform the outdated system of choosing the leadership of the two Bretton Woods institutions, it was disheartening to note that the need for the reform of this practice was apparently not even on the agenda of those entrusted with such responsibility. This suggests that the United States of America has little inclination, if at all, of giving up its “traditional right” of appointing the President of the World Bank. Similarly, Europe appears disinclined to change with respect to its historical “entitlement” to appointing its national to the leadership of the Fund. Needless to add, such “traditions" or “rights” have no place in the governance of modern institutions. The selection process must, of necessity, be based on merit, certainly not on the current primary criterion of nationality. Even the British seem to have seen the light on this important matter with respect to appointments to the House of Lords, which used to be based more on heredity. It is my sincere hope, therefore, that as you continue your deliberations tomorrow, this Retreat will explore new and innovative ways for the Board to effect appropriate changes to its governance practices, in the interest of all stakeholders. One of those changes, as many member countries have submitted, should be the policy or practice of selecting and appointing the leadership of both the World Bank and the Fund. In addition, there is implementation of the main elements of the Medium Term Strategy, with emphasis on quota and voice as well as surveillance reform. We all look forward to reaching the goal of an increasingly assertive International Monetary Fund based on its relevance. Such relevance to developing and developed countries alike must be earned through good governance in all its manifestations. Distinguished members of the high echelons of the Fund, with these words, it only remains for me to wish you success in your collective endeavours to advance the course of this great institution. I wish you fruitful deliberations in your Retreat. Thank you for your attention.
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Keynote speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, at the official launch of Capital Bank Lilmited GICC, Gaborone, 28 May 2008.
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Linah K Mohohlo: Promoting competitive, cost-effective banking in Botswana Keynote speech by Ms Linah K Mohohlo, Governor of the Bank of Botswana, at the official launch of Capital Bank Lilmited GICC, Gaborone, 28 May 2008. * * * I am most grateful to the Board and Management of Capital Bank for inviting me to be the guest speaker on the occasion of the launching of their bank in Botswana. Let me begin by recognising the presence of the Governor of the Reserve Bank of Malawi, Mr Victor Mbewe, who has timed his visit to Botswana to coincide with the official opening of Capital Bank. His welcome presence this evening is testimony to the regulatory and supervisory collaboration between the two sister central banks; the Reserve Bank of Malawi and the Bank of Botswana. Capital Bank Limited (Capital Bank) is a subsidiary of First Merchant Bank of Malawi, and was granted a commercial banking licence by the Bank of Botswana in December last year. At the time of licensing First Merchant Bank (FMB), which is headquartered and operating mainly in Malawi owned 51 percent of the shares of Capital Bank. The remaining 49 percent of the shares are held by citizens of Botswana, Kenya and the United Kingdom. One of the attractions of the bank’s application for a banking licence was the parent bank’s proven track record and strength in financing small and medium scale enterprises (SMEs). As you know SMEs play a major role in contributing to sustainable economic growth and poverty reduction. Therefore, access to credit is crucial for their survival. Based on the performance of the parent bank in Malawi, it is my hope that Capital Bank will leverage on its experience and infrastructure in servicing this niche market in Botswana, and in so doing, contribute to sustainable economic growth and job creation. I am further encouraged to learn that Capital Bank has expressed commitment to offer good quality service, accompanied by positive real interest rates on savings and competitively priced banking products. This suggests that the bank is fully aware that it will grow its business and prosper only when customers receive the standard and quality of service to which they are entitled. Master of Ceremonies: Capital Bank establishes its presence in Botswana at a time when competition in the banking sector is intensifying. You will recall that in 2006, the market witnessed the entrance of a regional bank; and hot on the heels of that bank, Capital Bank has come to being; this brings the number of commercial banks operating in our country to seven. This is a welcome development for the Botswana banking sector and the wider financial industry. I would, therefore, like to take this opportunity to implore Capital Bank to immediately make its presence felt in the domestic market and contribute positively to the promotion of a competitive, soundly-based and growing financial sector. As we are all aware, a major development challenge for many countries in our region is the need to increase the availability and access to high quality banking facilities and services at affordable cost to both businesses and households. Not so long ago, a survey sponsored by a consultancy on financial sector issues, Finmark Trust, found that almost 57 percent of the population in Botswana do not have access to any form of banking. In addition, the branch network, marketing and other banking services were found to be highly concentrated in urban and semi-urban areas. The survey also found that the criteria and the initial deposit required for opening a bank account were restrictive. As a result, large segments of the population could not gain access to financial services. The Bank of Botswana had also obtained credible evidence that the reasons for this undesirable state of affairs included very high transaction costs arising from, among others, high bank account maintenance fees and multiple bank changes, which were regrettably not matched by the quality of service. My appeal is made against the background of a public outcry with regard to the cost and quality of financial intermediation, as well as public perceptions of a lack of transparency, particularly in respect of bank charges. Commercial banks continue to be regarded as not operating in conformity with their pledge to serve and deliver world-class service and satisfy market needs. Overall, the banking industry is still considered to be solely profit-oriented, and interested only in high returns and not in offering high quality service. These findings suggest that it is imperative for all players in the financial services industry to turn the right corner and embrace a more “financial inclusive” approach in reaching out to the unbanked members of society. It is no secret that the high cost of banking services retard efforts to encourage financial saving and discourage full use of the banking facilities, at a time when banking is no longer a luxury but a need. While it is appreciated that the cost of providing banking facilities and infrastructure in a vast but sparsely populated country such as Botswana can be significant, it is important that the level of banking charges should be seen to be commensurate with the quality of banking services. The Bank of Botswana has continued to engage in a healthy dialogue with all interested parties on the matter. While a lot remains to be done, the Bank of Botswana is encouraged by the progress made towards making banking more cost effective. I realise, however, that it is important to strike an appropriate balance between bank profitability, on the one hand, and the provision of top-class banking services to all sectors of the community, on the other hand. Indeed the discernible progress is exemplified by the many banking halls which have been revamped to look modern and a lot more welcoming to customers. Furthermore, the products on offer are increasingly diversified and responsive to the needs of the public and wider economy. The volume of business has also increased, as indicated by the growth of total banking assets, deposit liabilities, loans and other forms of credit, particularly in the last five years. It is expected that the entry of Capital Bank will further boost these and other performance ratios. In Botswana, we take pride in a sound, profitable and solvent banking system which ranks among the best in the continent. Even third party observers have attested to the fact that Botswana has a highly profitable banking sector which operates in a solvent, soundly managed but not overregulated financial system. We must build on this foundation in all facets of our business and aim at providing excellent service at all times. We must also instil a positive attitude in our staff and create an enabling environment for international exposure so that staff can be in a position to meet modern day customer expectations with confidence. As I have intimated to the Chief Executive Officers of banks, the realisation of lofty ideals such as competence, efficiency and effectiveness depends on the quality of staff. This can be achieved through a lot more staff training and exposure than has been the case so far. In this regard, it is my belief that the concern expressed by observers about shortage, if not, absence of skills in banking and finance and related disciplines is, to some extent, of our own making. It appears that somehow there is a mistaken belief that it is the Government’s and/or Bank of Botswana’s responsibilities to train staff for the banking and/or financial sectors. Even if that were the case, what about on-the-job training! Surely, it is the employers’ responsibility. I have no doubt Capital Bank will find that the issue of training, about which I feel very strongly, is debated at for a such as the Bankers Association of Botswana, the Botswana Institute of Bankers, Financial Markets Committee, National Payments Committee and the Banking Committee. I am confident that the Managing Director of Capital Bank will make a meaningful contribution to the deliberations on this and other issues as he engages in industry-wide consultations, collaboration and information sharing with his counterparts. You are rest assured of support from the Bank of Botswana through the existing enabling regulatory and supervisory framework, within the context of strict adherence to prudential norms that are in line with best international practice of governance. On a related matter, I want to believe that Capital Bank’s local Board of Directors will have corporate responsibilities that include ability to make independent judgements in adjusting business strategies and operations in line with local market conditions. While a parent bank has the responsibility to make major policy decisions affecting the group, it is crucial that, within this hierarchical structure, important decisions relating to the day-to-day operations of a subsidiary banks are made in the host country, and not referred on a regular basis to either regional or head offices abroad. Otherwise there is a risk of undermining and weakening local management as they will be denied the opportunity to make decisions on the operation of the local business. The fact is that staff will not realise their potential unless there is an enabling environment for them to discharge their responsibilities. Some, if not all, of your staff are skilled individuals, and I know that I am speaking to the converted, when I say that successful companies revolve around their people, so long as they are equipped with the requisite ability and room to perform. From this perspective, you are encouraged to identify the best of our citizen staff for key positions in your staff complement, obviously not at the expense of competence, efficiency and effectiveness. Last, but not least, I want to believe that customer service will be extended courteously. The staff of Capital Bank should live up to the Setswana sayings: “Maitseo ke namane ya moroba! Tlhong botho!” In English one could say, “manners maketh a man”, and a dose of humility makes it even better. Needless to say, your customers deserve to be treated with utmost respect. I hasten to add that we live in difficult times as it seems money and morality appear to have meeting point, and greed seems to occupy centre stage. I am referring here to the current major economic turning point in the face of the bubble that burst due to the unsustainable debt in the US housing market that sent undesirable ripple effects across major banking and financial centres. No wonder observers are now cynical about banks in the face of plummeting shareholder value and foreclosure on housing loans in affected markets. In the circumstances, you in banking business are well advised to put in place robust and effective internal controls environment and risk management infrastructure, and educate your staff so that they are in a position to prevent fraudulent transactions. On a slightly different but related matter, the Chairman of Capital Bank commented on the upward adjustment of interest rates that was effected earlier this week. I took it as an invitation for me to comment briefly on the Bank’s primary objective of maintaining price stability. While monetary policy has to respond to a sustained increase in inflation, as it is currently the case due to the escalating oil and food prices, this is done in the context of the framework articulated in the Bank’s Monetary Policy Statement. As I stated at the launch of the Statement in February this year, monetary policy indeed focuses on the containment of inflation within a medium-term (3-year) horizon on the basis of inflation forecasting. This is in view of the significant transmission time lag before policy action takes effect. Accordingly, therefore, monetary policy will be preemptive, as necessary, in order to mitigate secondround effects relating to unsustainable demands for wages and other domestic resource increases, which would lead to a further spiralling of inflation. It is just as important to anchor expectations of low and stable inflation. It is against this background that the bank rate was increased by half a percentage point to 15 percent on May 26, 2008. As I conclude, I wish to applaud the Board, management and staff of Capital Bank for bringing additional banking services and facilities to Gaborone. In the not too distant future, I would like to see expansion and extension of your services to other parts of the country. The magnificent premises I viewed last night are no doubt a benchmark for others to follow. My first impressions are that you will settle down to business at the speed of lightning. I thank you for your attention.
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bank of botswana
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