OECD Economic Surveys: Euro Area 2010

Euro Area SPECIAL FEATURE: Macroeconomic imbalances Most recent editions Italy, June 2009 Japan, September 2009 Korea, J...

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Euro Area SPECIAL FEATURE: Macroeconomic imbalances Most recent editions Italy, June 2009 Japan, September 2009 Korea, June 2010 Luxembourg, May 2010 Mexico, July 2009 Netherlands, June 2010 New Zealand, April 2009 Norway, March 2010 Poland, April 2010 Portugal, September 2010 Romania, October 2002 Russian Federation, July 2009 Slovak Republic, November 2010 Slovenia, July 2009 South Africa, July 2010 Spain, December 2010 Sweden, December 2008 Switzerland, December 2009 Turkey, September 2010 Ukraine, September 2007 United Kingdom, June 2009 United States, September 2010

OECD Economic Surveys

Euro Area


Australia, November 2010 Austria, July 2009 Belgium, July 2009 Brazil, July 2009 Canada, September 2010 Chile, January 2010 China, February 2010 Czech Republic, April 2010 Denmark, November 2009 Estonia, April 2009 Euro area, December 2010 European Union, September 2009 Federal Republic of Yugoslavia, January 2003 Finland, April 2010 France, April 2009 Germany, March 2010 Greece, July 2009 Hungary, February 2010 Iceland, September 2009 India, October 2007 Indonesia, November 2010 Ireland, November 2009 Israel, January 2010

Volume 2010/20 – Supplement 2


Euro Area

Please cite this publication as: OECD (2010), OECD Economic Surveys: Euro Area 2010, OECD Publishing. http://dx.doi.org/10.1787/eco_surveys-euz-2010-en This work is published on the OECD iLibrary, which gathers all OECD books, periodicals and statistical databases. Visit www.oecd-ilibrary.org, and do not hesitate to contact us for more information.

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isSn 0376-6438 2010 subscription (18 issues) isSn 1995-364X subscription BY COUNTRY isbn 978-92-64-09000-2 10 2010 20 1 P

-:HSTCQE=U^UUUW:

December 2010

Volume 2010/20 – December 2010 Supplement 2


OECD Economic Surveys: Euro Area 2010

Please cite this publication as: OECD (2010), OECD Economic Surveys: Euro Area 2010, OECD Publishing. http://dx.doi.org/10.1787/eco_surveys-euz-2010-en

ISBN 978-92-64-09000-2 (print) ISBN 978-92-64-09001-9 (PDF)

Series: OECD Economic Surveys ISSN 0376-6438 (print) ISSN 1609-7513 (online)

OECD Economic Surveys: Euro Area ISSN 1995-3747 (print) ISSN 1999-0804 (online)

 

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TABLE OF CONTENTS

Table of Contents Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8

Assessment and recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

Chapter 1. Exiting from the crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

The financial crisis triggered a severe recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policy support has helped to stabilise the economy and encourage recovery . . . . . A moderate recovery is underway. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21 29 32

A coherent approach to economic governance is required at euro area,  EU and national levels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43 43

Chapter 2. Resolving and avoiding unsustainable imbalances . . . . . . . . . . . . . . . . . . . . .

45

Large and persistent external imbalances built up during the upswing . . . . . . . . . . 46 External balances have been driven by internal economic and financial imbalances . 49 Measures to restore stability in the near and longer term are needed at European and national level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80 81

Annex 2.A1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

Chapter 3. Rebuilding the public finances and fiscal discipline . . . . . . . . . . . . . . . . . . . .

87

Fiscal consolidation is required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Sound fiscal policy would contribute to more effective economic stabilisation . . . 98 Strengthening fiscal discipline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Chapter 4. Minimising risks from imbalances in European banking . . . . . . . . . . . . . . . 121 The bank lending cycle was unsustainable and contributed to imbalances . . . . . . 122 Upgrading regulation and supervision to reduce risk . . . . . . . . . . . . . . . . . . . . . . . . . 133 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

3

TABLE OF CONTENTS

Boxes 1.1. 1.2. 2.1. 2.2. 2.3. 2.4. 3.1. 3.2. 3.3.

Measures to deal with the fiscal crisis in Greece and in Europe . . . . . . . . . . . . . 31 Summary recommendations on exiting the crisis . . . . . . . . . . . . . . . . . . . . . . . . . 42 Economic stabilisation in a monetary union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Inflation differentials in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Economic adjustment through migration to overheating economies . . . . . . 58 Summary recommendations on macroeconomic imbalances . . . . . . . . . . . . . . . . . . 79 Experience from sub-federal fiscal crises in OECD countries. . . . . . . . . . . . . . . . 102 The Netherlands Bureau of Economic Policy Analysis . . . . . . . . . . . . . . . . . . . . . 114 Summary recommendations on fiscal policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

4.1. 4.2. 4.3. 4.4. 4.5. 4.6. 4.7. 4.8. 4.9.

Measuring international banking claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Euro membership and cross-border holdings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comparison of leverage in the United States and the euro area . . . . . . . . . . . . . The macroeconomic impact of the new Basel capital requirements . . . . . . . . . Macroprudential policy in Spain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The supervisory architecture prior to the crisis and the reforms . . . . . . . . . . . . Major financial firms live globally but die locally: the case of Fortis . . . . . . . . . The Nordic-Baltic Cross-Border Stability Group (NBCBSG) . . . . . . . . . . . . . . . . . . Summary recommendations on banking regulation and supervision . . . . . . . .

126 131 135 136 140 145 151 153 155

Tables 1.1. 2.1. 2.A1.1. 3.1. 4.1. 4.2.

Selected economic indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Trade in goods and services by partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Net financial assets by sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Medium-term fiscal objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Bank capital: current and future requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Pro-forma leverage ratios under GAAP and IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Figures 1.1. 1.2. 1.3. 1.4. 1.5. 1.6. 1.7. 1.8. 1.9. 1.10. 1.11. 1.12. 1.13. 1.14. 1.15. 2.1. 2.2. 2.3.

4

The euro area has experienced a severe recession . . . . . . . . . . . . . . . . . . . . . . . . Money market spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank credit default swap rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Developments during the credit cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Household net financial assets and savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sectoral balances for the euro area . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The labour market is stabilising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inflationary pressures remain subdued. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rates on new loans to euro area residents . . . . . . . . . . . . . . . . . . . . . . . . Contribution to real GDP growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Growth by deficit and surplus countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Potential write-downs on securities and loans facing the euro area  banking sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Largest banking exposures to sovereign debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Broad money and nominal GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . External balances in euro area countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current account balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net foreign asset positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21 22 22 25 26 27 27 28 29 30 32 33 34 35 40 47 48 48


TABLE OF CONTENTS

2.4. 2.5. 2.6. 2.7. 2.8. 2.9. 2.10. 2.11. 2.12. 2.13. 2.14. 2.15. 3.1. 3.2. 3.3. 3.4. 3.5. 3.6. 3.7. 3.8. 3.9. 3.10. 3.11. 4.1. 4.2. 4.3. 4.4. 4.5. 4.6. 4.7. 4.8. 4.9. 4.10. 4.11. 4.12. 4.13. 4.14.

Determinants of the current account balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . Growth and imbalances in the euro area . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . External balances, interest rate gaps and competitiveness . . . . . . . . . . . . . . . . . Inflation differentials across US urban areas and EU states. . . . . . . . . . . . . . . . . Net foreign migrant flows and demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employment growth in Spain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net saving and investment balance and the current account . . . . . . . . . . . . . . . House price volatility and the tax treatment of housing . . . . . . . . . . . . . . . . . . . Loan growth and imbalances in the euro area . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gaps between change in loans and deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deficit countries are experiencing the largest overall adjustment . . . . . . . . . . . Contribution to total domestic demand growth. . . . . . . . . . . . . . . . . . . . . . . . . . . Government budget balances have deteriorated . . . . . . . . . . . . . . . . . . . . . . . . . . Credit spreads have widened . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Government gross debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The debt-to-GDP ratio has increased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General government debt scenarios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Planned consolidation compared with past experience . . . . . . . . . . . . . . . . . . . . Contributions to changes in the euro area debt-to-GDP ratio . . . . . . . . . . . . . . . Composite indicator of strictness of fiscal rules . . . . . . . . . . . . . . . . . . . . . . . . . . Typology of fiscal agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Budgetary developments and fiscal councils . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impact of fiscal councils. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Many countries experienced large lending booms . . . . . . . . . . . . . . . . . . . . . . . . Bank lending standards and loan growth in the euro area. . . . . . . . . . . . . . . . . . Loan loss provisions and economic growth in the euro area . . . . . . . . . . . . . . . . Leverage of largest EU banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leverage and tier 1 capital ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking flows played a major role in accumulation of imbalances . . . . . . . . . . Locational vs. consolidated banking statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected bilateral consolidated banking claims . . . . . . . . . . . . . . . . . . . . . . . . . . . Domestic banks have a big role in cross-border flows . . . . . . . . . . . . . . . . . . . . . Cross-border provision of financial services in the euro area . . . . . . . . . . . . . . . Assets of branches and subsidiaries of euro area credit institutions . . . . . . . . . Loan loss provisioning in Spain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . European system of financial supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank supervisory staff of national authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . .


50 51 56 57 59 59 61 62 63 64 67 70 89 89 90 91 96 98 99 103 112 115 115 123 123 124 124 125 126 127 128 129 130 132 141 143 149

5

This Survey is published on the responsibility of the Economic and Development Review Committee of the OECD, which is charged with the examination of the economic situation of member countries. The economic situation and policies of the Euro Area were reviewed by the Committee on 28 October 2010. The draft report was then revised in the light of the discussions and given final approval as the agreed report of the whole Committee on 16 November 2010. The Secretariat’s draft report was prepared for the Committee by Sebastian Barnes and Artur Radziwill under the supervision of Piritta Sorsa. Research assistance was provided by Isabelle Duong. The previous Survey of the Euro Area was issued in January 2009.

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BASIC STATISTICS OF THE EURO AREA (2009) Euro area1

United States

Japan

LAND AND PEOPLE Area (thousand km2) Population (million) Number of inhabitants per km2 Population growth (1999-2009, annual average % rate) Labour force (million) Unemployment rate (%)

2 526 325.6 129 0.5 157.3 9.3

9 167 307.0 33 1.0 154.2 9.3

395 127.5 323 0.1 66.2 5.1

12 409.5 34 167

14 043.9 45 745

5 068.9 32 465

15.7 11.2 13.9

20.7 12.5 12.2

30.7 42.2 –11.3 84.4

31.9 41.4 –7.1 192.7

1.3948 1.3898

130.3 113.7

ACTIVITY GDP (billion USD, current prices and exchange rates) Per capita GDP (USD, current prices and PPPs) In per cent of GDP: Gross fixed capital formation Exports of goods and services Imports of goods and services

19.6 19.72 18.92

PUBLIC FINANCE (per cent of GDP) General government: Revenue Expenditure Balance Gross public debt (end-year)

44.0 50.7 –6.2 86.3

EXCHANGE RATE (national currency per euro) Average 2009 October 2010 EURO AREA3 - EXTERNAL TRADE IN GOODS (main partners, % of total flows) Exports

Imports

18.7 14.8 10.8 14.4 5.0 10.0

14.0 12.7 10.5 12.3 6.4 18.1

Denmark, Sweden, United Kingdom Other European Union member countries Other Europe OECD America OECD Asia/Pacific Non-OECD dynamic Asia4 and China 1. 2. 3. 4.

OECD euro area (unless otherwise stated). All euro area countries. OECD euro area excluding Slovenia. Chinese Taipei; Hong Kong, China; Indonesia; Malaysia; Philippines; Singapore and Thailand.

SHARE IN EURO AREA GDP Current market prices

30

30 26.8

25

25 21.3

20

20 17.0

15

15 11.8

10

10 6.4

5 0

3.8

DEU

FRA

ITA

ESP

NLD

BEL

5

3.1

2.7

1.9

1.9

1.8

AUT

GRC

FIN

PRT

IRL

0.7

0.4

0.4

SVK

LUX

SVN

0

1 2 http://dx.doi.org/10.1787/888932358922

EXECUTIVE SUMMARY

Executive summary

T

he euro area has experienced a severe recession, followed by a sovereign debt crisis in some euro area countries, in the wake of the global financial crisis. This was the first major test of the robustness of the euro area in a downturn. Swift monetary policy easing, massive intervention to support the financial system and supportive fiscal policy helped to stabilise the financial system and mitigate the contraction in private demand. Excessive economic, financial and fiscal imbalances built up in some euro area countries during the upswing, hindering the efficient operation of the monetary union, and led to growing vulnerabilities. These contributed to especially severe economic and fiscal crises in some countries, leading to spillovers mainly through financial markets across the euro area. Exiting from the crisis. A modest recovery is now underway, although risks remain. Financial conditions have strengthened. Activity has picked up, but the recovery is likely to be muted. Fiscal consolidation is necessary, although it may drag on growth in the short term. As soon as upward risks to price stability in the medium term emerge, monetary policy stimulus should be withdrawn. Non-standard measures should continue to be wound down in line with improvements in the monetary policy transmission mechanism. It is essential that the banking system is restored to good health and remaining weaknesses resolved. The stress test exercise carried out at the EU level in 2010 was an important step forward, which has increased transparency and reinforced the credibility of the euro area financial sector. Structural reforms would facilitate on-going economic adjustment and lift growth prospects. Resolving intra-euro area imbalances. Large current account deficits and surpluses in euro area countries in the run up to the crisis were associated with underlying economic, financial and fiscal imbalances. National economies were subject to a range of diverging pressures, which were compounded by movements in real interest rates that led to divergent saving and investment behaviour in euro area economies. For some countries, low real interest rates sparked credit, consumption and housing booms and weakened competitiveness. The banking system channelled funds from countries with high savings to deficit economies, in the context of weaknesses in supervisory oversight. Market discipline, together with fiscal and financial policies, failed to prevent the build-up of large imbalances in excess of fundamentals within the monetary union. Rebalancing economies with large imbalances has already begun, but further structural reforms are needed to facilitate the process. During the crisis, some deficit countries have faced severe economic, financial and fiscal pressures. Adjustment will be a difficult and prolonged process in some deficit countries, particularly where prices and wages need to adjust to help shift resources from domesticallyfocussed sectors that grew too big during the boom years. Avoiding unsustainable imbalances. A new cross-cutting approach to economic and financial management is required to stabilise national economies more effectively. This should rest on a broad range of policies that can tackle the sources of macroeconomic imbalances, including sound fiscal policy and the development of macroprudential tools. Stabilisation would be facilitated by structural policies that help economic adjustment, including ensuring that wage setting

8


EXECUTIVE SUMMARY

mechanisms work well and that housing policies do not exacerbate property cycles. The surveillance of country-level economic, fiscal and financial imbalances by EU institutions should be stepped up. Rebuilding the public finances. The fiscal position has deteriorated sharply, leading to large deficits and adding to already high debt levels in some euro area countries. Credit spreads have increased on some countries’ debt and Greece required external assistance. Detailed and credible multi-year plans to stabilise the public finances are required. Reducing budget deficits to a sustainable level would nevertheless leave indebtedness at historically high levels in many countries. Prolonged fiscal consolidation and reforms will be needed to bring debt to a more prudent level, increase the ability to withstand future shocks and to prepare for future ageing costs. Improving fiscal discipline. Many euro area governments failed to use economic good times to consolidate. Market discipline and fiscal frameworks should be strengthened. A permanent crisismanagement framework should be put in place subject to strong conditionality. Stronger governance should be pursued at EU level through a reinforced Stability and Growth Pact (SGP). In this context, a substantial legislative reform of economic and fiscal governance is already underway. Minimum fiscal standards set by the SGP should be better enforced: a range of sanctions, including financial penalties, should be applied quasi-automatically under the SGP early in the surveillance process, and an appropriate operational definition for required debt reductions should be set out. Fiscal frameworks at the national level should be reinforced. Medium-term rules, such as multi-year expenditure paths or ceilings, are needed. Well-designed independent national fiscal councils to make forecasts and assessments of fiscal policy would improve fiscal outcomes and increase transparency, while their design should reflect national specificities. Strengthening the banking system. Weaknesses in financial regulation and supervision created an environment prone to excessive risk-taking and unsustainable credit cycles in the euro area, as in other OECD economies. Risk was underestimated, capital buffers were inadequate in some cases and liquidity management was not sufficiently monitored. Substantial risks were shifted off balance sheet. Large systemic institutions channelled cross-border flows, partly contributing to growing imbalances and risks in some places. Significant steps have already been taken by the EU authorities to address these issues. Stronger microprudential rules should be implemented in line with the Basel III capital accord, as planned by the EU authorities and as part of a global approach, as well as on-going EU reform initiatives. Macroprudential regulation should be stepped up, including a national counter-cyclical capital buffer in line with Basel III. The activities of systemic banks should be more closely regulated. Effective macroprudential supervision should be developed through the European Systemic Risk Board (ESRB), as well as at national level, to deal with local financial and economic imbalances. Managing cross-border risks. Close but incomplete banking integration in the euro area, together with the absence of a single EU system of bank regulation and supervision, created risks and complicated the resolution of cross-border difficulties. The new supervisory framework is a major achievement. European Supervisory Authorities will be set up, next to an enhanced system of supervisory colleges, to build up a more coherent supervisory framework under the decentralised architecture. A review is foreseen after at most three years to determine whether further steps towards more integration are needed and whether a single supervisor would be more fit for the purpose. Burden-sharing agreements should be in place for all systemic cross-border institutions. There should be credible, effective and harmonised resolution tools in all EU countries. Subject to appropriate regulation, removing obstacles to financial integration would help create a more stable banking system.


9

OECD Economic Surveys: Euro Area 2010 © OECD 2010

Assessment and recommendations The crisis is the first major test of the resilience of the euro area Euro area countries have experienced their most severe recession of the post-war era, alongside other OECD economies, followed by a sovereign debt crisis in some euro area countries. This has been the first major test of the resilience of the euro area since monetary union. The end of a prolonged global credit and asset price boom around mid2007 led to turmoil in interbank markets, which intensified into a full-blown international financial crisis from September 2008 after the failure of Lehman Brothers. World trade dropped sharply and there was a rapid retrenchment of private consumption and investment, exacerbated by low confidence and financial sector weakness. Unemployment has increased significantly, although a substantial fall in average hours worked helped to accommodate the weakness of labour demand. While headline inflation rates have been volatile, underlying inflationary pressures have weakened as the result of the scale of economic slack. The euro area in aggregate avoided some of the largest excesses of the global credit cycle and proved fairly resilient in the downturn. Liquidity provision from the European Central Bank (ECB) responded swiftly to the financial turmoil and the ECB’s balance sheet expanded substantially. Temporary government interventions through guarantees and other measures further helped to prevent a more dramatic contraction of bank credit, at the cost of shifting the burden from private debt holders to tax payers. Monetary policy rates were rapidly reduced. Governments further supported demand through discretionary fiscal expansion and allowing a considerable deterioration in the budget balance as revenues contracted, although fiscal policy was constrained in some countries by the weak position of the public finances and rising credit spreads. However, in some individual euro area countries, there was a large build-up of economic, financial and fiscal imbalances during the upswing. Policies and markets failed to stabilise the range of shocks acting on different economies. Imbalances led to the misallocation of resources and increased the vulnerability of some deficit economies to a future downturn. Weak policy settings and structural problems in some cases exacerbated these pressures.

Recovery is now underway but will be muted Financial conditions are improving and activity has picked up. A gradual and sustained recovery in underlying activity is now underway. This has been supported by considerable policy stimulus. Consumption and investment have begun to expand. Nevertheless, the

11

ASSESSMENT AND RECOMMENDATIONS

pace of recovery is likely to be muted as the result of on-going private sector balance sheet rebuilding in the wake of the crisis. While expansion in economic activity in some countries has been faster than had been expected earlier in the year, adjustment to marked macroeconomic and financial imbalances in other countries will weigh on the aggregate performance of the euro area. Fiscal consolidation is essential and will increase confidence, although it may dampen the recovery in the short run. Meanwhile, the crisis is likely to have reduced the level of potential output through a lower capital stock, a weakening of the labour market and higher risk premia. This will further constrain the scope for recovery. Excess capacity is nevertheless likely to remain high for some time, restraining inflationary pressures. As soon as upside risks to price stability in the medium term emerge, monetary policy stimulus should be withdrawn. This would contribute to avoiding distortions created by low interest rates relative to long-run norms. Non-standard measures should continue to be wound down in line with improvements in the monetary policy transmission mechanism. Substantial risks remain around the recovery and it is crucial that the banking system is returned to good health to support growth. Structural reforms in labour and product markets would facilitate economic adjustment and will be particularly important for achieving vigorous growth in the coming years.

Large-scale government intervention supported the banking system Government balance sheets have been leveraged to shore up the financial system, as well as to support demand. Deposit guarantees were increased to maintain and reinforce depositors’ confidence in the financial system. State guarantees of other bank liabilities have been widespread with countries adopting their own schemes along co-ordinated EU policy orientations based on the common state aid rules. Some countries had to recapitalise banks to prevent the meltdown of their financial systems. In the early days of the crisis, financial rescue packages had to be implemented very quickly. Initial reactions were thus fragmented and bailed out debt holders. Few countries have developed a comprehensive approach to deal with weaknesses in the banking system. Policy support to the financial system should continue to be unwound as global and local conditions allow, but further recapitalisation of banks could be necessary. All countries should have a full set of effective, credible and harmonised bank resolution tools. There have been two EU-wide stress tests of banks. The 2010 stress test was particularly important in addressing uncertainties regarding some financial systems and has contributed to greater financial stability. Stress tests should become a regular exercise and be further harmonised.

Fiscal policy helped to cushion the downturn but the public finances are now in poor shape A sharp increase in government borrowing helped to stabilise activity, largely through the automatic stabilisers and discretionary fiscal stimulus measures. In the wake of the crisis, many euro area countries have large deficits and rising public debt. Revenues have fallen due to the economic slowdown and in some countries the collapse of tax receipts related to the credit and housing cycles, while public expenditure has increased. In some countries, there have also been substantial costs related to supporting the financial system. At the same time, credit spreads on government debt have increased sharply for

12



some countries. Fiscal consolidation is the immediate priority to stabilise the public finances and should begin by 2011 at the latest in all countries. Consolidation is already underway in some places but credible and detailed medium-term plans need to be set out for all countries. Strengthening the fiscal institutions would help to increase credibility. Reducing deficits to stabilise debt-to-GDP ratios would nevertheless leave indebtedness at a high level by historical comparison, further reducing the margin for manoeuvre in the face of future ageing costs and possible downturns. Prolonged consolidation is thus required in most countries to reduce the debt-to-GDP ratio to prudent levels.

Monetary policy has provided stimulus The swift reduction in the policy rate, starting in autumn 2008, eased financing conditions and supported activity in the context of weakening inflationary pressures. Policy rates are lower than during the previous downturn, although long-term interest rates are at a similar level. The potential disruption to the normal functioning of monetary policy transmission was addressed by the adoption of non-standard measures. The increased average maturity of refinancing operations and the shift to full allotment tenders at a fixed interest rate helped to ease market tensions. As a result, overnight market interest rates fell to well below the policy rate. In addition, the ECB provided a US dollar swap line facility and purchased covered bonds for monetary policy purposes. The size of the Eurosystem balance sheet has roughly doubled since the pre-crisis period, mostly related to longerterm repurchase operations that are now gradually being phased out. In May 2010, the Securities Market Programme was introduced to purchase public and private debts with the aim of supporting the monetary policy transmission mechanism through the stabilisation of certain securities markets. These exceptional measures helped to stabilise the economy during the crisis but lessons should be drawn for the future. The crisis has underlined the destabilising effect that asset and credit cycles can have on activity and inflation. While macroprudential policy should be the primary tool to manage financial cycles, the recent crisis indicates that consideration should continue to be given to factors that may present risks at medium- to long-term horizons, such as asset prices and balance-sheet growth. Through the monetary pillar, the ECB already pays close attention to monetary and credit developments. In this respect, it is essential that monetary analysis continue to be enhanced in order to be effectively and systematically incorporated into the policy process.

The governance of the euro area could be strengthened The co-ordination of the response to the crisis has been complicated by the governance arrangements of the euro area with many powers remaining at national level and multiple actors at the EU and euro area levels. The institutional framework was strengthened with the entry into force of the Lisbon Treaty in December 2009, which for the first time recognised the Euro Group and its role in enhancing co-ordination of economic policies. The Lisbon Treaty empowered euro area members of the Council to take formal decisions related to certain euro area matters. With an effective crisis-management framework, the actions of the ECB to fulfil its price stability mandate in crisis situations could be facilitated. OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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Large imbalances in some euro area countries created problems Some euro area countries ran large and persistent external imbalances during the upswing. The scale of these savings and investment mismatches appears too large to be explained by economic fundamentals alone and in part reflects underlying economic, financial and sometimes fiscal imbalances at national level. Countries were exposed to a range of divergent underlying pressures, including “catch-up” growth and overly optimistic growth expectations in lower income economies, financial liberalisation, national structural reforms and different demographic pressures. Diverging real interest rates played a destabilising role that contributed to the imbalances. Low real rates sparked strong credit and house price cycles in some economies. With sluggish productivity growth, upwards pressures on wages and prices from booming sectors left competitiveness impaired in some deficit countries. Strong saving and weak investment in some surplus countries, combined with weaknesses in financial regulation, led to funds being channelled to overheating economies. Achieving macroeconomic and financial stabilisation at national level proved difficult in view of the different pressures acting on local economies, together with structural problems and the absence of market discipline. In some cases, fiscal imbalances added to the problem. Large imbalances that appear excessive led to a misallocation of resources, masked underlying economic weaknesses and increased vulnerability. When the financial crisis hit, those countries with large current account deficits were the most exposed and faced the combined pressures of rebuilding of household and corporate balance sheets, impaired financial systems and weak public finances.

Structural measures can help reduce imbalances Rebalancing economies with large imbalances, both deficits and surpluses, will be a prolonged process. In deficit countries, adjustment will be difficult as prices and wages need to change to restore international competiveness and to shift resources away from domestically-focussed sectors that grew too big during the boom years. This may require considerable restraint with wages and prices. Institutional barriers to the required price adjustment should be removed. Falls in wages and prices cannot be ruled out and in some cases may prove inevitable. Structural policies have a key role in rebalancing economies. In deficit countries, reforms can boost productivity and help to bring costs back in line. In surplus countries, structural changes could strengthen domestic demand and enhance productivity growth, notably in the non-tradable sectors.

A cross-cutting approach is needed to avoid harmful imbalances A new approach to economic and financial management is now required to stabilise national economies, alongside structural reforms to make economies more robust and balanced. The policy framework was not sufficient to prevent the emergence of national economic, financial and fiscal imbalances, and unprepared to deal with the subsequent crisis. In the context of a common monetary policy and single currency, greater differentiation of other policy settings is required to stabilise national economies, and

14



unsustainable policies at the national level that can lead to spillovers need to be avoided. The new cross-cutting approach should rest on a broad range of policies that can tackle the sources of macroeconomic imbalances, including sound fiscal policies, the development of macroprudential tools and structural reforms. Wage-setting mechanisms should be more attuned to maintaining competitiveness. Distorting housing market policies that exacerbate housing cycles should be removed. Structural barriers that impede economic adjustment, productivity gains and sustainable growth should be addressed.

Surveillance and oversight of imbalances should be stepped up Euro Group and EU surveillance, alongside stronger national frameworks, would help to detect and avoid harmful imbalances. The upgrading of such oversight is already underway and would be further strengthened by current legislative proposals. The focus at European level should be on spillovers between countries, which have largely operated through financial channels. Surveillance should be based on a wide range of indicators accompanied by a qualitative assessment. This needs to be closely co-ordinated with financial and fiscal monitoring. The availability of comparable and coherent statistics on national developments, particularly in the banking system, should be increased. While monitoring at the EU level gave warnings about imbalances prior to the crisis, these did not lead to corrective action. A graduated procedure needs to be put in place whereby surveillance is intensified as risks to euro stability emerge and the Council issues recommendations and warnings on imbalances that pose significant risks. While identification of harmful imbalances is not straightforward, this should not be a deterrent to setting up a procedure that would help identify, avoid and correct harmful imbalances that jeopardise or threaten to jeopardise the proper functioning of the euro area.

Fiscal discipline needs to be improved Weak underlying fiscal positions and trend increases in debt in many countries resulted from a failure to reach sound fiscal positions in line with the SGP in economic good times. In particular, the budgetary stance was too lax in most countries and, in some cases, exceptional revenues from the credit cycle were spent rather than used to strengthen the fiscal position or prepare for future pension costs. Policies were insufficient to achieve sound positions and contributed to excessive imbalances in some cases. Weak fiscal positions limited the budgetary room for manoeuvre during the crisis. Strengthening national and EU-wide fiscal institutions would help to improve budgetary outcomes in the future and reinforce the credibility of current consolidation efforts. To strengthen market discipline, a credible mechanism for fiscal crisis management is required. Reducing moral hazard and making conditionality a key element are essential features of any future crisis-management framework. For solvent countries facing liquidity pressures, this should involve a permanent liquidity-support mechanism subject to strong conditionality. If conditionality is not fulfilled, financing support should be withdrawn and the framework should be prepared to deal with this eventuality. Sovereign risk should be fully reflected in financial regulations. The EU programme for Greece should be implemented as planned to achieve the high level of conditionality set out.


15


The basic fiscal standards set by the EU Stability and Growth Pact (SGP) should be better enforced to protect euro area economies from weak fiscal positions. EU-level auditing powers have increased. The monitoring of fiscal positions should be improved, especially in terms of debt and off-balance sheet positions, structural balances and debt management. The “corrective arm” of the Pact should be enforced systematically by the Council, and funds should be posted in a non-interest bearing account as soon as an excessive deficit is identified. An appropriate operational definition of the reduction in debt for countries with debt above 60% of GDP should be put in place so that the debt criterion can be applied effectively. The “preventive arm” of the SGP needs to be enhanced. It should be overhauled so that it provides a system of sanctions applied early in the surveillance process along the lines of current legislative proposals that would be more credible than those currently provided under the SGP. Sanctions should range from intrusive surveillance and warnings by the Council to financial sanctions. Monetary penalties should include the requirement that funds be posted to an interest-bearing account until corrective policies have been implemented. Sanctions should be applied quasi-automatically by reversing the voting majorities, which would increase the likelihood that analysis and recommendations of the Commission are followed. These principles are reflected in a package of legislative proposals currently under consideration. Consideration should be given to other measures to increase the costs of taking fiscal risks through non-compliance with EU fiscal requirements, such as making treatment in financial regulations less favourable. The creation of the “European Semester” may help to co-ordinate fiscal with other policies and increase the integration with national budgetary processes. The presentation of Stability Programmes should be further harmonised and based on independent forecasts.

National fiscal frameworks should be stronger National governments are ultimately responsible for their public finances. While a more effective Pact is essential to avoiding spillovers from fiscal instability, strengthening national frameworks within the SGP is crucial to achieving more sustainable public finances. All euro area countries should adopt and abide by broad-based medium-term frameworks for the public finances based on multi-year paths or ceilings for both current and capital expenditures. Going beyond the minimum standards in the proposed EU Directive should be encouraged. It is important that political will at national level supports the rules and that there is national ownership of the fiscal frameworks. The establishment of well-designed independent national fiscal councils would be appropriate in many countries in order to set the official forecasts of the public finances and provide analysis and assessment of fiscal policy. Political commitment to the independence of these institutions is crucial to improve the management of the public finances.

Stronger bank regulations are needed for financial stability Upgrading regulation, reinforcing supervision and better aligning incentives within the banking sector would increase financial stability in the context of enhanced regulation of the financial sector more broadly. The boom in credit during the upswing was supported by easier bank lending standards, a low level of provisions and the rising leverage of large systemic banking groups. The rapid growth of cross-border banking in the wake of deepening financial integration after the creation of the euro channelled funds from

16



banking systems with excessive liquidity into overheating economies with housing booms. During the financial crisis, a sharp reduction in cross-border lending added to the difficulties of borrower countries. Stronger microprudential rules should be implemented in line with the Basel III capital accord, as planned by the EU authorities and as part of a global approach, and on-going EU reform initiatives. This would include, among other measures, raising the size and quality of capital buffers, and implementing an overall leverage ratio as a backstop. In addition, liquidity regulations and the risk-weighting system should be strengthened, as well as governance and risk management. Limits to the integration of EU financial markets, especially in the retail sector, led to large concentrations of risks. Supervisors should take a more systematic and harmonised view of the geographic concentration of risks when assessing regulatory capital. Large complex financial institutions were a major conduit for crossborder activities and, by underestimating country and credit risks, became a major source of risk transmission and systemic risk during the crisis. Consideration should also be given to stronger supervision, additional capital surcharges and levies for systemic institutions. Macroprudential policy was generally little used in the run up to the crisis, even as systemic risks built up. Some financial regulations had a pro-cyclical impact. Both macroand microprudential supervision should be based on a through-the-cycle approach to risk. Microprudential supervisiors should ensure that bank provisioning is forward-looking. A system of counter-cyclical capital buffers based on a simple numerical rule applied to national credit growth should be introduced as outlined in current EU consultation documents and international proposals. The creation of the European Systemic Risk Board (ESRB) is a welcome development. It is important that its decision-making is effective and that it plays a full role in achieving macroeconomic stability. EU-wide stress tests should continue to be undertaken on a regular basis and harmonised further. Given the need to differentiate policies at national level to counter imbalances, all euro area countries should have appropriate national macroprudential arrangements in place, alongside EU structures.

Weaknesses in cross-border supervision remain a risk The system of financial supervision and crisis management remains organised on national lines, reflecting the national fiscal responsibilities, while banking activities are increasingly organised on cross-border basis. Although this has not been the primary problem during the financial crisis, it made it harder to apply consistent and harmonised standards and supervise banks during the upswing. The creation of the European Supervisory Authorities (ESAs) and extension of the system of supervisory colleges to all large cross-border banks is a major achievement. The fiscal safeguard rules constraining the ESAs’ powers should be narrowly applied. A common supervisory database with harmonised definitions of key variables should be created for large cross-border institutions. A review of the new supervisory arrangements is foreseen after at most three years to determine whether further steps towards more integration are needed and whether a single supervisor would be more fit for the purpose. The burden on banking supervision is increased by the combination of some highly-integrated EU wholesale markets and segmentation in other sectors, which leads to large cross-border banking flows. Subject to appropriate regulation, remaining obstacles to financial integration should be removed to encourage a more stable banking structure.


17


Crisis management has been made more difficult by differences in legal structure across countries and the need to allocate costs. Burden-sharing agreements should be in place at least for all systemic institutions and legal ring-fencing of assets should be limited where this complicates resolution. Operational arrangements for deposit guarantee schemes should be harmonised and their funding could be switched to an ex ante basis. Bank resolution funds financed by risk-based levies could be introduced.

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Chapter 1

Exiting from the crisis

The euro area has experienced a financial crisis and severe recession, alongside other OECD economies, followed by a sovereign debt crisis in some euro area countries. The end of the global asset price and credit booms led to weaknesses in the financial sector that started to appear in 2007. This intensified in September 2008, following the failure of Lehman Brothers, leading to a full-blown financial crisis and a dramatic contraction of private demand and world trade. Considerable policy stimulus has helped to stabilise the economy through a rapid easing of monetary conditions, supportive fiscal policy and large-scale government support to the financial system. Financial conditions have improved and a gradual recovery is now underway, although it remains fragile. However, the pace of recovery is likely to be held back by the necessary fiscal consolidation and the need to rebalance private demand. Monetary policy stimulus should gradually be withdrawn as soon as upward price pressures that would threaten price stability arise. Support measures for the financial system should be withdrawn as conditions allow. Fiscal consolidation should begin no later than 2011 and a sustained period of adjustment is required. Potential output is likely to be lower in the wake of the crisis, underlining the importance of structural reforms in labour and product markets to boost economic performance. Lessons should be drawn from the crisis to make the economy more robust and reduce the risks from economic, financial and fiscal instability.

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1.

EXITING FROM THE CRISIS

T

he economic and financial crisis has been the first major test of the robustness of the euro area, while providing a perspective on how effectively the monetary union has functioned since its creation. The euro has performed well in many respects. Against the background of the international credit cycle and global imbalances, the euro area as a whole avoided some of the worst excesses of the financial crisis and has proved relatively resilient in the downturn (OECD, 2010a). A moderate recovery appears to be underway in the euro area economy (Table 1.1). There are encouraging signs of strengthening domestic demand. Financial conditions have strengthened. However, large imbalances in some countries have hampered the smooth operation of the monetary union and increased risks, leading to areawide problems during the crisis and painful adjustment in some countries. The rebuilding of private balance sheets, the banking system and the public finances will now drag on the recovery, while providing a continued source of financial risks and vulnerability.

Table 1.1. Selected economic indicators Annual change Projections1 2007 Real gross domestic product (GDP) Private consumption Government consumption Gross fixed investment Inventories2 Net exports2 Headline inflation (harmonised CPI) Core inflation3 Short-term interest rate Employment Unemployment rate (% of labour force) Current account balance (% of GDP) Government balance (% of GDP) Government debt (Maastricht def., % of GDP)

2.8 1.7 2.2 4.6 0.0 0.4 2.1 1.9 4.3 1.8 7.4 0.3 –0.6 66

2008 0.3 0.3 2.3 –1.0 0.0 0.0 3.3 1.8 4.6 1.0 7.4 –0.8 –2.0 70

2009 –4.0 –1.1 2.4 –11.3 –0.8 –0.7 0.3 1.4 1.2 –1.8 9.3 –0.4 –6.2 79

2010

2011

2012

1.7 0.5 1.0 –1.1 0.5 0.9 1.5 0.9 0.8 –0.5 9.9 –0.2 –6.3 84

1.7 1.0 –0.0 1.6 0.1 0.8 1.3 1.2 1.1 0.3 9.6 0.4 –4.6 87

2.0 1.7 –0.1 2.8 0.0 0.5 1.2 1.2 1.8 0.6 9.2 1.0 –3.5 89

1. These projections are based on OECD Economic Outlook, No. 88. 2. Contribution to GDP growth. 3. Excluding energy, food, drink and tobacco. Source: OECD, OECD Economic Outlook 88 Database.

This chapter sets out euro area-wide economic and financial developments, together with the policy response. Lessons are drawn for the conduct of financial crisis management and euro area monetary policy, and the role of comprehensive structural reforms to improve economic performance is outlined. However, many of the economic challenges now facing the euro area are rooted in imbalances at national level that need to be addressed through national fiscal policies, macroprudential regulation and structural policies within the common euro area framework. These are covered in subsequent chapters: ●

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Chapter 2 analyses the mechanisms that led to unsustainable imbalances and the policies that in broad terms would reduce the likelihood of severe problems related to imbalances in the future. OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

1.


●

Chapter 3 sets out the immediate need for fiscal consolidation and the institutional reforms required for fiscal policy to be set on a more sustainable and counter-cyclical basis in the future.

●

Chapter 4 identifies measures to strengthen micro- and macroprudential regulation.

In essence, all chapters cover different aspects of the same problem: fiscal, financial and structural policies need to be strengthened at the euro area level to improve its overall functioning, while greater national differentiation is required within the monetary union to provide more stability at national level. The close relationship between financial, fiscal and structural pressures requires a coherent cross-cutting package of measures to strengthen all three pillars.

The financial crisis triggered a severe recession The euro area has experienced a severe recession. The pace of the decline in output and its size was without precedent in recent decades (Figure 1.1). Output declined for five consecutive quarters beginning in the second quarter of 2008. The cumulative decline from peak to trough amounted to 5.3% of GDP with output falling in total by more than 4% over the last quarter of 2008 and the first of quarter of 2009 alone. Following intensification of the financial crisis and a drop in confidence, external demand dropped sharply: the value of extra-euro area exports fell by more than one-fifth from peak to trough. Domestic demand contracted as the result of uncertainty, tighter financial conditions, rising unemployment, lower asset prices and the need to rebuild balance sheets. Nevertheless, consumption held up relatively well, declining from peak to trough by 1.7%, while total investment fell by over 15%.

Figure 1.1. The euro area has experienced a severe recession Year-on-year percentage change of real GDP Per cent

Per cent

10

10

8

8

6

6

4

4

2

2

0

0

-2 -4

Euro area United States

-6 1960

65

70

-2 -4 75

80

85

90

95

2000

05

10

-6

Source: OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932358941

Financial turmoil developed into a full-blown crisis The economic downturn in the euro area was triggered by severe distress in international financial markets. This began in August 2007 and reached a crisis point in mid-September 2008. The initial period of stress was marked by illiquidity and unusually high funding costs in interbank markets, falls in equity prices and a generalised increase


21

1.


in risk premia and uncertainty across many markets. This followed higher-than-expected default rates on US subprime residential mortgages (OECD, 2009a). From midSeptember 2008, the turmoil intensified following the failure of Lehman Brothers investment bank. On-going suspicions about the health of the financial institutions and failure of some of them led to a near-panic in financial markets. Banks were very reluctant to lend to each other, especially outside the overnight market. Term interbank lending rates soared, although less than in the United States, with spreads peaking in the euro area at close to 200 basis points at the three-month horizon, compared with a pre-crisis average of 5 basis points (Figure 1.2). Credit default swap rates on bank debt also increased sharply and bank equity prices plunged (Figure 1.3), alongside a wider tightening of credit conditions for both market and bank finance.

Figure 1.2. Money market spreads1 Three-month spreads, last observation: 2 November 2010 Basis points

Basis points

400

400 Euro area United States Japan United Kingdom

350 300

350 300

250

250

200

200

150

150

100

100

50

50

0

Jan

Jul

Jan

2007

Jul

2008

Jan

Jul

2009

Jan

Jul

0

2010

1. Spread between three-month interbank rates (Euribor in the euro area, Libor in the United Kingdom, the United States and Japan) and overnight swap rates. Source: Bloomberg and Datastream.

1 2 http://dx.doi.org/10.1787/888932358960

Figure 1.3. Bank credit default swap rates1 Basis points

Basis points

600

600 Euro area United States United Kingdom

500

500

400

400

300

300

200

200

100

100

0

Jan

Jul

2007

Jan

Jul

2008

Jan

Jul

2009

Jan

Jul

0

2010

1. Banking-sector five-year credit default swap rates. Source: Datastream.

1 2 http://dx.doi.org/10.1787/888932358979

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1.


A strong policy response played a key role in stabilising financial markets. As early as August 9 2007, the ECB indicated that it stood ready to ensure orderly conditions in the euro area money market. During the initial phase of the crisis, existing operating procedures were used with greater flexibility to reduce pressures in the interbank market: supplementary refinancing operations with maturities of three and six months; more fine-tuning operations; some operations with full allotment; changing the timing of allocation in main refinancing operations to front-load liquidity during maintenance periods; and use of the USD Term Auction Facility to provide dollar liquidity to European markets. The main refinancing rate was increased to 4.25% in July 2008. The overall size of the ECB’s balance sheet did not materially increase during this phase of the crisis. As the crisis intensified in mid-September 2008, a number of further measures were undertaken: ●

The main refinancing rate was rapidly cut by 50 basis points in October 2008 and then almost every month until May 2009 when the rate reached 1%, as inflationary pressures weakened.

●

The main and longer-term refinancing operations were offered using a fixed-rate tender with full allotment against eligible collateral.

●

The standing facilities corridor around the main interest rate was narrowed in October 2008 from 100 to 50 basis points either side of the main refinancing rate but then widened again in January 2009 before being reduced to 75 basis points in May 2009.

●

The list of eligible collateral was extended to include some syndicated loans and instruments such as Certificates of Deposit not traded in regulated markets. The credit threshold was lowered from A– to BBB– (except for asset-backed securities). As the crisis continued, new measures were undertaken:

●

Twelve-month operations were undertaken, beginning in June 2009.

●

In July 2009, a covered bond purchase programme was launched with the target of purchasing EUR 60 billion of bonds over a period of one year with a minimum rating of AA or equivalent.

●

The Securities Markets Programme was launched in May 2010 to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism, through purchases of public and private securities. Specific operations are conducted to re-absorb the liquidity injected through the programme.

The overall effect was a huge increase in the size of the ECB’s balance sheet. Lending by the ECB to euro area credit institutions rose from around 5% of GDP prior to the crisis to well above 8% of GDP at times. This has contracted to around 6.5% of GDP and is further declining. In practice, the vast scale of the 12-month operations combined with the reluctance of banks to lend to each other beyond the very shortest horizons meant that there was a large overhang of liquidity in the market. As a result, market interest rates were close to the lower bound of 25 basis points implied by the ECB’s overnight deposit facility. Weaker banks that found it difficult to access market finance were heavy borrowers at the policy rate, even though it was well above the market rate, due to the lack of counterparties willing to lend to them.


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1.


The onset of the full-blown international financial crisis in September 2008 led to heavy government support for the financial system in euro area countries. This began with Ireland’s unilateral guarantee of almost all liabilities, including deposits, of banks having substantial domestic business on 30 September 2008. This created pressure for other countries to issue similar guarantees to avoid funds flowing towards protected jurisdictions. On 7 October, the ECOFIN Council took a number of decisions towards a co-ordinated response to the crisis.1 This included raising guarantees on deposits to a minimum of EUR 50 000, although most individual countries went further.2 The Council also urged greater flexibility in the application of mark-to-market valuation under the International Financial Reporting Standards (IFRS) accounting standards. The Economic and Financial Committee (EFC) would ensure daily contact between EU countries on financial matters. General principles were agreed for government intervention, there was a call for full transparency by EU banking institutions and the recapitalisation of vulnerable systemically relevant financial institutions was deemed appropriate.

The crisis marked the end of a prolonged credit expansion The sharp deterioration in financial conditions marked an end to the prolonged global credit cycle during which low risk-aversion and a global savings glut contributed to reducing the cost of borrowing to historically low levels and expanding the volume of credit substantially. This spread to unsustainably high equity values and strong growth in house prices in many countries. The easing of financial conditions and the house price boom were weaker in the euro area as a whole than in the United States (Figure 1.4) and some other major economies, although within the euro area the credit cycle in some individual countries was particularly intense (Chapter 2). In the euro area, banks played a key role in the financial cycle. Total credit to the non-financial private sector from euro area monetary financial institutions increased in real terms by around 40% between 2003 and 2007. The growth of credit was facilitated by easier lending conditions and increased leverage among large cross-border financial banks (Chapter 4). As the credit cycle turned, the cost and availability of finance for households and nonfinancial corporations tightened significantly. However, this took place in an environment of sharply falling loan demand from the real sector, following the deep economic downturn. Thus, it is not clear that credit supply constraints were necessarily binding in a significant way. The cost of bank finance was pushed up by the increase in interbank lending spreads and dysfunction in the money market, as well as the drying up of securitisations as a source of bank funds. The ECB Bank Lending Survey showed a high proportion of banks tightening lending standards as a result of the weak outlook and funding constraints. This was more pronounced for corporate lending and, within household lending, for consumer loans. The retrenchment of credit standards appears to have been stronger in countries experiencing more intense financial stress. The overall cost of external finance for companies further increased as spreads on corporate bonds rose, notably for higher risk debt, and equity values declined. Overall, the growth of lending of euro area monetary and financial institutions plunged as the credit cycle turned and outstanding credit contracted somewhat, mainly as the result of weakness in demand (Figure 1.5). This cyclicality has been less marked than in the United States.

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1.


Figure 1.4. Developments during the credit cycle 1998 Q1 = 100

Euro area

1998 Q1 = 100

United States

200

200 Equity prices

180

180

160

160

140

140

120

120

100

100

80

80

60

60 1998

99

2000

01

02

03

04

05

06

07

08

09

10

Per cent

12

Per cent

House price growth

12

1

8

8

4

4

0

0

-4

-4

-8

-8 1998

99

2000

01

02

03

04

05

06

07

08

09

10

Index

Index

4

4 Financial conditions indices2

2

2

0

0

-2

-2

-4

-4

-6

-6 1998

99

2000

01

02

03

04

05

06

07

08

09

10

1. Year-on-year percentage change. US house price measured by Federal Housing Finance Agency (FHFA). 2. A unit decline in the index implies a tightening in financial conditions sufficient to produce an average reduction in the level of GDP by ½ to 1% after four to six quarters. See details in Guichard et al. (2009). Source: FHFA, Datastream and OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932358998


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Figure 1.5. Bank lending Year-on-year growth rate, per cent

15

15

Loans to the private non-financial sector 1

10

10

5

5

0

0 Euro area United States

-5

-10

2000

01

-5

02

03

04

05

06

07

08

09

10

20

-10 20

Loans to euro area firms and households Loans to non-financial corporations Consumer loans to households Loans to households for home purchase

15

15

10

10

5

5

0

0

-5

2000

01

02

03

04

05

06

07

08

09

10

-5

1. Data refer to commercial banks for the United States and monetary financial institutions for the euro area. Source: Datastream.

1 2 http://dx.doi.org/10.1787/888932359017

Private demand shrank in response to financial worries and the rebuilding of balance sheets The sharp fall in private demand was driven by a switch to rebuild balance sheets after the credit cycle, accelerated and aggravated by concerns about credit availability and confidence effects. Excessive private debt accumulation prior to the crisis led to increased savings in the wake of the crisis. The household saving rate increased from 9.5% to 11.5% of disposable income, at the same time as the value of net financial assets slumped (Figure 1.6). Similarly, the sharp fall in investment led to a rapid reduction in the borrowing needs of non-financial corporations. The increase in the savings rate, which in aggregate was smaller than in the United States and the United Kingdom which had initially much lower saving rates, can be seen most strongly in euro area countries that had the largest credit booms such as Ireland and Spain, while the savings rate was stable or even fell in some euro area economies (Chapter 2).

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Figure 1.6. Household net financial assets and savings As a percentage of disposable income

240

11.0 Net financial assets (left scale) Savings (right scale)

230

10.5

220

10.0

210

9.5

200

9.0

190

8.5

180

1999

2000

01

02

03

04

05

06

07

08

09

10

8.0

Source: OECD, OECD Economic Outlook 88 Database.

1 2 http://dx.doi.org/10.1787/888932359036

The narrowing of the internal imbalances through the reduction in net borrowing by the corporate sector and higher household saving was partly offset by growing fiscal deficits (Figure 1.7). This was the result of the automatic stabilisers, the fall in revenues associated with the credit cycle and the co-ordinated discretionary fiscal expansion across many euro area countries. The growing public sector deficit helped to attenuate the demand effects of the rapid retrenchment of private sector imbalances. Furthermore, financial rescue measures resulted in governments assuming some liabilities accumulated by the private sector, so that there was a limited parallel shift from private to public sector indebtedness.

Figure 1.7. Sectoral balances for the euro area Four-quarter moving sum, as a percentage of GDP

8

8 Net lending/borrowing

6

6

4

4

2

2

0

0

-2

-2

-4

-4 Financial corporations Households Non-financial corporations

-6 -8

2000

01

02

Government Total economy

03

04

05

-6 06

07

08

09

10

-8

Source: ECB.

1 2 http://dx.doi.org/10.1787/888932359055


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Unemployment increased but reductions in average hours helped to accommodate the crisis As a result of the sharp fall in demand, the euro area unemployment rate increased rapidly from around 7% to reach close to 10% of the labour force (Figure 1.8). It has stabilised at a rate just below the historical peak of the mid-1990s. The increase in unemployment was very large in some deficit countries, where economic and financial imbalances have been adjusting. In Spain, the unemployment rate jumped from 8% to 20%. By contrast, the unemployment rate in Germany barely nudged up. Overall, compared with previous recessions, the cumulative fall in employment has been small relative to the drop in output (OECD, 2010a). The weakness in labour demand has been accompanied by a reduction in average hours worked and a fall in output per hour worked, although adjustment tended to occur more in terms of employment in countries that are adjusting to excessive domestic demand prior to the crisis. While temporary short-time working schemes and employers’ fears of skill shortages have played a role, the overall robustness of the labour market could suggest that past structural reforms have helped to make labour markets more flexible and robust to cyclical downturn. This will be a crucial determinant of whether the current high level of unemployment persists as activity recovers. Labour hoarding reflected in below-trend labour productivity poses a higher risk that the recovery could be weak in terms of employment growth in the near term, while high unemployment and persistent weakness in demand in some peripheral economies may lead to scarring effects on employment.

Figure 1.8. The labour market is stabilising Per cent

Per cent

0.8

10.5

1

Employment growth (left scale) Unemployment rate (right scale)

0.6

10.0

0.4

9.5

0.2

9.0

-0.0

8.5

-0.2

8.0

-0.4

7.5

-0.6

7.0

-0.8

6.5

-1.0

2002

03

04

05

06

07

08

09

10

6.0

1. Quarter-on-quarter percentage change. Source: OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359074

Inflation moderated substantially With weak demand, core inflation has moderated to a low level, with the annual average change in prices close to 1% (Figure 1.9), though up from the trough reached in spring 2010. Although the moderation of inflation has been significant, core inflation has only reached a similar rate to that during the slowdown in 2000. This may be surprising given the size of the fall in demand. Headline inflation slowed more strongly due to the global fall in energy and food prices, and experienced a brief period of annual deflation in the third quarter of 2009. Low

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Figure 1.9. Inflationary pressures remain subdued Contribution to year-on-year inflation

5

5 Core inflation Processed food Energy and unprocessed food HICP inflation1

4 3

4 3

2

2

1

1

0

0

-1

-1

-2

2002

03

04

05

06

07

08

09

10

-2

1. Year-on-year percentage change of the harmonised consumer price index (HICP). Source: Eurostat.

1 2 http://dx.doi.org/10.1787/888932359093

inflation has been associated with wage moderation due to the difficult situation in the labour market: annual nominal hourly labour cost growth rate decelerated from a peak of 4% in the last quarter of 2007 to 1.6% in the second quarter of 2010. Inflation expectations appear to have remained well anchored, despite some fluctuations in indexed-link bond yields.

Policy support has helped to stabilise the economy and encourage recovery Monetary policy was eased swiftly and extensive liquidity support helped to stabilise markets The ECB provided rapid and powerful monetary stimulus in response to the crisis. Furthermore, changes to monetary operations helped to support the financial system and thereby maintain credit supply. Short-term nominal interest rates fell rapidly to reach their lowest ever levels, standing well over 100 basis points below their post-Asian crisis and post-dot.com bubble rates. In practice, overnight market interest rates were well below the policy rate due to the large amount of liquidity in the market, although interest rate spreads on corporate and household borrowing widened. Given short-term inflation expectations, real rates have been more accommodative than in earlier episodes. Policy support, in particular unconventional liquidity measures, played a key role in stabilising the situation in financial markets. Money markets started to function again and many banks regained access to short-term funds. Financial conditions gradually improved as policy rates remained low and confidence recovered, although fragilities have been exposed by successive rounds of financial market volatility. While three-month interbank rates have remained at extremely low levels, the reduction in lending rates for nonfinancial corporations and households has only partly reflected the fall in banks’ funding rates. While appropriate benchmark lending rates often differ from short-term interbank rates, a basic measure of spreads in lending to non-financial corporations increased from 130 basis points prior to the crisis to 240 basis points (Figure 1.10). High lending spreads compared with depressed spreads prior to the crisis may in part reflect higher risk premia and more difficult access to funds. These effects may be sustained to the extent that risks have been permanently re-assessed and the crisis has reduced competition, for example, through increasing concentration in the banking sector. OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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Figure 1.10. Interest rates on new loans to euro area residents1 Per cent

Per cent ECB official rate Three-month interbank rate Loans to non-financial corporations up to EUR 1 billion, floating rate & up to 1 year Consumer credit loans, up to 1 year Home purchase loans, over 10 years

10 8

10 8

6

6

4

4

2

2

0

2003

04

05

06

07

08

09

10

0

1. Loans by euro area monetary financial institutions. Source: ECB.

1 2 http://dx.doi.org/10.1787/888932359112

The effective euro exchange rate has shifted significantly at different points of the crisis. A proximate cause of the large decline around May 2010 was the fiscal crisis in the euro area, which weakened confidence in the currency as a whole and led to the sale of extra-euro area holdings of government debt. This depreciation of the exchange rate was beneficial to activity, particularly in countries such as Germany, which have a large share of exports invoiced in currencies against which the euro has fallen in value. A key risk for the euro is that mediumterm appreciation pressures could arise from weakness of the US dollar, amplified by dollar pegs in many large emerging markets. For some specific euro area countries, important links to non-euro trading partners such as Sweden, Switzerland and the United Kingdom have had important effects on their effective exchange rates during the crisis. Financial conditions appear to be recovering, despite setbacks such as those during the fiscal crisis in May 2010. The most recent ECB Bank Lending Survey shows a reduction in the net proportion of banks anticipating tightening lending standards for enterprises and households. Bank credit to households showed first signs of growth in the beginning of 2010, while credit to non-financial corporations has bottomed out. So far, the downturn in credit to the non-financial private sector was not surprising given that the fall in activity, and especially investment, naturally reduced the demand for borrowed funds. It remains to be seen whether credit constraints will emerge as a significant constraint as loan demand picks up. However, weak bank credit growth to non-financial corporations combined with strong issuance of debt securities by corporations in the early part of 2010 may point to some weakness in the supply of bank lending (IMF, 2010).

Fiscal support has been constrained by sustainability concerns Activity has been supported by the widening of the euro area budget deficit from 0.6% of GDP in 2007 to close to 6.5% in 2010 (Chapter 3). This largely reflects the operation of the automatic stabilisers, both in response to the downturn in activity and the collapse of buoyant revenues related to the financial boom. Discretionary stimulus measures were generally limited in most countries, with some exceptions such as Germany (OECD, 2010c). The room for fiscal support has been constrained by the weak starting position of public finances in many euro area countries combined with the costs associated with the

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financial crisis. Credit spreads widened for many euro area countries to very high levels as a result of rapidly deteriorating fiscal positions and an increase in risk aversion, although yields on government debt are generally lower overall. These pressures culminated in the sovereign risk crisis in May 2010. Mounting pressure on Greek public finances followed a loss of confidence, beginning with a massive restatement of data on the budget balance in October 2009. The confidence shock spread to other countries in the euro area with weak fiscal situations. The lack of a mechanism for dealing with countries with liquidity or solvency problems added to the cost of this situation. Furthermore, a commitment to help Greece in February 2010 was made without any specific details, and thus lacked credibility in financial markets and encouraged markets to test it, leading to sovereign spread pressures that unfolded dramatically in May. Co-ordinated EU and IMF programmes with Greece were adopted in May, which imposed strict conditionality in terms of fiscal consolidation and structural reforms in return for financing for three years (Box 1.1). Also in May, EU Member States agreed on the creation of

Box 1.1. Measures to deal with the fiscal crisis in Greece and in Europe Following the intense pressures on the sovereign debt of some euro area countries in the spring of 2010, measures were announced in May 2010 to deal with the fiscal crisis in Greece and rising bond spreads in a number of other euro area countries. The support for Greece has two elements and is accompanied by strict conditionality to reduce moral hazard: ●

Bilateral loans from euro area countries, except from Slovakia, co-ordinated and pooled by the European Commission and totalling up to EUR 80 billion over a three-year period. These funds are provided on an intergovernmental basis in proportion to the participating countries’ adjusted ECB capital key.

●

EUR 30 billion provided by the IMF under its Stand-By Arrangement.

A further potential support was created under the European Financial Stability Mechanism (EFSM) which expands the existing balance-of-payments assistance facility and is available under strict conditionality. The EFSM allows the Commission to raise up to EUR 60 billion on behalf of the EU for lending to all EU countries experiencing or being threatened by severe economic or financial disturbances. Furthermore, the European Financial Stability Facility (EFSF) was set up, which can provide up to EUR 440 billion in funds for lending to euro area countries subject to strong conditionality. It is based on an intergovernmental agreement between euro area countries. The EFSF has a mandate to establish new loan facility agreements during a three-year period. It is able to borrow on capital markets guaranteed by euro area countries and is set up as a limited liability company. Each euro area country has agreed to guarantee 120% of each debt issuance to ensure that the EFSF has a credit rating of AAA and the fund will have a cash reserve to enhance its credit standing. Guarantees are provided on a pro-rata basis, according to their adjusted share of the paid up capital at the ECB. The IMF has announced its intention to provide funds of up to half the EU and euro area's contribution in the context of joint programmes. The potential size of the total package, combining EU and IMF support, is equivalent to just over 9% of euro area GDP. In addition, the ECB put in place the Securities Market Programme. The creation of these facilities had an immediate stabilising effect on financial markets. However, the package does not address longer-term solvency concerns arising from the high debt burdens of some euro area governments, and sovereign spreads have since gone back to their peak levels. Reforms are necessary to help tackle longer-term solvency concerns effectively, beyond the horizon of the support offered by the new EU package.


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two additional instruments, the European Financial Stability Mechanism (EFSM), for both euro area and non-euro area countries, and the European Financial Stability Facility (EFSF) to provide financial support under strict conditionality for euro area countries (Chapter 3). At the same time, the ECB set up the Securities Markets Programme with the ability to make outright purchases of government and private debt to restore an appropriate monetary policy transmission mechanism through the stabilisation of certain securities markets. By September 2010, around EUR 60 billion of government bonds had been purchased, largely from euro area countries with difficult access to market financing.

A moderate recovery is underway A moderate recovery is underway (Figure 1.11). The euro area economy began to stabilise in the second quarter of 2009 and output has expanded for four consecutive quarters. The immediate recovery was driven by a rebound in trade and stockbuilding. Subsequently, the recovery has become more broad-based with consumption slowly recovering from late 2009 and investment having now begun to expand. The increase in activity of almost 1% during the second quarter of 2010 was exceptionally strong, only partly reflecting a weather-related rebound from weakness in the first quarter and other temporary factors, such as fiscal incentives fading away and forthcoming indirect tax increases.

Figure 1.11. Contribution to real GDP growth Contribution to change over previous quarter % points

% points

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

-1.0 Private consumption Government consumption Total investment Other domestic demand Net exports GDP growth

-1.5 -2.0 -2.5 -3.0

2002

03

04

-1.5 -2.0 -2.5 05

06

07

08

09

10

-3.0


1 2 http://dx.doi.org/10.1787/888932359131

The OECD forecasts that a moderate recovery will continue, driven by both domestic and external demand (OECD, 2010f). The growth will be increasingly driven by private demand, as fiscal consolidation plans are implemented. However, its pace will be held back by continued balance sheet adjustments in the private sector. Consumption is likely to expand at an increasing pace due to the recovery in financial wealth, stabilisation of house prices and low real interest rates. Investment would continue to grow supported by high corporate profits, but will be held back by excess capacity. Unemployment is likely to fall only slowly as hours of work lengthen, while the large slack will keep inflationary pressures weak in the short term. Considerable uncertainty remains about the pace and

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strength of the recovery and, although some significant downside risks remain, risks overall are broadly balanced. Over the coming years, the unwinding of imbalances is likely to reverse the regional growth pattern that prevailed in the run up to the crisis. Countries with large current account deficits will seek to rebuild their balance sheets, while there is scope for domestic absorption to expand in surplus economies (Figure 1.12). Adjustment may be particularly prolonged for countries that need to improve competitiveness if downward nominal rigidities hold back adjustment. In contrast to the previous upswing, area-wide monetary policy will tend to be accommodative for surplus countries and restrictive for economies undergoing adjustment from excessive internal demand, given expected inflation differentials. The consequent inflation pressures may help to rebalance euro area economies, alongside the on-going adjustment to savings and investment.

Figure 1.12. Growth by deficit and surplus countries1 Contributions to year-on-year percentage change of the euro area GDP % points

% points

4

4

2

2

0

0

-2

-2 Surplus countries Deficit countries Euro area

-4 -6 -8

2002

03

-4 -6 04

05

06

07

08

09

10

-8

1. The deficit and surplus countries are defined by their average current account balance as a share of GDP between 2002-07. Deficit countries are Greece, Ireland, Italy, Portugal, Slovak Republic, Slovenia and Spain, and surplus countries include Austria, Belgium, Finland, France, Germany, Luxembourg and the Netherlands. Source: OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359150

The monetary stimulus will need to be gradually withdrawn. In absence of upward pressures to inflation, the current low policy rate can be maintained in the short run, while market interest rates are allowed to recover as emergency liquidity is drained. However, the policy rates should be raised as soon as upward pressures to inflation start to threaten medium-term price stability. The unwinding of unconventional policy measures has already begun with the maturing of 12-month operations. Short-term fine-tuning operations are helping to smooth this process. Many of these measures can be left to simply expire provided financial conditions improve sufficiently so that monetary policy transmission is normalised. If held to maturity or sold when prices are favourable, holdings under the Covered Bond and Securities Markets Programmes should not lead to losses and in principle these positions should be smoothly unwound as market conditions allow. A key uncertainty in the coming years regards the level of potential output, as discussed below, and how quickly price pressures will emerge as activity expands. Monetary policy can remain more accommodative for longer if fiscal consolidation, which is likely to restrain demand growth in the short term, is undertaken as planned and downward pressures to inflation arise that would threaten price stability in the medium term. However, potential distortions in financial markets, that might emerge if low interest rates


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remain below long-run norms for a prolonged period, have to be carefully monitored. There is a risk of keeping rates too low for long and this could have repercussions in a global context, potentially leading to asset-price misalignments and harmful capital flows. Fiscal consolidation is now needed to return the public finances to a sustainable footing. Current programmes are largely aimed at reducing deficits to below 3% of GDP by 2013. This approach is in principle differentiated by the situation of each country, although in practice this is limited and some countries that had overheating economies have had to embark on strongly pro-cyclical consolidation as the result of rising financing costs. As discussed in Chapter 3, a major and sustained effort will be required to bring the debt-to-GDP back to its pre-crisis level and, in particular, to reduce it below the 60% of GDP threshold in the Stability and Growth Pact (SGP). The approach should be differentiated across countries depending on the urgency of consolidation needs and their economic situation. Despite massive public support, the health of the European banking sector remains the key risk for the recovery. On the one hand, profits have improved despite large chargeoffs and loan provisions due to low funding costs, high net income from interest margins and investment banking activities. As banks made relatively modest dividend payments and raised large amounts of equity from the markets, they increased their capital positions in 2009 and improved the quality of capital by converting some of their hybrid liabilities into equity. However, they are unlikely to have cleaned their balance sheets of all weak assets and will continue to suffer continued losses from the lagged effects of the downturn. Potential write-downs on loans remain high and further strengthening of the capital base is likely to be necessary to ensure that the supply of credit is adequate (Figure 1.13). Banks in some countries may also face difficulties in meeting new capital requirements, although extended implementation period should reduce pressures. Banks’ vulnerability continues to cause stress in the interbank market but the scale is not comparable to the peak of the crisis. Both spreads between three-month interbank and expected average overnight rates, and particularly credit default swap (CDS) spreads on banks’ bonds remain well above precrisis levels and proved sensitive to the fiscal crisis in May 2010.

Figure 1.13. Potential write-downs on securities and loans facing the euro area banking sector EUR billions

EUR billions

200

200

150

150

100

100

50

50

0

-50

0 Loans Securities

2007

2008

2009

2010

2011

-50

Source: ECB (2010), Financial Stability Review, June.

1 2 http://dx.doi.org/10.1787/888932359169

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The results of the EU-wide stress tests (CEBS, 2010) published in July 2010 reduced uncertainty. Under the assumptions used and conditional on maintaining government support, the vast majority of banks appeared to be able to meet regulatory requirements even under the stressed scenario. The accompanying data, however, indicated that banks in some countries continue to hold large and highly concentrated banking and trading book exposures to sovereign debt of their own country (Figure 1.14). Emergency measures announced in May 2010 to address financial market turbulence in some countries of the euro area have diminished significantly the risks of losses on banks’ holdings of Greek and southern European assets. Nevertheless, longer-term sovereign debt sustainability remains a challenge and banks from some peripheral countries, although fundamentally well-capitalised, continue to face difficulties in tapping interbank markets. As a result, they continue to be highly dependent on liquidity from the European Central Bank.

Figure 1.14. Largest banking exposures to sovereign debt Exposures as a share of tier 1 capital, March 2010

Exposures to:

250 Greece

Italy

Spain

250 Portugal

Ireland

200

200

150

150

100

100

50

50

0

GRC BEL DEU PRT

LUX ITA BEL DEU

ESP DEU BEL FRA

PRT BEL DEU ESP

IRL DEU PRT DNK

0

Source: A. Blundell-Wignall and P. Slovik (2010), “The EU Stress Test and Sovereign Debt Exposures”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 4, OECD Financial Affairs Division. 1 2 http://dx.doi.org/10.1787/888932359188

Potential output is likely to be lower in the wake of the crisis The economic crisis is likely to result in a permanent loss in the level of potential output. Even with the recovery, GDP may never catch up to its pre-crisis expected trajectory. The extent of these losses is very uncertain, but current OECD estimates suggest a peak euro area-wide reduction of about 3% in the level of potential output (OECD, 2010a). About two-thirds of the shortfall under this scenario results from an assumed cost of capital that is ultimately higher compared with before the crisis, which reduces the capital-labour ratio and labour productivity. The remainder of the fall is projected to stem from labour market changes. Evidence of previous severe recessions in OECD countries suggests that sharp increases in unemployment are long-lasting and often not completely reversed in subsequent recoveries. The peak increase in the euro area structural unemployment rate is estimated at around 0.5% percentage points, although this varies widely across countries. The effect of a prolonged period of slack in the labour market is assumed to reduce trend labour force participation, with the youngest and oldest workers being most severely affected. For a typical OECD country, this effect could reduce potential output by up to 1 percentage point over the medium term. There may be an additional


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adverse effect on total factor productivity from lower research and development (R&D) expenditures, but the magnitude of this effect is particularly difficult to estimate. R&D investment might even be countercyclical in less credit-constrained firms (Aghion et al., 2008). The crisis itself is not expected to affect rates of potential growth in the longer term, although trend growth is nevertheless expected to continue to slow, primarily due to ageing effects. The lower level of potential output and the weak underlying trends underline the importance of growth-enhancing structural reforms to labour and product markets. Comprehensive structural reforms are essential for limiting the long-term effects of the crisis, bringing productivity and labour utilisation up to the levels of the top OECD performers, and meeting the objectives of Europe 2020 Strategy of “a smart, sustainable and inclusive Europe”. Easing of restrictive product market regulations and employment protection are particularly important to boost potential growth in many countries. Reductions in anti-competitive product market regulation (PMR) can accelerate average euro area productivity growth and support real convergence across countries. Productivity gains obtained from such reforms could improve significantly potential output growth through the spillovers across sectors (Bourlès et al., 2010). Only modest steps to reduce PMR have been taken so far in this crisis, but aligning anti-competitive PMR to OECD best practice might raise GDP per capita levels by as much as 2.5% in the typical euro area country even without allowing for gains from increased employment (Boulhol et al., 2008). Raising competition in network industries, encouraging greater competition in the services sector are among main challenges (OECD, 2010b), while re-energising the single market should address “missing links” and “bottlenecks” (Monti, 2010). Labour market reforms can also have substantial effects on GDP-per capita levels in the long run: for example, a 5 percentage point reduction in unemployment benefit replacement rates could increase employment rates by about 2.5 percentage points, amounting to a roughly similar gain in the level of GDP per capita (Bassanini and Duval, 2006). Raising retirement age and reducing implicit tax on continued work at older ages would also have an important contribution to GDP per capita, in the range of 0.5% to 1% in the typical euro area country for a reform improving respective indicators by one standard deviation of their most recent values across OECD countries (Barnes et al., forthcoming). Removing barriers to labour mobility by increasing the portability of pensions and social welfare rates, as well as facilitating the recognition of qualifications, would help to enhance the functioning of labour markets, and support rebalancing growth pattern across countries. Long-term growth can also be boosted by educational reforms and strengthening innovation, while leadership in transition to low-carbon economy should give Europe long-term competitive edge (OECD, 2009b).

Support for the financial system has been ad hoc , although within co-ordinated policy guidelines Government support for the financial system was piecemeal at the beginning of the crisis but co-ordination across countries improved as the crisis deepened, with agreements reached in October 2008 on an EU response to the crisis and four Commission communications on state aid. Although EU legislation, ensuring the harmonisation of the minimum level guaranteed has been in force since 1994, deposit guarantee schemes continued to provide varying degrees of protection and were adjusted in 2008; further harmonisation is currently proposed. Most euro area countries adopted national guarantee

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schemes, but some relied only on ad hoc measures. Few countries provided other liquidity interventions. The use of capital injections has been confined to a small number of institutions and has exceeded 5% of GDP only in Belgium and Ireland. A few euro area countries have provided relief for impaired banking assets. Germany and Ireland have set up “bad bank”–type arrangements to take impaired assets from banks’ balance sheets. While banking problems differed across countries, the heterogeneous approach suggests that countries may also have been tacitly pursuing different approaches. All interventions were subject to EU state aid and competition rules. State aid rules were temporarily relaxed in 2008 to deal with the financial crisis,3 although the approach continued to apply the same rules across EU countries and thereby helped to minimise to a certain extent the potential for increasing cross-border market distortions. However, many financial interventions were designed primarily with domestic banking groups in mind, and while non-domestic institutions could join, few took up this offer in practice, given support schemes at home. This may have contributed to cross-border disintermediation (Chapter 4). Past experience suggests that the fiscal costs of banking crises, including the impact of weak demand, are reduced by early intervention to identify which banks are strong, which banks would benefit from measures to strengthen their balance sheets, and which banks need to be put through a resolution mechanism (OECD, 2002). Early intervention avoids the cost of allowing impaired institutions to limp on for extended periods of time. Transparency has also been helpful. In the United States, confidence was boosted by the publication of results of a national stress test on the largest 19 US-based banks on 7 May 2009. Just over half of the sample of banks, including the two largest, was asked to raise additional capital. The first EU-wide stress tests’ results were published on 1 October 2009. These covered 22 banks and published results referred to the aggregate position only, although they noted that no bank would see its tier 1 capital ratio fall under 6% in the adverse scenario. In the meantime, many countries gathered additional information about their banking systems in the context of guarantee and other support measures. It was only with a second round of EU-wide stress tests published in July 2010 that institution-specific details became available (CEBS, 2010). The exercise was extended to include 91 institutions, collectively representing 65% of EU bank balance sheets and at least 50% of each country’s banking market. In Spain, all banks were subject to the test. Overall, seven European banks were found to be inadequately capitalised and measures were put in place to support them. The publication of the stress tests improved confidence in the banking system. While it is important for supervisors to identify and address problems quickly, this can be more difficult to achieve where cross-border co-ordination and burden sharing are required. There is a risk that this leads to a form of supervisory forbearance and inaction, either due to lack of information among the different parties or because of the complexity of resolving the problem. However, in cases where national authorities in one country would be in a relatively strong position in the event of an institution getting into trouble, these same factors could also lead to an institution being put through a resolution process prematurely. Strong co-ordination is therefore required in cases of cross-border institutions. An important problem in the overall management of banking crisis is that few losses have been carried by the private sector, which creates a risk of moral hazard. The EU Common Principles only refer to “existing shareholders” bearing the due consequences of OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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the intervention, consistent with the fact that no debt holders have thus far been required to carry losses. Although it is rare in the OECD experience for debt holders to carry losses, this did happen during the crisis with, for example, the failure of Washington Mutual and Lehman Brothers in the United States. Furthermore, the Common Principles are ambiguous about whether systemically important institutions should be rescued. While it can be difficult in practice to assess whether the failure of an institution would have a systemic role, it is nevertheless important in principle that interventions focus on systemic institutions and it appears that some banks that were helped were not systemic in terms of size, complexity or interconnectedness. Many countries have lacked an effective set of resolution tools, which would allow banks to be rapidly restructured or wound down. This has made it difficult to prevent the government taking responsibility for supporting financial institutions. Crisis-management arrangements should be stepped up and all countries should have a robust set of legal instruments to ensure swift and effective resolution of weak financial institutions (Chapter 4). Significant reforms to financial crisis management are proposed to address these weaknesses (EC, 2010a).

Financial conditions and the severe slowdown have tested monetary policy Overall, monetary policy during the crisis has been effectively deployed to support nominal demand against a background of low inflationary pressures, as the ECB has played an important role in maintaining liquidity in financial markets and avoiding a credit crunch. Furthermore, the adjustments needed to the ECB’s operating framework were on the whole relatively limited and could be constructed in a coherent way. However, the ECB has undertaken actions during the crisis that will need to be taken into account in the future design of monetary policy implementation and the experience of this first crisis since the creation of the monetary union should be used to anticipate any future crisis. The Eurosystem has greatly expanded its balance sheet, mainly by lengthening the average maturity of its repurchase operations, combined with a temporary broadening of its eligible collateral, complemented by appropriate risk-management measures. Furthermore, given the functioning of the euro area money markets and the low level of market interest rates, the ECB is likely to have suffered from strong adverse selection effects, with weaker institutions tending to rely more heavily on ECB finance and less liquid collateral being submitted to the ECB. The central bank also experienced very limited losses on its operations during the crisis in connection with the failure of Lehman Brothers. The absolute increase in risk is likely to have been very small as a result of these crisis actions. This is because risky assets remain a small share of the balance sheet and monetary operations are based on collateralised lending, so that a loss would only in principle arise if both the borrower and the issuer of the collateral were to fail. In addition, the ECB’s risk management procedures impose valuation margins that lead to positions being over collateralised. The Governing Council of the ECB can call on additional capital from member countries to protect itself against a weakening of its balance sheet. The ECB reviews its collateral policy on a regular basis and it is appropriate that this should continue. The monetary policy transmission mechanism has been affected since the crisis by a dysfunction in the financial markets. Together with subdued inflation tending to increase real rates, higher spreads and tighter lending conditions, these factors raise the question of whether additional policy stimulus may have been warranted in the form of lower policy interest rates or explicit quantitative easing measures to raise the money supply. ECB

38


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policy rates remained slightly above the so-called zero nominal lower bound during the crisis, while overnight market rates fell to very low levels. Some other major central banks reduced policy rates marginally further, although the additional stimulus from so doing is likely to have been quite small. One constraint is how wide the difference between deposit and marginal lending rates should be. A sufficient gap is required to provide incentives for market participants to intermediate between themselves rather than simply use the central bank as a central clearing house. In addition, with low levels of policy rates, the deposit rate would have come close to zero. In Sweden, this was even reduced to a negative rate. In principle, policy interest rates could be lower than zero subject to the constraint that the services provided by overnight deposits remain more valuable than the penalty on holding them. The ECB did not engage in quantitative easing along the lines adopted by some other OECD countries, which had the expressed intention of boosting the money supply. The ECB has, however, made limited purchases of government debt under the Securities Markets Programme in the secondary markets aimed at ensuring adequate functioning of the transmission mechanism in the face of intense pressures in sovereign debt markets. The ECB has taken unprecedented measures during the crisis to fulfil its mandate of price stability. In that context, the ECB has made it clear that it is willing to adopt unconventional measures on a large scale to protect the monetary policy transmission mechanism. As a result, the ECB has become more involved with financial and fiscal issues. Most directly, the Covered Bond and Securities Markets Programmes have led the ECB to purchase both corporate and government debt. The ECB has also been involved in the development and progress monitoring of the rescue package for Greece. These actions could be justified by the crisis situation. Furthermore, the firm anchoring of inflation expectations suggests that there has not been a significant negative effect on the credibility of the ECB. However, with an effective crisis-management framework, together with sounder economic, financial and fiscal governance, the actions of the ECB in fulfilling its mandate of price stability could be facilitated. The disruptive effects of the credit and asset price cycles raise the question of whether monetary policy can better meet its price stability objective by taking into account these pressures. The ECB’s two-pillar monetary strategy already puts great emphasis on monetary and credit developments. However, over 2002 to 2007, the average squared deviation of the annual inflation rate at monthly frequency from the implicit target was only 0.4%, while the growth of the M3 monetary aggregate was always well above the 4.5% reference rate and averaged almost 8%. Although the monetary pillar cannot be interpreted mechanically, this deviation raises serious questions. Furthermore, the unconditional relationship between the growth of broad money and nominal GDP broke down spectacularly around the end of 2000 (Figure 1.15). Recent empirical analysis by the ECB suggests that this can be explained by shifts in wealth (see Stark, 2010 for an overview). However, this begs the question of whether the rising value of assets was not itself the result of fast credit growth and ample liquidity. Consideration should continue to be given to factors such as asset-price and balance sheet growth that may present risks to price stability at medium– to long-term horizons. The monetary pillar of the ECB already leads to close attention being paid to monetary and credit developments. Recent developments in this analysis are set out in Papademos and Stark (eds) (2010). This approach should continue to be enhanced in order to be incorporated effectively and systematically into the policy process, and to ensure that inflation expectations remain well-anchored.


39

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Figure 1.15. Broad money1 and nominal GDP Year-on-year percentage change Per cent

Per cent

14

14

12

12

10

10

8

8

6

6

4

4 Broad money Nominal GDP

2

2

0

0

-2

-2

-4

1982

84

86

88

90

92

94

96

98

2000

02

04

06

08

10

-4

1. Broad money defined as M3 aggregate. Source: ECB and OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359207

Monetary policy is a blunt instrument to deflate bubbles, except at the margins.4 This calls for effective macroprudential policies. While there are difficulties in real time in identifying unsustainable credit and asset price movements, a reasonable assessment is not impossible. Macroprudential policy should address the structural reasons for booms, make the financial system less cyclical and allow for discretionary regulatory measures if bubbles and unsustainable credit booms nevertheless emerge. The creation of the European Systemic Risk Board (ESRB), as well as other measures to strengthen financial regulations, should contribute to addressing this problem (Chapter 4). Information from the monetary pillar could be a valuable input into the work of the ESRB. As regards monetary policy, it is important that the monetary analysis continues to enter into policy decisions in a symmetric way. The ECB’s upgraded set of monetary models should be used regularly in support of the monetary analysis in the Monthly Bulletin (OECD, 2009a).

A coherent approach to economic governance is required at euro area, EU and national levels The weaknesses that have been exposed in policies at both the euro area and national levels are in some ways similar in nature, if not extent. The crisis has shown the close interconnections between financial, economic and fiscal developments with increasing financial risks bursting into a severe downturn and a large burden on the public finances through the unanticipated shortfall in revenues and in some cases large costs associated with supporting the financial system. Likewise, in the build-up to the crisis, the dynamics of the financial market contributed to growth and led to buoyant fiscal revenues. The same pressures, sometimes with greater intensity at national level, were responsible for large imbalances across the euro area. These were related to failures at euro area-wide and country level markets to assess risks and exert discipline, while policies failed to dampen these pressures. Bold and cross-cutting reforms are needed at the EU, euro area and national level to improve economic, financial and fiscal stability. To address the large economic, financial and fiscal imbalances, greater differentiation of national policy settings is required within a reinforced common framework of minimum standards. While the appropriate monetary

40


1.


policy framework is basically in place, fiscal and macroprudential policies need to be upgraded at both the European and country level. A wide range of reforms is currently under consideration by the euro area and EU authorities. Given the current political architecture of the euro area and the European Union, policy solutions must be designed taking into account the absence of a fiscal union and the ultimate responsibility each country has for its public finances. This limits how far fiscal policies can be controlled at EU level and makes it more difficult, for example, to undertake some common projects such as an integrated system of banking supervision. Market discipline on the behaviour of private and public economic agents can play a mutually reinforcing role to institutional solutions such as enhanced regulation, oversight and enforcement. Furthermore, given that neither approach has been shown to be sufficient, use of the two approaches will be helpful to make the system as robust as possible. Across many areas, including financial and fiscal discipline, the development of more effective crisis-management tools is required both to improve the way crises are handled and strengthen the ex ante credibility of no bailout commitment. Structural reforms to labour and product markets should be prioritised, not only to raise living standards but also to make the euro area and national economies more resilient (Duval et al., 2007). Such policies can mitigate the impact of economic shocks on the economy and their persistence. Although there may be a trade-off between these effects, empirical evidence suggests that the net impact of less rigid policies on the economy is positive (Duval and Vogel, 2007). Reforms to reduce wage and price stickiness would be particularly effective, given the relatively high barriers to adjustment in many euro area countries compared with the most flexible OECD economies. These barriers include stringent employment protection legislation (EPL), high coverage of collective agreements bargained between unions and firms, and restrictive product market regulation (PMR). While comparatively stringent policy settings may have dampened the initial impact of the crisis in many euro area countries, they could now delay economic recovery and possibly lead to larger cumulative output losses than elsewhere, as occurred in the aftermath of the 2000-01 economic downturn (OECD, 2006). There have been significant cross-country differences in the past in the response of long-term unemployment to shocks, with stringent PMR and high unemployment benefit replacement rates amplifying the response, and public spending on active labour market policies (ALMPs) dampening it. Reforms would help stem a rise in structural unemployment and a decline in labour force participation, and assist necessary structural changes in sectors permanently affected by the financial crisis. Structural policies leading to greater price adjustment and higher productivity are particularly important for deficit countries needing to rebalance demand, improve price competitiveness and deal with high rate of unemployment (EC, 2010b; OECD 2010d,e). While a flexible and integrated Single Market is a prerequisite for smooth functioning of the monetary union, it is paradoxical that euro area countries are less compliant with the single market legislation than other EU countries (Monti, 2010). Co-ordination of the response to the crisis has at times been complicated by the institutional framework of the European Union and the euro area, with powers allocated across national and supranational bodies, as well as a multitude of actors. Speed and cohesion of action and communication can be very important in a crisis. This is easier to achieve within a nation state where the decision-making process is less complex. With the entry into force of the Lisbon Treaty in December 2009, the Euro Group has been recognised


41

1.


for the first time as an EU body, albeit informal, to enhance co-ordination of economic policies. Moreover, the Treaty empowers euro area members of the Council to take formal decisions related to certain euro area matters. Article 136 of the new Treaty gives euro area countries the legal possibility to strengthen the co-ordination and surveillance of budgetary discipline and to adopt specific policy guidelines for the euro area.

Box 1.2. Summary recommendations on exiting the crisis Recovery is now underway but substantial risks remain. Resolving economic, financial and fiscal imbalances that built up in some countries will be a difficult and prolonged process (Chapter 2). Measures to stabilise and repair the financial system ●

Policy support to the financial system should gradually be wound down as conditions allow, including by gradually raising the cost of using support measures. The authorities should ensure that banks are adequately capitalised and transparent about the extent of their problems.

●

EU-wide stress tests of the banking system should be repeated at regular intervals and further harmonised.

●

All euro area countries should have a full set of policy instruments to resolve financial difficulties, allowing failing institutions to be resolved in an orderly, timely and efficient way (Chapter 4). These should ensure that the costs of bank failures are carried as much as possible by shareholders and creditors.

Monetary policy ●

Monetary policy stimulus should be withdrawn as soon as upward pressures to inflation emerge.

●

Non-standard policy measures should continue to be withdrawn in line with improvements in the monetary policy transmission mechanism, but policy should remain prepared to react if downside risks in the financial sector materialise.

●

Consideration should continue to be given to factors such as asset prices and balancesheet growth that may present inflation risks at medium– and long-term horizon. Monetary analysis should continue to be enhanced in order to be effectively and systematically incorporated into the policy process.

Macroprudential policy ●

The creation of the European Systemic Risk Board (ESRB) is welcome, alongside other measure to make the financial system more robust and to reduce likelihood of disruptive financial cycles (Chapter 4).

Fiscal policy

42

●

Fiscal consolidation is the immediate priority to stabilise the public finances and should begin by 2011 in all countries (Chapter 3). Temporary stimulus measures should be withdrawn as planned. Front-loaded measures are required in some countries.

●

Detailed and credible forward-looking and multi-year consolidation plans should be set out in all countries. Consolidation should focus on expenditures, particularly long-term spending commitments, and designed to minimise the impact on growth, both in the short run and further ahead.


1.


Box 1.2. Summary recommendations on exiting the crisis (cont.) Improving economic performance and creating growth ●

Structural reforms in labour and product markets should be undertaken to facilitate economic adjustment in the short term and raise growth of potential output. This should include meeting the objectives of Europe 2020 and deepening the single market. Fiscal consolidation provides an opportunity to reform tax systems and make provision of government services more efficient. The EU Services Directive should be fully transposed and implemented.

Governance of the euro area ●

National policies for euro area countries should be treated more systematically as matter for common concern, implying stronger links between EU and national policies and greater co-ordination between macroeconomic, fiscal, structural and financial policies.

●

Crisis-management arrangements should be strengthened by the creation of a permanent crisis-resolution mechanism, subject to strong conditionality.

Notes 1. Council of the European Union, 2894th council meeting, Economic and Financial Affairs, Luxembourg, 7 October 2008. 2. The March 2009 amendment of the EU Deposit Guarantee Schemes Directive raises this ceiling to EUR 100 000, to be gradually implemented by the end of 2010. 3. See Communication from the Commission “The Application of State Aid Rules to Measures Taken in Relation to Financial Institutions in the Context of the Current Global Financial Crisis” of 13 October 2008. 4. See “Counter-Cyclical Economic Policy” in OECD (2010a).

Bibliography Aghion, P. et al. (2008), “Credit Constraints and the Cyclicality of R&D Investment: Evidence from France”, Working paper, 198, Banque de France. Barnes, S. et al. (forthcoming), “The GDP Impact of Structural Reform: A Simulation Framework”, OECD Economics Department Working Papers, OECD, Paris. Bassanini, A. and R. Duval (2006), “Employment Patterns in OECD Countries: Reassessing the Role of Policies and Institutions”, OECD Economics Department Working Papers, No. 486, OECD, Paris. Blundell-Wignall, A. and P. Slovik (2010), “The EU Stress Test and Sovereign Debt Exposures”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 4, OECD Financial Affairs Division, OECD, Paris. Boulhol, H., A. de Serres and M. Molnar (2008), “The Contribution of Economic Geography to GDP Per Capita”, OECD Economics Department Working Papers, No. 602, OECD, Paris. Bourlès, R. et al. (2010), “Do Product Market Regulations in Upstream Sectors Curb Productivity Growth? Panel Data Evidence for OECD Countries”, mimeo, OECD, Paris. Committee of European Banking Supervisors (CEBS) (2009), “CEBS’S Press Release on the Results of the EU-wide Stress Testing Exercise”, London, 1 October. CEBS (2010), “Aggregate Outcome of the 2010 EU Wide Stress Test Exercise Co-ordinated by CEBS in Co-operation with the ECB”, London, 23 July. Duval, R., J. Elmeskov and L. Vogel (2007), “Structural Policies and Economic Resilience to Shocks”, OECD Economics Department Working Papers, No. 567, OECD, Paris.


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Duval, R. and L. Vogel (2007), “How do Nominal and Real Rigidities Interact? A Tale of the Second Best”, OECD Economics Department, mimeo. European Central Bank (ECB) (2009), Financial Stability Review, December. ECB (2010), Financial Stability Review, June. European Commission (EC) (2010a), “An EU Framework for Cross-Border Crisis Management in the Banking Sector”, Commission Communication, COM (2010) 561, 20 October. EC (2010b), “A look at Past Episodes of Current Account Adjustment”, Quarterly Report on the Euro Area, Vol. 9, No. 3. Guichard, S., D. Haugh and D. Turner (2009), “Quantifying the Effect of Financial Conditions in the Euro Area, Japan, United Kingdom and United States”, OECD Economics Department Working Papers, No. 677, OECD, Paris. IMF (2010), Euro Area Policies: 2010 Article IV Consultation – Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Member Countries, Country Report No. 10/221. Monti, M. (2010), “A New Strategy for the Single Market: At the Service of Europe’s Economy and Society”, Report to the President of the European Commission, 9 May. OECD (2002), Financial Market Trends, No. 82, June, OECD, Paris. OECD (2006), OECD Employment Outlook: Boosting Jobs and Incomes, OECD, Paris. OECD (2009a), OECD Economic Surveys: Euro Area, OECD, Paris. OECD (2009b), OECD Economic Surveys: European Union, OECD, Paris. OECD (2010a), OECD Economic Outlook, No. 87, May, OECD, Paris. OECD (2010b), Going for Growth, OECD, Paris. OECD (2010c), OECD Economic Surveys: Germany, OECD, Paris. OECD (2010d), OECD Economic Surveys: Portugal, OECD, Paris. OECD (2010e), OECD Economic Surveys: Spain, OECD, Paris. OECD (2010f), OECD Economic Outlook, No. 88, November, OECD, Paris. Papademos, L. and J. Stark (eds.) (2010), “Enhancing Monetary Analysis”, ECB, Frankfurt. Stark, J. (2010), “Enhancing the ECB’S Monetary Analysis – What Have We Learnt?”, Speech at “The ECB and Its Watchers” conference, Frankfurt, 9 July.

44



Chapter 2

Resolving and avoiding unsustainable imbalances Some euro area countries accumulated large and persistent external imbalances during the upswing, revealing important weaknesses in the macroeconomic management of the monetary union. Greece, Ireland, Portugal and Spain ran large current account deficits by historical standards, while Finland, Germany and the Netherlands had substantial surpluses. Some of these deficits and surpluses were larger than appear justified by economic fundamentals. The massive debt accumulation made deficit economies vulnerable to shocks, complicated their recovery from the world financial crisis, and has challenged the stability of the euro area. In some countries, fiscal policy failed to counter and sometimes aggravated these pressures. External imbalances were driven by underlying domestic economic, financial and sometimes fiscal imbalances. These were the result of a combination of a wide range of country-specific shocks and insufficient macroeconomic and financial stabilisation. Movements in real interest rates in some countries contributed to diverging borrowing and saving patterns, which fuelled credit booms and a weakening of competitiveness in some deficit countries. Weaknesses in financial regulation and over-optimistic growth expectations encouraged excessive risk-taking in both deficit and surplus countries. Harmful imbalances can be characterised by a misallocation of resources and increased vulnerability. When the financial crisis hit, some deficit countries faced the combined problems of a sharp contraction in private demand, an impaired financial system and weak public finances. Unwinding large imbalances, in both deficit and surplus countries, will be a prolonged and difficult process. A new and cross-cutting approach to economic and financial management in the euro area is required to ensure balanced development in the future. While the shocks that led to this build-up of imbalances may not recur, similar pressures are likely to arise within the monetary union in the future. Macroeconomic, financial and fiscal management should be strengthened in an integrated way, alongside structural reforms. This should aim to achieve the differentiation necessary to improve stabilisation of national economies, while ensuring that the euro area as a whole is protected from unsustainable developments in individual countries. Important legislative changes are underway at EU level to improve the surveillance of imbalances and to help ensure that the necessary corrective action is undertaken where risks emerge.

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2.

RESOLVING AND AVOIDING UNSUSTAINABLE IMBALANCES

L

arge and persistent intra-euro area imbalances built up during the economic upswing, creating tensions that contributed to the economic and financial crisis, although the euro area as a whole was close to current account balance. This chapter begins by analysing how far these current account imbalances reflected the efficient operation of a monetary union and to what extent these imbalances may have been excessive. There were large current account surpluses and deficits in some euro area countries as the result of internal economic, financial and fiscal imbalances, combined with structural misalignments and rigidities. The stabilisation of underlying shocks was ineffective and real interest rates divergences sometimes played a destabilising role, particularly in deficit countries where easy borrowing conditions led to credit and house-price cycles combined with an erosion of price competitiveness. The search for high yields acted as an incentive to excessive risktaking in surplus countries. Excess saving in surplus countries was channelled through capital markets into deficit countries: while this process could in principle facilitate the efficient allocation of capital, there was a misallocation of capital due to weaknesses in financial regulation and expectations that turned out to be too optimistic. The second section of the chapter sets out the immediate need to resolve the existing imbalances, beginning by stabilising the financial sector and public finances of countries that have suffered the most severe downturns. Although there were idiosyncratic features to the imbalances over the past decade, similar pressures are likely to arise again within the monetary union. A new and cross-cutting approach is required to prevent excessive imbalances arising to the same extent in the future. This should rest on a broad range of policies to address the sources of imbalances, including sound fiscal policy and more effective macroprudential policies, supported by structural reforms. It is essential that policy settings are more differentiated across countries, while ensuring that the euro area as a whole is protected from unsustainable positions at national level. There is a role for enhanced surveillance of imbalances at Euro Group and EU levels. The fiscal and financial aspects of the necessary reforms, both at the EU and national levels, are developed in greater depth in Chapters 3 and 4 respectively.

Large and persistent external imbalances built up during the upswing Some euro area countries ran very large current account imbalances during the upswing, which were among the largest in OECD countries. From 2002 to 2007, the current account deficits in Greece, Portugal and Spain averaged over 7% of national GDP (Figure 2.1, upper panel).1 By contrast, Finland, Germany and the Netherlands ran average surpluses of over 5% of GDP. Deficits were not primarily financed by foreign direct investment (FDI). As the aggregate euro area current account position was close to balance, the borrowing of countries such as Italy and Spain effectively largely counterbalanced large German and, to a lesser extent, Dutch surpluses (Figure 2.1, lower panel). Since the beginning of the financial crisis, the dispersion of current account balances has narrowed considerably with some reduction in surpluses and, with the collapse in domestic demand, a more marked narrowing of deficits, notably in Spain (OECD, 2010a).

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Figure 2.1. External balances in euro area countries 15

15 Average current account balances in OECD countries As a percentage of national GDP, 2002-07

10

10

5

5

0

0

-5

-5

3

CHE

NOR

JPN

SWE

DNK

CAN

KOR

MEX

POL

GBR

CZE

TUR

NZL

AUS

ISL

HUN

LUX

FIN

NLD

BEL

-10

Other OECD countries DEU

AUT

ITA

FRA

IRL

SVN

ESP

SVK

PRT

GRC

Euro area countries

USA

-10

3 National contributions to the euro area current account balance As a percentage of euro area GDP

2

2

1

1

0

0

-1

-1

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Germany France Italy

1992

94

Spain Other Euro area

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-2

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1 2 http://dx.doi.org/10.1787/888932359226

The scale and persistence of the imbalances was greater than in earlier decades (Figure 2.2). In 1998, current account imbalances in the euro area countries ranged from – 5% to 7% of GDP with the average absolute imbalance at 3% of GDP. By 2007, the range had widened to –14% to 8% of GDP and the average absolute imbalance had doubled to 6% of GDP. Although euro area countries have experienced large imbalances in the past, with Ireland and Portugal for example running very large deficits in the early 1980s, the broadbased widening of external imbalances during the upswing was new. The large imbalances contributed to a wide dispersion of net international liabilities. Greece, Portugal and Spain had accumulated net foreign liabilities of over 70% of national GDP by 2008 (Figure 2.3). This degree of external indebtedness was among the highest in the OECD and large by the historical experience of euro area countries. Only Finland had previously experienced a similar situation, following the collapse of the Soviet Union. Net foreign asset positions in creditor euro area countries also reached a high level with a net positive position of 20% of GDP in Germany and more than 40% in Belgium and


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Figure 2.2. Current account balances1 As a percentage of national GDP

10

10

5

5

0

0

-5

-5 Germany France Greece Ireland

-10 -15 1975

80

Italy Netherlands Portugal Spain

85

90

-10 -15

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2000

05

1. The shaded area indicates the range between the 25th and 75th percentiles. Source: OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359245

Luxembourg.2 The net asset positions as a share of GDP of the latter three countries are similar to those of Japan and Norway. The euro area as a whole was close to balance in terms of the net foreign asset position as the large internal imbalances were largely offsetting. However, the absolute size of the net asset positions of some countries was significant in global terms: Germany’s net foreign asset position in 2008 was just under 40% of the size of Japan’s in dollar terms and around 60% of China’s.

Figure 2.3. Net foreign asset positions As a percentage of GDP, 2008

125

Euro area countries

125

Other OECD countries

100

100

75

75

50 25

50 25

75th percentile1

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-25

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KOR

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MEX

POL

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BEL

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DEU

FIN

SVN

Euro area AUT

ITA

FRA

IRL

SVK

ESP

-100

GRC

-75

-100

PRT

-75

1. Calculated for the period 1985-2008 with Australia (1986-2008), Austria, Belgium, Canada, Finland, France (19892008), Germany, Italy, Japan, Netherlands, New Zealand (1989-2008), Spain, Sweden, Switzerland, United Kingdom and United States. Source: IMF, International Financial Statistics.

1 2 http://dx.doi.org/10.1787/888932359264

The changes in net external positions over the period 2002 to 2007 were marked. Net foreign asset positions in Portugal and Spain each declined by around 25 percentage points of GDP, while Germany increased its net position as a share of its GDP by close to 20 percentage points. There was also a large deterioration in France. Countries with external debts in 2002 tended to run large deficits, while creditor countries tended to run surpluses, exacerbating the initial differences in net foreign assets positions. This effect

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only partly stems from the inclusion in the current account of interest payments being paid on existing debt or income earned on net foreign assets. The changes in the net foreign asset position as a share of GDP were tempered by high nominal growth in some debtor countries and weak growth in creditor countries. Overall, revaluations and other adjustments also had a substantial impact on the net external position of euro area countries (Lane, forthcoming). Although it is impossible to disentangle these effects, their combined impact is strongly negative for most euro area countries over the period 2002 to 2007, reflecting the currency mismatch of euro area countries’ positions combined with the weakening of the dollar.

External balances have been driven by internal economic and financial imbalances The scale of the current account imbalances and the accumulated net foreign asset and liability positions in some euro area countries raises questions about whether such large and unprecedented developments can be justified by underlying economic needs. In theory, current account deficits and surpluses and international saving and borrowing are an important mechanism for open economies to accumulate wealth or borrow, and to engage in international risk-sharing. To the extent that these positions reflect preferences, technology and initial wealth, they are part of the gains from international trade and finance. Indeed, facilitating such movements of capital by removing nominal exchange rate risks was one of the motivations for monetary union. While long-term solvency implies that countries cannot continuously increase their indebtedness faster than income, some foreign borrowing may be sustainable to finance productive investment and to smooth consumption. For mature economies with ageing populations, building up foreign assets may be an effective way of funding future consumption.

Fundamentals only explain part of external imbalances in the euro area International evidence confirms that current account positions are in part determined by fundamental economic factors that underlie relative consumption and investment across countries. Differences in income levels, GDP growth, real interest rates and demographics play an important role (Chinn and Prasad, 2003). Increasing financial market integration has eased constraints on international saving and borrowing and led to a trend widening in the dispersion of current account positions (Faruqee and Lee, 2009). Other observed but less deep economic factors such as nominal rigidities, the fiscal policy stance and the trend level of unemployment also play a role (Cheung et al., 2010). In principle, monetary union would have been expected to reinforce the role of fundamentals for euro area countries and this has been borne out by experience (EC, 2009). For the euro area in recent years, these fundamental factors do appear to explain a substantial part of the current account imbalances, based on empirical analysis for OECD countries using time-averaged panel econometric techniques (Barnes et al., forthcoming). The results in this study are broadly in line with earlier studies of the international evidence, as cited above. The analysis suggests that demographic factors played a small role in most cases. Germany’s demographic position would have been expected to generate a substantial surplus, while a country with a relatively young population such as Ireland would have been expected to have run a deficit (Figure 2.4).3 Income and growth differentials also had an impact on the current account, reflecting the flow of capital to low-income high-growth countries, but these effects were relatively


49

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small. The initial net foreign asset position had a large impact on imbalances over the period 2002 to 2007. Other factors also have an identifiable role in determining the current account, even if they are not deep economic fundamentals and may even reflect economic excesses. In particular, the budget deficits in Greece and Portugal made significant contributions to their weak external positions.4 Strong housing investment, associated with unsustainable property booms, accounts for large contributions to the current account deficits of Ireland and Spain.

Figure 2.4. Determinants of the current account balance Contributions to current account balances over the period 2004 to 2008 % of GDP

% of GDP

10

10

Demographic 1 Catch-up related 2 Fiscal position Net foreign assets

8 6

Housing investment Other 3 Residual Current account balance

8 6

4

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FIN

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NLD

1. Sum of contributions of youth dependency, old-age dependency and expected old-age dependency. 2. Sum of contributions of the level of GDP per capita and GDP growth. 3. Sum of contributions of the real interest rate and other factors. Source: Barnes, S., J. Lawson and A. Radziwill (forthcoming), “Current Account Imbalances in the Euro Area: A Comparative Perspective”, OECD Economics Department Working Papers, OECD, Paris. 1 2 http://dx.doi.org/10.1787/888932359283

Nevertheless, the scale of imbalances over the period in both euro area and other OECD economies cannot be fully explained by historical relationships. While observed factors and historical relationships typically explain the sign of the imbalance, they tend to underestimate the size. Between 2004 and 2008, both the large current account surpluses of Germany and the Netherlands, and the major deficits in Greece, Portugal and Spain, have greater unexplained components in this model than for other euro area countries. Notably, there is also a large unexplained component to the US current account deficit. The unexplained component of current account balances for the most recent period is noticeably larger than for earlier periods.5 While the larger residuals cannot by definition be explained within the model, one explanation could be stronger financial market integration. However, the broadening dispersion of current account positions internationally during this period appears to be “well ahead of the underlying dispersion trends” (Faruqee and Lee, 2009). This phenomenon is similar across both euro area and other OECD countries. It is consistent with evidence that the strong global credit cycle and

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global savings and investment trends over this period exaggerated underlying imbalances. Furthermore, the global credit cycle may have distorted some of the fundamental factors treated as exogenous in the analysis, such as growth differentials and real interest rates. Given the unusually large unexplained component of recent imbalances and the explanatory role of factors such as fiscal policy and housing booms, current account imbalances in some euro area countries as elsewhere would appear to have gone beyond what can be explained by fundamentals.

Imbalances arose from diverging economic pressures and domestic imbalances Euro area countries were exposed to a wide range of diverging underlying economic pressures over the past decade. The imperfect economic integration of euro area countries and structural rigidities, combined with these diverging forces, required strong economic, macroprudential and fiscal management at the national level in line with the requirements of a shared currency and the associated absence of country-specific monetary policy. The external account ended up playing an important role in absorbing differences in nominal demand across countries, leading to large, persistent and sometimes excessive imbalances (Box 2.1). For many euro area countries, there was a close relationship between internal and external balances during the most recent upswing (Figure 2.5). Countries with aboveaverage growth such as Greece, Ireland and Spain suffered from some degree of domestic overheating, leading to current account deficits. Rampant private demand in many cases, driven by low real interest rates and strong credit growth, appears to be the main explanation for the strength of domestic absorption, with the exception of Greece where lax fiscal policy played a big role. By contrast, Austria, Belgium, Germany and the Netherlands had growth below the euro area average and also accumulated large current account surpluses. As discussed above, the scale of the external imbalances appears larger than underlying economic developments can explain. Developments in some other countries were more idiosyncratic. Italy and Portugal experienced very low growth, weaknesses in competitiveness and current account deficits. In the case of Portugal, this weak position is partly the result of over-reliance on consumption and housing activity in the early 2000s of similar nature to that seen more recently in other deficit countries

Figure 2.5. Growth and imbalances in the euro area Annual average, 2002-07 Total domestic demand growth, in %

Total domestic demand growth, in %

6

6 IRL

SVK

5 4

SVN

5

ESP GRC

4

FIN LUX

3

Unweighted average FRA

2 1 0 -10

3

BEL

2

NLD

AUT ITA

PRT

1

DEU

-8

-6

-4

-2

0

2

4

6

8

10

0 12

Current account balance, % of GDP


1 2 http://dx.doi.org/10.1787/888932359302


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Box 2.1. Economic stabilisation in a monetary union The objective of macroeconomic policy should be to achieve an efficient and sustainable growth. Efficiency in this sense occurs where marginal costs of production are minimised over time and consumption follows intertemporal preferences. This requires balancing total demand and supply in the domestic economy, internal balance, and making sure that the current account position is consistent with the efficient level of external capital accumulation or reduction, external balance (Williamson, 1983). If the efficient net external position is zero, this implies that domestic absorption is equal to potential output. Economic adjustment to country-specific shocks Even in a simple stylised framework, the dynamics of economic adjustment to country-specific shocks are complicated for small open economies in a monetary union. Under the assumptions of the standard Mundell-Fleming model with a fixed nominal exchange rate and perfect capital mobility, a shock to nominal demand in one country has a large effective impact on aggregate demand because the supply of money is perfectly elastic so there is no crowding out from higher interest rates (Flemming, 1962; Mundell, 1962). Monetary conditions are perfectly accommodating. Shocks to nominal demand, however, create inflationary pressures in the domestic economy. Under the assumption that tradeable goods prices are fixed in international markets, only nontradeable goods prices increase in response to a positive shock to demand. This raises the overall price level. The change in the price of non-tradeables relative to tradeable goods leads to a loss of competitiveness. This causes expenditure to shift towards tradeable goods, while stronger demand for labour in the non-tradeable goods sector drives up economy-wide wages and labour and production switch to non-tradeable goods. The current account balance deteriorates. This competitiveness channel contributes to the stabilisation of domestic economy under standard assumptions by accommodating shocks to demand through net exports and thereby attenuating the inflationary consequences. Given that nominal interest rates are fixed for the euro area, the real interest rate channel acts as an amplifying and destabilising force. A negative shock to domestic demand, for example, will tend to reduce the price level and increase competitiveness. As prices fall, the real interest rate rises, further dampening domestic demand in the short run. Furthermore, with nominal price rigidities, optimal monetary policy would be set partly to offset the combined impact of the initial shock and the rigidities (Galí and Gertler, 1999) so there is a further cost in real interest rates not being able to follow optimal policy, as for example suggested by a standard Taylor rule. This cost will be higher if nominal rigidities are stronger. These adjustment channels taken together imply that a positive nominal demand shock leads to a state where internal balance is restored through changes in the price of non-tradeable goods that alter domestic consumer prices and shift the external balance of the economy. A corollary of this situation is that real consumption can be increased by domestic expansion for a time. However, this situation is inefficient as marginal costs in the economy are moved away from their efficient level and changes in the net asset position may not reflect underlying preferences, wealth and technology. The equilibrating mechanisms to achieve external balance, by contrast, are more subtle with current account balance being restored by the need to repay borrowing or run down savings to meet the long-run solvency constraint. This may occur gradually or through dramatic reassessments by lenders of the prospects of different economies. Even with price flexibility, shocks may result in persistent deviations of external balance from its efficient level and the forces to balance the current account may be weak for long periods. The failure to respect this long-run constraint, either on the part of borrowers or lenders, may contribute to prolonging the adjustment period.

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Box 2.1. Economic stabilisation in a monetary union (cont.) Financial accelerator effects add to economic instability Low real interest rates can aggravate imbalances while the economy is strong, as they can trigger domestic credit cycles and financial accelerator effects. There are two main conventional channels for financial accelerator effects (Bernanke and Gilchrist, 1995): the balance sheet channel, whereby the value of collateral or availability of cash flow determine how far potential borrowers are able to commit to repay loans, and the bank lending channel, whereby the supply of bank credit is affected by the strength of banks’ balance sheets. The balance sheet channel has a strong country-specific effect because the value of property-related collateral, which is particularly important for household and commercial property lending, depends on local property prices: a credit-induced rise in house prices will tend to increase the value of houses in the same locality. The country-specific effect of a given interest shock also depends on structural features of the national credit market (Catte et al., 2004). Risk appetite may also be higher when real interest rates are low: risk appetite is related to the temporal marginal rate of substitution (Lucas, 1978). Given that the real interest rate inside the monetary union varies because consumers in different countries face different non-tradeable goods price developments, risk preferences will also vary. In addition, there may be irrational exuberance in countries where the economy has been booming.

(OECD, 2010c). Weak subsequent labour productivity gains coupled with insufficient wage moderation have since frustrated the rebalancing of the economy and caused the large current account deficit to be sustained. In the case of Italy, the main cause of the current account deficit is the weak Italian economic performance resulting from structural problems and the reorganisation of industrial production (OECD, 2009a). As anticipated by the Optimal Currency Area literature, imbalances have tended to be particularly large in those countries experiencing the most asymmetric shocks relative to the euro area average, as well as those that were the least integrated with other euro area economies and had high structural barriers to economic adjustment. The diverging economic pressures have had a number of sources. Greece, Ireland and Spain have over recent decades been experiencing a period of economic catch-up from low levels of income compared with other euro area countries, which creates a number of tensions. A similar process took place in Portugal, although this stalled over the past decade and the correction has been prolonged. Firstly, productivity growth in some catch-up countries, notably Ireland, occurred at a faster pace in the tradeable goods sector, giving rise to inflation as resources were reallocated from the non-tradeable goods sector in line with the Balassa-Samuelson effect. However, this effect is not systematic across countries.6 While such inflation is consistent with equilibrium adjustment, the resulting lower real interest rates has a destabilising effect. Secondly, a rapidly changing economy can be difficult to stabilise. When future productivity gains are anticipated, current consumption and investment will be high relative to the supply capacity of the economy, which can cause demand and prices of non-tradable goods to run ahead of actual increases in productivity in the tradeable sector, thereby crowding out some of the gains in export performance (Corden and Neary, 1982). Furthermore, the ending of the catch-up phase can also be difficult to identify contemporaneously, particularly when domestic demand is booming and the overall growth of the economy remains strong. Comparing the upswing from 2002 to 2008 with the period from 1994 to 2000 in Spain, for


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instance, suggests this type of over-shooting as domestic demand accelerated slightly to an annual average of 4.4%, while export growth dropped from around 11% in the earlier period to just over 4%. In Ireland, economic performance weakened on most measures between these periods as activity also became much more domestically focussed (OECD, 2009b). This pattern of weakening underlying economic performance, combined with strong real estate investment and borrowing, has parallels to the “bubble economy” of Japan in the late 1980s (Hayashi and Prescott, 2002). Thus borrowing by countries such as Greece, Ireland, Portugal and Spain took place against strong expectations of growth that have not been sustained. Financial liberalisation and gains in monetary policy credibility with the creation of monetary union, which combined to reduce the cost of borrowing, were particularly large for the group of countries that subsequently had large deficits. During the five years leading up to monetary union, the nominal long-term interest fell by more than 5 percentage points in Italy, Portugal and Spain, compared with an average of around 3 percentage points for the euro area as a whole. The fall in nominal borrowing costs reflects a combination of lower real interest rates, lower expected inflation and a reduction in risk premia. Lower inflation may further ease credit constraints early in the life of a loan, where there is front-loading of real repayments. These developments were matched by a widespread convergence in market interest rates across countries (ECB, 2010). For some countries, this implied a reduction in credit spreads that further added to relatively large falls in real interest rates. At the same time, the development of the single European capital market contributed to expanding the availability of capital for euro area countries (OECD, 2009c). Small countries may face a very high elasticity of supply of credit within a larger currency union once currency risk is removed and given that increasing exposure to their country-specific risk does not have a large impact on overall portfolios (Chapter 4). These capital flows may be overwhelming for small and lessdeveloped financial systems (Portes, 2001). Monetary union appears to have increased the elasticity of net capital flows to income differences between euro area countries compared to the past with no effect on capital flows from other countries (Schmitz and von Hagen, 2007). Strongly divergent economic pressures also contributed to the large surpluses in some countries. Although the size of the German economy implies that it has a large weight in the euro area economy (it accounts for around a quarter of euro area GDP), ECB policy will not necessarily fully stabilise domestic developments there. During the upswing, Germany experienced an idiosyncratic sequence of economic developments at the opposite end of the range from Greece, Ireland, Portugal and Spain. Following the economic downturn in 2000, the early phase of the recovery was heavily influenced by continued adjustment to the consequences of German reunification: lost competitiveness needed to be regained and the unwinding of the construction boom continued to weigh on investment (OECD, 2010b). Production was restructured and in part relocated through strong FDI outflows to Central and Eastern Europe. A high priority was given to structural reform with a number of significant labour market reforms and an overhaul of the pension system, which lowered replacement rates and set out a future increase of the retirement age to 67. This may have increased household savings. Uniquely among euro area countries, house prices in Germany fell over this period. At the same time, there was marked pay restraint leading to a reduction in unit labour costs. These German-specific factors led domestic demand to expand at an annual average rate of just 0.3% on average over the period 2002 to 2007

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(compared with 1.8% for the euro area), while exports increased at an average annual pace of 7.5%. In the Netherlands, meanwhile, a sharp increase in pension contribution rates following the bursting of the “dot com” bubble considerably weakened consumption, while fiscal consolidation efforts also contributed to boosting national saving.

Fiscal policy failed to prevent or even contributed to the build-up of imbalances The role of fiscal policy in imbalances varies across countries. Cross-country experience suggests that the relationship between current account and fiscal balances is relatively weak on average. Based on a large sample and a wide variety of techniques, econometric evidence suggests that a strengthening of the fiscal balance of 1 percentage point of GDP leads to an increase in the current account of around 0.2 to 0.3 percentage points of GDP (Abbas et al., 2010).7 The effects may be larger than average if the change in the fiscal position is viewed as permanent, particularly in the longer run and for small economies (Kumhof and Laxton, 2009). During the upswing, Ireland and Spain ran small budget deficits and eventually surpluses. While these were insufficiently large to counteract private sector imbalances and were boosted by buoyant tax receipts linked to the financial cycle and housing, the fiscal position did not actively contribute to their current account deficits and their government debt-to-GDP ratio declined substantially. By contrast, Greece ran deficits averaging 5.4% of GDP during the period from 2002 to 2007, while deficits averaged well over 3% of GDP in Portugal. These can account for a large share of the overall current account deficit, although the overall impact is likely to have been lower in line with the offsetting effects implied by the semi-elasticities given above. During this period, Germany and the Netherlands ran budget deficits but these were more than offset by strong private saving.8 Fiscal tightening during this period, while contributing to medium-term fiscal stabilisation, accounted for part of the increase in the national saving rate.

Stabilisation of shocks was ineffective Diverging pressures on nominal demand shocks and varying underlying economic developments, combined with structural rigidities, made economic and financial stabilisation hard to achieve. As variations in nominal demand translated into inflation, real interest rates played a de-stabilising role. During the upswing, ex post real interest rates were on average negative in high growth countries, such as Greece, Ireland and Spain, and barely positive in Italy and Portugal. By contrast, real interest rates averaged 1.8% in Finland, 1.5% in Germany and around 1% in Austria, France, Luxembourg and the Netherlands. While it is inherently difficult to assess real ex ante interest rates as the relevant inflation expectations are hard to observe, the persistence of inflation differentials over this period was marked and ex post real rates may provide some guidance about ex ante rates. In addition, survey balances of consumer expectations from the EC Inflation Perceptions survey broadly follow outturns and were highest in countries such as Greece, Italy and Spain. There is also a close correlation between current account positions and the cumulated deviation of real interest rates from a simple Taylor rule (Figure 2.6).9 This means that the Taylor principle for economic stability, whereby real interest rates rise sufficiently to dampen inflation pressures, has not been met. Although similar tensions are likely to arise within countries and in other currency unions, the extent of these


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Figure 2.6. External balances, interest rate gaps and competitiveness Annual average, 2002-07 Interest rate gap 1

Change in nominal unit labour cost

-0.5 -1.0

IRL

DEU BEL FRA PRT

-1.5 -2.0

GRC

NLD

5 4

ITA FIN

ESP

GRC ESP

FRA

PRT

ITA

3

NLD

BEL

2

AUT Euro area

-2.5 IRL

-3.0 -3.5 -10

FIN

AUT

6

Euro area

0.0

-8

-6

-4

-2

0

1 DEU

2

4

6

8

Current balance, % of GDP

-10

-8

-6

-4

-2

0

2

4

6

8

0


1. Interest rate gap defined as the deviation of short-term interest rates from a simple Taylor rule with coefficients of 0.5 on the output and inflation gaps, a core HICP inflation target of 1.9% and neutral real interest rate of 2.1%. Source: OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359321

differentials in the euro area may have been relatively large. Inflation differentials across urban areas in the United States are much lower than across euro area countries and, as they are less persistent, their impact on economic behaviour is likely to be more transitory and limited (Box 2.2).

Box 2.2. Inflation differentials in the United States The problems of ineffective macroeconomic stabilisation inside the euro area should in principle also be at work in other currency unions. The United States has functioned as a currency union in various forms since 1789 and provides the most obvious point of comparison for the euro area in economic size and population. Have inflation differentials in the United States played a similar role to those within the euro area? It is difficult to make an exact comparison. The US consumer price index (CPI) and the EU harmonised index of consumer prices are constructed in different ways and measure somewhat different concepts of consumer prices. Also, there are no state-level data for the United States and the most comparable data cover 14 urban areas only. Finally, it is difficult to compare the aggregate variability that would be expected all other things being equal between 13 countries and 14 urban areas. However, subject to these caveats, it is tempting to conclude based on these data, that the variability is relatively similar within the euro area as across US urban areas (Figure 2.7, left panel). However, the US CPI series includes an important “shelter” component which closely reflects local property prices, while the HICP excludes costs associated with owner occupation of housing. Given the wide and sizeable variation in housing prices across US urban areas in recent years, there may be an upwards bias in the variation of US urban area inflation relative to the euro area. Comparing US urban-area level CPI inflation excluding housing with inflation in the euro area based on a derived measure excluding rents, the dispersion of these measures of inflation across US urban areas is markedly lower than between euro area economies over the same period (Figure 2.7, right panel).

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Box 2.2. Inflation differentials in the United States (cont.) Figure 2.7. Inflation differentials across US urban areas and EU states1 Standard deviation across units

1.4

United States

Euro area

CPI, all items

1.4

CPI, excluding shelter

1.2

1.2

1.0

1.0

0.8

0.8

0.6

0.6

0.4

1998 2000

02

04

06

08

1998 2000

02

04

06

08

0.4

1. CPI for the United States and HICP for the euro area. Source: Eurostat and US Bureau of Labor Statistics.

1 2 http://dx.doi.org/10.1787/888932359340

The destabilising effect of inflation through lower real interest rates depends not only on the dispersion of inflation across local economies but also the persistence of these differentials. Short-term deviations from area-wide inflation that rapidly correct are likely to have little impact on economic behaviour, while persistent and predictable differentials are more likely to influence borrowing and saving decisions. Based on inflation excluding shelter, the persistence of annual inflation rates across US urban areas is much lower than for euro area countries. The standard deviation of the change in the price level with the euro area average over the period 2002 to 2007 is 4.4%, while it was just 0.4% for US urban areas. The apparently lower and less persistent variability of inflation across US urban areas suggests that the pressures of monetary union there could be lower than in the euro area. For example, there is no clear relationship between the implied real interest rate (based on CPI excluding shelter) and the change in house prices during the economic upswing, by contrast with the clear pattern in the euro area. This transatlantic difference may reflect different sizes or patterns of shocks, or greater price flexibility across US urban areas. There are also important differences in the structure of the currency union, including the large role of the federal government in the United States, greater structural rigidity than in some euro area countries and a much more integrated financial and banking system, including the system of federal deposit insurance.

The variation in the strength of domestic demand contributed to divergent trends in competitiveness. Real effective exchange rates (on a GDP deflator basis) in the euro area and in almost all countries appreciated over the period 2002 to 2007 with the notable exceptions of Germany, whose real effective exchange rate was broadly unchanged, and Finland. The appreciation was particularly marked in Spain (15%), Ireland (13.5%) and Greece (13%). Broadly similar patterns hold for other measures of price competitiveness and for both intra-euro or wider effective exchange rate measures (EC, 2010a).10 Consistent with the underlying theory, price increases were particularly marked in the non-traded OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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services sectors of overheating economies and especially in construction (Égert and Kierzenkowski, 2010). While some of these movements may have been equilibrium adjustments in prices, others most likely reflect unsustainably strong aggregate demand. In some cases, underlying productivity and structural developments have played a part in determining overall imbalances, in particular where wage and price developments have been out of balance with productivity growth. In particular, Italy suffered a marked decline in export performance for structural reasons that was not offset by a reduction in prices. The weakness of the Portuguese economy after the boom of the late 1990s is likely to have been attenuated if competitiveness had been restored, thereby rebalancing the economy from the consumption to the production of export goods. These problems have often been the result of structural policy settings, such as restrictive product market regulation and heavy employment protection legislation. These have held back growth and for some countries slowed adjustment to shocks. The low underlying productivity growth of Spain was a drag on competitiveness, combined with strong price increases. Indicators of the market orientation of product and labour market regulations suggest that Greece and Portugal lag well behind OECD averages and that their economies are relatively inflexible with scope to reform remaining in Spain, despite reforms over the past decade (OECD, 2010d). In Germany, structural barriers to the development of the non-tradeable sector reduced investment and biased activity towards the export sector (OECD, 2010b). Stabilisation, particularly of the external balance, was complicated by a number of other factors during the upswing. Firstly, while prices increased and the real exchange rate appreciated in overheating economies, the effect was dampened by large net inflows of migrants (Box 2.3). This made it difficult to assess how far demand was from a sustainable level. Secondly, price rigidities and persistence tend to slow adjustment through prices and

Box 2.3. Economic adjustment through migration to overheating economies Movements of factors of production in open economies play an important economic role and can have a stabilising effect in monetary unions, helping to offset asymmetric shocks. While labour mobility in Europe is generally much lower than in the United States, the high openness of euro area countries does lead to flows of migrants from the EU and other countries. Labour mobility is facilitated by the Single Market, further encouraged by EU enlargement, as well as links with former colonies. The pull and push factors leading to migration are complicated. However, growth and imbalances in the domestic economy appear to have been a driver for migration flows over recent years (Figure 2.8). Based on the net annual flow of non-national migrants per thousand of the population, there was little variation across countries in the average flow from the mid-1980s to 2001. There was also little relationship to growth. By contrast, net migration flows were much stronger in some cases over the period from 2002 to 2007. Ireland and Spain had annual average migration of over 1% of the existing population in these years. Although the relationship is not close, migration does appear to have been related to growth and to current account imbalances: some of the strong domestic demand was absorbed by migration. It is notable that this additional labour appears to have been heavily employed in the non-tradeable sectors, such as construction or services, rather than in boosting labour supply in the traded goods sector. Since the peak of the cycle, net migration flows have slowed and reversed in the overheating economies.

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Box 2.3. Economic adjustment through migration to overheating economies (cont.) Figure 2.8. Net foreign migrant flows and demand Average net inflow 1

Average net inflow1

16

IRL

2002-07 • 1984-2001

14

16

IRL

ESP

2002-07 • 1984-2001

ESP

14

12

12

10

10

8

8

6

2 0

1

2

•

BEL •

PRT • FIN

3

•

•

• FRA • ••

4

5

Real GDP growth, average rate

6

-10 -8

-6

-4

6

AUT

ITA

BEL NLD FRA • • • DEU •• •

4

0

AUT

ITA PRT

-2

0

2

4

NLD

• DEU

FIN

4

6

2 8

0 10

Average current balance, % of GDP

1. Net inflow of foreign population per thousand inhabitants. Source: OECD, OECD Economic Outlook and International Migration Databases. 1 2 http://dx.doi.org/10.1787/888932359359

High migration flows in Ireland and Spain accounted for a large and increasing share of the overall increase in employment during the most recent part of the economic upswing. In Spain, the share of non-nationals in the labour force went from 4% in 2001 to reach 13% by 2007 (Figure 2.9). There were similar developments in Ireland where foreign workers came to account for around 10% of the workforce. There was also a rise in net inflows of migrants in some countries such as Italy, albeit to a much lesser extent. The substantial net flows of migrant workers into economies with strong domestic demand during the upswing are likely to have helped to accommodate strong growth,

Figure 2.9. Employment growth in Spain Contributions to annual growth rate, per cent

6

6

4

4

2

2

0

0

-2

-2 Nationals Foreigners Total

-4

-4

-6

-6 1997

98

99

2000

01

02

03

04

05

06

07

08

09

Source: Eurostat.

1 2 http://dx.doi.org/10.1787/888932359378


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Box 2.3. Economic adjustment through migration to overheating economies (cont.) reducing the responsiveness of wages and prices to domestic demand. While this helped to accommodate inflation pressures, this would tend to increase the current account deficit through higher domestic consumption and increased workers’ remittances. The temporary flatness of the supply curve induced by migrant flows complicates the assessment of sustainable levels of output and the setting of economic policy, both through making it more complicated to assess inflationary pressures and through uncertainty about how permanent migration will be.

the underlying pressures can be difficult to detect. It is unclear how much of the price persistence was intrinsic and how far it reflected a correlated series of shocks or the strength of the long credit cycle. The experience of Ireland is notable: inflation was persistently above the euro area average for many years prior to the crisis but the price level has since drastically fallen. Thirdly, capital markets did not adequately price the risk associated with economic and financial imbalances in individual euro area countries, and credit conditions were not tightened in countries that were clearly overheating prior to the crisis. The recent experience both in the euro area and elsewhere has differed from the past where current account reversals typically occurred when deficits reached 5% of GDP (Freund and Warnock, 2007), perhaps as the result of financial liberalisation or the financial boom during the “great moderation”. This experience also contrasts with earlier experience under the Exchange Rate Mechanism (ERM), where relatively high domestic inflation and losses of competitiveness would result in speculative pressures on the exchange rate peg, leading to changes in nominal exchange rates. Within a monetary union, the potentially important signals and market discipline played by the nominal exchange rate were lost, while credit spreads did not respond to large imbalances until recently.

Domestic savings and investment imbalances led to large changes in balance sheets Demand imbalances and destabilising real interest rates, together with some local factors, drove persistent borrowing and saving in euro area countries. In particular, high net saving in countries with weak growth was associated with current account surpluses, while low saving in overheating economies contributed to deficits (Figure 2.10). Government deficits accounted for some of the weakness in current account positions for Greece, France, Ireland and Italy, and for a significant part of the surplus in Finland, although the size of these fiscal positions overstates their economic impact on the external balance. The non-financial business sector has played a large role in overall saving and borrowing with substantial net borrowing in France, Italy and Spain and strong net lending in Finland and the Netherlands. Overall, the picture across countries is complicated, reflecting the wide variety of forces acting on each economy. However, the relationship between household saving and external balance is more systematic. This is consistent with the underlying economic adjustment mechanisms. The real interest rate channel should have the strongest impact on the household sector, through its impact on consumption of nontradeable goods, rather than the business sector which is likely to be more sensitive to international conditions.

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Figure 2.10. Net saving and investment balance and the current account Percent of GDP, average 2002-07

10

10

5

5

0

0

-5

-5 Net saving and investment balance:

-10

-10

Non-financial corporations Financial corporations General government Household and non-profit institutions

-15 GRC

ESP

IRL

ITA

FRA

AUT

Current account balance

-15 BEL

DEU

FIN

NLD

Source: OECD, National Accounts and OECD Economic Outlook Databases.

1 2 http://dx.doi.org/10.1787/888932359397

These large and persistent savings and investment imbalances led to large changes in net financial wealth of economic sectors in some countries (Table 2.A1.1). The household sectors in Ireland and Spain reduced their net financial wealth by around 25 percentage points of GDP from 2002 to 2007, through heavy borrowing, with their net financial position relative to income reaching a level below that in many other euro area countries. Although the decline in financial balances was associated with the rising value of housing assets, much of the increase in house prices proved to be unsustainable and has been reversed subsequently. By contrast, German households increased their net financial wealth by almost 30 percentage points of GDP over the same period, while there were increases of about half that size in Austria and France. For non-financial corporations, the net financial asset position of Spanish corporations declined by around 60 percentage points of GDP due to low saving and high investment. By contrast, companies resident in the Netherlands increased their financial position to a net balance in excess of 15% of GDP over the period. High profits, low dividends payouts and relatively weak investment in Germany had a similar effect (OECD, 2010b). Apart from determining net financial wealth, real interest rates also led to changes in the leverage of different sectors. These effects appear stronger and more systematic for households: the ratio of household debt to financial assets rose considerably in Greece, Ireland and Spain over the period from 2002 to 2007, while it actually fell in Austria and Germany.

Housing booms and credit cycles aggravated imbalances Low real interest rates sparked housing and credit cycles in some countries (Ahrend, 2010). Changes in non-tradeable goods prices have a strong impact on the housing market: as it is essentially a non-tradeable investment good, demand for housing is particularly sensitive to real interest rate developments (EC, 2006). House prices in Spain increased by close to 80% in nominal terms from 2002 to 2007, with prices increasing by around 70% in France and 45% in Ireland. The share of housing investment in Ireland peaked at over 13% of GDP and around 9% in Greece and Spain. Although the stock of dwellings per capita in these countries was well below OECD norms in the 1990s and population growth rate was relatively fast, the pace of housing construction was nevertheless spectacular. These


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underlying dynamics, combined with very low or negative real interest rates, created highly favourable conditions for the emergence of housing bubbles. The expected increase in prices implied that borrowing to invest in housing appeared profitable irrespective of any actual or imputed rents (Fuentes Castro, 2010). In addition, high construction prices have been an important channel for crowding out exports through pushing up domestic costs (Égert and Kierzenkowski, 2010). The effect of strong domestic demand on housing was further amplified during the upswing in Ireland and Spain by large inflows of migrants, further adding to the demand for accommodation. There is close relationship between housing investment and current account deficits (Barnes et al., forthcoming). The pressures on housing demand were augmented by poorly-designed policies. Firstly, generous taxation of owner-occupied housing distorts incentives towards housing and increases post-tax gains to home owners from rising property prices, while subsidising the rising cost of housing for those looking to buy. There is a close relationship historically between the variability of house prices and tax distortions for euro area countries (Figure 2.11). These tax distortions amplify the impact of financial liberalisation and of lower unemployment on the house price to income ratio (Andrews et al., forthcoming). Secondly, the impact of changes in demand on house prices is strengthened by a low elasticity of supply of housing in most euro area countries. Although in some cases this is the result of a high density of population, planning practices are relatively restrictive in euro area countries compared with the norm in other OECD countries and obtaining planning permission can be a lengthy process.

Figure 2.11. House price volatility and the tax treatment of housing Variability of house prices1

Variability of house prices1

1.6

1.6 IRL

1.4

1.4

NLD

1.2

1.2 ESP

1.0

1.0

FIN

FRA ITA

0.8

0.8

0.6

0.6

0.4

DEU

0.4 R2 = 0.88

0.2 0.0

0.2

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5 Tax wedge

0.0 2

1. Root mean square deviation of real house price from exponential trend, 1970-2009. 2. Difference between after-tax and pre-tax real interest rate on mortgage loans; 1999 tax rules, interest rates and inflation. Source: Van den Noord, P. (2004), “Tax Incentives and House Price Volatility in the Euro Area: Theory and Evidence”, Économie Internationale and OECD calculations. 1 2 http://dx.doi.org/10.1787/888932359416

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Strong domestic demand and low real interest rates led to financial accelerator effects that reinforced initial positive demand shocks in some countries experiencing overheating. Loans to the real economy increased at an average rate of around 20% in Greece, Ireland and Spain over the period 2002 to 2007, compared with no change in Germany and close to 5% in a number of other surplus countries (Figure 2.12). Lending was closely associated with external imbalances. These effects partly operated through rising property prices, which appeared to strengthen household balance sheets and provided collateral to finance additional borrowing and lending. The growth of loans for house purchase follows a similar pattern and was also closely associated with deviations of real interest rates from a simple Taylor rule. The partly self-perpetuating effects of the credit cycle may have contributed to the persistence of internal demand pressures and the scale of external imbalances. The rapid growth of credit to the non-financial-sector in some countries reflects domestic credit cycles, which were fuelled in part by credit flows from banks with surplus positions in other countries.

Figure 2.12. Loan growth and imbalances in the euro area Annual average, 2002-07 Growth of MFIs loans to non MFIs, %

Growth of loans for house purchase, %

30

30

25

IRL

IRL

25

ESP

ESP

20 15

GRC

20

GRC

ITA ITA

10 PRT

FIN FRA

5

PRT BEL AUT

-8

-6

-4

-2

0

2

4

15 10

NLD

5 DEU

DEU

0 -5 -10

NLD

FIN FRA BEL AUT

6

8


-4

-3

-2

-1

0 0

-5

Interest rate gap 1

1. Interest rate gap defined as the deviation of short-term interest rates from a simple Taylor rule with coefficients of 0.5 on the output and inflation gaps, a core HICP inflation target of 1.9% and neutral real interest rate of 2.1%. Source: ECB and OECD, OECD Economic Outlook Database.

1 2 http://dx.doi.org/10.1787/888932359435

Recycling of euro area savings from surplus to deficit countries through the euro area banking systems tended to concentrate risks at the country level. As discussed in Chapter 4, despite the high level of financial integration at the wholesale level, many aspects of the euro area financial system retain profoundly local characteristics, particularly in terms of retail activity. This led to local concentrations of risk rather than efficient diversification across the euro area. In particular, local banks are largely responsible for intermediating between domestic non-financial borrowers and depositors. These banks then fund or redistribute any imbalances between the two through international market and interbank sources. This may leave local banks carrying much of the risk and can also lead to additional risks relating to maturity mismatch, given the more volatile nature of market funding. It also reinforces domestic credit cycles as financial accelerator effects tend to work in the narrower national market rather than in the large euro area, yielding stronger feedback effects. The absolute size of bank assets in some countries became very large relative to national income,11 a development which was exacerbated by the ability to access market funding from other euro area countries. There OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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were strong flows of capital from banks and other financial institutions from countries with sluggish domestic credit growth to overheating credit markets, as the result of the large volume of funds at their disposal and weaknesses in financial oversight. This contributed to a large gap between the growth of domestic loans and deposits in many euro area countries: economies with external surpluses saw deposit growth significantly outstrip loan growth, while deficit countries tended to experience the opposite (Figure 2.13). In terms of the euro area as a whole, Germany and the Netherlands were significant providers of funds, while France, Italy, Ireland and Spain were the major borrowers. International bank credit flows were often relatively short-term in nature, leading to a risky maturity mismatch in the borrowing countries.

Figure 2.13. Gaps between change in loans and deposits1 As a percentage of 2004 GDP

4

Gap as a % of euro GDP (left scale)

60

Gap as a % of national GDP (right scale)

40

2 20 0

0

-20 -2 -40 -4

-60 DEU

NLD

BEL

GRC

SVK

PRT

FIN

AUT

IRL

ESP

ITA

FRA

1. Change in loans of credit institutions (CIs) to non-CIs minus change in deposits of CIs from non-CIs between 2004 and 2008. Source: ECB (2010), Structural indicators for the EU banking sector and OECD, OECD Economic Outlook Database. 1 2 http://dx.doi.org/10.1787/888932359454

Weaknesses in financial regulation and supervision encouraged a significant increase in risk-taking during this period, while regulatory shortcomings in some euro area countries and the lack of effective macroprudential regulation facilitated this risk taking (Chapter 4). While Spain took the strongest steps to counter the financial cycle through dynamic provisioning and measures that controlled the use of securitisation, this was insufficient to prevent a strong credit and housing cycle even if these measures appear to have offered some protection to the banking system. Weaknesses in financial regulation in countries without pronounced domestic credit cycles nevertheless added to problems in other countries through financial markets. This was important in countries with weak domestic credit demand, and their banking activity and profits became increasingly reliant on supplying credit abroad. The transfer of risks and funds increased potential for spillovers between countries and macroeconomic risks in countries experiencing strong and unsustainable inflows of credit. International banking activity can involve the transfers of risks between countries, as well as flows of funding. These are not necessarily identical: a foreign banking subsidiary may be funded by domestic liabilities, but the equity exposure is transferred to the foreign company. Financial integration has increased these overall transfers of risk over time and the Bank for International Settlements (BIS) data show a sharp increase during the years running up to the crisis. For example, the increase in consolidated German

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banking claims on Spain during the upswing was equivalent to around 15% of Spanish GDP (Chapter 4). In particular, the willingness of foreigners to take domestic risk has had an important effect on overall risk-taking by banks in smaller euro area economies experiencing domestic booms. While risk sharing is in principle a desirable feature of greater financial integration, if inappropriately managed it can increase vulnerability to shocks in other countries. When the international financial crisis struck, many euro area countries were particularly exposed either to enormous credit risks in their own financial systems or through cross-border exposures. There was a marked contraction in cross-border banking and financial intermediation, with a sharp deterioration in the availability of finance to countries such as Greece, Ireland and Spain (Chapter 4). This was managed through a combination of public support and heavy reliance on ECB funding. In the absence of a system of cross-border financial support, this added to fiscal pressures when public support was provided to the banking system.

Imbalances in some countries had spillovers for other monetary union economies The high degree of economic and financial integration between euro area countries creates numerous channels through which developments in one country may affect others. In particular, the monetary union contains a small number of larger countries: Germany accounts for over a quarter of euro area GDP, France around one-fifth and Italy for around one-sixth. Developments in these countries or in groups of highly correlated economies have the potential to create noticeable spillovers on others. Interdependencies between countries are not necessarily malign. For instance, a positive shock to technology in one country that temporarily raises interest rates and draws in capital from other euro area countries is an efficient reallocation of resources that benefits all, even if it temporarily reduces investment and consumption elsewhere. Openness yields valuable risk-sharing opportunities so that shocks in one country are partly shifted onto others. This lessens the overall impact of the shocks and all countries benefit from the ex ante insurance, even if some are negatively affected ex post. However, spillovers are more problematic if they transmit to others policy mistakes or lack of efficient adjustment in the domestic economy. The strength of demand in one country can have effects on demand in other countries through the trade channel, both in the sense of changes in external demand and changes in the terms of trade as well as through third markets. These effects, however, are likely to be relatively small compared with other forces acting on the economy. Firstly, although euro area countries are relatively open by international standards, this degree of openness is by no means uniform with total exports accounting for not much more than a quarter of GDP in many of the large economies (Table 2.1). Furthermore, a large part of trade is with non-euro area economies. Some groups of countries are more closely interconnected: exports to Germany account for around one-fifth of national GDP in Austria, Belgium and the Netherlands. However, for most euro area countries, the exports to Germany account for less than 5% of GDP, although imports are usually higher. Secondly, the effects of shifts of domestic demand and prices on export and import demand are modest for many categories of expenditure. Econometric evidence suggests that the marginal import propensity for euro area countries is around 0.2 for private consumption, 0.1 for public consumption and 0.4 for investment (Pain et al., 2005). Furthermore, the import propensity of exports is around 0.4 on average and higher for small open trading economies such as


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Table 2.1. Trade in goods and services by partner As a percentage of GDP, 2007 Exports Total

EA131

Imports

Other EU (excl. CEE)

CEE2

Total

EA131

Other EU (excl. CEE)

CEE2

Austria

57.6

30.6

3.5

6.8

53.1

31.6

2.4

4.8

Belgium

111.7

66.8

11.6

3.6

106.6

61.8

10.0

2.6

Finland

47.2

12.9

8.5

3.2

43.0

13.5

8.4

2.5

France

26.8

12.7

3.1

1.1

29.4

14.3

3.4

3.2

Germany

46.6

19.2

5.4

4.2

40.3

15.4

3.7

3.5

Greece

21.6

6.6

3.6

1.4

31.2

13.5

2.8

1.2

Ireland

82.0

31.5

18.3

1.6

70.3

18.2

18.3

0.8

Italy

28.7

12.5

2.6

1.8

29.8

13.4

2.0

1.5

Luxembourg

157.1

95.6

22.5

2.1

116.2

77.3

12.1

1.1

Netherlands

76.1

40.8

10.2

3.5

67.5

29.1

7.1

1.9

Portugal

33.5

20.0

3.9

0.5

41.7

26.7

2.6

0.6

Slovak Republic

65.2

42.3

4.4

18.8

87.4

30.3

2.7

19.2

Spain

26.7

13.5

4.4

0.7

34.3

16.6

3.3

0.9

1. Euro area 13 countries (the ones listed in the first column). 2. Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Romania. Source: OECD, Monthly Statistics of International Trade.

Belgium, Ireland and the Netherlands, where many imports are re-exported with little additional value added. Taken together, the size of trade with other euro area countries and trade elasticities suggest that the trade channel is likely to have a smaller effect than some other forces acting on the economy such as real interest rates. The financial channel has proved a more powerful mechanism to transmit developments in one country to others through positions in financial markets, interlinkages between financial institutions and changes in market valuations. Part of the expansion of credit during the upswing was financed through cross-border lending, particularly through the intermediation of domestic banks between the real economy and international banking markets. This conduit between savers and borrowers is in part a reflection of the effective allocation of capital in the EU single capital market and between euro area countries. However, it also provides a mechanism through which regulatory failures or imbalances can be transmitted from one economy to another. Once the credit cycle turned, these linkages created a range of negative spillovers between countries. National financial systems have been exposed to risks emanating from other euro area countries. There has been broader contagion between countries with banks in other countries facing higher funding costs because of lack of transparency about their exposures or concerns that they face the same risks as have been revealed in other countries. Banks in some countries have faced sudden stops with others withdrawing credit to them and exposing a large underlying liquidity mismatch. The common euro area monetary policy stance may transmit shocks between countries if the euro area interest rate is changed in response to conditions in one country that have a material impact on the euro area as a whole. This effect partly offsets some of the spillovers between countries discussed above. While many euro area economies are too small to have a significant impact on the area-wide policy stance even if their situation is very far from the euro area average, developments in the larger countries or in groups of

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closely related economies may have a greater impact on the area-wide policy stance. For example, relatively low overall growth and weak domestic demand in Germany are likely to have kept euro area interest rates lower over the past decade than would otherwise have been the case, while a disproportionate share of inflation in the euro area as a whole can be accounted for by the overheating economies.

Large imbalances are leading to costly adjustment The unwinding of large imbalances has led to serious economic, financial and fiscal problems in some euro area countries, particularly in those with external deficits, weaknesses in competitiveness and high levels of indebtedness. During the initial fall in output, the experience across euro area countries was relatively similar. While activity in Ireland fell by almost 10% between 2007 and 2009, the GDP of Germany with a large external surplus also registered a relatively large fall of more than 6%. However, the underlying causes of these developments was radically different: surplus countries with a high degree of openness were typically severely affected through the exposure to foreign trade, which contracted sharply towards the end of 2008 through a combination of confidence effects and also reliance on excessively strong demand in other countries. By contrast, the fall in output in deficit countries was dominated by the abrupt adjustment of internal imbalances. While the rebound in global trade is helping surplus countries make up the losses, the weakening of the economies in deficit countries is more sustained due to credit constraints and the need to rebuild balance sheets (Figure 2.14). The sharp fall in demand in deficit countries is closely related to a rapid correction of underlying imbalances: between 2007 and 2009, the household saving ratio in Spain rose by 8.8 percentage points and by 7.6 percentage points in Ireland as consumers have needed to repay debt and rebuild their positions. In addition, there was a substantial tightening in the financial balance of the non-financial corporate sector, particularly in Ireland and Spain (EC, 2010b). At the same time, construction activity and house building collapsed where there had been housing booms. Unemployment has increased sharply in Ireland and Spain: the unemployment

Figure 2.14. Deficit countries are experiencing the largest overall adjustment Current balance, % of GDP, 2007

Current balance, % of GDP, 2007

15

15 LUX

10

10

DEU NLD

5

5

FIN Euro area

0

SVN

IRL

SVK

-5

ESP PRT

-10 -15 -10

0

FRA

ITA

-5

AUT BEL

-10

GRC

-8

-6

-4

-2

0

2

4

6

8

-15 10

% change in real GDP, 2007-11


1 2 http://dx.doi.org/10.1787/888932359473


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rate in Spain is close to 20%, and is above 10% in Greece, Ireland and Portugal. This is consistent with international evidence that larger deficits have tended to take longer to adjust than smaller imbalances and have been associated with significantly slower income growth relative to trend during the current account recovery (Freund and Warnock, 2007), and that adjustment tends to be more severe where external imbalances were driven by consumption or strong banking flows. For countries that have borrowed heavily, repaying debts will be difficult if the funds have not been used to finance productive investment; much of the borrowing was used to finance private or public consumption and high rates of housing investment linked to booming house prices. While adjustment in surplus countries is likely to be less severe, they nevertheless remain sensitive to weaknesses in the recovery in world trade. Financial pressures have forced large adjustments and made economic rebalancing more difficult. Large monetary and debt overhangs in highly indebted countries have added to the rapidity and strength of pressures to rebuild balance sheets, thereby further depressing domestic demand. In addition, the housing and construction booms fuelled by credit in earlier years reversed sharply. Large borrower and surplus countries have experienced strong pressures on their financial systems. These in part reflect their heavy exposures to domestic credit cycles, asset prices and the high level of risk. These pressures were already evident before the international financial market turmoil began, with the housing boom in Ireland peaking in 2006 and the growth of housing activity in Spain already slowing. However, countries with high levels of debt were also extremely vulnerable to deteriorating conditions in international financial markets. In some cases, there was a sudden drop in confidence in economies with large current account deficits, leading to especially high credit spreads and restricted access to borrowing. As crossborder banking activity contracted, relatively small economies with high debts felt these effects most strongly (Chapter 4). To date, losses and the costs of financial rescue have been particularly large in these countries. In addition, their reliance on ECB funding appears to have been especially high. The risk exposure of creditor countries is more difficult to assess as, while there have been losses on overseas activities of some banks, risks of lending to banks in other countries were partly absorbed through government rescues. Weak demand and the end of credit booms have put pressure on government revenues and spending of borrower countries, while public support for financial rescues has led to substantial costs and increases in liabilities as private debt became public. The public debtto-GDP ratio increased between 2007 and 2009 by almost 40 percentage points in Ireland, 19 points in Greece and 17 points in Spain. These countries have been unable to allow even the automatic stabilisers to function fully and so discretionary policy has been procyclical.12 Given these deteriorating positions and greater sensitivity to risk, credit spreads to high debt countries increased markedly.

Measures to restore stability in the near and longer term are needed at European and national level The scale of economic, financial and fiscal imbalances in the euro area has brought to the fore the importance of conducting national policies consistent with the requirements of the monetary union. While the creation of the euro has brought many benefits, recent developments have highlighted the greater challenge of stabilising national economies inside a monetary union, that can lead to macroeconomic and financial imbalances at

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national level. At the same time, the euro area and EU oversight failed to prevent or react to the build-up of large imbalances. As growth rates are likely to continue to be diverse among euro area countries, the functioning of the monetary union needs to be strengthened by a broader set of policies aimed at addressing the sources of imbalances. The immediate priority is to deal with the financial, economic, fiscal and social consequences of the imbalances that have accumulated over recent years. However, a new cross-cutting approach needs to be undertaken to reduce the risks and costs of future imbalances. This would lead to a more complete and successful monetary union. This section sets out the framework for tackling these problems. Putting fiscal policy on a sounder footing is discussed in more detail in Chapter 3 and the role of improved financial and macroprudential oversight is set out in greater depth in Chapter 4. Structural policies can also play an important role in resolving and avoiding imbalances.

Restoring macroeconomic and financial stability is an immediate priority Before sustainable recovery can begin, weaknesses in the financial system need to be repaired, so that normal credit intermediation is able to support the economy, and fiscal policy must be placed on a sustainable path. While this holds in the euro area as a whole (Chapter 1), this is especially important for countries where borrowing proved excessive. Considerable progress has been made in this direction in a number of countries. In addition to measures to provide temporary support to the financial system, Ireland and Spain have taken comprehensive measures to resolve banking sector weaknesses. In Ireland, the National Asset Management Agency (NAMA) is taking property-related loans off banks balance sheets, alongside government capital injections and the nationalisation of some banks (OECD, 2009b). In Spain, saving banks (cajas) have been restructured and in some cases recapitalised. To improve fiscal sustainability in the face of rising credit spreads, dramatic consolidation measures have been taken in Greece, Ireland, Portugal and Spain. External imbalances in euro area countries have narrowed since their peak. The current account surplus in Germany fell from 7.7% of GDP in 2007 to 5% in 2009, while Spain’s position narrowed from a deficit of almost 10% of GDP to 5.4%. The changes in the external position reflect substantial adjustments in the economic imbalances within different euro area countries. In particular, there have been sharp reductions in private domestic demand in Ireland and Spain (Figure 2.15). However, some corrections are cyclical and are likely to reverse as economies recover. Furthermore, the reduction of domestic imbalances has left output below potential, especially in the most severely affected countries.

Imbalances need to be reduced to sustainable levels Lasting rebalancing of euro area economies will be achieved when activity returns closer to its sustainable level and external accounts are realigned with levels justified by economic fundamentals. In the short run, there is a case to continue to support demand during period of adjustment. Overall, euro area monetary policy stimulus will help all economies to recover but this will be insufficient for countries with the most severe downturns. The room for fiscal support at the national level is, however, in some cases severely constrained. In addition, action is required to rebalance economies with large imbalances. Surplus countries need stronger demand for non-tradeable goods, while making efforts to increase productivity in this sector. At the same time, deficit countries need to switch demand away from imports and output towards producing for export. Saving needs to moderate, where it is excessive, and debt repayment is required in


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Figure 2.15. Contribution to total domestic demand growth Contribution to change between 2008 Q1 and 2010 Q2, at annual rate

2

2

0 -2

♦

-4

♦

♦

♦

♦

♦

♦

♦

♦

♦

♦

♦

♦

-2

♦

-4

-6

-6

-8 -10 -12

0

♦ ♦ IRL

SVN

GRC

ESP

FIN

ITA

Euro area

SVK

-8 Total domestic demand Government consumption Private demand and other demand

LUX

FRA

PRT

NLD

AUT

-10

BEL

DEU

-12


1 2 http://dx.doi.org/10.1787/888932359492

countries that have become heavily indebted. To the extent that high or low rates of saving reflect inefficiencies and structural rigidities, reforms should be undertaken to eliminate these impediments. Government demand has provided some support to economies undergoing severe adjustment, although this has been limited in countries such as Ireland and Greece by pressures on the fiscal position. While fiscal consolidation is required in these countries, it is vital that the path to rebalancing the economy and the public finances allows for some time to adjust and that there is not an abrupt and inefficient realignment. Debtor countries need to be able to continue to finance their debts, while running down the overall stock of outstanding commitments. If the availability of credit to domestic private borrowers were to suffer a liquidity shock, it is likely that governments would step in to support them. It is therefore essential that solvent governments have continued access to finance. In the short run, the European Financial Stability Facility (EFSF) is available subject to conditionality to provide liquidity insurance for euro area countries. More fundamentally, it is crucial that governments take measures to reduce the risks of liquidity shocks materialising by pursuing ambitious and sufficiently front-loaded fiscal consolidation policies with medium-term orientations, supported by structural reforms to facilitate the fiscal adjustment. The required adjustment will be a difficult and prolonged task. In deficit countries, improving external competitiveness would help to boost external demand and maintain employment in the short run. An overall decline in relative prices is required to return to a sustainable position over the longer term, as well as to increase exports to repay foreign debts. Without the flexibility to devalue the nominal exchange rate, this will require considerable wage and price restraint, and falls in the price level cannot be ruled out in some economies. Evidence based on past adjustment of current accounts in industrialised countries suggests that, in the absence of nominal exchange rate flexibility, rigidities in domestic prices are harmful for growth (EC, 2010a). The required change in relative prices, however, is large: it would take five years of flat prices in Greece, Ireland, Portugal and Spain with inflation at 2% in other euro area countries for real exchange rates to return to their 1999 level, although this exercise is likely to give an upper bound as the initial

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position may not have been an equilibrium (OECD, 2010a). Furthermore, the impact on demand of improved external price competitiveness would be relatively weak in countries such as Greece and Portugal that have a low openness to trade. There is some indication that this adjustment is already underway: Ireland has been experiencing a period of deflation since late 2008 and the price level measured by the core national consumer price index is close to 7% below the peak. Inflation in other deficit countries has also been weak. Over the short term, weak or negative inflation will tend to increase the real interest rate, which will dampen the recovery by delaying consumption and reducing investment. Achieving the necessary price adjustment will also be difficult, particularly where labour market institutions lead to nominal wage rigidity. Wage adjustment has played an important role in moderating the impact of adjustment on growth during past current account adjustment episodes (EC, 2010a). Although formal wage indexation only applies in a small number of countries (including Spain), informal arrangements or the structure of wage bargaining more generally can make it difficult to adjust wages downwards. As Portugal has shown over the past decade, price rigidities can lead to the economy remaining depressed for many years. Government policy in most cases can have only limited direct impact on private sector wages and prices. However, labour market regulations can impinge on private sector wages and the bargaining process. Furthermore, public employment will influence overall demand for labour and public sector wages may provide an important signal for private wage setters. Consolidation plans in Greece, Ireland and Spain have included nominal cuts in public wages. Important labour market reforms currently underway in Spain could also make a useful contribution to the adjustment process. Any process of deflation needs to be carefully managed. In principle, the risk of a deflationary spiral induced by unstable inflationary expectations should not apply for individual euro area countries as inflation expectations would be anchored by the ECB’s definition of price stability, and the fall in prices would necessarily help to depreciate the real exchange rate. There is very little guidance at all in the past experience of OECD members about deflation with only Finland and Japan having experienced marked deflationary phases. Even in the case of Japan, the decline in the price level has been fairly moderate. One problem with deflation is that falling prices increase the real value of debts denominated in nominal terms, exacerbating the nominal debt overhang. The debtdeflation trap (Fisher, 1933) could slow the recovery in private demand and contribute to budgetary pressures, both by increasing the real value of debt and by reversing nominal fiscal drag. Structural policies have a key role to play in rebalancing economies, and higher productivity can ease the burden on wage and price adjustment where competitiveness is weak. For countries with large current account deficits, reforms to make product markets more competitive would improve productivity (Boulhol and Turner, 2008). In the tradeable goods sector, this would help to make goods more attractive on world markets, while fewer barriers to competition in the non-tradeable services sector would lower prices and help to switch resources to other activities. Detailed recommendations in this direction have been made in recent OECD Economic Surveys for Greece, Ireland, Portugal and Spain. For countries with high debts, structural reforms that raise growth would make debts easier to repay and sustain. For countries with large external surpluses, structural reforms in the services sector of the economy would both raise the overall performance of the economy, support internal demand overall and help to switch demand towards consumption of domestic OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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production (OECD, 2010b). For example, aligning the level of economy-wide product market regulation in Germany with OECD best practice could raise private investment by 0.7 percentage points of GDP (Koske et al., 2010).

Improving national macroeconomic and financial management to avoid future imbalances While the exact sequence of events that led to the current imbalances is unlikely to recur, the risk of future imbalances will remain unless policies are put in place to improve macroeconomic management. The imbalances built up over the 2002 to 2007 period partly reflect idiosyncratic factors, notably pressures on catching up economies stemming from the creation of monetary union itself and an unusually pronounced global credit cycle. Future shocks could stem from structural changes such as different demographic developments or productivity trends, as well as through errors in the setting of policy or financial regulations. While small deviations from internal and external balance are inevitable, the key challenge is to avoid large, persistent and costly imbalances of the kind built up during the past decade. The likelihood of shocks that can lead to such imbalances depends partly on the degree of similarity across countries. The endogenous optimal currency theory suggests that this may increase over time inside a monetary union (Frankel and Rose, 1998). Although there is evidence that monetary union membership has increased integration through trade and foreign direct investment decisions (Warin et al., 2009), this integration remains incomplete. While greater integration may help to reduce the possibility of asymmetric shocks, greater specialisation in production may have the opposite effect. Financial integration that improves risk sharing may help to stabilise nominal demand. However, this also remains imperfect and greater financial integration may aggravate the impact of shocks by generating stronger wealth effects (Hoeller et al., 2002). Moreover, regulations affecting price and wage nominal flexibility and employment protection play a role in the adjustment mechanism and matter for the extent to which common shocks have country-specific effects on price competitiveness (Biroli et al., 2010). Given that area-wide monetary policy cannot address local imbalances, these are primarily the responsibility of individual euro area countries. Furthermore, most of the costs of the failure to stabilise the national economy fall on the domestic population. In this sense, an imbalance is a first-order issue for the country concerned and a secondorder issue for other countries that are exposed to some of the same risks. Nevertheless, the potential for cross-border spillovers is important and can justify imbalances at national level being treated as a matter of concern for the euro area as a whole. Macroeconomic management of the domestic economy needs to be given a high priority as it cannot be assumed that area-wide policy will be sufficient to balance each economy. In a similar way to how monetary policy is set, there needs to be a clear and timely assessment of the state of the economy, the forces acting on it and the risks. A range of policy tools is then needed to manage the domestic economy and financial system in a similar way to that which would occur with national monetary policy if this were available. This can mean that national policy settings may need to diverge from their area-wide level, within an overall framework of sound and sustainable positions. For example, a system of counter-cyclical capital buffers for banks applied to national conditions could help to achieve this outcome (Chapter 4).

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Structural reforms would reduce the risk of imbalances Structural reforms have an important role to play as current account imbalances are driven partly by domestic structural policy settings in financial, product and labour markets as well as tax and benefit systems. The primary goal of structural policies is to raise living standards. At the same time, they can have important effects on the saving and investment decisions of households and firms as well as on public saving and investment (Blanchard, 2007). Structural policies also influence the speed at which firms and households adjust saving and investment behaviour to changes in macroeconomic conditions. There is evidence that higher social spending, higher unemployment benefits and stricter employment protection legislation (EPL) are associated with a lower saving rate and a weaker current account, most likely reflecting lower precautionary saving of households (Koske et al., 2010). Structural reforms to increase economic flexibility would not only help to deal with the consequences of imbalances but would also help to ensure that economies tend to develop in a more balanced way, both for those with excess demand but also where demand for domestic production has been weak. Economic structures need to be adapted to the disciplines of monetary union. It is essential that wage increases are kept in line with productivity to avoid distortions in competitiveness. There is a wide range of wage bargaining institutions in euro area countries. While there are few general conclusions about the optimal design of wage bargaining institutions,13 it is important that they work well. The explicit role of governments in private-sector wage setting is typically limited, although public sector wages influence private wage bargaining (Lamo et al., 2008). However, labour market institutions can have an impact on how these mechanisms work and the government may have an informal role in the process. Automatic wage indexation, which exists in various forms in Belgium, Luxembourg, Slovenia and Spain, can be a significant barrier to adjustment. The legal extension of pay deals to the whole sector is particularly problematic as unions neither fully internalise the costs of their actions nor is the outcome close to a decentralised market outcome (Calmfors, 1993).

Sound fiscal policy at national level should be the counterpart of ECB monetary policy In the absence of national monetary policy, fiscal policy is an instrument for macroeconomic management at national level. In the absence of substantial fiscal transfers between countries, temporary shocks in euro area countries need to be stabilised through changes in the fiscal balance, leading to the appropriate capital flows operating through capital markets rather than a federal budget. As discussed in detail in Chapter 3, fiscal policy should be set so that the automatic stabilisers are allowed to operate, both in good times where there is temptation to spend booming revenues and during downturns. Unsustainable fiscal policies should not be allowed to contribute to wider imbalances, although generally it was private sector imbalances that have been the major driver over the past decade. In addition, there needs to be the scope to deal with emergencies, such as problems in the financial sector. This implies that the outstanding debt stock should be kept at a prudent level. Chapter 3 gives specific recommendations aimed at improving fiscal frameworks both at the EU and national levels. The scope of discretionary policy aimed only at changing the overall fiscal stance is unlikely to have strong effects in many countries, not least due to leakages abroad as well as offsets in private behaviour, and must in any case take into account the sustainability of the public finances. Such an approach would be second-best in the sense that it does not necessarily directly address the


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underlying causes of private sector imbalances. Within these constraints, some targeted fiscal policy actions could help more closely to address imbalances, such as by changing government spending on non-tradeable goods or through targeted tax measures such as reducing support for housing. For example, a package of measures put in place in Ireland between 1998 and 2002 including these elements had a dramatic effect on holding back house price growth, although these measures were ultimately reversed.14 Fiscal policy in this sense should aim to minimise market distortions. Stabilisation through fiscal policy in the wake of the crisis has played an important role in supporting domestic demand in the short run in countries where private demand has contracted sharply as overstretched borrowers sought to rebuild their balance sheets. Although sustainable public finances are a pre-condition for providing this support, heightened risk aversion may make it difficult for countries to borrow even where this would appear to be justified. This can be provided in a number of ways, including selfinsuring through the creation of rainy day funds, or a system of pooled insurance. The latter is more efficient to the extent that shocks are not correlated across countries. As discussed in Chapter 3, a permanent mechanism should be put in place to deal with liquidity crises, incorporating strong conditionality.

Macroprudential policies need to be differentiated at country level Enhanced regulation could be used to address financial imbalances, including those whose origins lie in destabilising movements in real interest rates at national level. As argued in Chapter 4, more effective and better enforced microprudential regulation could help to reduce excessive risk-taking and protect the financial system from pressures caused by strong loan demand and excessively high asset valuations. Stronger microprudential regulation and supervision should make financial systems more robust to these pressures and increase the resilience of the financial system when risks materialise. In addition, the creation of an effective system of macroprudential regulation could serve both to ensure the sustainability of the financial sector and to limit the consequences on the macroeconomy of credit cycles. The highly international nature of EU capital markets, which also carries many advantages, needs to be taken into account in the design of appropriate policies. Heavy external borrowing has been associated with particular financial risks in euro area countries due to high capital mobility, especially the flow of funds and the transfer of risks between banks in different countries. As argued in Chapter 4, there is a particular need to: ●

Set macroprudential policies on a national or sub-national level, in addition to on a euro area and EU-wide basis. These need to apply to all credit to a particular country, irrespective of the location or identity of the lender, through the principle of jurisdictional reciprocity. Quasi-automatic capital buffers based on national credit growth should be a key instrument.

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National concentrations of risk should be systematically considered under Pillar 2 of the Basel system for determining regulatory capital.

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Liquidity regulation should be stepped up to reduce mismatches where banks use access to the interbank market to draw in funds from other countries to finance long-term domestic lending.

More comprehensive financial integration, including at the retail level, within an appropriate regulatory and supervisory framework would reduce local risk concentrations.

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As discussed above, the structure of the euro area financial system with high levels of integration in some businesses but not others has an inherent tendency to create fragility. Firstly, it intensifies local financial accelerator effects. Secondly, by easing credit constraints, it can lead to short-term capital flows that contribute to risk-taking in the domestic economy and increase the vulnerability of liquidity risks. Thirdly, limited retail integration implies that lenders will often be far away from the risks to which they are exposed and this increases asymmetric information. In addition, more intensive, and better regulated and supervised financial integration could help to reduce the risk of adverse effects from financial imbalances, but would not deal directly with this risky structure. Greater attention is needed to the cross-border implications of large exposures on national balance sheets (Chapter 4). In the absence of any cross-border mechanism, each euro area country has remained responsible for providing assistance to institutions in its jurisdictions or with a systemic impact in that country. This has posed a very serious financial burden on some countries. In federal systems, there is typically a federal safety net. For example, the US Federal Deposit Insurance Corporation (FDIC) provides a federal system of insurance linked to federal supervision. Removing distortions in housing policies should reduce the volatility of housing markets. The housing cycle generated by low real interest rates was amplified by tax distortions in favour of owner-occupied housing and land use restrictions, as discussed above. In particular, favourable tax treatment through mortgage deductibility and generous tax relief for housing transactions should be curtailed. This would also contribute to improving structural budget positions. Furthermore, residential mobility in euro area countries is typically low with the number of households that changed residence within the last two years generally below the OECD average (Andrews et al., forthcoming). Reforms that improve the functioning of the housing market, such as reducing high transaction taxes and removing supply constraints, could also facilitate economic adjustment by removing barriers to labour mobility.

Stronger European surveillance and policy co-ordination Enhanced European surveillance and coordination of economic policies could help to increase the effectiveness of national policies to avoid imbalances. Co-ordination of policies could in principle take different forms, along a spectrum running from peer review and benchmarking through enforcement of common standards to co-ordinated use of discretionary policy. Such policies could be justified on at least two grounds. Firstly, to the extent that there are spillovers between euro area countries, the pursuit of sound national policies is even more important and should clearly be seen as an issue of common interest elsewhere. Secondly, closer co-ordination and reinforced surveillance of economic policy may help national authorities in setting policy and committing to policies that are otherwise difficult to apply. Within the context of the European Union, co-ordination around imbalances should be strongest with respect to euro area countries: these countries are in general the most economically and financially integrated, as well as sharing the same currency and central bank. In addition, euro area economies are more difficult to stabilise in the absence of nominal exchange rate flexibility and independent national monetary policy. The scope for gains from policy co-ordination is determined by the size of spillovers. As argued above, trade spillovers are likely to be fairly weak, so other economies would generally have little to gain through a change of policy settings in another country. Indeed, OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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changing overall demand for goods in one country would be a very indirect method of trying to help another economy to achieve balance. However, financial spillovers have been very large. The overall stress in euro area financial markets relates partly to weaknesses in specific countries. The crisis around sovereign debt in May 2010 had severe effects on many euro area countries, even though Greece accounts for less than 3% of euro area GDP. For example, the timing of movements in the euro area exchange rates, increases in credit spreads on the debt of other euro area countries and the state of the interbank market closely followed news about the situation in Greece. As argued in Chapter 4, the size of capital movements between countries can have very large effects on individual countries, both during the upswing of the credit cycle and in a crisis. Given the nature of spillovers, the underlying factors behind both excess saving and consumption or investment should be treated as issues of concern.

EU and Euro Group surveillance needs more teeth Surveillance of economic imbalances has long been undertaken at international level, both by the EU institutions and other international organisations. This has complemented analysis by national authorities, institutions and commentators. Extensive international warnings have been issued in the past about the risks from imbalances in the domestic economies of euro area countries, both for deficit countries such as Greece, Ireland, Portugal and Spain and for those running large surpluses but with sluggish domestic demand such as Germany. Surveillance of imbalances by the Commission has long been an integral element of its on-going monitoring of economic developments and policies in the euro area and other EU countries. This assessment has appeared regularly in the Euro Area Annual Report, published since 2006, and was discussed earlier in editions of the EU Economy Review and the Quarterly Report on Euro Area. Substantial analytical work on imbalances was published in The EU Economy: 2006 Review (EC, 2006). This work is followed up in the Surveillance of Intra-Euro-Area Competitiveness and Imbalances (EC, 2010a). The ECB has also stressed the importance of internal and external competitiveness in the Euro Group since at least 2005.15 There appears to be a high level of agreement about the risks of imbalances prior to the crisis. Based on the position of six euro area countries around 2001, the assessment of the cyclical position and warnings about overheating/excess demand were “similar” from the EU Council, the IMF Executive Board and the OECD (Hoeller et al., 2002). Such assessments are generally based on a broad range of indicators, although the 2001 study indicated that the ranking of risks across countries closely followed the inflation ranking. One key difficulty is assessing potential output, which is unobservable but crucial to any judgment about whether imbalances are excessive. For the same reasons, estimating Balassa-Samuelson-type effects on inflation related to productivity shocks in the tradeable goods sectors is difficult and makes it hard to judge the degree to which inflation is driven by excess demand. For the group of six countries in 2001, there was a “wide range of results” in terms of how far inflation differentials were driven by underlying factors (Hoeller et al., 2002). Overall, the ex ante identification about some of the imbalances was correct but the scale and nature of the problem was not fully understood or appreciated. There is nevertheless scope to improve surveillance at EU level, including a particular focus on the specific issues facing euro area economies. This should emphasise the extent to which imbalances are judged to be excessive and the risks involved. While countries should ultimately be the best placed to understand their economic situations, EU

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surveillance can bring a wider perspective and draw on the experience and benchmarks provided by other countries. Over the recent build-up of imbalances, there was insufficient policy action in response to warnings from the Commission and other bodies. At national level, such warnings were not treated as credible or were ignored, particularly because the necessary policy instruments and institutional frameworks were not in place. At the EU and euro area level, the ECOFIN Council and the Euro Group each provided a forum to discuss these issues. However, effective policies did not emerge from these discussions. The only welldefined instrument in this area was the adoption by the Council of Broad Economic Policy Guidelines (BEPGs), a reference document intended to guide the conduct of the whole range of economic policies at national and EU level. The key feature of the BEPGs in terms of policy co-ordination was the power given in the Treaty to issue a recommendation that corrective action be taken when economic policies “risk jeopardizing the proper functioning of economic and monetary union”. The policy guidelines have been framed in recent years in terms of stability and sustainability, which could be applied to the problem of imbalances. However, while the BEPGs appear to have had some benefits in stimulating useful discussion about these and other economic issues, peer pressure has not been effective either in enforcing it at the EU level or triggering “home grown” forces to deal with economic weaknesses (Deroose et al., 2008). In particular, only one recommendation to take corrective action was ever issued, to Ireland in 2001, and the strongly negative political reaction to this event appears to have effectively put an end to this initiative. Recent discussions in the Euro Group have also touched on issues related to imbalances. It is difficult to assess the impact of these meetings as they are closed, but the lack of transparency in itself hinders some of the mechanisms that could make peer review effective.16 In response to the lack of an effective enforcement mechanism in the past with respect to harmful imbalances, important legislative changes are underway to improve the identification of imbalances in the EU and to help ensure that the necessary corrective action is taken through an enforcement mechanism. Current proposals follow a two-stage approach. In the first stage, there would be an annual assessment of the risk of macroeconomic imbalances and vulnerabilities in EU countries by the Commission (EC, 2010c; EU Taskforce, 2010). This would be based on a scoreboard of macroeconomic and financial indicators with lower and upper thresholds set as alert levels. This could include variables such as the current account balance, the net investment position, measures of competitiveness, credit growth and changes in house prices. The Commission would conduct an in-depth review, incorporating a wider range of information and qualitative assessment, to determine whether the imbalances pose a risk. Assessing the balance of domestic demand and supply, as well as potential output, should play a key part in this analysis. It is important in selecting indicators and calibrating alert levels to achieve the appropriate balance of Type I (falsely identifying potential harmful imbalances) and Type II (failing to identify risky imbalances) errors. The costs of failing to identify growing vulnerabilities are high, while the in-depth review following initial identification based on the scoreboard would help to minimise the consequences of Type I errors originating from the scoreboard. Nevertheless, a system of indicators that failed to discriminate sufficiently between different countries and led to perpetual in-depth reviews of a large number of countries could lose credibility and political support. Monitoring of macroeconomic imbalances would be integrated with other elements of surveillance, notably of fiscal and


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structural policies, through the “European semester” (Chapter 3; EC, 2010a). Given the importance of financial spillovers, it is of particular importance that the assessment, warnings and recommendations of the European Systemic Risk Board (ESRB) are taken fully into account and that the ESRB undertakes detailed analysis of cross-border capital flows and risk concentrations (Chapter 4). The new calendar for surveillance would contribute to a broad-based assessment of policy settings that can lead to harmful imbalances. The second stage of the proposed approach is to introduce enforcement to ensure that economic policies of EU countries do not pose risks through imbalance to the proper functioning of economic and monetary union (EC, 2010c; EU Taskforce, 2010). The Commission would have the power to issue an early warning if problems were identified during the in-depth review. In the case of serious imbalances, the Council could place a country in an “Excessive Imbalance Position” based on a recommendation from the Commission, which would have to be rejected by a qualified majority under the new “quasiautomatic” voting procedure. A set of financial or structural policy recommendations would be addressed to the country in question, which would be required to report regularly on progress. The Commission would also monitor implementation. Some of the policies required to deal with imbalances are not within the direct control of the government; for example, wages are largely determined in the private sector. Therefore, policy recommendations and their monitoring would focus primarily on the existence of appropriate policies, rather than just the outcome in terms of imbalances. For euro area countries only, repeated non-compliance with the Council’s recommendations could ultimately lead to fines along the lines of those that exist for non-compliance with the Stability and Growth Pact. The implementation of these proposals would be a major upgrading of the surveillance of euro area imbalances and create a more developed enforcement mechanism. Nevertheless, it could remain difficult to ensure that appropriate corrective action is taken. In particular, the identification of harmful imbalances and how to resolve them is inherently complicated and requires some judgment. Defining “excess imbalances” is, for example, likely to be more difficult than identifying an “excessive deficit”, which is more closely based on simple numerical criteria. It requires a stronger element of judgment based on a broader range of indicators, which can create ambiguities about whether action is required or what form this should take. The enforcement of such decisions around the Broad Economic Policy Guidelines by the Council has proven to be ineffective in the past, even more so perhaps than for fiscal policy (Chapter 3). In particular, the warning given to Ireland in 2001 by the Council led to a political reaction and triggered a debate about the legitimacy of EU economic governance (Deroose et al., 2008). Such warnings were subsequently not invoked again. The effectiveness of the new institutions should be kept under review and, if achieving the necessary corrective action proves difficult, consideration could be given to a simple quantitative standard that would create a clearer presumption of policy action to address imbalances as a backstop. The lack of effective action in the past in response to imbalances and growing vulnerability needs to change. The possible difficulties in achieving effective enforcement need to be overcome and the difficulties involved should not be a deterrent to put in place procedures to identify, avoid and correct harmful imbalances that threaten to jeopardise the proper functioning of the euro area.

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Box 2.4. Summary recommendations on macroeconomic imbalances Economic, financial and fiscal imbalances in individual euro area countries hindered the efficient operation of monetary union and led to growing vulnerabilities. A new cross-cutting approach to economic and financial management is required to stabilise national economies. This should rest on a broad range of policies that can tackle the sources of macroeconomic imbalances, such as macroprudential instruments, sound fiscal policies and structural reforms. Important legislation changes are underway to improve EU monitoring of imbalances and to help ensure that corrective action is taken. Restoring macroeconomic and financial stability Rebalancing economies with large existing imbalances will be a difficult and prolonged task. There is an immediate need to resolve weaknesses in the financial sector, restore stability in the public finances and ensure governments have appropriate access to finance (Chapter 1). In addition, countries with large external imbalances should: ●

Allow prices and wages to adjust in deficit countries to help shift resources away from non-tradeable activities that over-expanded during the boom years. This may require considerable wage and price restraint. Institutional barriers that could impede required adjustment should be removed.

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Undertake efficiency-enhancing structural reforms that would facilitate adjustment and help rebalancing. In deficit countries, tackling barriers that hold back productivity would help to bring costs in line. In surplus economies, structural policies could strengthen domestic demand and enhance productivity growth, especially in the nontradeable sectors.

Avoiding unsustainable imbalances ●

Fiscal frameworks should be improved at both EU and national level to avoid unsustainable fiscal positions, improve macroeconomic management and avoid fiscal crises (Chapter 3).

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Financial and macroprudential oversight in the EU should be strengthened (Chapter 4). To avoid excess imbalances, responsibility for macroprudential policy should be clearly identified at national and EU level; financial regulation should avoid excessive local concentrations of risk; and counter-cyclical capital buffers should be introduced based on national credit growth. Financial integration should be pursued, subject to appropriate regulation.

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National wage-setting institutions and labour market should be reformed to ensure wage developments are responsive to competitiveness developments. Automatic indexation of wages should be phased out.

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Distorting and inefficient housing policies that increase the cyclicality of demand or constrain supply unnecessarily should be removed to dampen housing cycles.

Surveillance and oversight of imbalances Important legislative changes are currently underway to strengthen the oversight of harmful imbalances. Current proposals should be implemented. This should ensure that: ●

EU surveillance of imbalances is stepped up and focuses on spillovers between countries, bearing in the mind the specific needs of euro area countries. This process should be integrated through the “European Semester” with fiscal and structural surveillance, as well as building on the analysis of cross-border capital flows and risk concentrations, as well as recommendation and warnings, by the ESRB.


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Box 2.4. Summary recommendations on macroeconomic imbalances (cont.) ●

There is an annual assessment of imbalances based on a scoreboard covering a broad range of indicators, together with a qualitative assessment. The indicators could include the net foreign asset position, the current account, credit growth, house prices and competitiveness measures. In-depth country studies would be required to complete an overall assessment of the risks.

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The availability of comparable and consistent statistics on euro area countries is increased, particularly with regard to national banking systems and cross-border flows.

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Where risks to euro area stability from imbalances are identified, the Commission and the Council should apply a graduated procedure for euro area countries, whereby surveillance is intensified and ultimately country-specific recommendations and warnings issued. The difficulties of identifying harmful imbalances should not deter the application of sanctions where risks appear elevated and there is repeated noncompliance with the recommendations to undertake corrective action.

Notes 1. As Slovenia and Slovakia only joined the euro area in 2007 and 2009 respectively, they are excluded from the analysis below which focuses on the build-up of imbalances during the 2000s. 2. Based on IMF International Financial Statistics. There are alternative measures of net international investment positions. 3. The current age-dependency ratio boosts current consumption relative to income, while future increases in the age-dependency ratio increased current saving. 4. The fiscal balance is typically positively correlated to the current account balance but the effect is much less than one-for-one. 5. This is not the case for Finland. 6. The Balassa-Samuelson effect in the case of Ireland is strong and positive on inflation but it is relatively small in some countries that experienced relatively low inflation (Égert, 2010). However, the effect is not systematic across countries (see also EC, 2009). 7. This effect is in line with estimates reported in Barnes et al. (forthcoming) for OECD and euro area countries, along with previous studies in the current account literature. 8. Except for 2007 when Germany ran a surplus. 9. A similar relationship holds for real interest rates. The simple Taylor rule used in Figure 2.6 assumes a common neutral interest rate and inflation rate-target and therefore ignores potentially important differences across countries. Furthermore, it depends on highly uncertain estimates of the output gap. 10. Alternative measures include the consumption deflator-based real exchange rate, unit labour costs and export price. 11. See Box 1.1 “How Big is the Irish Banking Sector?” in OECD (2009b). 12. In the case of Spain, discretionary fiscal stimulus was used to cushion the initial impact of the crisis but this was more than unwound by subsequent retrenchment at a time when overall demand has been very weak. 13. See Chapter 3 “Wage-setting Institutions and Outcomes” of OECD (2004). 14. See Box 1. “Tax breaks for housing and policy flip-flops” in Rae and van den Noord (2006). 15. See introductory statement by Jean-Claude Trichet at the Hearing at the Economic and Monetary Affairs Committee of the European Parliament in Brussels on 21 June, 2010. 16. “La France va évaluer la compétitivité de l’Allemagne”, Le Figaro, 13 July, 2010.

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ANNEX 2.A1

Table 2.A1.1. Net financial assets by sector Per cent of GDP Non-financial corporations

Total economy

Change 2002 2007-02

Change 2002 2007-02

Change 2002 2007-02

Change 2002 2007-02

–20.3

–9.1

11.2

–80.6

–94.5

–13.9

97.1

114.0

16.9

–37.2

–30.7

6.4

–20.7

–11.2

9.5

–21.2

–19.8

1.4

43.0

33.2

–9.8

–78.1 –103.5

–25.3

215.5

212.1

–3.4

–93.3

–73.3

19.9

44.1

35.3

–8.8

41.3

31.4

–9.9

Finland

–35.4

–30.0

5.4 –133.7 –171.3

–37.6

62.9

67.2

4.4

31.6

71.0

39.5

–39.3

–33.0

6.3

–40.9

–29.0

11.9

France

12.9

14.3

1.4

–40.8

115.9

133.0

17.1

–41.8

–34.0

7.8

–0.7

–16.6

–15.9

3.0

–0.3

–3.3

Germany

–1.8

19.3

21.1

–63.7

–71.5

–7.8

94.1

123.6

29.4

–40.8

–42.9

–2.1

–10.4

9.2

19.6

5.6

28.0

22.4

Greece

–56.2 –100.5

–44.4

–61.7

–92.8

–31.0

107.4

92.3

–15.2

–94.7

–70.4

24.3

–49.0

–70.9

–21.9

–58.9 –101.9

–43.0

Ireland2

–18.0

–19.5

–1.5

–93.2

–76.0

17.2

90.0

64.6

–25.4

–14.0

0.3

14.2

–17.1

–11.1

6.0

–20.0

–21.0

–1.0

–4.3

.7

5.0 –103.7 –105.2

–1.5

193.6

188.6

–5.1

–95.7

–87.1

8.6

–5.8

–3.7

2.1

–15.3

–23.1

–7.8

–.9

44.1

–86.8

13.1

155.7

168.9

13.2

–60.3

–37.4

22.9

–4.4

44.7

49.1

–27.0

5.9

33.0

–56.6

–90.6

–34.0 –146.0 –167.8

–21.8

129.8

127.6

–2.2

–34.4

–44.2

–9.8

–50.6

–84.4

–33.8

–62.6

–98.3

–35.6

Slovak Republic –27.5

–45.2

–17.7

–45.5

–53.3

–7.9

38.6

13.5

–25.1

–1.7

0.8

2.5

–8.5

–39.0

–30.5

–25.2

–53.3

–28.1

Spain

–38.4

–77.0

–38.6

–96.0 –157.3

–61.3

94.1

95.5

1.3

–40.3

–19.0

21.4

–42.2

–80.8

–38.6

–46.9

–83.4

–36.5

Slovenia

–3.5

–21.8

–18.3

–92.1 –122.6

–30.5

66.9

79.1

12.2

14.2

17.6

3.4

–11.0

–25.9

–14.8

5.3

6.1

0.9

Euro area

–4.9

–2.5

2.4

–83.1 –104.0

–20.9

124.8

135.4

10.6

–52.5

–43.2

9.3

–10.9

–11.9

–1.0

..

..

..

Portugal

–99.8

2007

Change 2007-02

Belgium

45.0

2007

Change 2002 2007-02

Austria

Netherlands

2007

International investment position

2007

–74.8 –115.6

2007

Net non-financial sector1

Government

2002

Italy

2007

Households

1. Sum of non-financial corporations, households and government. 2. Non-consolidated data. Source: IMF (2010), International Financial Statistics; OECD (2010), National Accounts of OECD Countries – Financial Balance Sheets, Stocks, Vol. IIIb


85


Chapter 3

Rebuilding the public finances and fiscal discipline The public finances are in poor shape following the crisis. There has been a large increase in government borrowing as a result of the operation of automatic stabilisers and discretionary fiscal stimulus. High government borrowing also reflects the end of buoyant revenues, related to the credit cycle, used to finance unsustainable spending increases. Support to the financial system has increased government liabilities in some countries, adding to already high overall debt levels. Credit spreads for many governments have widened substantially and confidence is fragile. Budgetary pressures have been particularly severe for countries unwinding excessive private or public borrowing. A major consolidation effort will be required to meet commitments under the Stability and Growth Pact to stabilise and reduce the debt-to-GDP ratio. This is already underway in some countries. A tight budgetary position over many years will be required in many economies to return to prudent debt levels. The current weak fiscal position partly has its origin in poor policy settings and the failure to achieve sufficiently sound fiscal positions in economic good times. The budgetary stance in most countries was too lax, leaving countries exposed to a sharp deterioration in public finances and without sufficient budgetary room for manoeuvre when the crisis broke. In countries with large imbalances, fiscal policy failed to counter these pressures and in some cases reinforced them. During the years of rich revenue growth, the opportunity to save to meet future ageing costs was wasted. The weak position going into the downturn meant that some countries had to tighten policy in the midst of severe downturns. Weak enforcement of the Stability and Growth Pact, particularly of the preventive arm, failed to achieve prudent budgetary management. Fiscal discipline needs to be improved so that the public finances are put on a more sustainable footing and there is more room for manoeuvre in the face of future shocks. Upgrading fiscal institutions would help to make this process more credible. To improve market discipline, a permanent liquidity support mechanism is required to support countries that are solvent, subject to strong conditionality. Sovereign risk should be fully reflected in financial regulation, particularly the setting of capital requirements. Institutions at the EU level should be enhanced, primarily through measures to improve the enforcement of the rules. Major legislative changes are underway at EU level to address these issues. However, national governments remain primarily responsible for the public finances. Within the basic EU rules, the strengthening of national fiscal institutions is crucial. Broad-based medium-term frameworks for the public finances should be in place in all countries based on paths or ceilings for expenditure. Furthermore, all countries should adopt independent fiscal councils to provide forecasts of the public finances and assessment of the fiscal stance. Political commitment to the independence and relevance of these institutions will be crucial to making them work.

87

3.

REBUILDING THE PUBLIC FINANCES AND FISCAL DISCIPLINE

T

he public finances are now in poor shape following the crisis. Fiscal policy during the upswing was insufficiently prudent in most euro area countries and failed to use strong revenues to improve the long-run fiscal position. In addition, fiscal policy failed to prevent the build-up of large imbalances in some countries and actively contributed to destabilising the economy in some. The first section of this chapter sets out the immediate consolidation requirements, the need to stabilise debt-to-GDP ratios and bring indebtedness down to more prudent levels over time. The second section sets out the weaknesses in fiscal performance in the years running up to the crisis that contributed to ineffective economic stabilisation. The third section discusses how a combination of structural and institutional reforms could improve fiscal performance by enhancing market discipline and the power of peer review. However, strengthening political commitment and institutions at the national level will be crucial to making fiscal positions sustainable, improving stabilisation of national economies and avoiding excessive imbalances.

Fiscal consolidation is required The public finances have deteriorated sharply The fiscal position in the euro area has deteriorated sharply since 2008: the budget deficit increased from 0.7% of GDP in 2008 to 6.3% in 2009, while the debt-to-GDP ratio measured on the Maastricht basis increased by over 9 percentage points to reach 79%. This is broadly in line with the deterioration in the United States and for the OECD as a whole. The annual increase in the budget deficit as a share of GDP is very large by historical standards and substantially exceeds the increases in previous downturns in 1975, 1981, 1995 and 2001. The deterioration in the public finances reflects the effects of the economic and financial crisis: revenues have dropped and spending has increased as the result of the normal automatic stabilisers. Tax receipts related to booming financial and property markets evaporated and some countries undertook discretionary fiscal expansion to support the economy. Government debts further increased in some countries as the result of liabilities related to supporting the financial system, some of which are also held off-balance sheet. The scale of the weakening in public finances has been particularly marked in countries that are having to unwind excessive private or public sector borrowing. The general government balance between 2007 and 2010 weakened by around 12% of GDP in Ireland, even allowing for major emergency fiscal tightening and excluding major costs related to bank recapitalisations, and more than 10% of GDP in Spain (Figure 3.1). The sharp contraction of private demand, as private-sector economic imbalances adjusted, led to powerful effects from the automatic stabilisers and a marked drop in housing boomrelated revenues. Excessive risk-taking by the financial sector in countries with large imbalances has added to fiscal costs. The deterioration in the general government balance as a share of GDP was less than the euro area average for Austria, Germany, Italy and Luxembourg. In some countries, such as Germany, sizeable discretionary fiscal packages explain a substantial part of the weakening of the public finances.

88


3. REBUILDING THE PUBLIC FINANCES AND FISCAL DISCIPLINE

Figure 3.1. Government budget balances have deteriorated Per cent of GDP

6

6 2007 1 2010

4

4

2

2

0

0

-2

-2

-4

-4

-6

-6

-8

-8

-10

-10

-12

LUX

FIN

DEU

AUT

BEL

ITA

SVN

NLD

Euro area

PRT

FRA

GRC

SVK

ESP

IRL

-12

1. OECD estimates. For Ireland, the balance shown in the figure excludes the capital injections into the banking system. Source: OECD, OECD Economic Outlook 88 Database.

1 2 http://dx.doi.org/10.1787/888932359511

The credit spread on government borrowing for many euro area countries has risen sharply since the crisis, although in most cases the low overall level of interest rates means that long-term interest rates are lower. While yields on government debt were broadly similar across all euro area countries over most of the past decade, the spread between German and other euro area countries began to widen in late 2008 and in the early part of 2009 (Figure 3.2). This increase was largely explained by higher risk aversion with some greater differentiation according to national fiscal conditions (Haugh et al., 2009). Flight-toquality effects may have lowered yields on German debt somewhat, amplifying the difference with other countries. However, the price of credit default swaps suggested even larger increases in the market price of euro area sovereign risk. As financial conditions in general improved during the course of 2009, euro area sovereign spreads generally narrowed. However, spreads rose again during 2010 as the fiscal crisis in Greece led to a reassessment of credit risk in the euro area. Spreads remained high even after May 2010,

Figure 3.2. Credit spreads1 have widened % points

% points

10

10 Greece Ireland Italy Portugal Spain Other 2

8 6

8 6

4

4

2

2

0

Jan

Apr

Jul

Oct

2008

Jan

Apr

Jul

2009

Oct

Jan

Apr

Jul

Oct

0

2010

1. Benchmark bond 10-year over German bond yields. 2. Unweighted average of the spreads for Austria, Belgium, Finland, France and the Netherlands. Source: Datastream.

1 2 http://dx.doi.org/10.1787/888932359530


89

3.


when the support package for Greece was put in place, the European Financial Stability Facility (EFSF) was created and the European Central Bank (ECB) began to purchase government bonds in the secondary market through the Securities Market Programme. Despite some initial narrowing, spreads have remained at a high level and come under strong pressure at times. These yields are not high by historical standards for most countries, reflecting very low long-term bond yields due to a strong preference for low-risk assets and low expectations for growth and inflation. Only in Greece, Ireland, Portugal and Spain are long-term borrowing costs similar to or higher than prior to the crisis. Nevertheless, the current level of yields may give a misleading impression of future borrowing costs if there is a cyclical recovery in bond yields and credit spreads remain at their current levels. The generalised increase in spreads in the early part of 2010 appears to be the result of spillovers from the situation in Greece. The direct spillovers are limited. However, the contagion effects through a wider re-evaluation of the prospects for other economies with large imbalances and weak fiscal positions were important. Although the circumstances were different, the deterioration in Greece was interpreted by some market participants as a signal about the state of the public finances in other countries. In addition, noncompliance with the Stability and Growth Pact and revisions to fiscal data called into question the credibility of the EU fiscal framework as a whole.

The crisis will leave public debt too high in many countries Debt-to-GDP ratios will stand at a historically high level in many euro area countries, even assuming that indebtedness is stabilised rapidly. This would continue an upwards trend in many OECD countries, including many in the euro area, since the 1970s (Figure 3.3). The debt-to-GDP ratio for euro area countries in 2009 is just over double its level in 1979. While the ratio typically stabilises or even falls during an upswing, this has been insufficient to restore the initial position and so debt levels after each recession have been progressively higher. Current levels of debt are elevated by historical comparison. Prospective indebtedness in the euro area, however, is much lower than in Japan and somewhat lower than in the United States in both gross and net terms. Per capita gross

Figure 3.3. Government gross debt As a percentage of GDP

200

150

100 Japan (left scale) Euro area (right scale) Germany (right scale) France (right scale) Spain (right scale) United States (right scale)

80

60

100 40 50 20

0 1960

65

70

75

80

85

90

95

2000

05

0


1 2 http://dx.doi.org/10.1787/888932359549

90



debt in the euro area in dollar terms is around half the level in the United States and a quarter of what it is in Japan, although per capita incomes are also lower in the euro area and the circumstances of each major economy are different. The degree of indebtedness, however, varies considerably across euro area countries (Figure 3.4). The debt-to-GDP ratios in Belgium, Greece and Italy stand at a particularly high level, while debt will remain fairly low in Finland, Luxembourg, Slovakia and Slovenia. While euro area countries largely issue debt in the common currency, the burden of debt would tend to remain high in countries where nominal growth will be weak as competitiveness is restored and reductions in the price level would increase the real value of outstanding debt. In Greece, Portugal and Ireland, not only is public debt high but the net foreign asset position is also highly negative so that the government helps to account for the high overall indebtedness of the country as a whole.

Figure 3.4. The debt-to-GDP ratio has increased1 Percent of GDP

120

120

2007 2010 2

100

100

80

80

60

60

40

40

20

20

0

GRC

ITA

BEL

IRL

Euro area

FRA

PRT

DEU

AUT

NLD

ESP

FIN

SVK

SVN

LUX

0

1. Maastricht definition. 2. OECD estimates. Source: OECD, OECD Economic Outlook 88 Database.

1 2 http://dx.doi.org/10.1787/888932359568

While many euro area countries have experienced a tendency to rising indebtedness over past decades, there have been some exceptions. Belgium, Finland and the Netherlands managed to reduce their debt-to-GDP ratios quite substantially since 1995 with only a relatively modest deterioration during the crisis. Ireland and Spain also reduced their debts over this period, although this was facilitated by high growth and ultimately much of the improvement was based on unsustainably strong revenues and excessive imbalances that have led to a sharp deterioration in their debt positions during the crisis. By contrast, indebtedness increased in both France and Germany since 1995 and during the upswing. These developments account for a large part of the trend increase in the euro area as a whole, together with rising debts in Austria and Portugal. Indebtedness decreased marginally in Greece and Italy during the upswing but remained at very high levels compared with the euro area average. In general, such reduction in the debt-to-GDP ratio that occurred during the upswing was the result of nominal growth exceeding interest rates rather than through running primary surpluses. The tendency to rising indebtedness is undesirable and trying to maintain current high debt levels would be imprudent. There are good reasons to reduce debt from the currently high


91

3.


level. Firstly, high debt levels increase the future need to refinance debt and reduce the ability to withstand shocks without facing market pressures. While markets re-evaluated fiscal risks in many euro area countries, the effect on interest rate spreads was larger where the debtservice ratio was high and there was a weaker fiscal track record. These effects have been nonlinear with respect to debt and research has pointed to a threshold somewhere around 75% to 90% of GDP, beyond which the effect of debt levels becomes substantially larger (Égert, 2010). Such problems may be more acute for small countries within a monetary union, whose bonds generally would be substitutable for the debt of other countries given the shared currency, and therefore can be very sensitive to news about the country. In other respects, the less liquid and more volatile debt markets for small countries complicate financing. Secondly, these market reactions make it more difficult to stabilise the economy: based on past experience, there is evidence that fiscal policy has tended to become pro-cyclical at levels of debt higher than 90% of GDP, while policy has been fairly neutral at above 30% and counter-cyclical for lower debt levels (Égert, 2010). Thirdly, the high level of debt itself can reduce the effectiveness of fiscal policy by making households more worried about future fiscal adjustment and thereby reduce their current consumption in anticipation. Over a sample of OECD countries, the short-run private saving offset of fiscal stimulus is larger for countries with debt above 70% (Roehn, 2010). Overall, recent analysis suggests that high public debt levels have adverse effects on growth even in developed countries. Reinhart and Rogoff (2010) find evidence that growth rates fall by around 1% when the public debt-to-GDP ratio exceeds 90%.1 However, past relationships should be interpreted with caution, not least because debt ratios of above 70% of GDP have historically implied that a country has had a relatively high level of debt, while many OECD countries in coming years will have debt-to-GDP ratios at or above these thresholds. The limited historical experience of such indebtedness makes it difficult to draw inferences about the absolute level of the debt-to-GDP ratio. Furthermore, in recent years, real interest rates have been lower than in the past, which may make it easier to support high levels of debt if these low financing costs were to be sustained.2 Although current levels of indebtedness are high by historical comparison, it is difficult to assess what level of debt is optimal or prudent. Economic theory gives limited guidance about the appropriate level of debt provided that the long-run budget constraint is respected, which can be achieved by a constant deficit-to-GDP ratio. However, there are four principal considerations:

92

●

The ability to finance debt in the market. This becomes more difficult as debt levels increase because the sustainability of debt becomes increasingly sensitive to sharp deteriorations in the budget balance, costs associated with calamities such as the financial crisis or large changes in interest rates or growth prospects. As this crisis has shown, these effects tend to work in the same direction so that public finances may weaken dramatically. It would therefore be prudent to maintain debt at a wide margin, perhaps 20% of GDP, below the level at which constraints were expected to emerge. This margin could be narrower if emergency liquidity support is available.

●

The ability to finance debt in the longer term. Strong growth prospects relative to interest rates imply that the ability to repay debt will increase at a faster rate than debt accumulates. With strong growth prospects, current debts will tend to shrink relative to the size of the economy. But, generally, weak growth prospects in the euro area mean that the current debts would continue to be a large burden in the future. This also depends on what debt is used to finance: productive investments, for example in necessary infrastructure, should pay for themselves in terms of higher growth, while OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010


debts accumulated to fund consumption will not. However, government investment as a share of GDP is lower in most euro area countries than the OECD average. ●

Tax distortions should be minimised from an efficiency perspective. Higher debt requires higher interest payments and debt sustainability requires that these be financed primarily through taxation. Although debt held within the country has a largely redistributive effect from tax payers to bond holders, this nevertheless requires taxes to be raised. However, even for a debt-to-GDP ratio of 100% of GDP, interest payments would probably only amount to 5% of GDP so the distortion would not necessarily be large.3

●

Intergenerational equity may be incompatible with shifting debts to future generations. This is a complex ethical and practical question, as future generations will inherit both some of the wealth and the liabilities accumulated by current generations. However, it is questionable how far future generations should be held responsible for decisions they did not take and the possibility of imposing costs on future generations creates poor incentives for current taxpayers. Large unfunded future pension costs add to the undesirability of high and rising public

debt, as these are also potentially a significant claim on future taxation and raise some of the same questions of intergenerational fairness. Ageing-related costs are already rising in many countries and will pick up in many cases during the next decade. In the absence of reform, ageing-related expenditures in many euro area countries will rise substantially in the coming years and pension expenditures alone will generally be between 10% and 15% of GDP for euro area countries in future decades (EC, 2010b). Abstracting from changes in tax revenues as a share of GDP related to ageing and assuming that non-ageing related expenditures remain constant as a proportion of national income, simple calculations suggest that the costs of increased ageing that would not be met out of current taxation are very large and generally of a similar order in present value terms to outstanding public debt. In most cases, the present value of these costs exceeds 100% of GDP and is very much larger for a few countries. There has been considerable pension reform in euro area countries over the past decade (OECD, 2009b) and renewed efforts are underway in some countries. The scope to raise tax burdens to offset the costs of ageing is limited given the already high tax rates in most euro area countries. However, paying down government debt or pre-funding of pensions are strategies to help meet future pension liabilities and to avoid future generations subsidising current workers and pensioners. Some smoothing of pension costs may be particularly relevant in the context of the retirement “baby boom”, which creates an inherent rise and fall in the pension costs even if there is no change in benefits across generations. The recent increase in the debt burden is therefore a huge setback in preparing for future demographic ageing, with the revenue-rich years of the boom having been largely wasted as an opportunity to prepare for the retirement of “baby boom” generations. Despite the difficulties of establishing the appropriate debt level, a number of OECD countries have set targets or ceilings: in New Zealand, the government fiscal target is net debt of 20% of GDP, while the United Kingdom set a ceiling of net public debt at 40% of GDP prior to the crisis. Poland has a constitutional limit of gross debt of 60% of GDP with a target of 50 to 55%. The euro area also has a ceiling set in the Stability and Growth Pact (SGP) for gross debt at 60% of GDP with the expectation that debt will be reduced at a “satisfactory pace” to meet this objective. As a ceiling, this reference value is reasonable but it will require significant fiscal consolidation to be achieved. It is important for the credibility of the SGP that all its stated objectives including for debt are pursued coherently.


93

3.


Fiscal consolidation is an immediate priority and should aim to reduce indebtedness Fiscal consolidation to stabilise the public finances is the priority. Deficits should be cut so that the debt-to-GDP ratio stops rising and then further measures should be taken to reduce indebtedness to a more prudent level. Marked consolidation is already underway for Greece, Ireland, Portugal and Spain, as the result of the rapid rate of debt accumulation, rising borrowing costs and underlying economic adjustment. While some consolidation has come in other countries as discretionary measures expire, consolidation should begin in all countries by 2011 at the latest. Credible and detailed plans for consolidation in future years are needed to maintain the credibility of fiscal policy and a low risk premium on borrowing costs. Otherwise, there is a risk that countries could lose control over the consolidation process. The absence of such credibility had serious consequences for Greece and required very tough consolidation to restore market confidence. This credibility is in turn necessary for financial stability to the extent that fiscal weakness can spill over into financial markets and onto banks. Countries have committed, notably through the Stability Programmes for 2009-10 submitted early in 2010, to have deficits at or below 3% of GDP in most cases by 2013 at the latest. Given that only a small part of the measures necessary to achieve these objectives has been set out in detail, it is important that appropriate policy action is taken to secure the implementation of these objectives. The submission of Stability Programmes and revised medium-term budgetary strategies by national authorities in early 2011, as well as national budgetary processes, provides an opportunity to give greater clarity about fiscal policy actions for the coming years. The scale of the reduction in deficits, required to bring public debt under control across euro area countries, is large relative to past OECD experience but not atypical following a severe downturn. The aggregate budget deficit for the euro area is similar, as a share of GDP, to its level during the 1980s and up to the mid-1990s, while the largest deficits of euro area countries now are similar to those of Belgium, Ireland, Italy and Greece in the 1980s. A key difference, however, is that nominal interest rates and expected inflation are much lower than in the past so that aggregate euro area long-term interest rate, which was close to 11% in 1990, is now well below 4%. However, the debt-to-GDP ratio is much higher, leaving debt service requirements somewhat similar as a share of GDP. The underlying primary fiscal balance required to stabilise the debt-to-GDP ratio at prevailing interest rates and growth rates is broadly in line with the past. The Stability and Growth Pact (SGP) provides the framework for fiscal consolidation in the near term. All euro area OECD countries, except Luxembourg, are currently subject to Excessive Deficit Procedures (EDPs). Most are expected to reduce their budget deficits to below 3% of GDP by 2013, with Italy and Belgium to do so by 2012 and Greece and Ireland having until 2014 to meet this objective. Stability Programmes published in the early part of 2010 set out plans to exit the EDPs in each country, although a number of countries have announced additional measures during the fiscal crisis in May 2010. However, in most cases, there has been little by way of legislation so far to support these objectives and few details have been provided about the expenditure and revenue decisions that will bring about the anticipated consolidation. Furthermore, the economic assumptions about nominal growth, tax elasticities and interest rates underpinning the Stability Programmes are relatively optimistic and so additional discretionary measures could be required if tax revenues do not pick up as anticipated and these objectives are to be achieved (EC, 2010b). Further ahead, additional consolidation efforts in the SGP framework would, provided that EDPs have ended, be guided by the medium-term

94



objectives (MTOs) for the structural fiscal balance (Table 3.1). Reducing actual deficits to 3% of GDP by around 2013 is unlikely to meet the MTOs given the likely state of the economic recovery at this time. While there would still be modest gains from cyclical recovery, the remaining deficits would largely be structural and thus require additional fiscal consolidation. It is important for the rebuilding of the credibility of the SGP that sufficient progress is made towards all these objectives.

Table 3.1. Medium-term fiscal objectives Structural balance (% of GDP) Austria

0.0

Belgium

0.5

Finland

0.5

France Germany

0.0 –0.5

Greece

0.0

Ireland

–0.5

Italy

0.0

Luxembourg

0.5

Netherlands

–0.5

Portugal

–0.5

Slovak Republic Slovenia Spain

0.0 –1.0 0.0

Source: European Commission (2010), “Public Finances in EMU – 2010”, European Economy, No. 4, Brussels.

Two stylised consolidation scenarios are shown in Figure 3.5 based on consolidation paths set out in early 2010 and the OECD’s medium-term scenario. 4 The “Stability Programme” scenario essentially assumes that countries reach the actual fiscal balances outlined in the current Stability Programmes, which were published early in 2010. There is then no further discretionary fiscal action. These typically bring the deficit to 3% of GDP or a little lower. For most euro area countries, this allows the debt-to-GDP ratio to rise somewhat over the coming years before stabilising at around its peak. For high debt countries, there is some decline as the implied primary balance with a deficit of 3% is large enough to achieve some easing of the debt burden. The “Convergence to Medium-Term Objectives” scenario begins as the first scenario but assumes that countries then continue to consolidate at a pace which improves the structural balance by 0.5 percentage points of potential GDP until the MTO is met. Under this scenario, the debt-to-GDP ratio would decline in almost all euro area countries. However, the decline in most countries is modest and 11 countries would still have debt-to-GDP ratios in excess of the 60% of GDP reference value by 2020. Of course, there is considerable uncertainty around the underlying assumptions of these scenarios, particularly at longer horizons, and interest rates and growth could ultimately be less favourable for stabilising the public finances. It would be prudent, however, for countries to reduce the debt-to-GDP ratio more rapidly than the modest pace implied in most cases by the current MTOs. But the appropriate rate of debt reduction is difficult to define and depends on a number of country-specific factors. Up to now, the Excessive Deficit Procedure has not set a clear quantitative standard for the necessary minimum pace and the Treaty only specified that the pace of reduction of the debt ratio needs to be “satisfactory”. As with debt itself, the


95

3.


Figure 3.5. General government debt scenarios1 Percent of GDP

’Stability Programme’ scenario 160 140 120

160 Austria Finland Ireland Luxembourg

Netherlands Spain Slovak Republic

140 120

100

100

80

80

60

60

40

Belgium France Germany

20 0

2008 10

12

14

16

18

20

22

24

2008 10

12

40

Greece Italy Portugal

14

16

18

20

20 22

24

0

’Convergence to Medium-Term Objectives’ scenario 160 140 120

160 Austria Finland Ireland Luxembourg

Netherlands Spain Slovak Republic

140 120

100

100

80

80

60

60

40

Belgium France Germany

20 0

2008 10

12

14

16

18

20

22

24

2008 10

12

40

Greece Italy Portugal

14

16

18

20

20 22

24

0

1. See assumptions given in text. Source: OECD, OECD Medium-Term Database and OECD calculations.

1 2 http://dx.doi.org/10.1787/888932359587

pace of reduction depends on the costs of maintaining debt at a certain level and the funding risks this creates, the smoothing of tax distortions, and intergenerational equity. A standard argument based on tax smoothing is that the debt should largely be taken as given and gradually paid back over time at a smooth rate or simply rolled over (Lucas and Stokey, 1983). However, the deficit bias means that this approach would lead to ever higher debt. One-off taxes to repay debt, as opposed to reducing the deficit, could be less distorting particularly in their effects on capital accumulation, provided that their one-off nature is credible. In political economy terms, larger adjustments can also be more costly and so it is optimal to begin consolidation early rather than pushing larger efforts into the future even for relatively high discount rates (Cournède, 2007). High levels of debt can have a non-linear effect on financing costs, which supports front-loading debt reduction in this situation (Koutsogeorgopoulou and Turner, 2008). Much may depend on the past record of countries in reducing debt (Ostry et al.¸ 2010). Current legislative proposals set out an operational definition of the required reduction in the debt-to-GDP ratio under the SGP as

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a reduction of the distance with respect to 60% over the previous three years at a rate of the order of one-twentieth per year (EC, 2010c). The definition of standard is an essential step towards effective enforcement of the debt criterion. The pace of the implied debt reduction is fairly brisk, while the averaging over three years allows some flexibility with respect to asset sales and limited room for manoeuvre during each time window. The exact formula, however, implies a strong degree of front-loading in the early years for countries with high debt.5 This could be desirable given the risks associated with high levels of debt, although it imposes some efficiency costs relative to slower adjustment. By contrast, the implied pace of convergence for countries with indebtedness closer to 60% of GDP is very slow.6 However, convergence to and adherence with the MTOs are likely to impose a much stricter standard than the formula for debt reduction so that the debt criterion would only be the binding constraint for countries that are sufficiently far from their MTOs.

Consolidation efforts will need to be very large Reaching the objectives set by the Stability Programmes and then the Medium-Term Objectives will be difficult given the scale of the consolidation required. Based on the experience of 84 fiscal consolidation episodes in 24 OECD countries since the late 1970s, the overall size and duration of consolidation under the “Stability Programme” scenario is not out of line with past experience (Guichard et al.¸ 2007; Figure 3.6). The main exceptions are Greece and Ireland.7 However, the “Convergence to Medium-Term Objectives” scenario implies that consolidation would have to be longer and in a number of cases larger than has been normal in the past. Further measures to reduce debt at a faster pace would require an exceptional effort.

Achieving sustainable consolidation Large-scale and durable consolidation such as now required in most euro area countries can be economically and politically difficult to achieve. Past experience suggests that consolidation is more likely to be durable if based on reducing expenditure rather than raising taxes, and if accompanied by strong fiscal institutions (Guichard et al., 2007). While short-term measures can be relatively easy to implement, fiscal one-offs and gimmicks do little to improve the underlying situation (Koen and van den Noord, 2005). Consolidation can be more difficult to achieve when growth and inflation are low because revenues rise more slowly and there are fewer gains from nominal and real fiscal drag. This may be particularly binding for countries with weak domestic demand and requiring downwards adjustments in relative prices to boost competitiveness as the result of excessively strong domestic demand during the upswing. The short-term effect of consolidation on growth is difficult to assess and depends on the circumstances and the nature of the consolidation: the more-or-less direct contractionary effect on aggregate demand and the weak offsetting effect of area wide monetary policy in response to national fiscal measurse may be counter-balanced by confidence effects as sustainability is restored. Furthermore, anticipation of future consolidation may bring forward demand. In the longer term, consolidation is an opportunity to improve the efficiency of the tax system and public spending which may be beneficial to growth. Indeed, most euro area countries have considerable scope to increase the output of public services such as health and education without additional spending through efficiency improvements. Fiscal consolidation would be supported by credible and detailed multi-year plans with a sufficiently long horizon to show how debt will be managed to a reasonable level, alongside improved EU and national institutions.


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Figure 3.6. Planned consolidation compared with past experience1 Improvement in budget position, % of potential GDP

Improvement in budget position, % of potential GDP

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1. See assumptions given in text. Source: Guichard, S. et al. (2007), “What Promotes Fiscal Consolidation: OECD Country Experiences”, OECD Economics Department Working Papers, No. 553, and OECD, OECD Medium-Term Database and OECD calculations. 1 2 http://dx.doi.org/10.1787/888932359606

Sound fiscal policy would contribute to more effective economic stabilisation Fiscal policy in the euro area has often played an insufficiently stabilising role. During the upswing, there were only sizeable primary surpluses in the euro area as a whole during two years at the peak of the cycle and the relatively weak growth performance over the period did little to reduce the euro area debt-to-GDP ratio (Figure 3.7). The cyclically-adjusted euro area primary balance amounted to only about 3% of annual GDP for the period of growth as a whole. In 2007, the last year entirely prior to the crisis, the majority of euro area countries were running fiscal deficits with the aggregate euro deficit at 0.65% of GDP. Based on the OECD’s current estimates of structural fiscal positions, only Finland, Luxembourg and Spain had underlying surpluses, with the euro area as a whole running an underlying deficit of 1.3% of GDP. Furthermore, the strength of these underlying positions was overstated because of revenue buoyancy related to the credit and housing booms. This fits the long-run pattern of asymmetric fiscal policy with large deficits and accumulation of debt during recessions and little progress to reduce debt during boom years.

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Figure 3.7. Contributions to changes in the euro area debt-to-GDP ratio1 As a percentage of GDP

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1 2 http://dx.doi.org/10.1787/888932359625

When the crisis came, discretionary fiscal stimulus was around 1.5% of GDP, despite the severity of the downturn, monetary transmission being impaired and the monetary policy rate being at a very low level (OECD, 2009c). Discretionary stimulus was unevenly distributed across countries because of limited room for fiscal manoeuvre in many countries: half of the overall stimulus came from Germany with a further quarter from Spain. Stimulus measures in France and Italy were extremely modest. All euro area countries now need to tighten fiscal policy, even though the recovery remains at an early stage. In addition, Greece, Ireland, Portugal and Spain actively tightened fiscal policy during intense periods of crisis due to market pressures despite particularly weak economies as the result of the unwinding of imbalances. The scale of the deterioration in the public finances in Ireland and Spain, through the automatic stabilisers and fall in revenues, was nevertheless such that the government has provided enormous support for the economy by spending more than it was taking out. However, it is doubtful that, for example, the reduction in housing transaction tax revenues had much of an effect on supporting private consumption in Ireland and Spain. A stronger and more prudent underlying budgetary position would imply that the fiscal balance leans more effectively against the cycle. Given the potentially destabilising role of real interest rates at the national level, sound fiscal policy could be a key instrument for avoiding excessive imbalances. It is less clear that discretionary fiscal policy can be effective. Although monetary policy and the nominal exchange rate will not react to changes in the national fiscal stance, euro area economies are highly open and so many of the effects of stimulus will tend to leak into the broader European and global economy. Furthermore, it is difficult to make discretionary fiscal policy timely, temporary and targeted so that stimulus may come too late given the lags in the decision-making process. It was fortuitous that the slowdown in 2008 should have occurred in the autumn when many national budgets were being set. The effectiveness of fiscal policy is likely to be less, in the absence of a clear fiscal framework against which discretionary and temporary decisions can be taken, as well as more difficult to assess. The main tool for fiscal policy is therefore automatic stabilisation, which should naturally fill the requirements of being targeted, temporary and timely, although there is some evidence that the automatic


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stabilisers have become less powerful over time (Debrun et al., 2008). However, for this to work in a downturn, it is essential that the public finances are in sufficiently good shape that sustainability concerns do not constrain their use. To deal with macroeconomic imbalances, it may be useful to develop budgetary instruments that target some of these problems specifically by, for example, influencing financial behaviour or the terms of trade. This would need to operate alongside macroprudential and structural policies. For fiscal policy to be able to lean against downturns, it is vital that the public finances are in good shape and that countries are able to access finance to support deficits. During the crisis, market finance has become more costly for some countries to access. While this partly reflects a necessary reassessment of risk, some of this effect may reflect abnormally strong risk aversion. Prior to the fiscal crisis in Greece, there were limited mechanisms to provide support for a euro country facing liquidity crises other than the support available to members of the International Monetary Fund (IMF). A balance of payments support facility run by the European Union was too small to provide meaningful help for euro area countries, although it was expanded during the crisis to help Greece. There are in principle a number of ways to avoid liquidity problems. In general, maintaining sound public finances and a strong institutional setting that leads to clear commitments about the sustainability of future finances should avoid losing market access. Furthermore, refinancing needs depend on both the overall level of debt and its maturity structure. Most euro area countries in 2008 had largely long-term debts, although debts that needed to be rolled over in the coming year amounted to around 20% of GDP in Italy and Portugal (Eurostat, 2008). By contrast, Greece was somewhat insulated by the very low share of short-term debt in the existing stock, although the combination of the large deficit and the refinancing need in 2010 became overwhelming. However, much of issuance in the euro area since the beginning of the crisis has been fairly short-term. This may appear attractive when short-term interest rates are low as it keeps interest payments low, but it is risky if interest rates ultimately rise by more than currently anticipated in market prices and it also creates rollover risks. When market conditions become unfavourable during a crisis, countries can draw down on reserves or liquidate assets. Indeed, they may build up “rainy day” funds in anticipation of such risks. In Ireland, heavy pre-funding of future financing needs in 2009 together with the National Pension Reserve Fund (even if not designed for that purpose) have provided some protection against the crisis and the need to borrow in the market. If liquidity shocks are not strongly positively correlated across countries, it is more efficient to have a system of insurance whereby countries with market access lend funds to those whose access is restricted. This should not in principle involve a fiscal transfer provided that the loans are provided at interest rates that reflect the riskiness of the fiscal position of the borrowing. The existence of such insurance may mean that it is never actually required. The European Financial Stability Facility (EFSF) temporarily fills a gap in the institutional architecture by creating a liquidity facility for euro area countries, subject to the necessary strong conditionality. A permanent liquidity support mechanism for solvent countries should be put in place in anticipation of future crises subject to strong conditionality. Access to this new mechanism should be contingent on a record of compliance with recommendations made under the SGP. The priority as a creditor of the claims of this new mechanism should be clearly established. Consideration should be given to allowing the fund to stabilise the secondary markets for public debt, with possible implications for the role taken by the ECB Securities Market Markets Programme.

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Strengthening fiscal discipline The setting of fiscal policy needs to be improved to avoid high levels of debt, manage long-term fiscal pressures, allow full operation of the automatic stabilisers and to minimise the risks of liquidity shocks. These objectives are closely connected and avoiding high debt is central to meeting the other goals. Monetary union creates particular issues with respect to fiscal discipline as countries issue debt overwhelmingly in the shared currency. There is a risk that each country will take excessive fiscal risks as it only contributes a small part to overall area-wide fiscal conditions. In addition, the experience with the Greek crisis in May 2010 showed that there can be powerful contagion between national fiscal positions to the extent that countries are viewed as likely to support each other. Markets may also fear losses on the exposures of national financial systems to sovereign debt, which may in turn lead to fiscal costs. The high correlation of movements in bond yields across euro area countries suggests that developments in one country can be seen as a signal or increase the focus on the state of public finances in other countries. As long as this scope for contagion exists, it is difficult to develop time-consistent “no bailout” policies. A combination of improved market discipline, EU institutional reform and stronger national institutions is most likely to improve fiscal outcomes. These policies are complementary and, as none can be guaranteed to be effective, strengthening each pillar is the most robust strategy to improving fiscal performance.

Market discipline and more credible “no bailout” commitments Market discipline could help to improve fiscal discipline by sanctioning risky policies through appropriate increases in borrowing costs. Admittedly, markets have a mixed record when it comes to assessing risks and under-estimated a wide range of risks during the credit boom. Euro area sovereign credit spreads prior to the financial crisis were negligible and broadly similar across countries: spreads over German government debt were at around 25 basis points for Greece, Italy and Portugal. Market prices proved a poor predictor of developments during the crisis, particularly for Ireland and Spain which had relatively low debt but fragile revenue bases. While the market reaction may subsequently have been excessive in some cases, market prices have differentiated between the riskiness of different countries. Greater transparency about fiscal positions, together with improved financial regulation, would help markets to assess risk more effectively. The effectiveness of market discipline is undermined if there is a perception that debts will be repaid regardless of a country’s fiscal situation through a bailout. Article 125 of the Treaty, the so-called “no bailout” clause, forbids countries from assuming each others’ debts.8 However, it does not prevent lending to a country to allow it to service or repay its existing debt. Prior to the crisis, there was room to doubt whether a euro area country could receive support from other countries given that no precise instrument existed to do so. However, the package for Greece in May 2010 demonstrated that support could be made available for euro area countries. For three years, the European Financial Stability Facility (EFSF) will be open to provide support on broadly similar terms to this package. While the existence of such funds could increase moral hazard by weakening the budget constraints, this risk can be mitigated or avoided by imposing strict conditionality. These conditions make it costly for countries to have recourse to this funding, while ensuring that measures to address the underlying problem are put in place. The tough conditionality imposed on Greece, together with the participation of the IMF, is likely to discourage any country from seeing this as an easy option. However, it will be important for maintaining fiscal discipline OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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in the future that Greece is held to its current undertakings, even as the incentive to comply weakens as the primary budget surplus is restored. Enforcing “no bailout” conditions is difficult, as the experience of sub-federal governments in OECD countries shows (Box 3.1). The time-consistency problem means that ex post it may not be in the short-term interest of other countries not to help because of the possible spillovers through trade, the financial sector and contagion. In addition, if the underlying financing problem is related to liquidity, it is desirable for countries with liquidity to provide assistance to those whose access is impaired. One approach to committing credibly to not bailing out is to build a strong reputation. This has existed visà-vis the states of the United States for a long time. Depending on how the crisis in Greece is resolved, the euro area may establish a similar precedent for applying strong conditionality. Tellingly, a number of euro area states announced additional consolidation

Box 3.1. Experience from sub-federal fiscal crises in OECD countries The experience of sub-federal governments within OECD countries provides some insights into fiscal policy inside the monetary union as such governments do not issue their own currency. Over past decades, there have been a number of sub-national fiscal crises in OECD countries, including in the Italian regions in 1978, in Germany with Saarland and Bremen from the late 1980s, in Australia and Canada in the early 1990s and the bailout of Mexican local governments in 1995. Episodes where there has been strong fiscal pressure at state-level are more widespread. The United States has a long history of sub-national default with a number of states declaring bankruptcy in the 1830s and 1870s, and a number of municipal defaults in the 1930s (Inman, 2001). A small number of municipalities have faced severe stress since the 1970s and other public entities have defaulted on occasion. Some US states are now experiencing difficult budgetary situations, however, explicit federal bailout appears highly unlikely. Two sets of factors contribute to state-level fiscal pressures. Firstly, unbalanced assignments of revenue and spending powers often create tensions with excessive demands for spending or too little scope to raise revenue. Secondly, soft budget constraints can encourage states to borrow excessively in the hope of a transfer from the central government. Given that tax and expenditure powers are almost entirely in the hands of nation states, assignments in the euro area are balanced but the tightness of the budget constraint has been more ambiguous. National responsibility for banking supervision adds an additional fiscal risk for euro area countries compared with many other OECD subnational governments, although the Swiss cantonal banks have posed fiscal problems. For sub-national level governments that have the power to borrow, there are two basic approaches to achieving fiscal discipline. Firstly, there are institutional measures. Most have balanced budget rules and face legal restrictions on their ability to borrow (Sutherland et al., 2005). Thirty-two US states have balanced budget provisions in their constitutions and a further 11 have similar statutory requirements. Six out of eleven Canadian provinces have anti-deficit laws. Secondly, it is rare for sub-national borrowing to be explicitly guaranteed and this should, in principle, create market discipline. However, there is often a perception that such debt is implicitly backed by the national government and this weakens the disciplining force of the market. Applying the same methodology as Sutherland et al. (2005) to the euro area, the strictness of fiscal rules in the euro area appears weak compared with subnational governments (Figure 3.8). While monitoring is much more comprehensive than for most sub-national bodies, the binding rules to enforce fiscal commitments appear weak.

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Box 3.1. Experience from sub-federal fiscal crises in OECD countries (cont.) Figure 3.8. Composite indicator of strictness of fiscal rules Sub-index score

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6

8 75th percentile

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ESP1

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KOR

PRT

AUS

DEU1

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DEU2

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POL

CZE

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2

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AUT

4

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4

1. State government. 2. Local government. Source: Sutherland et al. (2005), 'Fiscal Rules for Sub-Central Governments: Design and Impact', OECD Economics Department Working Papers, No. 465, OECD, Paris, and OECD calculations for the euro area. 1 2 http://dx.doi.org/10.1787/888932359644

A number of crises have resulted in the provision of bailouts to sub-national governments. A very small number of constitutions make explicit provision for this type of support, usually in very narrowly defined circumstances, such as natural disasters. In Germany, states may apply for federal assistance. Bailouts may also be channelled through implicit channels such as fiscal equalisation mechanisms. There are also numerous examples of ad hoc support being provided, realising implicit guarantees. In the euro area, the so-called “no bailout” clause in the Treaty has prevented states from assuming each other’s debts but not euro area states from providing finance to Greece and other EU countries. The experience of sub-national governments in OECD countries suggests that it is generally difficult to enforce “no bailout” conditions because of the time-inconsistency problem. When a state is in trouble, the central government will have an incentive to act if failure would lead to: macroeconomic spillovers; losses on loans from the central government or other states; financial instability due to banks’ exposure; pressure on the central bank to provide loans; a contagion effect to the cost of borrowing in other states or for the country as a whole. The United States has built up a strong reputation with no explicit state bailout since the 1870s. Most recently, the federal government signalled little willingness to help California during the crisis. At municipal level, support was provided to New York in 1975 but this was “within the tradition of very limited local bailouts” (Inman, 2001) and Philadelphia did not seek federal help during its crisis in 1990. Fiscal crises often lead to reform of the finances of sub-national governments. These may be “top down” reforms, as in Australia in the 1990s, that strengthen the control of the federal government over the sub-federal governments in return for funds to resolve the immediate financial problems of states. By contrast, reform in the 1990s in Canada was essentially “bottom up” with the provinces applying stricter rules on themselves. It remains to be seen how far the fiscal crisis in the euro area will lead to reforms. Reform processes for subnational governments have not always been successful. For example, after the bailout of the Mexican states, many of the original problems quickly re-emerged.


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measures even as Greece was being supported. Policies to reduce spillovers would further help to increase the credibility of the “no bailout” commitment as these would improve ex post incentives not to bailout a country. In particular, excessive concentration of exposures of euro area financial institutions and limited transparency about their holdings magnify the consequences of weaknesses in national fiscal positions (Blundell-Wignall and Slovik, 2010). Stronger supervisory requirements in this regard would not only benefit financial stability (Chapter 4), but also enhance the credibility of the commitment not to bailout countries with solvency problems. An effective system of crisis management is also required to make “no bailout” conditions more credible. In particular, there must be a credible option to withdraw support if conditionality is not met. In the absence of such a mechanism, a high level of uncertainty is likely about what would happen if a country were no longer able to fulfil its financial obligations and the possible spillovers that could result may force countries to bailout a country which has run a lax fiscal policy. Sovereign risk should be taken into account in the design of financial regulation (Chapter 4). The creation of a permanent liquidity-support mechanism subject to appropriate conditionality would be helpful in this regard as it provides a mechanism to help countries with liquidity problems in a defined way. If conditionality is not met, support should not be available under this mechanism and a mechanism should be put in place to deal with this eventuality. There should be greater transparency about the exposures that euro area countries have vis-à-vis each other and the seniority in principle of inter-governmental lending would need to be clarified. Given that euro area countries largely issue debt under their own jurisdiction, any necessary legal changes could be implemented through primary legislation. The wide range of different conditions attached to bonds in each country makes it difficult for investors to assess the position in different countries, which is encouraged by the exemption of sovereign debt from EU securities legislation.

EU institutional reform The Stability and Growth Pact (SGP) provides the basic framework for fiscal policy in the European Union, including for the euro area. This set of institutions is intended to address the moral hazard associated with national fiscal policies in the euro area and to protect the European Central Bank from the pressure of high debt in all countries. The SGP has a “corrective arm”, set out by the Excessive Deficit Procedure (EDP), and a “preventive” arm that aims to support this objective more generally. Following the economic crisis, almost all euro area countries are subject to the EDP because their deficits are larger than the 3% of GDP reference point set out in the Protocol on the Excessive Deficit Procedure. The “exceptional circumstances” clause of the Pact, which was widened in 2005 (OECD, 2009a) has not been invoked despite the severity of the downturn. A major package of legislative proposals is now under discussion with the aim of strengthening the EU fiscal framework (EC, 2010c; EC, 2010d; EC, 2010e) and these issues have been examined by an EU Taskforce on economic governance (EU Taskforce, 2010). It is intended that this package of reforms will have been agreed by the summer of 2011, although the “European Semester” will be applied from 2011.

Institutional design A difficulty with the implementation of the SGP has been that the “corrective arm” is most likely to bind during downturns because it is triggered by the actual budget balance.

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It is therefore unlikely to provide effective guidance about prudent fiscal policy during upswings. This may have contributed to the tendency to do too little to strengthen the public finances during good times. By late 2008, no euro area member was subject to the EDP. Italy and Portugal had been subject to the EDP from 2005 to 2008, while France, Germany and Greece had been in EDPs for a number of years up to 2007. In 2007, France, Greece, Italy, Portugal and Slovakia had deficits at or greater than 1.5% of GDP. While the severity of the crisis has been exceptional, many countries had too little room to cope with negative shocks and even a downturn of a normal business cycle magnitude would have resulted in many countries having excessive deficits. In principle, a binding constraint at 3% of GDP could have encouraged countries to run sufficiently small deficits to make the probability of hitting the constraint low, but this has not been the case. Following the revision of the Pact in 2005, the “preventive arm” of the SGP was developed to improve underlying budgetary positions. This was intended to make breaches of the 3% deficit reference value less likely and to provide a better path for budgetary positions looking further ahead. A medium-term objective (MTO) for the structural fiscal balance was set for each country. MTOs targeted either a surplus, balance or a deficit no larger than 1% of GDP. The methodology for determining the MTOs has been recently revised to incorporate a measure of implicit liabilities relating to ageing, while retaining a structural deficit cap of 1%. The methodology has not been published. For those countries which have not reached their MTO, there is an expectation that the structural fiscal balance should be improved by at least 0.5 percentage points each year until the objective is reached, with some leeway in bad times and an expectation that faster progress would be made in good times. The “preventive arm” has had a number of weaknesses. Firstly, half of euro area countries had not met their MTOs by 2007 and progress towards them was uneven. Many countries did not reach their MTOs and some of those that did were helped by exceptional and unsustainable growth and financial cycles (OECD, 2009a). The convergence process has been hampered primarily by the lack of political will, but also by the absence of an operational definition of “good times” in which progress towards MTOs should exceed 0.5% of GDP. Secondly, the structural budget balance measure used to assess the MTO gave a highly misleading picture of the underlying fiscal position. The problems were twofold: the output gap was inaccurately assessed and highly buoyant government revenues tended to improve the estimated structural position of the economy without any real strengthening of fiscal policy settings. These effects were amplified by the credit cycle and economic imbalances, which led to strong demand in some countries but a low measured output gap. These generated large and unsustainable revenues from financial and housing transactions. Thirdly, until recently, countries were able to set their own MTOs within limits and there was no systematic link to their fiscal needs (OECD, 2009a). This practice has now been superseded, but the range of MTOs across countries remains relatively narrow compared with differences in long-run fiscal pressures. Fourthly, the MTOs do not appear to have achieved a high level of recognition or acceptance as a framework for budgetary decisions. The medium-term objectives would be more effective if measures of underlying fiscal positions were improved, in particular to take into account economic and financial imbalances, and if countries were required to specify in greater detail how progress towards them will be achieved over the coming years. Current legislative proposals set out a new additional principle of “prudent fiscal policy-making” (EC, 2010c). This is basically defined as ensuring that the annual OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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expenditure growth does not exceed a “prudent” estimate of medium-term growth, unless explicitly covered by offsetting tax measures or the MTOs is already “significantly overachieved”. Where it is a binding constraint, it implies that policy would be countercyclical through the automatic stabilisers with expenditures growing at a steady pace and revenues following the cycle. As a result, the actual budget balance would be stronger in good times than in downturns. Given that the underlying basis of the new principle is a concept of structural growth, it provides some guidance about how MTOs should be achieved. It also shifts emphasis towards expenditure growth. The new principle still requires an assessment of structural growth, which is inherently difficult. However, it avoids relying on estimates of structural elasticities of government revenues to growth, which are especially problematic to estimate in an accurate way because of structural breaks and non-linearities. In terms of enforcement, expenditure growth is more directly under the control of the authorities than tax revenues so compliance with this principle will be more observable than for MTOs. But, there is a risk that the focus on expenditure creates an incentive to reduce taxes as a substitute for higher spending, particularly in the form of tax expenditures. The impact of the Stability and Growth Pact on national budgetary decisions has been limited by the lack of integration of the EU level and national budgetary procedures. In particular, national budgets in most euro area countries are legislated at the end of the calendar year with the underlying forecast assumptions set in the autumn. This information was then submitted into Stability Programmes, prepared in the early part of the following year and assessed by the Commission and the ECOFIN Council in the spring. This ex post assessment was unlikely to have an ex ante effect on policy, not least because the main decisions about fiscal policy for the current year were already taken by the time the EU review was completed but that circumstances could change significantly between then and the following budget. The creation of the European Semester from 2011, which modifies the timing and procedures for EU budgetary and economic surveillance, will help to address this problem with final recommendations on fiscal policy being made by the EU in July. This will more-or-less coincide with the beginning of the budget cycle in many countries and thus should increase national “ownership” of EU fiscal goals and analysis.9 In addition, greater emphasis on multi-year planning, as described below, would also help to align the long-term objectives of the Stability Programmes with a national debate and commitment over the same horizon. However, the effectiveness of this approach will still continue to depend on political will both at the EU and national levels.

Enforcement The effectiveness of the SGP framework has been impaired by the lack of effective enforcement. Under the “corrective arm” of the Pact, enforcement should in principle be relatively simple given that the reference value of a budget deficit of 3% of GDP should be observable. A key problem, however, has been that the only penalties available have been ex post fines: these lack credibility because they would only apply to countries already facing budgetary problems and enforcing the sanctions would add to those difficulties. In addition, procedural delays and difficulties in identifying compliance with undertakings to take corrective action have impeded the swift return to SGP norms. Legislative proposals from the Commission imply a slight increase in some delays, from four to six months, but would clarify the criteria for assessing compliance with recommendations by putting greater emphasis on variables that are under the direct control of the national authorities,

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particularly in terms of government spending (EC, 2010c). More importantly, it is proposed that a sum equivalent to the fine under the EDP of 0.2% of GDP should be deposited in a non-interest bearing account as soon as an EDP begins, which could be returned to countries if corrective action is undertaken. This combines a small sanction, the foregone interest, combined with an upfront fiscal cost, which may be more credible than threatening to levy a similar fine when a country is deeper into budgetary problems. In addition, a range of sanctions and fines linked to the EU budget is envisaged when the new EU budget is negotiated. The Treaty requires a Council decision at each step of the EDP from the finding that deficit is “excessive” to the imposition of penalties. These steps are not automatic and a fine has never been exposed. In 2003, the Council decided not to act despite a Commission recommendation to step up the EDP against France and Germany. This set a poor precedent. The European Court of Justice subsequently ruled that the Council can de facto put in abeyance the excessive deficit procedure, even against the recommendation of the Commission, although it cannot alone revise the EDP recommendations. Enforcement by the Council is therefore crucial, but it has not worked well either in ensuring compliance with the Pact or in terms of its deterrence effect. There are limits within the existing Treaties to how far more binding rules can be applied, without a change in behaviour by the Council. However, legislative proposals from the European Commission and recommendations from the EU Taskforce set out a “reverse voting majority” mechanism within the existing Treaty that would consider a proposal on sanctions, either under the “corrective” or “preventive” arms of the SGP, to be adopted unless the Council rejects the proposal by an appropriate qualified majority within a given time delay (EC, 2010c; EU Taskforce, 2010). This could make it more likely that the Council backs the technical analysis of the Commission given that the required number of countries needed for the recommendation to pass would fall under this procedure. Nevertheless, this “quasi-automaticity” still relies on the willingness of members of the Council to enforce fiscal discipline on each other. There is a risk that the new procedures could change voting incentives in a perverse way: if countries are behaving strategically by not sanctioning others to set a precedent that reduces the risk of being sanctioned themselves, the reversed voting majorities may lead to a shift in behaviour whereby some countries act more leniently to offset the impact of the reform. Furthermore, while recent experience may underline to countries the risks created by the unsustainable budgetary positions of other euro area governments, the large number of countries that will be in EDPs in the coming years (especially if the debt criterion is operationalised) may build a constituency against stricter application of the fiscal rules. The enforcement of the reference value of public debt in excess of 60% of GDP has been more limited than for the deficit rule. This partly reflects the overall focus of the Excessive Deficit Procedure, which by its nature is mostly concerned with the budget balance. Furthermore, few countries exceeded the reference value for debt in the years leading up to the crisis. The debt criterion can lead to enforcement action “unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace”. This phrase leaves considerable room for interpretation. While it would be unreasonable to expect countries far above the reference level to reach it over a short period of time, progress in the past has been mixed during the past cycle. While Belgium managed to reduce its debt-to-GDP ratio by around 20 percentage points over a six-year period, indebtedness was roughly unchanged in Italy. Current legislative proposals suggest that OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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debt reduction should be at an annual pace of closing one-twentieth of a three-year weighted average of the gap in the debt-to-GDP ratio over a three-year period (EC, 2010c). The proposed introduction of an operational definition of the required reduction in debt is welcome, although formulating the exact rule is complicated as discussed above. Enforcement of the “preventive arm” of the Pact has proved more difficult than for the “corrective” part and has been the main weakness of this mechanism. The key problem has been lack of sanctions to ensure that fiscal policy is set in the good times to avoid problems in economic downturns and remove the bias towards higher debt. Application of the framework relied solely on peer review to achieve the MTOs and appropriate convergence towards them. National authorities are required to submit annual Stability Programmes. The Commission and the Council have the power to monitor, examine and assess proposed national adjustment paths. This includes making recommendations on the necessary adjustment measures and, where divergence from the objective persists, to make public recommendations on prompt corrective measures. While weak fiscal policy settings were identified through this approach, too little was done to ensure that all countries achieved sustainable medium-term budgetary positions. Sanctions are inherently more difficult to apply in this case as they involve a greater element of judgment. Nevertheless, the introduction of ex ante sanctions into this arm of the Pact would be an important step forward. This would be reinforced by “quasi-automatic” decision-making, as well as clearer criteria for judging compliance with corrective action. Proposed legislation from the European Commission (EC, 2010c) sets out new sanctions to include: ●

New procedural sanctions consisting of a warning from the Commission and ultimately from the Council. More frequent and intrusive surveillance by the Commission and the Council would be undertaken for countries with weak fiscal policy settings.

●

A financial penalty of posting 0.2% of GDP to an interest-bearing account for as long as the country is deemed to be in breach of its obligations (EC, 2010c). The suspended funds could be forfeited if the fiscal weaknesses are not addressed with an unanimous decision of the Council required to lift the sanction.

The implementation of current legislative proposals would mark an important step forwards by addressing some of the key weaknesses in the existing system, notably the weak credibility of ex ante sanctions, the failure of peer pressure to enforce the preventive arm and the making of decisions by the Council “quasi-automatic”. While the new reforms would be welcome, past experience suggests that there is a strong risk that the Council would continue to enforce sanctions weakly and that the Commission might not use its powers, even if expanded.10 In essence, it is impossible completely to overcome the problem of responsibility for fiscal policy basically being exercised at national level, while trying to impose judgements about economic policy reached at EU level. Given the strong responsibilities that remain at national level, it is important that the design of institutions is consistent with this allocation of responsibilities. This should be reflected in financial regulations and supervisors should be charged with ensuring that debt from countries running risky fiscal policies carries appropriate capital charges and that excessive exposures are avoided.

Monitoring Enhanced enforcement of the SGP requires better monitoring of the fiscal positions of euro area countries and greater transparency. This would facilitate fiscal dialogue at the EU

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and national level, as well as making it easier for investors to assess risk. The DirectorateGeneral for Economic and Financial Affairs (DG ECFIN) has increased its resources and is undergoing an internal restructuring to strengthen its capacity to monitor economic and fiscal developments in EU countries. The presentation of Stability Programmes should be enhanced. Projections should be presented in a more similar way across countries. The presentation should clearly distinguish between a scenario based on a “no change” assumption (incorporating only specific legislated changes) and plans that assume hypothetical future decisions. Forecasts should be made for at least the next three years, or for as long as it is expected to take to reach MTOs. Projections should identify expected current spending, capital spending and tax revenues, based on an outline of specific measures to achieve the stated objectives. Stability Programmes are currently set out using national fiscal forecasts. These are in most cases largely provided by national finance ministries and so are not politically independent. There is bias towards overly optimistic forecasts, which imply an easier trade-off between spending decisions and raising revenue (Jonung and Larch, 2006). In the current round, the Commission judged many forecasts to be “optimistic” (EC, 2010b). The Commission and the Council base their assessments of the Programmes on the Commission’s own projections. However, the dialogue about policy is partly obscured by differences in underlying economic and budgetary assumptions, aggravated by national forecasts being based on data from the autumn rather than the early spring. Appropriatelymandated national forecasters could in principle have some advantages over the Commission in making forecasts, in particular through privileged access to highly detailed confidential expenditure and revenue data. Stability Programmes would benefit from national forecasts being formulated by independent fiscal councils as set out below. This is likely to facilitate the assessment of policies by removing any political bias in national forecasts, providing a more similar set of assumptions between national and EU authorities. The analysis of monitoring of structural budget positions should be improved, as these underpin the “preventive arm” of the SGP, and should systematically reflect uncertainties in fiscal forecasting. The assessment of structural positions should not solely be grounded in estimates of the output gap, which is an unobserved variable and difficult to estimate in real time. Estimates of the structural fiscal position should follow a disaggregated approach, allow for time-varying tax elasticities and structural breaks. As discussed in Chapter 2, economic and financial imbalances are much wider in scope than the balance between internal demand and supply. Furthermore, capital flows and immigration may lead to shifts in short-run supply that make the output gap particularly difficult to identify. The creation of the European Semester and co-ordination with broader economic policy orientations should bring broader developments systematically into the setting of EU fiscal policy recommendations. The effect of credit and asset prices on revenues should be systematically taken into account. The presentation of forecasts of the budget balance and estimates of the underlying budgetary position should reflect economic, data and model uncertainty and the representation of fiscal forecasts should be less reliant on point estimates.11 While this would add to the complexity of the discussion, it would provide a better reflection of the state of knowledge about the future of fiscal positions. In addition, it would help to highlight risks to the fiscal position when the economy is performing strongly.


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Large revisions to GDP and the fiscal position in Greece threw the weaknesses in the collection of accurate and timely statistical data into sharp relief. Based on current data, Greece would have exceeded the reference value in 2008 and the EDP would not have ended. These weaknesses further undermine the credibility of the system. The auditing of fiscal positions should be strengthened and make greater use of independent auditing. Eurostat’s powers to validate data were increased in July 2010, including a system of methodological visits where weaknesses are identified and increased powers to oversee the preparation of fiscal statistics at national level.12 Eurostat should allocate sufficient resources to fiscal monitoring and weaknesses in national audit processes should be addressed as the credibility of fiscal data is essential to the effective operation of EU fiscal institutions and market discipline. Fiscal monitoring should be broadened along two dimensions. Firstly, surveillance and transparency around off-balance sheet liabilities should be strengthened. In a narrow sense, this should cover off-balance sheet operations that can distort the headline statistics on the public finances, as well as important off-balance sheet positions such as government guarantees, special purpose vehicles that may ultimately create a liability for the state, and obligations under Public Private Partnerships (PPPs). It is important that gaps in monitoring do not bias policy decisions towards less transparent forms of support. This will be particularly important as tighter budgets in the coming years will create strong incentives to avoid fiscal discipline. More broadly, liabilities under public-private partnerships should clearly be accounted for in budget annexes. Secondly, the monitoring and availability of data about debt management should be stepped up. This is extremely important given the role that short-term financing needs can have on market pressures, which have been a key conduit for contagion during the crisis. Given these liquidity risks, these issues should be given prominent scrutiny and all countries should move into line with best practice in terms of institutional arrangements and management of liquidity and market risks. Fiscal stress tests should be undertaken to explore and communicate these risks.

Reform of fiscal frameworks at national level The poor fiscal outcomes of many euro area countries, however, suggest that national authorities have faced two kinds of problems. Firstly, political incentives often lead to short-term decision-making and excessive risk-taking. In addition, the conditions of monetary union together with low risk aversion in financial markets may have weakened some elements of market discipline. Countries, which did little to reduce their high debtto-GDP ratios since 2000, were clearly taking large fiscal risks. Secondly, it is technically very difficult in real time to distinguish structural from cyclical revenues and to build up sufficient reserves. Despite apparently good fiscal outcomes at the time, it is clear ex post that some countries should have made a greater effort to improve their fiscal positions. By 2007, Ireland and Spain had reduced their debt-to-GDP ratios to among the lowest in the euro area and were among the few countries to run budget surpluses. While there were some indications at the time that the fiscal position in these countries may not have been sufficiently solid given the overheating of domestic demand, the scale of the subsequent weakening has been a surprise relative to forecasts both by the authorities and external commentators. Furthermore, it may be politically very difficult to justify sufficiently large surpluses to address such domestic imbalances. To address these weaknesses, budgetary frameworks at national level should generally be upgraded through a combination of well-

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designed fiscal rules (consistent with the SGP framework) and the introduction in many countries of independent national fiscal councils.

Medium-term fiscal frameworks Wider user of medium-term fiscal frameworks in euro area countries would help to strengthen fiscal performance. These rules can embody sound budgetary principles in decision-making and help governments to pre-commit to setting policies in a particular way. There are several basic types of fiscal rules, including deficit and debt rules, as well as revenue and expenditure rules. Rules may either specify a target or a ceiling. Deficit and debt rules are highly appropriate at the EU level, given that the main externalities in fiscal policy between countries arise from unsustainable public finances. However, other types of rules may be useful at national level, not least because deficit and debt rules are less likely to bind during periods of economic expansion when governments find it difficult to save. While this problem can in principle be overcome by basing the rules on estimates of the structural fiscal balance, this measure is unobservable and difficult to estimate accurately. Deficit rules (including the SGP) are the most commonly used fiscal rules among OECD countries and are in place in some form in almost all countries (Guichard et al., 2007). Medium-term expenditure rules have significant advantages compared with deficit rules. They involve setting a multi-year plan or ceiling for government expenditures. These build on the sensible practice of viewing the public finances from a multi-year perspective, both to see through the cycle and avoid boom and bust in government spending. The implication is that these plans will be met irrespective of actual government revenues, so that stronger than expected revenues are saved rather than spent (Anderson and Minarik, 2006). Unlike deficit rules, expenditure-based rules are likely to be binding through the cycle. Indeed, the disadvantage of deficit rules is that they will typically require consolidation when the economy is already in a weak state. Expenditure rules have the additional advantage that expenditure is generally more directly under the control of the authorities than revenues, which are more cyclical and autonomous (Atkinson and van den Noord, 2001). This implies that violations of the rules are easier to observe and enforce. To be effective, expenditure rules must cover all categories of expenditure to avoid gaming of the system by reclassifying expenditures to categories outside the cap.13 This argues against the use of “Golden Rules”, which exclude government investment, because there is ambiguity about which category some types of spending belong (Fatas, 2005). The main argument against expenditure rules is that they may reduce the quality of public finances by distorting expenditure decisions, for example leading to cuts in pro-growth investment to meet the cap. However, a broad definition of expenditure should not in itself lead to these problems. A large number of OECD countries now have some system of expenditure targets while some others have rules about the use of windfall tax revenues, which can be seen as potentially having a similar effect (Guichard et al., 2007). The importance of expenditure-based rules is recognised in the new concept of “prudent fiscal policy-making” in current EU legislative proposals, which imply a basic rule (EC, 2010c). Overall, there is some evidence that the existence of fiscal rules is associated with better fiscal outcomes, although much depends on their design and the circumstances (EC, 2006b; Guichard et al., 2007). In the euro area, Austria, Greece, Ireland, Luxembourg, Portugal, the Slovak Republic and Spain have not had rules for central government or the general government public finances beyond the excessive procedure and SGP rules.14 While several of these countries appeared to perform well during the upswing, the most


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severe fiscal problems in the downturn have all been among countries in this group. The experience of countries with strongly overheating economies raises two important issues for expenditure rules. Firstly, the implied surpluses would have been extremely large during the upswing and would most likely have led to strong pressure on governments to renege on their commitments. Secondly, the scale of the reversal of fortunes in these countries was very large and so even prudent expenditure plans made after several years of boom would most likely have been totally unrealistic for the coming years. Taken together, these considerations imply a need for some well-defined clauses setting out exceptional circumstances when the rules may be relaxed, while maintaining discipline in the face of strong revenue booms. The exact design of fiscal rules may be difficult and can imply trade-offs between various objectives, such as stabilisation of the cycle and maintaining the pace of investment. The design of fiscal rules to achieve consolidation in the coming years may involve some special considerations beyond those that are eventually required to keep the public finances on a prudent path. It would be appropriate to design fiscal rules at a national level, within the minimum deficit and debt criteria set out by the SGP, fully to reflect national circumstances, preferences and approaches. There is some scope for EU monitoring to help ensure that these rules are well-designed, but it is important that political will at national level supports the rules and that there is national ownership of the fiscal frameworks.

Independent national fiscal councils Enforcement of the fiscal rules and budgetary outcomes would be improved if all euro area countries had independent national fiscal councils. These could reduce political biases, increase the commitment to rules and raise the level of analysis and debate around fiscal policy. In principle, independent fiscal institutions could assume a variety of tasks, ranging from setting the ultimate objectives of fiscal policy to providing technical input to the policy-setting process such as a forecast or to making a normative assessment of the fiscal position (Figure 3.9). However, there are good reasons for limiting the scope of independent fiscal bodies more than for central banks given the lower level of agreement about objectives and stronger distributional impact of fiscal policy. No OECD country has an independent fiscal authority in the sense given below, but an increasing number have

Figure 3.9. Typology of fiscal agencies Fiscal agencies

Independent fiscal authorities

Setting longor short-term objectives based on high-level principles

Setting targets (for fiscal balance) in the context of a fiscal rule

Fiscal councils

Adjusting some pre-determined tax and expenditure packages

Providing objective analysis of fiscal policies

Providing independent budget forecasts

Providing normative assessments and recommendations

Source: Debrun, X., D. Hauner and M. S. Kumar (2009), “Independent Fiscal Agencies”, Journal of Economic Surveys, 23(1), pp. 44-81.

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adopted some form of fiscal council (Debrun et al., 2009). The creation or upgrading of existing independent fiscal councils has been recommended in recent OECD Economic Surveys of Belgium, Finland, Greece and Ireland. Independent fiscal councils in euro area countries should be allocated two tasks: ●

Preparing independent forecasts of the public finances to remove bias.

●

Independent fiscal policy assessment. At a minimum, this should include assessing whether fiscal rules have been met. This is particularly important where judgment is required. More broadly, a fiscal council can provide normative commentary on the state of the public finances and also the fiscal stance. This analysis can also be applied to political parties’ election manifestos.

This mandate would improve transparency and the quality of public debate about fiscal issues. In most countries, there is already a wide range of commentators on fiscal policy, such as research institutes, academics and banks. However, these commentators do not have formal mandate to provide such scrutiny and lack accountability. This can undermine their impact on the public debate. Furthermore, these ad hoc commentators do not have the privileged access to confidential government data that is required to undertake detailed and robust analysis of the public finances. The resources available to commentators for fiscal policy tasks are also typically very small relative to those required to undertake thorough analysis. Many euro area and OECD countries already have an institution that performs some of the functions of a fiscal council (EC, 2006a; Hagemann, forthcoming). Many have a forecasting role but this is usually limited to setting underlying macroeconomic assumptions. Only a few euro area countries have a fiscal council that produces forecasts for the government balance and debt. There is typically some analysis of the fiscal policy position, although monitoring of budgetary implementation or analysis of outcomes with respect to fiscal rules is less common. The normative role is generally limited to a commentary on whether rules or budgetary plans are respected and how to deal with slippages. Implementing fiscal councils in all euro area countries with the dual mandate of preparing independent forecasts and assessing the fiscal position would therefore be a major change. The design of fiscal institutions can help to ensure their effectiveness. The optimal configuration will depend on the circumstances of each country. However, the mandates of national fiscal councils must be clear and achievable. Agencies need to be assured of full discretion in carrying out their mandates. Independence from political influence and the executive is crucial and adequate firewalls are required to ensure the independence of staff and everyday operations. Conversely, they must be democratically accountable, for example to national parliaments, for meeting these objectives. In addition, the funding of independent agencies should be protected as far as possible from political influence and be sufficient to carry out the important tasks that have been delegated to them. The development of independent central banks over recent decades provides a model in some respects in terms of independence, analytical capabilities, the collection of data necessary to carrying out this analysis, and an increasing emphasis on communication and transparency. The integration of national fiscal councils with the other political and budgetary processes is a key determinant of their effectiveness. This explains why such national institutions might be able to achieve results where EU surveillance cannot. In the OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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United States, the Congressional Budget Office (CBO) prepares a baseline against which budget proposals are prepared, although this role is somewhat impaired by a legal obligation to follow current law rather than a more realistic policy scenario. The CPB in the Netherlands is also highly integrated into both the political and budgetary process (Box 3.2).

Box 3.2. The Netherlands Bureau of Economic Policy Analysis Established in 1945 as the Central Planning Bureau, the Netherlands Bureau of Economic Policy Analysis (CPB) plays a prominent and visible role in the fiscal policy arena in the Netherlands. Its main responsibilities are to provide independent macroeconomic and budgetary forecasts, but its remit also includes analysis of a wide range of topics, including the welfare state, the labour market, regulation and international economics. It also undertakes cost-benefit analysis of large-scale public projects, as well as long-run studies, such as on the environmental issues and the impact of population ageing on Dutch public finances. The CPB’s main responsibility is to provide independent macroeconomic and budgetary forecasts. The agency makes no normative recommendations. Its autumn forecast is coordinated with submission of the government’s budget, and incorporates the estimated economic and budgetary impacts of proposed fiscal policy measures. Significantly, the CPB’s activities and contributions to the preparation of the budget are not mandated, but have become routine practice. In fact, CPB plays a special role tailored to Dutch coalition politics insofar as all political parties submit their economic programmes to the CPB for assessment, which facilitates comparisons. Moreover, employers’ and employees’ organisations also rely on CPB forecasts for wage negotiations. Transparency is given very high priority. The director regularly testifies before the Parliamentary Commission on Economic Affairs, and all CPB studies receive considerable media coverage and often spur public debate. Although formally part of the central government, CPB early on gained and has maintained considerable independence. The agency’s independence is attributable to a number of factors. First, its funding from public sources is both adequate and secure enough to provide the agency sufficient freedom to set its own research agenda. Second, its independence is maintained through a quid pro quo; its independence from political interference requires that the agency itself not interfere in the political debate (Bos and Teulings, 2010). The CPB stands out as an institution that has over the decades become fully integrated into the policy-making process while retaining a solid reputation for professionalism and impartiality in its analysis. It currently employs around 180 staff.

The experience with independent fiscal councils is encouraging, even if there are few examples of the type of institution with the full mandate proposed here for euro area countries. Over the period from 1995 to 2005, the unweighted average fiscal performance of OECD countries with fiscal councils in terms of the cyclically-adjusted primary balance and the reduction in debt was stronger than for those without fiscal councils (Figure 3.10). This parallels similar findings based on the same methodology for the European Union (EC, 2006a). This prima facie evidence is difficult to evaluate because of the endogeneity of the decision to create a fiscal council: these are more likely to be created in countries that are serious about budgetary discipline, although the need for such institutions may be less where budgetary processes are already sound and have political support.

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Figure 3.10. Budgetary developments and fiscal councils1 1995-2005

1.5 1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0 1. 2. 3. 4.

1.5

OECD countries 2 with fiscal council in 2005 OECD countries 2 with no fiscal council in 2005

Cyclically-adjusted primary balance 3

Change in gross debt 4

-1.0

Change in expenditure 4

Fiscal councils as defined in EC (2009), Public Finances in EMU – 2009 and OECD calculations. OECD countries excluding Chile, Mexico, Slovenia and Turkey. Average balance over the period. Average yearly percentage point change in the ratio to GDP over the period.


1 2 http://dx.doi.org/10.1787/888932359663

More detailed analysis of fiscal institutions, however, indicates that they may be influential. A cross-country empirical study of EU countries based on detailed indicators of fiscal institutions shows a strong relationship between a composite indicator of de jure influence and the perceived impact on fiscal discipline (Debrun and Kumar, 2008). Furthermore, formal guarantees of political independence are positively associated with the de jure influence of the institution (Figure 3.11).

Figure 3.11. Impact of fiscal councils Perceived impact on fiscal discipline

Formal guarantees on political independence

8

8 EST

7

ESP

7

NLD

BEL

DEU

6

ESP

LUX

6

PRT EST

5

BEL

DNK NLD

4

5 4

HUN

HUN

3 ITA AUT

1 0

3

LUX

DEU

2

GRC ITA AUT FRA

GBR FRA

PRT DNK

GBR

2 1

GRC

0

1

2

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5

6

7

8

De jure influence on the budget process

0

1

2

3

4

5

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0

De jure influence on the budget process

Source: Debrun, X. and M.S. Kumar (2008), “Fiscal Rules, Fiscal Councils and All That: Commitment Devices, Signaling Tools, or Smokescreen?”, Proceedings of Banca d'Italia Public Finance Workshop, Roma. 1 2 http://dx.doi.org/10.1787/888932359682

While the experience of institutions with the full range of the necessary powers is limited, there is some evidence that these bodies can be effective if well-designed and truly independent. Much of their success will also depend on how serious policy-makers are about fiscal prudence and allowing these institutions to flourish. However, it is precisely this link to local circumstances that provides legitimacy in the national policy process and strong integration to the budget. At the EU level, the European Commission already plays a OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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somewhat analogous role by monitoring national fiscal positions and compliance with the SGP rules. The Commission is not politically independent in the same way as a national fiscal institution would need to be. Nevertheless, it has a mandate to protect the EU interest and so should not be subject to influence from national governments.

Box 3.3. Summary recommendations on fiscal policy The immediate priority is to stabilise the public finances and then reduce the debt-toGDP ratio to more prudent levels over the coming years. Strengthening the fiscal framework would enhance the credibility of the consolidation process. Stronger market discipline and fiscal frameworks are required to avoid pro-cyclical policy settings and to ensure long-run sustainability. The institutional design should reflect that national governments retain the main responsibility for the state of their public finances, while EU institutions are needed to avoid fiscal spillovers and to mitigate moral hazard. Major reforms to EU fiscal institutions and new standards for national fiscal frameworks are set out in proposed legislation and in the EU Taskforce report. These are due to be largely in place by the summer of 2011. Rebuilding the public finances The immediate priority is to restore budgetary positions: ●

Fiscal consolidation should begin by 2011 at the latest in all euro area countries. The pace should be differentiated across countries. Consolidation should generally focus on reducing current expenditures.

●

The debt-to-GDP ratio should be reduced at a sustained pace to reach a prudent level in all euro area countries of no more than 60% of GDP. This will require prolonged consolidation in many countries. Consistent progress should be made in meeting medium-term objective (MTOs) under the Stability and Growth Pact.

Strengthening the fiscal framework at EU level Enforcement Enforcement of the EU fiscal rules should be strengthened in line with current proposals:

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●

The corrective arm should be systematically enforced by the Council and sanctions applied as appropriate. Funds should be posted in a non-interest bearing account as soon as an excessive deficit is identified. The application of “exceptional and temporary” factors should continue to be used sparingly.

●

A clear operational definition of the required effort to reduce the debt-to-GDP ratio when it is above the 60% threshold should be put in place.

●

The preventive arm of the Pact should provide for sanctions where there is a serious risk of a breach of EDP references values. Sanctions should be applied early in the process and should include more intrusive surveillance and warnings from the Council. Monetary penalties should include posting funds to an interest-bearing account until corrective policies have been completed.

●

Decisions by the Council with respect to the new sanctions mechanisms should be made “quasi-automatic” by allowing the Commission to make recommendations to the Council that would reverse the voting majorities compared with the current system.



Box 3.3. Summary recommendations on fiscal policy (cont.) Integration into economic decision-making ●

The creation of EU budgetary processes with the so-called “European Semester” is welcome as the timing should encourage a larger role in national budget processes. Furthermore, the link between fiscal and other policy considerations, such as imbalances and structural reforms should be stronger, while avoiding a trade-off between policy objectives.

Monitoring ●

The analysis of structural budget positions should be improved and reflect the risks associated with imbalances, in particular asset price cycles. The analysis should focus less on point estimates and could include sensitivity analysis to assess the degree of risks.

●

Fiscal reporting and monitoring should take greater account of government debt positions, off-balance sheet and contingent liabilities, and debt management issues.

●

The presentation of Stability Programmes should be further harmonised and enhanced. Projections should clearly distinguish between legislated policies and policy intentions.

●

Stability Programmes should be made on the basis of economic and fiscal forecasts prepared by independent national fiscal councils.

Strengthening market discipline through an enhanced crisis-management framework A credible mechanism for fiscal crisis management is required to provide support for solvent countries facing liquidity pressures and to provide for effective resolution in other cases: ●

The EU/IMF plans with respect to Greece should be implemented as planned to achieve the degree of conditionality outlined.

●

A permanent liquidity support mechanism should be established for countries with fundamentally sound fiscal positions that face liquidity problems. The facility should impose strict conditionality. Consideration should be given to allowing this facility to intervene directly in secondary government debt markets.

●

If conditionality is not fulfilled, liquidity support should be withdrawn and a mechanism should be put in place to deal with this eventuality. Sovereign risk should be fully reflected in financial regulations.

Strengthening fiscal frameworks at national level While a more effective SGP would help to avoid spillovers from fiscal instability, strengthening national framework within the overall architecture of the Pact is crucial to achieving more sustainable public finances and better macroeconomic management at national level. Current legislative proposals set out minimum standards for national fiscal frameworks and suggest the creation of independent national fiscal councils. ●

All euro area countries should put in place broad-based medium-term fiscal frameworks based on multi-year paths or ceilings for both current and capital spending (including tax expenditures). These should ensure compliance with obligations under the SGP.

●

Many euro area countries would benefit from putting in place well-designed independent national fiscal councils. These should be responsible for producing detailed fiscal forecasts, analysis of the fiscal position, and ex post assessment of adherence to the fiscal rules. Councils should collect relevant data for fiscal policy analysis and enhance communication around the public finances. Political commitment to the independence and relevance of these institutions is essential. Fiscal councils should be adequately resourced.


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Notes 1. Caner et al. (2010) find a threshold around 80% of GDP. 2. The impact of lower inflation expectations through nominal interest rates is more complex, depending on whether the inflation tax is more efficient than other taxes. 3. For example, the semi-elasticity of the tax burden as a share of GDP implied by recent OECD research is only around –0.2 and this can be lowered if taxes are raised in the most efficient way (Arnold, 2008). 4. The scenarios take GDP growth and interest rates assumed in the June 2010 Medium-Term Baseline as exogenous (OECD, 2010). Cyclical effects are captured using the standard OECD methodology. The “Stability Programme” scenario assumes that countries reach the actual fiscal deficits outlined in the Stability Programmes earlier in the year (with the exception of Greece, which has been updated in line with its IMF programme). It is then assumed that there is no change in the structural balance over the rest of the forecast horizon. 5. A country with a debt-to-GDP ratio of 100%, nominal growth of 3.5% and facing interest costs of 4.5% would be required to run a primary surplus in the early years of close to 3% of GDP. By contrast, a country with a 70% debt-to-GDP ratio would only be required to run a primary balance of around 1.5% of GDP. 6. Under the assumptions in the previous footnote, it would take well over a decade for country with a debt-to-GDP ratio of 80% to get its debt ratio down to 70%. 7. Consolidation for Ireland is understated under this methodology as some of the current episode occurred prior to 2010. 8. The article states that “The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.” 9. This was approved by ECOFIN on 7 September 2010. 10. See Chapter 3 for discussion of a similar issue that arose with the enforcement of warnings and the Broad Policy Guidelines in relation to Ireland. 11. Part IV.3 of “Macro-financial and (Contingent) Fiscal Risks – An Analysis with Composite Indicators” of EC (2010b) constructs indicators of macroeconomic and fiscal risks. 12. Council Regulation (EU) No. 679/2010 of 26 July. 13. An exception may be justified for social security expenditure related to unemployment. 14. In Spain, there are expenditure ceilings and several debt limits for regional and local authorities.

Bibliography Anderson, B. and J. Minarik (2006), “Design Choices for Fiscal Policy Rules”, OECD Journal on Budgeting, Vol. 5, OECD, Paris. Arnold, J. (2008), “Do Tax Structures Affect Aggregate Economic Growth? Empirical Evidence from a Panel of OECD Countries”, OECD Economics Department Working Papers, No. 643, OECD, Paris. Atkinson, P. and P. van den Noord (2001),“Managing Public Expenditure: Some Emerging Policy Issues and A Framework for Analysis”, OECD Economics Department Working Papers, No. 285, OECD, Paris. Blundell-Wignall, A. and P. Slovik (2010), “The EU Stress Test and Sovereign Debt Exposures”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 4, OECD Financial Affairs Division, OECD, Paris. Bos, F. and C. Teulings (2010), “Lessons from the Netherlands”, paper presented at the Conference on Independent Fiscal Institutions, Budapest, March 18-19. Caner, M., T. Grennes and F. Koehler-Gelb (2010), “Finding the Tipping Point – When Sovereign Debt Turns Bad”, World Bank Policy Research Working Paper, WPS 5391.

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Cournède, B. (2007), “The Political Economy of Delaying Fiscal Consolidation”, OECD Economics Department Working Papers, No. 548, OECD, Paris. Debrun, X. et al. (2008), “Government Size and Output Volatility: Should We Forsake Automatic Stabilisation?”, Bruegel Working Papers, No. 55. Debrun, X. and M. Kumar (2008), “Fiscal Rules, Fiscal Councils and All That: Commitment Devices, Signalling Tools, or Smokescreen?”, Proceedings of Banca d’Italia Public Finance Workshop, Roma. Debrun, X., D. Hauner and M. Kumar (2009), “Independent Fiscal Agencies”, Journal of Economic Surveys, 23(1), pp. 44-81. European Commission (EC), (2006a), “Independent Fiscal Institutions in the EU Member states”, Brussels. EC (2006b), Public Finances in EMU – 2006, Brussels. EC (2010a), Enhancing Economic Policy Coordination for Stability, Growth and Jobs – Tools for Stronger EU Economic Governance, Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee, and the Committee of the Regions, COM(2010) 367/2, Brussels, 30 June. EC (2010b), “Public Finances in EMU – 2010”, European Economy, No. 4, Brussels. EC (2010c), Proposal for a Council Regulation (EU) No. …/… amending Regulation (EC) No. 1467/97 up speeding up and clarifying the implementation of the excessive deficit procedure, 29 September, Brussels. EC (2010d), Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EC) No. 1467/97 on the strengthening of surveillance of budgetary positions and the surveillance and coordination of economic policies, 29 September, Brussels. EC (2010e), Proposal for a Regulation of the European Parliament and of the Council on the effective enforcement of budgetary surveillance in the euro area, 29 September, Brussels. EC (2010f), Proposal for a Council Directive on Requirements for Budgetary Frameworks of the Member States, 29 September, Brussels. ECB (2010), Reinforcing Economic Governance in the Euro Area, note by the European Central Bank, Frankfurt, 10 June. Égert, B. (2010), “Fiscal Policy Reaction to the Cycle in the OECD: Pro– or Counter-Cyclical?”, OECD Economics Department Working Papers, No. 763, OECD, Paris. EU Taskforce on Economic Governance (2010), Strengthening Economic Governance in the EU, Report of the Taskforce to the European Council, 21 October, Brussels. Eurostat (2008), “Structure of Government Debt in Europe”, Statistics in Focus, 110/2008, Luxembourg. Fatás, A. (2005), “Is there a Case for Sophisticated Balanced-Budget Rules?”, OECD Economics Department Working Papers, No. 466, OECD, Paris. Furceri, D. (2009), “Stabilisation Effects of Social Spending: Empirical Evidence from a Panel of OECD Countries”, OECD Economics Department Working Papers, No. 675, OECD, Paris. Guichard, S. et al. (2007), “What Promotes Fiscal Consolidation”, OECD Economics Department Working Papers, No. 553, OECD, Paris. Hagemann, R. (forthcoming), “Improving Fiscal Performance Through Fiscal Councils”, OECD Economics Department Working Papers, OECD, Paris. Haugh, D., P. Ollivaud and D. Turner (2009), “What Drives Sovereign Risk Premiums? An Analysis of Recent Evidence from the Euro Area”, OECD Economics Department Working Papers, No. 718, OECD, Paris. Inman, R. (2001), “Transfers and Bailouts: Institutions for Enforcing Local Fiscal Discipline”, Constitutional Political Economy, Vol. 12, No. 2. Jonung, L. and M. Larch (2006), “Improving Fiscal Policy in the EU: the Case for Independent Forecasts”, Economic Policy, No. 21. Koen, V. and P. van den Noord (2005), “Fiscal Gimmickry in Europe: One-Off Measures and Creative Accounting”, OECD Economics Department Working Papers, No. 417, OECD, Paris. Koutsogeorgopoulou, V. and D. Turner (2008), “The Costs of Delaying Fiscal Consolidation: A Case Study for Greece”, OECD Economics Department Working Papers, No. 582, OECD, Paris.


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Lucas, R. and N. Stokey (1983), “Optimal Fiscal and Monetary Policy in an Economy Without Capital”, Journal of Monetary Economics, Vol. 12 (1). OECD (2009a), OECD Economic Surveys: Euro Area, OECD, Paris. OECD (2009b), Pensions at a Glance, OECD, Paris. OECD (2009c), OECD Economic Outlook, No. 85, June, OECD, Paris. OECD (2010), OECD Economic Outlook, No. 87, June, OECD, Paris. Ostry, J. et al. (2010), “Fiscal Space”, IMF Staff Position Note, Washington, September. Reinhart, C.M. and K.S. Rogoff (2010), “Growth in a Time of Debt”, American Economic Review, Vol. 100, No. 2. Roehn, O. (2010), “New Evidence on the Private Saving Offset and Ricardian Equivalence”, OECD Economics Department Working Papers, No. 762, OECD, Paris. Sutherland, D. et al. (2005), “Fiscal Rules for Sub-Central Governments: Design and Impact”, OECD Economics Department Working Papers, No. 465, OECD, Paris.

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Chapter 4

Minimising risks from imbalances in European banking The euro area financial system took excessive risks during the global credit boom, which in some countries led to an unsustainable increase in credit, higher asset prices and housing booms. This process helped to fuel large imbalances within the euro area. Banks played a key role in channelling funds from economies with large surpluses to deficit countries, leading in some cases to the accumulation of considerable risks for borrowers and lenders. Weaknesses in the regulatory and supervisory architecture contributed to these problems in the euro area, as in other OECD economies. Gaps in microprudential regulation created an environment prone to excessive risk-taking: capital buffers were too small; the quality of capital was inadequate; banks’ models underestimated risks; and risks were shifted off-balance sheet and beyond supervisory oversight. Liquidity risks were not adequately monitored. Systemic risks were allowed to build up as the authorities largely failed to counter the credit cycle. Some large systemic banks contributed to growing imbalances and vulnerability. The decentralised European supervisory architecture was not sufficiently effective in supervising large cross-border institutions. When the financial crisis hit, the co-ordination of cross-border rescues proved problematic and complicated efficient resolution. Stronger regulations are needed to improve financial stability. Effective microprudential regulation is the first line of defence. This should be upgraded by implementing the Basel III capital accord, as has been announced by the EU authorities, and a range of related measures. Some consideration should be given to an accelerated phasing-in. Macroprudential regulation should be significantly developed to mitigate pro-cyclicality and reduce systemic risks posed by large crossborder banks. The creation of the European Systemic Risk Board is welcome. To improve cross-border supervision, the European Banking Authority should have sufficient powers and resources to ensure that a system based on national supervision leads to coherent regulation and effective supervision. In addition, a cross-border crisis-management framework for Europe is needed. Overall, significant steps have already been taken by the EU authorities to address these issues and further reforms are underway.

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4.

MINIMISING RISKS FROM IMBALANCES IN EUROPEAN BANKING

E

xcessive risk-taking in the euro area during the global credit cycle contributed to the financial crisis, the severity of the economic downturn, and considerable fiscal costs. While the euro area in aggregate avoided some of the worst excesses, there were serious problems in a number of countries, particularly those that had run large external imbalances. The first section shows how banks increased risk-taking, and how crossborder bank flows were a key part of the build-up of macroeconomic and financial imbalances, as differences in borrowing and saving behaviour across countries led to excess funds from some countries partly being recycled elsewhere in the euro area. The second section sets out the main policy priorities, both to avoid excessive risk-taking overall and to prevent unsustainable financial imbalances in euro area countries. These include stronger microprudential regulations, developing macroprudential policy, improving cross-border supervision and setting up a cross-border crisis-management framework.

The bank lending cycle was unsustainable and contributed to imbalances The strong banking cycle during the recent upswing in euro area countries, as in other OECD economies, led to unsustainable borrowing and left the financial system vulnerable. Loan growth was well in excess of GDP growth (Chapter 1). When doubts about global credit quality appeared in 2007, credit began to slow, before contracting as banks made significant losses on their earlier activities and borrower demand deteriorated as the economy slowed. Within the euro area, economic imbalances across countries were associated with large variations in credit expansion (Chapter 2). The pace of borrowing in several deficit countries was extremely high due to low real interest rates, financial deepening, optimistic growth expectations and financial accelerator mechanisms. Key loan aggregates doubled or tripled in some cases between 2002 and 2007 (Figure 4.1). By contrast, credit growth was sluggish in several surplus countries and lending was largely stagnant in Germany. Credit expansion in deficit countries financed excessive savinginvestment gaps and fuelled consumption, housing and asset price booms. It also led to the misallocation of capital, especially towards the housing and non-tradable sectors. These developments added to macroeconomic risks: the severity of the 2008-09 downturn across countries was associated with the speed of credit expansion during the 2004-07 pre-crisis period (Lane and Milesi-Ferretti, 2010).

Banks took excessive risks The expansion of bank credit was facilitated by an easing of lending standards, as reported by the ECB Bank Lending Survey (Figure 4.2). This credit easing led to stronger bank lending and higher GDP growth (De Bondt et al., 2010). Credit growth in the pre-crisis period was reinforced by the balance sheet channel, as household and corporate assets swelled, thereby increasing the value of collateral, and through the bank lending channel, as banks had plentiful profits to fund additional capital and lending (Hempell and Kok Sørensen, 2009). These developments were, among other things, influenced by low interest

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Figure 4.1. Many countries experienced large lending booms Level in 2007 Index 2002 = 100

Index 2002 = 100

350

350 Loans for house purchase Credit for household consumption Loans to non-financial corporations

300

300

250

250

200

200

150

150

100

100

50

50

0

GRC

IRL

ESP

LUX

ITA

FIN

FRA

AUT

BEL

PRT

NLD

DEU

0

Source: ECB.

1 2 http://dx.doi.org/10.1787/888932359701

rates across the maturity spectrum, increased securitisation and gaps in bank supervision (Maddaloni and Peydro, 2010). Similar effects occurred elsewhere, notably in the United States (Bayoumi and Melander, 2008). As discussed in Chapter 2, this mechanism was particularly strong in euro area deficit countries, given the structure of financial markets and the tendency for these feedback mechanisms to operate locally.

Figure 4.2. Bank lending standards and loan growth in the euro area % of respondents

% growth

4

20 10

3

0 -10

2

-20 -30

1

-40 -50 -60 -70 -80

0

1

Easing of credit standards, % (left scale) Quarter-on-quarter % change in loan growth to non-financial sector (right scale)

2003

04

05

06

07

08

09

10

-1

1. Net percentage of respondents reporting easing of credit standards: average of credit to enterprises, home purchases and consumer credit. Source: ECB, Bank Lending Survey.

1 2 http://dx.doi.org/10.1787/888932359720

The risks associated with growing lending were not adequately reflected in the size of bank provisions, which declined to historically low levels while activity and credit were at cyclical highs (Figure 4.3). Provisions during the upswing fell by more, relative to aggregate output dynamics, than in any other recent credit cycle, and increased abruptly in the wake of the crisis. This is unsurprising given the point-in-time approach to provisioning, and limits on making general provisions that were the prevailing norm due to international accounting standards. OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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4.


Figure 4.3. Loan loss provisions and economic growth in the euro area Per cent

% growth

1.4

-1 Loan loss provision ratio (left scale) Real GDP growth (right scale, inverted)

1.2

0

1.0

1

0.8

2

0.6

3

0.4

4

0.2

1988

90

92

94

96

98

2000

02

04

06

08

5

Source: OECD, Bank Profitability Statistics Database; OECD Economic Outlook Database and OECD calculations. 1 2 http://dx.doi.org/10.1787/888932359739

Loan growth and risk-taking were facilitated by increases in bank leverage, as in other OECD economies. Assets grew faster than capital over the pre-crisis period from 2002 to 2006. While the increase in the aggregate leverage of the euro area banking system was small, it was substantial for the largest and most systemically relevant banks. The leverage ratio, defined as the ratio of total assets to tier 1 capital, for the major banks increased during the pre-crisis period by around one-third (Figure 4.4). At the same time, the tier 1 risk-weighted ratio of the largest euro area banks only weakened modestly over this period. This suggests an increasing discrepancy between total and risk-weighted assets, which might suggest that risk-based aggregates did not adequately reflect changes in total risk exposures. In addition, some risk exposures were put off balance sheet so that bank balance sheets failed fully to capture increasing risk-taking.

Figure 4.4. Leverage of largest EU banks1 46

5

Leverage 2 ratio (left scale) Reversed tier 1 ratio3 (right scale)

42

6

38

7

34

8

30

9

26

1994

95

96

97

98

99

2000

01

02

03

04

05

06

07

08

09

10

1. The 10 largest banks in the euro-area are selected based on their total assets in 2006, which is the last pre-crisis year, and include BNP Paribas, Crédit Agricole, Deutsche Bank, ABN AMRO, Société Générale, ING Bank, Banco Santander, UniCredit, Fortis and Commerzbank. 2. Ratio of total assets to tier 1 capital. 3. Ratio of risk-weighted assets to tier 1 capital. Source: The Banker Database and OECD calculations.

1 2 http://dx.doi.org/10.1787/888932359758

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4.


Across euro area countries, regulatory tier 1 capital ratios were relatively similar (Figure 4.5). However, leverage ratios generally remained much lower in deficit countries (except Ireland), while leverage was higher in a number of surplus countries with large and sophisticated financial institutions. These discrepancies might also reflect differences across countries in the supervisory approach, as shown for example by the treatment of asset-backed commercial paper conduits in different countries (Acharya and Schnabl, 2010). In the early 2000s, Spain required a full capital charge against assets in conduits, which meant that there was no difference between capital requirements for assets held on or off balance sheet. As a result, Spanish banks avoided substantial exposure to these conduits and off-balance sheet items accounted only for about 6-7% of total securitisation in Spain (Fernandez de Lis and Herrero, 2008). By contrast, the German regional banks (Landesbanken) benefited from grandfathered state guarantees, which reduced their cost of capital. Supervisors allowed these banks to invest in conduits, which were put off balance sheet for regulatory purposes even though they were included in financial reporting. The Landesbanken invested heavily in these conduits, financed through shortterm debt. As a result, they were exposed to risky assets originated in overheating overseas markets and incurred large losses when the crisis began.

Figure 4.5. Leverage and tier 1 capital ratios In 2006 Leverage1

25

Reversed tier 1 ratio 2

25

20

20

15

15

10

10

5

5

0

FIN

PRT

GRC

AUT

ESP

ITA

FRA

DEU

IRL

NLD

BEL

0

1. Ratio of total assets to tier 1 capital. 2. Ratio of risk-weighted assets to tier 1 capital; 2005 data for Austria and Germany. Source: ECB, EU Banking Sector Stability, November 2006 and November 2007.

1 2 http://dx.doi.org/10.1787/888932359777

Cross-border banking flows fuelled imbalances and increased risk The accumulation of macroeconomic imbalances within the euro area was accompanied by large cross-border banking flows. In several countries, the net external position of domestic residents towards foreign banks, measured on a locational basis, rapidly deteriorated (Box 4.1). This illustrates the close link between bank flows and changes in the overall dependence of domestic residents on external financing (Figure 4.6, first panel). Conversely, the domestic banking sector has a substantial share of aggregate foreign assets and liabilities (Figure 4.6, second panel). This share increased rapidly in several deficit countries during the pre-crisis credit boom, notably in Greece where it rose from 17% in 2002 to 31% in 2007.


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Figure 4.6. Banking flows played a major role in accumulation of imbalances % of GDP

% of GDP

40 20

40 Net external positions vs. foreign banks1

20

0

0

-20

-20

-40

-40

-60

-60

-80

-80 2000 2004 2007

-100 -120

-100 -120 -204

-140

DEU

BEL

FIN

FRA

GRC

AUT

ITA

NLD

ESP

PRT

IRL

Per cent

-140 Per cent

70

70 2

Share of the domestic banking sector in gross external assets and liabilities, 2007 60

60

Assets Liabilities

50

50

40

40

30

30

20

20

10

10

0

0 DEU

BEL

FIN

FRA

GRC

AUT

ITA

NLD

ESP

PRT

IRL

1. Calculated based on locational basis. 2. Excluding foreign direct investment positions maintained by banks. Source: BIS, Locational Banking Statistics and IMF, Balance of Payments Statistics.

1 2 http://dx.doi.org/10.1787/888932359796

Box 4.1. Measuring international banking claims The BIS locational banking statistics are based on the residency of the reporting bank. They include positions vis-à-vis banks’ foreign offices and complement monetary and credit aggregates, which makes the approach consistent with balance of payments statistics and the system of national accounts (McGuire and Woolridge, 2005). However, resident banks include domestic operations of subsidiaries of foreign-owned banks but exclude foreign subsidiaries of domestic banks. By contrast, the BIS consolidated banking statistics are based on the nationality of the reporting bank, based on the location of a bank’s head office. They exclude intragroup positions to capture solely exposures to unaffiliated counterparties. These statistics allow for a better monitoring of banks’ risk exposures. Consolidated statistics are particularly useful in understanding countries’ bilateral claims, when those are intermediated through financial centres located in third countries.

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Box 4.1. Measuring international banking claims (cont.) The difference between the two approaches is illustrated in Figure 4.7. Locational statistics report international banking claims for country X as the aggregate claims of banks B1 and B3 on residents outside country X. Consolidated statistics will report these claims aggregated for banks B1 and B2. For a financial centre, bank B2 located in country Y might play an important role in channelling credit from country X to country Z. In such a situation, the actual exposure of country X to borrowers in country Z would be reflected in the consolidated but not in the locational statistics.

Figure 4.7. Locational vs. consolidated banking statistics RESIDENCY

Consolidated

Country X

Country Y

Country X

B1

B2

Country Y

B3

B4

NATIONALITY

Locational

Source: Bank for International Settlements.

Net flows from large surplus countries to those with current account deficits and booming credit markets were particularly important (Figure 4.8). The extent of the mismatch between flows in opposite directions was large by historical standards and appears to have intensified as the credit cycle took off after the early 2000s. The consolidated claims on some of the large deficit countries were sizeable relative to their GDP, while these flows remained small from the perspective of surplus countries: for example, claims of German banks on Greece increased to just around 1.3% of German GDP prior to the crisis, but this represented 13.5% of Greek GDP. This illustrates the sensitivity of small financially open economies in a single financial market to conditions in other countries, particularly in large economies with big pools of saving and bank credit to allocate overseas. Even a relatively modest increase in the external holdings of a large country can dramatically increase the size of funds available to a small deficit economy. Relatively large and unbalanced bilateral consolidated claims accumulated between Portugal and Spain, but imbalances between other deficit countries remained modest. Bilateral claims between France and Germany remained broadly balanced. This rapid increase in cross-border banking claims tested banks’ capacity to channel funds to most productive uses (Portes, 2009). Banks in surplus countries were pushed particularly strongly to identify profitable investments abroad, as opportunities for domestic lending were limited due to weak aggregate demand and structural barriers to


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4.


Figure 4.8. Selected bilateral consolidated banking claims Claims of country X on country Y as a share of GDP of both countries in 2007 % of GDP of DEU

% of GDP of GRC

% of GDP of FRA

% of GDP of GRC 30

15 Germany vs Greece

3

DEU on GRC GRC on DEU

1.0

France vs Greece FRA on GRC GRC on FRA

10 2

0.5

5

0.0

2000

02

04

06

% of GDP of DEU

08

0

% of GDP of IRL 100

0

2

2000

02

04

0

2000

02

04

06

% of GDP of FRA

06

% of GDP of DEU

% of GDP of IRL 50

5

80

4

60

3

40

2

20

20

1

10

0

0

08 % of GDP of PRT

40

FRA on IRL IRL on FRA

30

0

2000

02

04

06

% of GDP of FRA

Germany vs Portugal 20

DEU on PRT PRT on DEU

1.0

15

1.5

08 % of GDP of PRT 20

25 1.5

08

France vs Ireland

DEU on IRL IRL on DEU

4

0

10

1

Germany vs Ireland 6

20

France vs Portugal 15

FRA on PRT PRT on FRA

1.0

10

10 0.5

0.5

5

5 0.0

2000

02

04

06

% of GDP of DEU

10

08

0

% of GDP of ESP

0

0.0

2000

02

04

06

% of GDP of FRA

08 % of GDP of ESP

25 Germany vs Spain

8

8

DEU on ESP ESP on DEU

6

15 10

4

2

5

2

0

0

0

2000

02

04

06

% of GDP of FRA

08

% of GDP of DEU

France vs Germany

8

10 FRA on DEU DEU on FRA

FRA on ESP ESP on FRA

6

4

15

France vs Spain

20

10

5

0

2000

02

04

06

% of GDP of PRT

08 % of GDP of ESP

6

Portugal vs Spain 30

6

PRT on ESP ESP on PRT

4

20

4

5

2 0

2000

02

04

06

08

0

2

10 0

2000

02

04

06

08

0

Source: BIS, Consolidated Banking Statistics Database and OECD, OECD Economic Outlook Database. 1 2 http://dx.doi.org/10.1787/888932359815

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4.


the development of some domestically focussed economic activities (Chapter 2). Direct cross-border lending to the non-financial sector remained limited, as banks primarily lent to other banks or invested in financial instruments of increasing complexity. The riskiness of these investments was underestimated not only by banks, but also by banking supervisors. This led to large losses during the financial crisis on some cross-border investments. Banks in deficit countries increased mainly their domestic risk-taking but also acted as a conduit for foreign financing. The limited supply of growth-enhancing projects and distorted credit demand due to low real interest rates led banks to finance housing and consumption booms. These booms became self-perpetuating, due to financial accelerators and unanchored asset price expectations. In some countries, high exposure to domestic sovereign risks and excessive dependence on cross-border wholesale short-term financing added to the problem. In Ireland, a deficit country that developed as a financial centre, banks were not only exposed to unsustainable domestic lending, but also to housing markets abroad, and became highly leveraged. Growing systemic risk was masked by strong profits and capital positions. Macroprudential policies were effectively applied only in limited cases, notably in Spain through dynamic provisioning. These policies did not succeed in preventing the accumulation of excessive risks in the banking system with regard to certain assets (such as real estate in Spain) nor macroeconomic instability, but they did contribute to the resilience of the banking system during the downturn. The key role of domestic banks in intermediating funds from foreign banks to domestic borrowers reflects incomplete financial integration and diversification in the EU retail banking market. Domestic banks generally dominate overall national exposures to, and claims on, foreign banks (Figure 4.9). This pattern is consistent with deeper financial integration in European wholesale and securities-related banking than in retail banking (Figure 4.10). Cross-border deposits of the non-financial sector in most countries are small, accounting for just 6% of the total on average. For countries where deposits are high relative to loans, banks rather than the non-financial sector allocated these funds through foreign lending. Similarly, ECB data show that the extent of cross-border lending to nonbank entities is only 5% of total loans to non-banks on average, up from 3% in the early years of EMU. The retail banking market remains fragmented, with non-trivial differences

Figure 4.9. Domestic banks have a big role in cross-border flows Share of domestic banks in total gross positions vs. foreign banks, 2007 Per cent

Per cent

100

100 Assets

Liabilities

80

80

60

60

40

40

20

20

0

BEL

FRA

PRT

AUT

DEU

FIN

ESP

ITA

NLD

IRL

GRC

0

Source: BIS, Locational Banking Statistics and IMF, Balance of Payments Statistics

1 2 http://dx.doi.org/10.1787/888932359834


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4.


Figure 4.10. Cross-border provision of financial services in the euro area1 Per cent

70 60 50

Per cent

Assets

70

Liabilities

Non-bank securities and shares Loans to non-banks Interbank loans

60

Non-bank deposits Interbank deposits

50

40

40

30

30

20

20

10

10

0

2000

02

04

06

08

10

2000

02

04

06

08

10

0

1. Cross-border activity as a percentage of the total provision of financial services in the euro area. Source: ECB (2010), Financial integration in Europe, April.

1 2 http://dx.doi.org/10.1787/888932359853

in lending and deposit rates for households and firms across the euro area. This fragmentation is not too surprising in view of the importance of local information or language in assessing small-business and consumer loans, and differences in national legal systems in the enforcement of repayment and foreclosure procedures. However, this structure creates inherent dangers for the European financial system: ultimate borrowers and lenders may be far removed from each other in terms of geography and their local markets. While banks with a local presence might be well informed about the nature of local risks, this may no more than shift the asymmetric information problem to the assessment of riskiness of the local bank and its activities by foreign lenders. At the same time, it creates a strong need to supervise cross-border activities effectively to avoid, for example, excessive maturity transformation due to the channelling of cross-border flows through short-term interbank markets. While financial integration has proceeded slowly in some respects, cross-border interbank flows have developed extremely rapidly through loans, deposits and purchases of securities especially in euro area countries (Box 4.2). A key development has been the growing role of non-deposit liabilities in recent years. Bond finance and securitised instruments have become more important as sources of funding, transforming balance sheets of banks. Cross-border interbank loans between euro area banks increased from 22% of total interbank loans in 2000 to 34% in 2008, while the holdings of securities issued in other euro area countries grew from a quarter to half of the total. The increasing importance of cross-border interbank flows in financing domestic banks, with highly concentrated exposures to the local retail markets, made them highly vulnerable to shifts in wholesale funding markets. From 2003 to 2007, money market funding increased from 12% to 16% of total liabilities, while short-term interbank funding rose from 0.1% to 2.9%. Large cross-border banks have substantially increased their role in cross-border credit flows. Prior to the crisis, there were 46 major EU banking groups (out of 8 000 banks) that together held two-thirds of total EU banking assets (ECB, 2007). Each of the largest 16 banks had operations in at least a quarter of all EU countries and held at least one quarter of their assets in other EU countries. The share of foreign assets in total assets for the largest banks is high: 82% for Deutsche Bank, 64% for Santander, 62% for UniCredit, 41% for BNP Paribas

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Box 4.2. Euro membership and cross-border holdings Increased financial integration has been a major feature of the world economy over the past decades. However, the monetary union, along with EU regulatory harmonisation, has contributed to this process and has raised the degree of integration among euro area countries. A study of bilateral cross-border bank holdings for a sample of 20 advanced economies over a 30-year horizon shows that common membership of the Economic and Monetary Union (EMU) raises bilateral bank holdings by 40% relative to a pair of non-members (Kalemli-Ozcan et al., 2010). Moreover, the analysis shows that this positive effect is mostly attributable to the elimination of currency risk among members of the euro area. In addition, regulatory harmonisation at the EU level has further boosted bilateral bank holdings. In earlier studies, Blank and Buch (2007) estimate a gravity model for cross-border bank assets and liabilities, and find a significantly positive euro effect on the distribution of bank assets, but a weaker one for bank liabilities. Coeurdacier and Martin (2007) also find a positive euro effect on bilateral bank lending among the member countries, in addition to increased lending by banks from outside the euro area to entities in the member countries. The relative increase in bilateral bank claims involving euro area members can be attributed to three different channels (Spiegel, 2009). Firstly, a “borrower” effect, by which EMU membership increases creditworthiness, raising borrowing from all sources. Secondly, a “creditor” effect that increases the attractiveness of a member country's banks as financial intermediaries, with EMU members increasing lending to all destinations. Thirdly, a “pair-wise” effect, whereby joint membership in the EMU increases the quality of intermediation when both lender and borrower are in the monetary union. This in turn focuses cross-border bank transactions on pairs of countries that are both members of EMU. The “pair-wise” effect appears to be the dominant factor.

and 29% for Société Générale (Claessens et al., 2010). These banks have been important drivers of enhanced financial integration in Europe. While the balance sheets of EU banks grew by 40% from 2004 to 2007, the assets of subsidiaries of euro area banks in other euro area countries grew by 84% (ECB, 2010a). Large cross-border banking groups played a particularly important role in channelling credit from surplus to deficit countries. These banks operated in multiple markets, and foreign direct investment (FDI) in the financial sector reduced lending rates through greater competition and improved cost efficiencies (Goldberg, 2007; De Blas and Russ, 2008). Large cross-border banks use their internal capital markets to minimise the correlation between the rates of growth of customer loans and deposits (Navaretti et al., 2010). Foreign subsidiaries were able to isolate their lending activities from fluctuations in funds and have been better able to profit from positive upswings in lending conditions in booming countries. While this form of integration is likely to have brought significant benefits including substantial diversification of risks, it may have contributed in some cases to greater risktaking. International differences in regulations and tax systems provide arbitrage opportunities that can be exploited through cross-border banking activity. Distortions in corporate governance and regulatory regimes may have provided incentives to expand overseas (CGFS, 2010). There may also be an incentive for bank executives to expand


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balance sheets through overseas acquisition to increase size-related compensation payments. In addition, international expansion may contribute to a bank becoming “too big to fail” or too costly to unwind, and too complex to be supervised effectively. The emergence of large banking groups contributed to home-host supervisory problems, while they became systemically important in several countries of operation. Dependence on subsidiaries as the dominant form of foreign establishment within the euro area (Figure 4.11) added to the complexity of supervision: for a sample of 30 OECD “systemically important financial institutions” (SIFIs), each has at least 100 majorityowned subsidiaries and more than half have over 500 subsidiaries (Claessens et al., 2010). The cross-border expansion through branches could sometimes lead to potential conflicts as the home country authorities provide branch supervision and the host country authorities are responsible for the stability of the local financial system. These problems were difficult to overcome given the fragmented supervisory architecture in the European Union. When the financial crisis hit, the co-ordination of cross-border rescue and resolution actions proved even more problematic, adding substantively to the fiscal costs of the crisis.

Figure 4.11. Assets of branches and subsidiaries of euro area credit institutions Per cent

Branches

A. As a share of GDP, 2008

Per cent

Subsidiaries

2255 %

500

25 B. Relative to total assets of the euro area

IRL

LUX

FIN

BEL

SVK

0

AUT

5

PRT

100

FRA

10

DEU

200

GRC

15

ITA

300

ESP

20

NLD

400

2004

2005

2006

2007

2008

0

Source: ECB (2010), Structural Indicators in the EU Banking Sector and OECD, OECD Economic Outlook Database. 1 2 http://dx.doi.org/10.1787/888932359872

The financial crisis led to deleveraging and cross-border disintermediation Growing concerns about credit risk plunged financial markets into turmoil and the turning of the cycle led to large losses (Chapter 1). This had a particularly large impact on economies and banking systems in deficit countries that had experienced strong creditfuelled booms, as well as increasing pressure on their creditors. The lack of trust between banks and the reassessment of risks led to a sudden deterioration in access to foreign finance for banks in some countries followed by strong disintermediation across borders. Banks raised their lending standards, putting pressure on borrowers, and deleveraged. This forced rapid deleveraging in the private sector, particularly in highly indebted deficit countries with large housing booms. The weakness of banks and the associated downturn led to large fiscal costs. Combined with a reassessment of sovereign risks, this created funding pressures for several countries and forced rapid fiscal adjustments. This

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unwinding of economic and fiscal imbalances in turn had a further strong feedback effect on the banking sector. Interconnectedness between banking systems across countries and between sovereigns and banks has highlighted problems with local weaknesses spilling over across countries. During the crisis, there was a dramatic decline in international capital flows and the greatest contraction was in cross-border banking flows (Milesi-Ferretti and Tille, 2010). This was particularly substantial in countries with the largest initial gross banking positions and the most negative net position in external bank assets. International balance sheets of banks contracted by 12% between the March 2008 peak and the end of 2009, mostly through lower interbank claims. Foreign claims on countries in the euro area fell especially quickly relative to other countries. There was an important shift in the funding strategies of banks as the freezing of wholesale money and interbank markets induced banks to seek more stable sources of funding, including through greater competition for deposits (ECB, 2009a). In relation to bond finance, net issuance by banks has declined. Moreover, banks have turned to the Eurosystem as a source of liquidity. To access liquidity, banks have also increased strategic reserves of eligible assets. A two-tier market structure developed after the onset of the turmoil in August 2007, with only large money-centre banks active in the cross-border money market and other banks relying heavily on domestic counterparties (Cassola et al., 2010). After the collapse of Lehman Brothers in September 2008, the situation further deteriorated with even cross-border trade among the money-centre banks drying up. In addition, there has been a substantial decline in cross-border M&A activity in the euro area banking sector (ECB, 2010b). The financial crisis has induced many banks to focus on core activities and markets, with less emphasis on cross-border expansion. In addition, the mergers and acquisitions (M&A) focus has shifted towards the consolidation of domestic banking systems, in part at the behest of national governments. Rescue packages, as with Fortis, have also tended to lead the reduction in cross-border banking activities and structures. On the other hand, some bank restructurings led to cross-border consolidation like in the Fortis case, where part of the bank was eventually acquired by BNP Paribas.

Upgrading regulation and supervision to reduce risk Regulatory and supervisory reforms are necessary to reap benefits from financial deepening and financial integration within the euro area without posing threats to stability. Strengthening of basic microprudential regulation should provide the first line of defence against systemic risks, but effective macroprudential oversight is also needed to prevent excessive credit cycles. Adequate channelling of information and strong co-operation between macro and microprudential supervisors is of the essence to ensure co-ordinated and global assessments of risks and policy responses. Supervisors’ actions also need to be better co-ordinated and harmonised. With cross-border banking activity driven mainly by a relatively small number of large banking groups (ECB, 2010b), enhanced home-host cooperation is particularly important. Furthermore, a robust system of cross-border crisis management is required. Beyond these key areas, several other regulatory and supervisory weaknesses contributed to the accumulation of risks that led to the banking crisis (Wehinger, 2008). These include: weak corporate governance and weak risk management control and


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inadequate remuneration practices at banks; the dominance of over-the-counter (OTC) transactions; and linkages with the shadow banking system, notably hedge funds and private equity funds. Substantial progress is also needed in these areas and many reforms are already underway, but these issues are not discussed further in this chapter.

More robust microprudential regulation should provide the first line of defence Microprudential regulation of capital and risk management and supervision were insufficient in the years running up to the crisis to prevent the build-up of systemic risks. Large banks increased their leverage and risk exposures, while the quality of their capital gradually eroded. While many banks held capital well in excess of minimum requirements, large dividend payments, share buy-back programmes and discretionary bonus payments weakened capital positions at the onset of the financial crisis, even as the outlook for financial sector was already deteriorating. As a result, the ability of the banking system to absorb the resulting trading and credit losses was impaired. Furthermore, the capital framework did not adequately cover all risks. Important on– and off-balance sheet risks, as well as derivative exposures, were not captured adequately. These proved to be highly destabilising during the financial crisis (Blundell-Wignall et al., 2009). This was aggravated by risk-management practices, with regulatory dependence on credit rating agencies contributing to less effective internal credit screening and due diligence (Persaud, 2008). Liquidity regulations were relatively under-developed and their harmonisation limited. Many banks held insufficient liquidity buffers and were strongly dependent on wholesale financing through interbank deposits and securities funding. This proved devastating for such banks during the crisis when liquidity in the interbank system dried up. Several of these issues have been addressed at the international level by the package of reforms agreed in September 2010 by the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee of Banking Supervision. Despite relaxation of more ambitious initial proposals and the long implementation periods, the package known as “Basel III” provides for a substantial strengthening of banking sector stability in the coming years. The most important elements include improving the quality, consistency and transparency of the capital base, and the introduction of leverage and liquidity ratios. When fully implemented on 1 January 2019, the regime will have the following elements: ●

The recognition in common equity of investments in financial institutions, mortgage servicing rights and deferred tax assets from timing differences will be limited to 10% of common equity, the highest form of loss-absorbing capital. Moreover, any amount by which the aggregate of these three items exceeds 15% of common equity is to be deducted.

134

●

The minimum requirement for common equity will be raised from the current 2% of risk-weighted assets, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments (Table 4.1).

●

The tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6%.

●

The capital conservation buffer above the regulatory minimum requirement will be calibrated at 2.5% and met with common equity after the application of deductions. Banks will face increasing restrictions on the distribution of earnings and bonus payments, when their capital ratios fall towards minimum requirements.


4.


Table 4.1. Bank capital: current and future requirements Per cent of risk-weighted assets Current requirement1

Requirement in 2019 (incl. conservation buffer)2

Requirement in 20152

Common equity tier 1 capital

2

4.5

7

Tier 1 capital

4

6

8.5

Total capital

8

8

10.5

1. Before the application of stricter capital definitions. 2. After the application of stricter capital definitions. Source: Basel Committee on Banking Supervision.

●

A non-risk-based leverage ratio will serve as an additional safeguard against attempts to game the risk-based requirements, and help address model risk. A minimum tier 1 leverage ratio of 3% will be tested during a parallel-run period, and would be introduced as a requirement in 2018 based on appropriate review and calibration. To ensure comparability, the leverage ratio for regulatory purposes will be based on an internationally harmonised definition, which is necessary due to significant differences in accounting methodologies across jurisdictions (Box 4.3).

●

Liquidity coverage and net stable funding ratios will be introduced and supported by a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system-wide level.

Box 4.3. Comparison of leverage in the United States and the euro area Differences in accounting standards complicate international comparability of leverage ratios and relative riskiness of banking systems in the United Sates and the euro area. For example, legally endorsable master netting agreements with single counterparties can be deducted from assets in the United States (based on US GAAP accounting rules), but not in the European Union (based on IFRS accounting rules). Pro-forma balance sheets in the two standards show significant differences in leverage ratios, and the differences in accounting standards lead to very different conclusions about relative leverage of banks (Table 4.2). This is because banks optimise their balance sheets according to the regulatory standards they are facing. It is therefore pertinent to use a common definition of the leverage ratio as was agreed by the Group of Governors and Heads of Supervision in July 2010.

Table 4.2. Pro-forma leverage ratios under GAAP and IFRS JP Morgan Chase

Total assets1 Equity1 Leverage (total assets/equity)

Deutsche Bank

US GAAP

Pro-forma IFRS

IFRS

Pro-forma US GAAP

2 032

3 517

1 501

891

165

165

38

38

12

21

40

23

1. USD million for JP Morgan Chase data and EUR million for Deutsche Bank. Source: Banker reports, OECD.


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However, the implementation timetable has been heavily back-loaded to mitigate potential adverse impacts of the new regulations on lending and growth in the shorter term (Box 4.4). More restrictive capital definitions will be phased in gradually from January 2013 over a period of 10 years. The implementation of the minimum capital ratios will be phased in from January 2013 to be fully implemented by 2015. After that is complete, a conservation buffer will be phased in by January 2019. The leverage ratio will be tested starting in 2013 and might be integrated into capital requirements in 2018, based on a review and calibration. After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015, while the Net Stable Funding Ratio (NSFR) may be effective from 2018.

Box 4.4. The macroeconomic impact of the new Basel capital requirements Estimates by the Macroeconomic Assessment Group (MAG) of the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) show that a 1 percentage point increase in the ratio of capital to risk-weighted assets will lead to a decline in the annual GDP growth rate of –0.04 percentage points during a four-year implementation period. The Basel III capital requirements, agreed by the Group of Governors and Heads of Supervision of the BCBS, raise the minimum common equity ratio by 2.5% and the tier 1 capital ratio by 2% by 1 January 2015. If banks choose to maintain the current size of discretionary capital buffers, this would have an impact on the annual GDP growth of about –0.1 percentage points during this period. A similar impact can be expected between 2015 and 2018, when a capital conservation buffer of 2.5%, is phased in. The actual impact is likely to be even lower as banks might use their discretionary capital buffers, which they hold in excess of the current regulatory minimum, to offset part of the required increase in regulatory capital. On the other hand, these estimates do not take into account the impact of the new definition of capital and new risk weights used to calculate capital adequacy ratios, but this additional impact will be small.

The risk coverage of the capital framework will also be strengthened. In addition to the trading book and securitisation reforms, the Basel Committee agreed to strengthen capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities. These enhancements, to be implemented at the end of 2011, will strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the other. The strengthened counterparty capital requirements will increase incentives to move OTC derivative activities to central counterparties and exchanges. The new Basel III accord now needs to be transposed into the EU Capital Requirement Directive (CRD) to become the backbone of the microprudential regulatory architecture in the European Union. The European Commission will present legislative proposals to implement Basel III in the CRD Directives in the first quarter of 2011. Some consideration should be given to an accelerated phasing-in. In addition, the upgrading of financial oversight needs to go beyond the Basel III accord in some areas, including concentration risks that need to be better addressed by EU supervisors, in particular to motivate banks to exploit risk diversification opportunities in the euro area more effectively. The strength of local credit cycles would also be reduced and market discipline improved, if risks related to geographic concentration of lending, including to sovereign debt, were appropriately

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managed. More fundamentally, Basel III does not fully address the problem that the “promises” that make up any financial system are not treated equally and continues to allow arbitrage between on– and off-balance sheet items (Blundell-Wignall and Atkinson, 2010).

Macroprudential policy should be developed The crisis exposed failures in mitigating systemic risk, or “the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially” (ECB, 2009c). The role of such macroprudential policy is mainly preventive, and should be distinguished from crisis management and crisis resolution. However, there are important links between these policies. For example, weakness in crisis management and resolution, for example bailouts with too mild conditions, might increase systemic risk through greater moral hazard. Interactions with monetary policy are also important. While monetary policy is aimed at maintaining medium-term price stability, macroprudential policy will remain the primary tool to manage financial cycles, and by preventing excessive cycles in asset prices and balance sheets, it can contribute to longer-term price stability. Moreover, financial stability is needed to ensure appropriate monetary policy transmission mechanisms (Chapter 1). There are two intertwined goals in mitigating systemic risk (CGFS, 2010): ●

Strengthening the resilience of the financial system to shocks and economic downturns.

●

Leaning against the wind or limiting the build-up of financial risks (including those emerging from innovation and changes in the structure in the financial sector) that can pose a risk to the financial sector and the wider economy. There is a widespread belief among central banks and supervisors that macroprudential

policy can be at times effective, but there are also clear limits as to what could be achieved (CFGS, 2010). Enhancing the resilience of the financial system through the use of instruments based on standard microprudential tools is considered more likely to be feasible than more general efforts to lean against the wind. This appears, for example, to be the experience of Spain during the housing boom and the financial crisis. Macroprudential policy is therefore strongly complementary to other policies. A boom in housing markets, for example, might be best addressed through a combination of macroprudential policies that tighten lending standards to this sector and changes in tax incentives and barriers to housing supply. The identification of systemic risks is a necessary condition for effective macroprudential policy. A battery of tools has been proposed to identify these risks (ECB, 2010c). Apart from exogenous shocks, there are two endogenous dimensions of systemic risks (Borio, 2003): ●

A cross-sectional dimension related to the interconnectedness between financial institutions, including systemically important ones.

●

A time dimension related to the build-up of financial imbalances through cycles.

Macro stress tests evaluate the resilience of banking sectors to large but plausible external shocks. Contagion and spillover models assess the cross-section dimension of systemic risk by analysing channels and speeds of transmission of shocks across the system. Early warning models provide measures of risk due to emerging financial imbalances. Finally, financial stability indicators provide measures of the actual degree of instability at any given moment.


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Measures to mitigate systemic risks should deal with vulnerabilities stemming from financial markets (margin requirements and haircuts) and market infrastructures (central counterparties), as well as banks. In terms of the banking system, there are two targets for these measures: ●

Bank balance sheets. These measures aim primarily at strengthening the resilience of the banking sector, but also cover the supply of credit and hence the build-up of financial risks. The cross-section dimension of systemic risk can be limited through a differentiated treatment of counterparty risk exposures, and capital and liquidity surcharges on systemically important institutions. Measures addressing the time dimension of systemic risk include minimum capital requirements, forward-looking provisioning, capital buffers and cyclical capital add-ons. These issues can be also addressed through a risk-based levy that would increase the cost of risk for systemic institutions. However, a levy does not increase the loss-absorbing capacity of the institutions, since the funds are not held by firms but are directed either to a dedicated fund or the general budget.

●

Credit demand. These measures affect directly the accumulation of exposures, and often aim at preventing excessive build-up of leverage in specific sectors of the economy such as housing and construction. These measures include limits on loan-to-value (LTV) or loan-to-income (LTI) ratios, collateral rules and collateral haircuts. The additional benefit of these measures is to give a clear signal about emerging systemic risks.

Most of these quantitative measures are based on adapting standard microprudential regulatory rules to the system level. Measures more tilted at leaning against the wind tend to be more macroeconomic in nature in their application (applied across all institutions), and dynamically adjustable (to promptly address changes in the degree and character of systemic risks). Combinations of balance sheet and demand measures are possible. For example, according to the CRD, lending with high LTV ratios would imply capital surcharges, while choosing the appropriate margin would be left to national discretion.

Systemically important institutions need stricter regulation and more intrusive supervision Systemically important financial institutions (SIFIs) played a major role in the financial crisis (ECB, 2010c). They contributed directly to the cross-section dimension of systemic risk, by increasing the complexity and interconnectedness of financial markets, and risk of contagion in the system. They tended to play a disproportionate role in the accumulation of imbalances, because of their role in cross-border lending and faster adoption of financial innovations. Moral hazard associated with SIFIs being too big or too interconnected to fail may have lowered default risk premiums and encouraged risk-taking and the expansion of balance sheets (Baker and McArthur, 2009). As these banks are often very large when compared with national economies, they can easily make a significant contribution to financing rapid and excessive credit growth on a national scale. Despite these special characteristics, large cross-border institutions have not been subject to specific regulatory measures. The contribution of a bank to systemic risk is the product of its systemic importance and its own riskiness. While the methodology for assessing individual institution’s risks is relatively well understood, the measurement of the systemic component poses challenges. The emerging consensus is that systemic importance can be assessed along three basic dimensions: size, interconnectedness and substitutability (ECB, 2010c). However, several qualitative aspects also need to be taken into account, making any classification tentative.

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It is important to view systemic importance as a continuous measure. Creating a finely granular ranking is preferable to a closed list of systemically important banks that would likely lead to distortions in regulatory, supervisory and market perceptions between institutions on both sides of any arbitrary threshold. Specific macroprudential measures directed at the SIFIs have two complementary objectives. The first is to reduce their systemic importance by changing the business model and simplifying resolution. This can be achieved by legally separating and reducing the size of different activities, such as proprietary trading, private equity and hedge fund investments. These considerations were reflected, for example, in the Volcker rule in the United States. Tax surcharges on large banks can also contribute to dealing with systemic risk by recovering the “too big to fail rents”, and offsetting their impact on the cost of risk. The development of recovery and resolution plans contributes to overcoming obstacles to orderly resolution. The second objective is to reduce the probability of default given the existing business model. Additional prudential requirements can contribute to both objectives at the same time. However, Basel II was favourable for large banks as their capital requirement ratios were relatively low, implicitly promoting size (Jokipii and Milne, 2006). The forthcoming Basel III proposals are expected to change this by penalising size and complexity by requiring higher loss-absorbing capacity. This would include combinations of capital surcharges, contingent capital and bail-in debt. Separation through regulation is a possible scenario, with gradual spinning-off of non-core banking activities. More effective and intrusive supervision and improved resolution mechanisms that minimise the risks of moral hazard are essential for dealing with SIFIs. While the additional prudential requirements are attractive, institutional complexity often reflects attempts to overcome regulatory requirements or taxation. Therefore, creating additional levels of anti-complexity regulations without enhanced supervision could lead to perverse outcomes. Moreover, while there is a general consensus about the supervisory toolkit available to reduce systemic risks of SIFIs, choosing the right tool for a given institution is not straightforward (ECB, 2010c). A decision about the application of capital surcharges, contingent capital and bail-in debt and more intrusive supervision requires close cooperation between the home authority and host authorities, with an important role played by the supervisory college. However, such decisions should be peer-reviewed and coordinated under the auspices of the European Banking Authority (EBA) to prevent divergent supervisory practices and an uneven playing field. Reinforced corporate governance principles and adequate incentives are also important to mitigate excessive risk appetite.

Increasing cyclical resilience Pro-cyclical amplification of shocks through banks and financial markets was one of the key systemic risks leading to the financial crisis (Penetta et al., 2009). A tendency to underestimate risk in good times and overestimate it in bad times increased the potential for credit and asset market booms and busts (OECD, 2010). While the aggregate effects in the euro area were not especially marked, this tendency was very strong in some individual euro area countries that faced destabilising real interest rates and large capital inflows, thereby contributing to economic imbalances. The regulatory framework contributed to pro-cyclicality through several channels (BCBS, 2010): accounting standards for both mark-to-market assets and held-to-maturity loans; margining and provisioning practices; and leverage among financial institutions, firms and consumers. Pro-cyclicality has potentially been also magnified through OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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cyclicality of minimum capital requirements that was linked to higher risk sensitivity of Basel II capital requirements (Lowe, 2002; Borio and Shim, 2007). As banks and supervisors failed to fully appreciate risks related to emerging exposures, capital requirements were kept too low, while evidence suggests that bank lending might become particularly cyclical when banks are both under-capitalised and illiquid (ECB, 2009c). Pro-cyclicality was not addressed adequately in the supervisory process, despite safeguards suggested by the Basel Committee to mitigate the cyclical consequence of Basel II. These included long-term horizons in the estimation of default probabilities, the introduction of loss-given-default estimates, and the recalibration of risk functions. Supervisors could also impose higher capital standards, based on stress tests that assumed increased riskiness of credit portfolios. A review to assess the impact of Basel II on the cyclicality of capital was also put in place. However, supervisory process remained driven by a point-in-time rather than a through-the-cycle perspective. To mitigate pro-cyclicality, Basel III includes several changes in the regulatory framework: ●

A leverage ratio to provide a basic backstop against excessive increases in total assets during upswings.

●

Capital conservation buffers to increase resilience across business cycles by promoting more energetic rebuilding of capital in the recovery and its protection in a downturn.

●

Changes in the methods of calculating the probabilities of default (PD) to dampen excess cyclicality of internal ratings-based minimum capital requirements.

●

A larger role for forward-looking provisioning to link provision to expected losses in a downturn, which can be very large after strong credit growth in an upturn (Box 4.5). This role needs to be supported by a change in accounting standards that adjusts principles of fair representation to the strongly cyclical reality of the banking business. It is also important that tax systems do not penalise higher levels of provisioning that reflect prudential approaches towards losses.

Box 4.5. Macroprudential policy in Spain The central bank of Spain, which was also the financial supervisor, used macroprudential policy to address the accumulation of financial risks during the upswing preceding the current crisis. The policy had two objectives: constrain credit growth and protect Spanish banks from future losses, drawing on the lessons of past banking crisis experienced in Spain in the late 1970s. A system of dynamic (or statistical) provisioning was introduced in July 2000 as a key tool to achieve these objectives. Total provisions under this system are the sum of specific and generic components. The specific provisions, calculated according to the IFRS accounting standards, reflect the riskiness of portfolios based on current losses. These tend to be strongly pro-cyclical. While credit loss ratios tend to be compressed in good times, accumulated provisions are often insufficient ex post, and provisions increase rapidly in a downturn. Forbearance among banks and supervisors in recognising bad loans may aggravate this pro-cyclicality. The generic provision in Spain was designed to counterbalance these effects by bringing the ratio of total provisions to credit in line with long-run expected losses, and therefore maintaining a sufficiently high bank capitalisation to prevent a credit crunch in a downturn.

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Box 4.5. Macroprudential policy in Spain (cont.) Taking the two types of provisions together, the dynamic provisioning formula has effectively two components: the first linked to the stock of credit, ensuring a stable provisioning ratio, and the second linked to the growth of credit, enforcing countercyclicality. The weights on these two components were linked to across-the-cycle risk estimates, derived either from internal models or a benchmark model provided by the central bank. The basic formula is given below:

(

total provisionst = specific t + generic t = specific t + αΔCt + β –

specific t Ct

( C = αΔC + βC t

t

t

The introduction of the dynamic provisioning in its original form had a strong countercyclical effect but this was weakened after its reform in 2004 (Figure 4.12). Some banks released part of accumulated provisions, while others stabilised provisions despite continued rapid credit growth. During the financial crisis, when specific provisions surged, reductions in generic provisions smoothed the increase in the total provisioning ratio, but failed to stabilise it. One reason was a high risk aversion justified by the extraordinary depth of the crisis; however, existing provisions might also have been insufficient, partly due to the introduction of the cap. Therefore, the 2004 reform illustrates the difficulties in using macroprudential tools prior to the crisis, when their role and effectiveness was contested not only by the banks, but also by the international accounting bodies and fiscal authorities (Fernandez de Lis and Herrero, 2010). The result was a system that allowed for less cyclical loan loss provisions, but which did not eliminate pro-cyclicality completely. It was more effective in creating a cushion in the good times than in discouraging rapid credit growth or rises in house prices.

Figure 4.12. Loan loss provisioning in Spain Ratio of provisions to loans to the private sector Per cent

Per cent Specific ratio Generic ratio Total ratio

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

1998

99

2000

01

02

03

04

05

06

07

08

09

10

0.0

Source: Bank of Spain.

1 2 http://dx.doi.org/10.1787/888932359891

Additional counter-cyclical capital buffers should be set to secure banks against risks from excessive credit growth. One important weakness of the Basel II regulatory framework was the lack of a link to the macro-financial environment in which banks operate. While several observers pointed to risks of excessive credit growth rates, for


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example related to housing booms, capital requirements did not reflect these risks. The approach based purely on supervisory discretion proved largely ineffective. An alternative approach based on a centrally determined rule with flexible implications is now reflected in the Basel III agreement on counter-cyclical buffers. The primary objective is to ensure that individual banks and banking systems accumulate capital during periods of rapid credit growth, so that they remain solvent, and are able to continue providing credit to the economy during a subsequent downturn. However, the buffer also has the potential to lean against excessive credit cycles by raising the cost of capital through additional capital requirements. According to Basel III, counter-cyclical buffers ranging from zero to 2.5% of common equity or other fully loss-absorbing capital will be implemented according to national circumstances. The proposed counter-cyclical buffer links capital requirements to deviations from long-term trends in credit-to-GDP ratios in different jurisdictions. Given the limitations of any simple rules, the authorities are expected to apply judgement in setting the buffer in their jurisdiction, but the credit-to-GDP guide will provide a common reference point. The buffer is not symmetrical and is expected to remain zero most of the time. Only evidence of excessive credit growth will prompt decisions for capital add-ons, and banks will be given 12 months to meet these requirements. On the contrary, reductions in buffers will take immediate effect to reduce the risk of a credit crunch. The counter-cyclical buffer operates on the principle of jurisdictional reciprocity. While capital add-ons applicable to counterparties/borrowers in each jurisdiction are decided by the respective authorities, they are binding for all lending banks irrespective of their country of residence. This ensures that the buffer add-on will create a level playing field for banks from different countries and, crucially, that capital requirements are not circumvented through crossborder lending. However, supervision will need to be strengthened to prevent other forms of circumvention, including lending through foreign non-financial subsidiaries or through expanded off-balance sheet items. Linking counter-cyclical buffers to the location of collateral can be useful in preventing regulatory avoidance. When implemented, these Basel III proposals could be complemented by other counter-cyclical instruments as part of the Pillar 2 supervisory process. First, capital requirements could be linked to the growth rate of credit in particular sectors such as housing and construction. Secondly, minimum loan-to-value and loan-to-income standards could be used as they proved effective in addressing excessive credit cycles in several countries (CGFS, 2010). Thirdly, strengthening vigilance, peer review and decisive enforcement of the supervisory processes remain critical conditions for ensuring less procyclical banking sectors in the future.

The European Systemic Risk Board Successful macroprudential policy requires an effective institutional framework for implementation. Before the crisis, it was not clear which institution in the existing supervisory architecture was responsible for monitoring and mitigating systemic risks in the integrated European financial system. The ECB played only a peripheral role in financial oversight (Hoeller and Rae, 2007). It did not have a privileged access to supervisory data and, while it regularly monitored financial stability in the euro area, there was a gap between systemic risk identification and the possilibity of a policy response. Raising awareness about growing risks prior to the crisis failed to influence behaviour of market participants and to contain these risks (ECB, 2010c). The crisis and the recognition of this

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problem led to the creation of the European Systemic Risk Board (ESRB), working in tandem with the European Supervisory Authorities (ESAs), including the European Banking Authority (EBA), as part of the new European System of Financial Supervision. In the new supervisory architecture, the ESRB will provide systemic risk assessments, issue risk colour-coded warnings, address recommendations to the EU and national authorities with specified timelines for the relevant policy response, including legislative initiatives, and monitor their implementation (Figure 4.13). National supervisors and central banks should also strongly strengthen macroprudential supervision at national level.

Figure 4.13. European system of financial supervision European Systemic Risk Board1 Macroprudential supervision ECB EU Central Banks ...

Chairs of EBA, EIQPA & ESMA

Micro-prudential information

European Commission

Information on systemic risk

Early risk warmings + Policy recommendations

European Supervisory Authorities Microprudential supervision

EBA

EIOPA

ESMA

National banking supervisors

National insurance supervisors

National securities supervisors

1. Advisory Scientific Committee and Advisory Technical Committee will also be represented in the General Board of the ESRB with voting rights, while national supervisors and the Economic and Financial Committee will be represented without voting rights. Source: ECB (2010), Financial Integration in Europe, April.

The ESRB will be established as a body without legal personality and with rather loosely defined competencies. The way it develops in practice and the reputation it achieves will be crucial to its effectiveness. The general board of the ESRB will consist of the ECB president (as the Chair, at least in the first five years of operation) and Vice-President, the governors of all EU central banks, a member of the European Commission, the chairpersons of each of the three European Supervisory Authorities, the chair of the Advisory Technical Committee and the Chair and two Vice-Chairs of the Advisory Scientific Committee as voting members, while the representatives of the national supervisory authorities and the President of Economic and Financial Committee will be non-voting members. The ECB will provide the secretariat and the analytical, logistical, administrative and statistical support, also drawing on advice from national central banks and national supervisors. As a rule, decisions on warnings and recommendations will be taken by a simple majority rule, but it is imperative to develop an effective internal decision-making process to avoid blockages and delays due to the size and complex composition of its general board. The ESRB will also have a consultative role in declaring financial


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emergencies. To be effective, the ESRB needs full access to supervisory information and sufficient resources to develop and keep refining the full suite of models to identify different dimensions of systemic risks. Similarly, the new ESAs will also need access to the relevant data produced by the ESRB, therefore strong information channels and coordination will have to be set up. The ESRB does not have binding powers, and the effectiveness of the “act or explain” process hinges crucially on the political will to act. ECOFIN should help enforce ESRB recommendations by pressuring non-complying countries. It is of great importance that the ESRB is allowed sufficient independence, its mandate is clearly defined, and that it acts in a robust way to withstand opposition to its warnings and recommendations that are likely to be strongly unpopular in national capitals and in banking headquarters. One risk is that the objectives of the ESRB could be overly ambitious and hence contribute to fostering a false sense of security among European authorities, which could undermine credibility of the newly created institution. On the other hand, the ESRB should seek to interpret its mandate broadly and consider issues related not only to the resilience of the banking system and other financial sectors, but also to macroeconomic stability because macroprudential instruments are a better way of dealing with some macroeconomic and financial tensions than monetary policy (Chapter 1). The ESRB and the EBA should work closely together to make sure that microprudential and macroprudential policies reinforce each other, and that European rules, tools and policies address emerging risks. This should involve a regular exchange of information and continuous dialogue with the ESRB issuing warnings and recommendations, when simple rules fail to address emerging challenges, and supervisory processes are not effective. Both institutions should jointly calibrate concentration, systemic importance and countercyclical regulation, taking into account country-specific and institution-specific systemic risks. The EBA will elaborate technical standards to guide national decisions and ensure jurisdictional reciprocity in the use of LTV/LTI limits and similar supervisory instruments. The implementation of macroprudential policy, including its counter-cyclical and anti-contagion dimensions, should reflect a guided discretion approach that combines framework rules with a certain degree of supervisory discretion. While binding rules maximise credibility and predictability of the supervisory system, it is extremely difficult to construct rules that address every possible contingency. Binding rules are also likely to be blunt, and hence reduce incentives to improve banks’ risk management frameworks (Borio, 2003). It is also likely that each subsequent credit cycle might be different so that too specific or strict rules might fail to capture its changing character. On the other hand, purely discretionary supervisory decisions either at individual bank or financial system levels might appear ad hoc and arbitrary, and lead to distortions to the level playing field. Such decisions are also likely to be more sensitive to political pressures, with the risk that authorities might wait too long before taking unpopular actions in response to cycles. Guided discretion is therefore the most promising approach to promote counter-cyclicality and minimising risks of contagion, with quantitative tools creating a presumption that the authorities will act in well-defined circumstances, although with judgment allowing some flexibility. Adequate monitoring and peer review of implementation of the agreed guidance will also help to ensure harmonised supervisory outcomes. The importance of national economic and financial imbalances and contagion suggests that national macroprudential arrangements need to be put in place, alongside

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the ESRB. While imbalances even in small countries may lead to area-wide risks to the financial system, there may be cases where problems are more local or become more quickly apparent to the national authorities. In addition, as argued in Chapter 2, macroprudential policies are one of the key tools to deal with national imbalances, particularly in a monetary union. A set of national institutions is required to assess the situation and take action. Many countries have already explicitly assigned financial stability tasks to designated national authorities, very often located within the national central bank. EU bodies such as the ESRB and the ESAs should support national policies, where appropriate, by ensuring that all EU financial institutions abide by the measures taken with respect to activities in a particular jurisdiction.

An effective system of cross-border supervision is needed A unique combination of integrated financial markets and nationally organised supervision (Box 4.6) has created severe challenges for effective supervision in the European Union. Integration means that contagion risks are increased and assessing counterparty risk is complicated. Large cross-border groups can be systemically important in several countries, while national supervisors tend to focus on local risks. Conflicts between home and host supervisors might emerge. Ensuring the level playing field requires increased cross-border harmonisation in rules and supervisory practices. Multiple and non-harmonised national supervisory rules and practices also imply high costs of regulatory compliance for cross-border banks.

Box 4.6. The supervisory architecture prior to the crisis and the reforms Cross-border supervisory challenges in Europe were addressed by granting a leading role to the home country supervisor in the Second Banking Directive in 1993. Home supervisors are responsible for licensing, regulating and supervising cross-border branches, although host countries are given the role of protecting depositors in emergency situations and retain control of liquidity in branches. Host supervisors are responsible for subsidiaries that are set up under local law, and an attempt to retain control over domestically-active institutions contributed to the emergence of subsidiaries as the dominant form of foreign establishment in Europe. The role of colleges of supervisors was increasing gradually, since the Capital Requirement Directive mandated their establishment as frameworks to reach agreement on key supervisory tasks, including ongoing supervision, crisis prevention and crisis management. The “Lamfalussy” process was set up in 2004 to improve institutional co-ordination for the supervision of international banking and insurance groups. At the first level, the Commission, the European Council and Parliament establish directives. At the second level, technical committees for implementing these directives are set up. At the third level, three European committees of supervisors are responsible for co-ordination and for advising the national supervisory authorities in banking (the Committee of European Banking Supervision, CEBS), securities (the Committee of European Securities Regulators, CESR) and insurance (the Committee of European Insurance and Occupational Pensions Supervisors, CEIOPS). At the fourth level, the European Commission is responsible for overseeing the transposition of directives into national legislation.


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Box 4.6. The supervisory architecture prior to the crisis and the reforms (cont.) In the wake of the financial crisis, the de Larosiere report (2009) found the “embryonic” agreements developed by the third-level committees ineffective, citing a lack of frankness, mutual confidence and co-operation among national supervisors. New EU legislation is intended to strengthen the role of these institutions, by upgrading them to the status of authorities, including the European Banking Authority (EBA). In order to ensure crosssectoral consistency in activities, a Joint Committee will co-ordinate the functions of the three new supervisory authorities in relation to financial agglomerates and other crosssectoral matters. The EBA will be granted several tasks to address some of key cross-border supervisory problems: ●

Developing proposals for technical standards.

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Resolving cases of disagreement between national supervisors, where legislation requires them to co-operate or to agree.

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Ensuring the consistent application of technical Community rules (including through peer reviews).

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A co-ordination role in emergency situations.

A single integrated EU supervisor for large cross-border banks might be the first best supervisory arrangement in the long run; however complexities and problems related to this model, notably difficulties in resolving cross-border burden-sharing, are important, and a review of the new supervisory arrangements is foreseen after at most three years to determine whether further steps towards more integrated supervision are needed.

The European Banking Authority needs sufficient powers and resources The European Banking Authority should ensure a high level of consistency in supervisory rules and practices. Considerable cross-country differences in legal and regulatory frameworks persist and can be harmful for a level playing field in European banking. National discretion is preserved by national specificities in transposing directives. There are almost 100 specificities for the Capital Requirements Directive (Kager, 2006). The practice of adding further national requirements over and above those prescribed by EU directives (“gold-plating”) is an additional problem. Many technical rules are determined at national level. This creates risks of regulatory arbitrage and regulatory competition. Home supervisors of various cross-border groups might have different views on major supervisory issues, leading to different outcomes for groups in direct competition. Enhancing supervision implies that:

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Harmonisation requires the elimination of options and gold-plating. The EBA will issue binding technical standards that are directly applicable. It is important that the application of these powers covers a sufficiently wide set of regulatory settings to achieve something close to a single rule book. Looking forward, newly emerging issues will be immediately tackled by the EU framework to prevent adding new discrepancies. New regulations should be more specific and leave less supervisory discretion.

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Robust and transparent decision-making procedures at the EBA are necessary to allow a progress towards a single rule book. Qualified majority voting will be used for decisions on technical standards and guidelines. All other decisions will be taken by simple majority. The process by which the European Commission has to approve binding technical standards


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proposed by the EBA (in certain cases countries and the European Parliament can raise objections) should be implemented in a way that avoids excessive delays. ●

The EBA will be empowered to investigate alleged incorrect or insufficient application of EU law by national supervisors, concluded by a recommendation. In case of non-compliance, the European Commission would be empowered to issue the formal opinion, take the necessary action, and as a last resort and in exceptional circumstances, the EBA would be empowered to adopt decisions addressed directly to financial institutions.

The EBA will have binding mediation powers to address potential differences in the interests of home and host supervisors. When a domestic institution expands abroad through branches, the home supervisor might have a tendency to underestimate risks created for host countries, as was most vividly demonstrated by the expansion of Icelandic banks. This is due to the agency problems where the home country provides branch supervision and the host country is responsible for the stability of the system, while information is asymmetric (Hoeller and Rae, 2007). Yet, host countries have only a limited ability to challenge the decisions and actions of the home supervisors. In particular, the peer review process developed within the level 3 committees proved ineffective (de Larosière Group, 2009). Similarly, the home country supervisors did not have effective means for challenging decisions of the host supervisors, particularly to protect the stability of cross-border banking groups. Notably, the Committee of European Banking Supervisors did not have the powers to play a dispute resolution role. These dispute resolution powers will be granted to the EBA. Following a conciliation phase, the EBA would be empowered to make binding settlement and require the national supervisory authority to take specific actions, and, in case of non-compliance, to adopt decisions addressed to individual financial institutions. Supervised institutions should have a right to appeal directly to the EBA and a peer review process should be strongly enhanced to ensure consistency in supervisory decisions. The major role of the EBA will be to strengthen the oversight and co-ordination of colleges and formulate detailed guidelines for their functioning. While colleges started to play a positive role in improving co-operation in information sharing among national supervisors, their role prior to the crisis remained limited. Colleges for major cross-border banks are obligatory only since December 2009 and all cross-border banking groups will need to have a college of supervisors in place by the end of 2010. Ensuring consistency among colleges will be complicated by their large number: there are currently over 120 colleges (de Larosière Group, 2009). In responding to these challenges: ●

The EBA will have powers to collect and share all relevant information in co-operation with the competent national authorities and colleges; initiate and co-ordinate EU-wide stress tests; promote effective and efficient supervisory activities; oversee the tasks carried out by the competent authorities; request further deliberations of a college; require the consolidating supervisor to schedule a meeting of the college or add a point to the agenda of such a meeting; develop draft regulatory and implementing technical standards to ensure uniform conditions of application with respect to the provisions regarding the operational functioning of colleges of supervisors; and issue guidelines and recommendations.

●

Practical arrangements are necessary for the effective functioning of colleges supervising global financial groups that sometimes involve more than a hundred national representatives. In practice, it might make sense to have more frequent meetings of core colleges, with less frequent meetings of the full college. Another challenge will be to organise interactions of “European” colleges with “global” colleges and to avoid two separate


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colleges for one bank. To service this system properly, the EBA will require very substantial resources to participate in college discussions in a meaningful way. Supervisory mistakes can result in large fiscal costs. Indeed, a more comprehensive reform of the supervisory architecture in Europe has proved extremely difficult, reflecting the principle that responsibility for financial stability should be aligned with fiscal authority (Goodhart, 2004; Goodhart and Schoenmaker, 2006). It is therefore very difficult to have strong European level supervisory authority in the absence of fiscal underpinning. This problem was reflected in the fiscal safeguard clauses that ensure that powers of the EBA could “not in any way impinge on the fiscal responsibilities of the member states”. To make the EBA truly effective, fiscal safeguards should be limited to cases where the impact on national fiscal obligations is direct and significant. Problems with burden sharing are a key obstacle blocking agreement towards direct supervision of large cross-border banks by the EBA. Given these constraints, the powers of the EBA should evolve gradually and a review of the new supervisory arrangements is foreseen after at most three years to determine whether further steps towards more integration are needed and whether a single supervisor would be more fit for the purpose. The mandates of national supervisors in Europe differ greatly, both in terms of their scope and enforcement powers. This complicates supervisory co-operation, particularly in situations of financial stress and reinforces risks of regulatory arbitrage: ●

Supervisory authorities in some countries should be institutionally strengthened. Both European and national institutions must have clear mandates and sufficient independence to undertake politically unpopular decisions (Rochet, 2008). In particular, sectoral competitiveness objectives and government policy goals (such as housing policies) should not prejudice decision-making at national level.

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The EBA will periodically organise and conduct peer reviews of some or all of the activities of competent authorities to further strengthen consistency in supervisory outcomes, ensuring uniform procedures and consistent approaches throughout the EU. To that end, the EBA shall develop methods to allow for objective assessment and comparison between the authorities reviewed.

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The EBA will play an active role in building a common European integrated supervisory culture. Peer reviews will examine the adequacy of resources and governance arrangements of the competent authorities. The EBA will play an active role in establishing sectoral and cross-sectoral training programmes, facilitating personnel exchanges and encouraging competent authorities to intensify the use of secondment schemes and other tools.

It is important to establish the high level of credibility for the EBA. Experience of umbrella supervisory institutions in other OECD countries is rather disappointing. For example, the Federal Financial Institutions Examination Council (FFIEC) in the United States failed to establish a sufficiently strong position vis-à-vis the various supervisory authorities. As national supervisors in Europe are large institutions with long histories, they may be hesitant to give up power to European authorities. The resources of the EBA need to be adequate to ensure harmonisation, effective peer review process and dispute resolution. Current proposals foresee a relatively small number of staff (40 in the first year of operations to be increased to 90 by 2014). Although the EBA will not be undertaking direct supervision, the number of staff is nevertheless very small compared to the number of bank supervisors working in national authorities (Figure 4.14). The adequacy of this allocation of resources will periodically be reviewed by the European Commission.

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Figure 4.14. Bank supervisory staff of national authorities 2007, full-time equivalent1

500

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1453

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300

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100

100

0

LUX

IRL

BEL

SVN

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AUT

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0

1. OECD estimate for Austria. Source: World Bank, Bank Regulation and Supervision 2007 Database.

1 2 http://dx.doi.org/10.1787/888932359910

Ineffective information sharing often reflects weak mutual confidence linked to conflicting interests. In particular, sharing information about problems in one jurisdiction might lead to immediate ring-fencing in other jurisdictions. As a result, national supervisors in the build-up to and during the first stages of the financial crisis were not prepared to openly discuss vulnerabilities of their financial sectors. However, there are several other obstacles to optimal information sharing: ●

Some national legal systems make open cross-border supervisory discussion difficult due to commercial and banking confidentiality laws. These laws need to be systemically reviewed and appropriately modified.

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Information sharing is complicated by lack of harmonisation in key supervisory definitions at the EU level, such as non-performing loans. Harmonisation would allow a meaningful cross-border dialogue, data tabulation, benchmarking, aggregation and European systemic risk analysis. This would also reduce reporting costs. Such harmonisation is underway under the auspices of the Commission.

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The supervisory architecture is very complex, and multiple reporting lines among home and host supervisors lead to possible information gaps and double information burdens. The EBA is now required to centralise the information received from competent authorities about institutions active in more than one country, and to share that information with the other competent authorities concerned. Building an EU-wide banking supervisory database would provide quasi-automatic access to supervisory information across borders. Eventually, banks could provide information directly to this database.

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Sharing qualitative information is difficult without intense and frequent operational contacts. The role of the EBA to take the lead in strengthening the functioning of colleges of supervisors is essential in this respect.

Removal of information barriers is not only crucial for improved cross-border supervision, but it is also likely to improve the quality of supervision more generally. For example, several nationally dominant banks have no peers within their country, but comparison to similar institutions abroad is often infeasible in the absence of effective information exchange. It is essential that newly created European bodies have full access to all national supervisory information. OECD ECONOMIC SURVEYS: EURO AREA 2010 © OECD 2010

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There is a strong case for strengthening market discipline through supervisory transparency and disclosure (i.e. Pillar 3 of Basel). Improved disclosure was an important element of the institutional response to the banking crisis in Japan in the 1990s and European countries continue to lag behind the global trend. One obstacle is the lack of harmonisation of confidentiality laws in Europe. More fundamentally, there is resistance from national authorities to putting domestic institutions at a competitive disadvantage. The EBA will have to overcome this co-ordination problem. The EBA should review the confidentiality levels across countries and propose uniform disclosure pattern across countries that would be consistent with the emerging single rule book.

An integrated crisis-management framework would reduce moral hazard The experience of the crisis in the euro area has shown that creditors, including holders of unsecured debt, have been protected from losses by public intervention. Although the value of shares has fallen considerably, equity investments have only rarely had their shareholdings diluted. This has added to the fiscal costs of resolution, aggravating budgetary problems and implying a substantial transfer of wealth. It is also likely to have signalled to financial institutions that bailouts may be available in future crises. Eliminating this moral hazard requires a framework for orderly and swift resolution that makes it possible for banks to fail without destabilising the financial system. The existence of such framework would have a first order impact on the behaviour of banks through the reduction of moral hazard problems: shareholders and creditors should not expect public intervention to relieve them from facing the full burden of a bank failure. While crisis management and resolution is already difficult at the national level (for example, Northern Rock, IKB or Hypo Real Estate), it is particularly problematic in the context of systemically important cross-border institutions. During a crisis, quick but effective decisions are required. Actions need to be legally robust but should not require time-consuming judicial intervention. The relevant authorities need adequate powers and the ability to act, and a clear line of command is important. Yet, several problems of crossborder supervision are magnified in situations of financial stress, sometimes leading to the collapse of effective co-operation. It is therefore important that the European supervisory architecture is complemented with integrated crisis-management and –resolution framework, able to deal with failure of large and complex cross-border institutions. Crisis management in the European Union still remains largely a national responsibility, mirroring the lines of fiscal responsibility. However, it has been increasingly supported by cross-border arrangements for co-ordination and information exchange. The CRD gives the consolidating supervisor responsibility for planning and co-ordinating supervisory actions in emergency situations, and requires the lead supervisor to alert all supervisors and central banks concerned as soon as is practicable when an emergency arises that could jeopardise the stability of the financial system in any EU country. The cooperation among EU authorities in the area of crisis management has been enhanced through the guidelines of the Committee of European Banking Supervisors and voluntary agreements in the form of non-binding memorandums of understandings (MoUs) between various authorities. Such agreements, which set out procedures for co-operation and information sharing in potential crisis situations, have been adopted at the regional and bilateral levels with respect to individual institutions. In addition, a series of multilateral MoUs set out the general framework for crisis management, bringing together all the relevant supervisory parties in 2003, 2005 and 2008.

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The existing crisis-management framework needs to be strengthened to deal with the challenges of the cross-border bank crisis and to secure the desired supervisory cooperation. Although the worst-case outcome of a disorderly failure of systemically important institutions has been avoided, fiscal costs proved very substantial. Examples of difficulties in managing the crisis (Fortis, Icelandic banks) also showed that close crossborder co-operation is helpful but may not always be sufficient, and ex ante burden-sharing agreements would have helped. Response to the crisis was often ad hoc, marked by supervisory retrenchment to national jurisdictions and setbacks to single financial markets (Box 4.7). In several cases, the home authorities intervened alone, shouldering very large fiscal costs, while redeployment towards the home market has been often implicitly or explicitly expected (Fonteyne et al., 2010).

Box 4.7. Major financial firms live globally but die locally: the case of Fortis Fortis was a major cross-border European financial group with total group assets of around EUR 800 billion before the crisis. Originating from the merger of Belgian and Dutch insurance companies, the group purchased BGL bank in Luxembourg. Following Fortis’ takeover of parts of ABN Amro in 2007, it sought to raise more capital. Doubts emerged about its solvency during 2008 as the international banking crisis unfolded and investors began rapidly to lose confidence in its viability. Even a long tradition of co-operation of financial regulators and considerable harmonisation of legal frameworks in the Benelux countries did not prevent a complicated, protracted and inflammatory resolution process along national lines (Lipsky, 2010). The initial agreement to save a group as a whole collapsed as it proved to be inadequate to stop the liquidity outflow of the bank, while finding an acceptable burden-sharing agreement was difficult. Fortis’ Dutch operations were eventually taken over by the Netherlands government. The Belgian government provided extensive liquidity support to the remaining entity, of which 75% was sold to BNP Paribas and the rest held by the Belgian state. Luxembourg now holds one-third of the capital of BGL with the rest owned by BNP Paribas. This outcome was probably more costly than a joint solution for the group; it constituted a setback for financial integration in the Benelux countries and left bitter feelings among national supervisors (Fonteyne et al., 2010).

The Memorandum of Understanding, signed by the supervisory authorities, finance ministries and central banks in June 2008, reflected the increasing recognition of the weaknesses of the existing framework (Eisenbeis and Kaufman, 2006). It contains common principles on crisis management including on the conditions for the use of public funds and on the subsequent possible burden sharing, a common analytical framework and practical guidelines for crisis management. Cross-Border Stability Groups (CBSGs) are foreseen for all large cross-border financial groups and they should be provided with common tools to enable effective co-ordination between the national authorities involved in a crisis. These tools include operational criteria and ex ante principles for ex post burden sharing. Recovery and Resolution Plans for supervised institutions are to be elaborated and regular crisis-management simulation exercises conducted. However, at the time of agreement, the idea to agree on detailed ex ante burden-sharing agreements has been rejected, due to fears of moral hazard, insufficient flexibility and impingement of national sovereignty.


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The establishment of the European System of Financial Supervision has been an important step towards more effective cross-border crisis management. The power to determine the existence of an emergency situation is now conferred on the Council, following a request by the European Commission, any of the European Supervisory Authorities, or the ESRB. In the emergency situation, the EBA will actively facilitate and, where deemed necessary, co-ordinate any actions undertaken by the relevant national competent supervisory authorities, and ensuring smooth exchange of information. It will be empowered to require national supervisory authorities to take specific actions to remedy an emergency situation. It may adopt an individual decision addressed to a financial institution requiring the necessary action to comply with its obligations under that legislation. The EBA may temporarily prohibit or restrict certain financial activities that threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system. However, no decision adopted by the EBA may impinge in any way on the fiscal responsibilities of countries, weakening its effectiveness in the emergency situation. To strengthen the EU crisis-management framework, the European Commission published a Communication in October 2010, leading to new legislation on crisis prevention, management and resolution (European Commission, 2010). The framework should include early intervention, crisis resolution and insolvency, and provide a harmonised toolbox of instruments in each phase supported by necessary legal changes and decision-making patterns. The roles and powers of national authorities, colleges and cross-border stability groups, the EBA and the ESRB should be outlined in detail, and triggers for intervention and of burden-sharing agreements defined: ●

In the early intervention phase triggered by breach or likely breach of prudential requirements, the supervisory authorities should take measures with the main objective of restoring the stability and financial soundness of an institution when problems are developing. Corresponding changes in national legislation are necessary so that national authorities have similar powers to require, for instance, the raising of private capital, restructuring activities or ceasing certain practices, or, if these measures prove inadequate, to initiate the resolution process.

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A crisis resolution involves actions limiting the impact of bank failure on the rest of the financial system. It can lead either to a return to financial health after deep restructuring or to a wind-up and liquidation. This requires that authorities in different countries have wide-ranging but harmonised powers to take decisions, including selling assets and transferring liabilities; setting up good and bad banks; imposing haircuts on unsecured creditors; forcing debt to equity conversion; and allocating losses to shareholders. They should have an authority to provide bridge financing, assume public ownership, recapitalise banks and conclude mergers and acquisitions.

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Possible changes in the insolvency framework would need to first focus on enhancing national insolvency frameworks, but also on eliminating main differences in national insolvency laws that may give rise to conflicts. These rules should allow asset transferability and harmonisation of the criteria under which insolvency proceedings are initiated. In the longer run, a special common insolvency framework for cross-border banks could be developed.

A fundamental problem in designing the crisis-management framework relates to burden sharing between taxpayers of different countries. Ex post decisions, which characterise the current arrangements in Europe, may lead to under-provisioning and

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delays for recapitalisation, because countries may have an incentive to understate their share of the problem so as to incur a smaller share of the costs (Freixas, 2003). This leaves typically the home country with the decision of whether to shoulder the costs on its own or to close the bank. On the one hand, ex ante decisions on burden sharing may accentuate moral hazard (OECD, 2009). They might also prove difficult to agree and enforce: even though the agreement on the Nordic-Baltic Cross-Border Stability Group reflects principles on burden sharing set out by the third EU-wide MoU (Box 4.8), “its provisions may not give

Box 4.8. The Nordic-Baltic Cross-Border Stability Group (NBCBSG) The co-operation agreement on cross-border stability, crisis management and crisis resolution signed on 17 August 2010 by finance ministers, central banks and financial supervisory authorities in the Nordic and Baltic countries,* established the first European cross-border stability group. It is likely to set the standard for others, as it is based on a good record of close supervisory co-operation and density of systemically important institutions in Nordic countries. The objective of this agreement is to ensure that countries not only co-operate effectively to prevent financial crises, but are prepared to deal with crisis situations. By agreeing in advance on procedures for co-operation, sharing of information, assessments and resolution, the agreement aims to reduce financial crisis costs to a minimum and, when relevant and possible, to share them in a balanced and equitable manner. The main tasks of the NBCBSG include: ●

Keeping up-to-date the necessary databases for financial and other relevant information regarding the financial groups.

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Identifying perceived legal and other possible obstacles to co-ordinated decision-making and joint solutions and encouraging authorities to work on their removals.

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Considering, to the extent agreed, alternative workable joint crisis-management tools and crisis-resolution mechanisms.

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Adopting the suggested information-sharing templates and assessment procedures.

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Initiating and evaluating stress tests and crisis simulations.

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Developing and updating criteria and models for possible sharing of net budgetary resolution costs. The agreement outlines the initial algorithm for burden sharing that is based on:

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The relative importance of the financial group (either parent, subsidiary or branch) in the countries as measured by asset shares (summing to 100%).

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The supervisory responsibilities for the same institution in the same countries (either 100% for home country status with full and exclusive power to act and influence, or 100% divided discretionarily among supervisory college members).

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Complementing factors, including systemic importance in a given country; the share of problem assets; quality of superior crisis prevention and early warning; and exceptionally high fiscal burden.

The agreement is not legally binding and recognises that the responsibility for the management and resolution of financial crises remains with the individual authorities, and that co-operation would remain fully voluntary. The agreement does not limit ring-fencing, where it is a legal obligation, as for example in Denmark, and is not based on a common bankruptcy framework. The benefits of the facility are therefore concentrated in early warning and early intervention phases, constituting a sort of prompt-corrective action approach. *

Denmark, Estonia, Finland, Iceland, Latvia, Lithuania, Norway and Sweden.


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rise to any legal claim on behalf of any party or third parties in the course of their practical implementation”. An effective crisis-management agreement is further complicated by ring-fencing: at the moment of a crisis, the authorities in several countries are obliged by law to protect domestic depositors and creditors, for example, by seizing local assets of the local branch of a foreign bank. Legal changes are therefore necessary so that principles of cross-border burden sharing are enshrined in law and interests of other countries are taken into account in the crisis-management process. As this affects the fiscal responsibilities of the individual countries, such legal changes would have to be carefully designed. Recovery and Resolution Plans (RRPs) or living wills are important instruments that may ensure that systemically important banks in distress can be either rapidly resolved or wound down without significant disruption to the financial system. RRPs should outline how a bank would react to a whole range of possible stresses, including contingency funding plans and sales of assets and business lines, making it simpler and less costly for authorities to resolve a bank by creating “a permanent state of readiness” (Bailey, 2009). To keep RRPs effective, national supervisors and the EBA will have to jointly recognise main impediments to cross-border resolution, and to ensure that RRPs remain accurate, adequate and updated through on-going stress tests and crisis-management simulation exercises. Finally, to be effective in the cross-border context, resolution plans may need to be supported by binding burden-sharing agreements and possibly by other resolution procedures enshrined in national legislation. Currently legislative proposals to fully harmonise deposit guarantee schemes (DSG) are being discussed. Prior to the crisis, there was significant variation in the design of deposit guarantee schemes across countries, as the harmonisation was limited to the minimum coverage level. Although European countries agreed during the crisis to gradually raise the ceilings of their schemes to a common level of EUR 100 000 by the end of 2010, variations in the types of deposits covered, the amount of coverage, risk-based premia and funding arrangements remained. It gave depositors incentives to engage in regulatory arbitrage. This happened among clients of UK banks. who transferred deposits to branches of Irish banks, which had been granted unlimited protection. The planned amendment of the DGS directive will significantly limit such differences by harmonising the coverage level and the scope of insured depositors and products. To make these regulatory changes effective, the European Banking Authority should now play an important role in peer reviewing and stress-testing national schemes, and helping to settle possible inconsistencies, to avoid uncertainty and cross-border spillovers from bank failures. The host country should also have the right to request confirmation that the home country has the financial capacity to effectively protect deposits of clients of branches to avoid the de facto transfer of liability towards the host country, as happened during the Icelandic banks crisis. Funding mechanisms are an important issue which complements the crisis management system. While the final cost of resolution should be borne by private stakeholders, up-front and temporary funding by public authorities may be necessary to ensure that banks can be wound up while covering different costs and providing continuity of certain key services. All possibilities should be analysed, including prefunded resolution funds financed with risk-based levies, but also broadening the mandate of deposit guarantee schemes, which already exists in all countries, to provide for, among others, bridge financing, transferring of assets and liabilities and financing bank/bad asset splits. The solution should not bring benefits to shareholders, management and uninsured

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creditors to avoid moral hazard and distortions of competition. Harmonised operations of resolution funding should mirror increasing broader integration in supervisory arrangements and strong co-ordination in the actions of the national resolution authorities. Otherwise, introductions of resolution funding mechanisms can have some negative implications in terms of level playing field and contribute less than desired to a better cross-border crisis management. Yet, the first two quasi-resolution funds are being set up unilaterally. Synchronisation in reforms leading to more internationally harmonised on-going microprudential supervision, macroprudential oversight and crisis-management framework is essential for ensuring stability and level playing field in the European banking system. Regular review of the new arrangements will determine whether further steps towards an integrated EU-wide framework for cross-border financial institutions might contribute to these goals.

Box 4.9. Summary recommendations on banking regulation and supervision The immediate priority is to ensure that the functioning of the financial system is not impaired and that weaknesses in the banking system are resolved (Chapter 1). Significant reforms have already been undertaken by the EU authorities to strengthen regulation of the financial system and cross-border supervision. These reforms need to be completed to help ensure a more effective regulation and supervisory architecture for the European financial system. Strengthening microprudential regulation Financial regulation should be made more effective in line with the Basel III accord. The EU already plans to implement this as part of the global approach and some consideration should be given to an accelerated phasing-in. The main priorities are to: ●

Increase the size of capital buffers and improve the quality of capital by relying more on common equity, including retained earnings.

●

Introduce a leverage ratio as a backstop to the risk-based capital measures and to discourage excessive leverage in the system.

●

Strengthen liquidity regulations. The new Capital Requirements Directive should also reflect other priorities:

●

Improve the risk-weighting system to ensure consistent treatment of all risks, irrespective of their balance sheet position.

●

Risk assessments should not rely unduly on credit ratings.

●

Risk concentration towards specific geographical and sovereign risks should be reflected in the determination of capital requirements.

Reducing systemic risk through regulation of systemically important institutions ●

Make the prudential requirements for systemically important firms commensurate with the costs of their failure, including by requiring higher loss-absorbing capacity through combinations of capital surcharges, contingent capital and bail-in debt.

●

Consider the merits of greater separation between banking and other risky activities, including by stricter rules on proprietary trading, derivative operations and off-balance activities.


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Box 4.9. Summary recommendations on banking regulation and supervision (cont.) ●

Complement regulation with more effective and intrusive supervision and improved resolution mechanisms that minimise the risk of moral hazard.

●

Consider penalising size and complexity through tax surcharges or risk-based levies.

Developing macroprudential regulation to mitigate pro-cyclicality ●

Ensure a through-the-cycle approach to risk and minimum capital requirements, and promote forward-looking provisioning.

●

Introduce a system of counter-cyclical capital buffers based on simple common rules, in line with Basel proposals, that would apply across jurisdictions.

●

Use other instruments, such as loan-to-value and loan-to-income regulations and consumer protection rules to attenuate housing cycles.

Establishing robust institutions for macroprudential supervision Effective macroprudential regulation would help achieve economic stability and is particularly important for countries in a monetary union. The implementation of such oversight remains at an early stage of development. However, the institutions in the EU should be at the forefront of these developments. ●

The creation of the European Systemic Risk Board (ESRB) is welcome but its progress should be closely monitored to ensure that decision-making is effective and recommendations are enforced so that it plays a full role in achieving financial and macroeconomic stability. Adequate resources and access to information will be required to develop early warning and systemic assessment tools.

●

Macroprudential frameworks should be put in place at national level with a clear allocation of responsibilities and resources, and clear connections between macroprudential oversight and other policies.

Strengthening cross-border supervision A single financial market requires an effective system of common micro– and macroprudential regulation and supervision, together with a sound cross-border crisismanagement framework. In its future reviews of the new EU supervisory structure, the Commission should assess whether a single integrated EU supervisor for large cross-border banking groups would be more fit for the purpose. While a more centralised system of supervision could be a long-run outcome, it is essential that current reforms strive to contribute effectively to consistent, coherent and effective supervision of large cross-border banking groups. Within this framework:

156

●

At the legislative level, wider use should be made of directly enforceable regulations, rather than directives that require transposition into national laws. National discretion should be very limited.

●

Ensure that the powers of the European Banking Authority (EBA), including the scope for setting binding technical standards, are sufficient to achieve a single European rule book.

●

To avoid diluting the powers of the EBA, fiscal safeguards rules should only be applied to exceptional cases, where the impact on national fiscal obligations is direct and substantial.

●

Allocate sufficient resources to the EBA to ensure that they are able to operate effectively and can challenge the analysis and positions of the national supervisors where necessary.


4.


Box 4.9. Summary recommendations on banking regulation and supervision (cont.) ●

A high minimum standard of competence of national supervisors in Europe should be ensured, and effective peer reviews will be essential.

●

Facilitate cross-border supervision and systemic risk monitoring through harmonised definitions of key variables, e.g. non-performing loans, and creating common supervisory database.

●

Increase market discipline by stronger transparency and disclosure in the supervisory process.

Introducing cross-border crisis-management mechanisms ●

National authorities should have an effective toolkit for bank resolution, harmonised as far as possible. These procedures should aim to ensure that risk remains with the shareholders and creditors, including the use of forced equity conversions for debt holders, and imposing haircuts on unsecured creditors.

●

Ensure that all systemically large cross-border institutions have functioning stability groups, supported by regularly updated living wills and burden-sharing agreements between countries, enshrined in national laws, to limit ring-fencing.

●

Eliminate the main differences in national insolvency laws that frequently lead to conflicts among national supervisors, including initiation of insolvency proceedings and transfer transferability.

●

The arrangements for deposit guarantee schemes, including the coverage level and the scope of insured depositors and products, should be harmonised and their funding switched to an ex ante basis.

●

Bank resolution funding mechanisms should be considered, including risk-based levies, in order to provide the means for the temporary costs of public intervention. International harmonisation is important to ensure a level playing field and to avoid shifting the burden across countries.

Improving the well-functioning of the single European capital market ●

Subject to effective regulation, measures should be taken to remove restrictions to the integration of EU capital markets, particularly at retail level.

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Glossary ALMPs BCBS BEPGs BIS CBSGs CDS CEBS CGFS CPB CRD

Active labour market policies Basel Committee on Banking Supervision Broad economic policy guidelines Bank for International Settlements Cross-Border Stability Groups Credit default swap Committee of European Banking Supervisors Committee on the Global Financial System Netherlands Bureau of Economic Policy Analysis (former Central Planning Bureau) Capital Requirements Directive

DGS EBA ECB EDPs EFC EFSF EFSM EMU EPL ERM ESAs ESRB FDI FSB GAAP IFRS IMF LCR LTI LTV MAG M&A MoUs MTOs NSFR OTC PD

Deposit guarantee schemes European Banking Authority European Central Bank Excessive Deficit Procedures Economic and Financial Committee European Financial Stability Facility European Financial Stability Mechanism Economic and Monetary Union Employment protection legislation Exchange rate mechanism European Supervisory Authorities European Systemic Risk Board Foreign Direct Investment Financial Stability Board Generally Accepted Accounting Principles International Financial Reporting Standards International Monetary Fund Liquidity coverage ratio Loan-to-income Loan-to-value Macroeconomic Assessment Group Mergers and acquisitions Memorandum of understandings Medium-term objectives Net Stable Funding Ratio Over-the-counter Probabilities of default

161

GLOSSARY

PMR R&D RRPs SGP SIFIs SMP TCE

162

Product market regulation Research and development Recovery and Resolution Plans Stability and Growth Pact Systemically important financial institutions Securities Market Programme Tangible common equity


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