Crises: past, present and future –

A euro area perspective

F k MF k MFrank MossFrank MossDirector General International and European RelationsDirector General International and European Relations

XIV annual inflation targeting seminar of the Banco Central do BrasilXIV annual inflation targeting seminar of the Banco Central do BrasilRi d J i 10Ri d J i 10 11 M 201211 M 2012Rio de Janeiro, 10Rio de Janeiro, 10--11 May 201211 May 2012

The global financial crisis was fuelled by an underpricing of risk in financial markets, also in the euro area

Ten-year government bond yields, 1990-2008 (%, monthly)

30

25

Germany Spain Greece Ireland Portugal Italy

20

10

15

5

10

0Jan-90 May-91 Sep-92 Jan-94 May-95 Sep-96 Jan-98 May-99 Sep-00 Jan-02 May-03 Sep-04 Jan-06 May-07 Sep-08

Note: Last observation refers to December 2008Source: Haver Analytics, National Sources and ECB Staff Calculations.

2

Which has led to overleveraging in some sectors …

Household debt to disposable income ratio (%, annual)

General government debt ratio(%, annual)

160

200

250 Germany Italy SpainGreece Ireland Portugaleuro area 140

160 Germany Italy SpainGreece Ireland Portugaleuro area

150

200

100

120

10060

80

5040

60

095 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

0

20

91 93 95 97 99 01 03 05 07 09

Note: Last observation refers to 2010.Source: National sources and ECB Staff Calculations.

Note: Last observation refers to 2010.Source: IMF Fiscal Monitor and ECB Staff Calculations.

3

although the bank-based financial system did not show excessive expansion in the euro area as a whole

Japan(percentage of GDP)

US(percentage of GDP)

Euro area(percentage of GDP)

140

Debt Financing Loans

Debt Securities

140

Debt Financing LoansDebt Securities

140

Debt Financing LoansDebt Securities

80

100

120

80

100

120

80

100

120

20

40

60

20

40

60

20

40

60

80

0

20

1980 1985 1990 1995 2000 2005 20100

20

2000 2005 20100

20

2000 2005 2010

Source: Bank of Japan, ECB staff.Notes: Debt financing corresponds to credit market instruments in the Japanese flow of funds data Last observation refers to 2010

Source: Board of Governors of the Federal Reserve System, ECB staff.Notes: Debt financing corresponds to credit market instruments in the US flow of funds

Source: ECB, ECB staff.Notes: Debt financing of euro area non-financial corporates is reported on a consolidated basis by netting out inter-company loans from the original non consolidated data and incl des pension f nd funds data. Last observation refers to 2010.

The vertical line refers to 1991 Q1, the onset of crisis.

data. Last observation refers to 2011 Q3. The vertical line refers to 2007 Q3, the onset of crisis.

non-consolidated data and includes pension fund reserves. Last observation refers to 2011 Q3. The vertical line refers to 2007 Q3, the onset of crisis.

But macroeconomic imbalances grew within a well-balanced euro area aggregate

Current account balance (% of GDP) Gross Savings to GDP ratio (%)

10 Germany Italy Spain

30 Germany Italy SpainGreece Ireland Portugal

5

Germany Italy SpainGreece Ireland Portugaleuro area

15

20

25Greece Ireland Portugal

0

0

5

10

10

-50

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Investment to GDP ratio (%)35 Germany Italy Spain Greece

-15

-10

25

30Ireland Portugal euro area

-2095 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

15

20

Note: Last observation refers to 2011.Source: IMF WEO and ECB Staff Calculations. Note: Last observation refers to 2011. Source: Eurostat.

4

1095 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

… fuelled also by of cost competitiveness divergences

Unit labour costs in selected euro area countries, nominal(index 1998 Q4 = 100, relative to Germany, based on sa data)

Euro area Germany France Italy SpainN h l d B l i A i G I l d

145

150

145

150

Netherlands Belgium Austria Greece IrelandFinland Portugal Slovenia Slovakia LuxembourgCyprus Malta

130

135

140

130

135

140

Investment to GDP ratio (%)

110

115

120

125

110

115

120

125

95

100

105

110

95

100

105

110

Source: Eurostat. Quarterly data up to Q3 2011 for all countries except Greece (Q1 2011). Cyprus and Malta are based on annual data, up to 2010. N t Th ULC i di t t 100 i th l t t b f th i f th ti t

95

1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1

95

Note: Last observation refers to 2011. Source: Eurostat.

4

Note: The ULC indices are set to 100 in the last quarter before the euro area accession of the respective country. The ULC developments presented for Greece and Portugal might differ from the calculations made by the National Central Banks. The quarterly pattern in Greek ULC is affected by substantial volatility in quarterly compensation of employees figures.

The situation was further worsened by the 2008 global financial crisis

Share of global GDP of countries with fiscal deficits of 8% of GDP or more (%)

Recessions and banking crises in OECD countries, 1960-2010 (number of

t i )countries)

40

45

25

30

35

15

20

25

5

10

Sources: ECB Staff Calculations. Sources: ECB, European Commission and ECB calculations.

0

Note: Last observation refers to 2011.Note: 23 OECD countries are considered: 12 euro area countriesand 11 other OECD countries.

5

Which led to an overpricing of risk

Ten-year government bond yields, 1990-2008 (%, monthly)

40

35

Germany Spain Greece Ireland Portugal Italy

25

30

15

20

5

10

0Jan-90 Jul-91 Jan-93 Jul-94 Jan-96 Jul-97 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Jan-11

Note: Last observation refers to March 2012.Source: Haver Analytics, National Sources and ECB Staff Calculations.

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And which caught the euro area ill-prepared

The situation in the euro area before the crisis

I Incomplete economic governanceI. Incomplete economic governance

• Ineffective fiscal rules to compensate for the absence of fiscal union, weakenforcement by the Commission and euro area Member States (EA MS)

• Lack of awareness of the importance of ensuring convergence after EMU entry, nomechanism to monitor and address structural imbalances within the euro area

II F t d fi i l i iII. Fragmented financial supervision

• No common macro-prudential supervisory structure to detect build-up of systemic riskin the financial sector

• Framework for managing cross-border banking dependent on soft coordinationbetween national supervisors

III L k f fi i l fi ll f t iIII. Lack of financial firewalls for euro area countries

• EU Balance of Payments assistance available only for non-EA MS

Fi i l i t b t EA MS l t l t d i th T t i f

1

• Financial assistance between EA MS was only contemplated in the Treaty in case fornatural disasters

A broad-based EU/euro area crisis response: a stronger focus on fiscal and structural adjustment needs (1)

Strengthening of fiscal discipline

N C it l i l ti t i f th fi l l f th St bilit d G th• New Community legislation to reinforce the fiscal rules of the Stability and GrowthPact, with a stronger enforcement mechanism and a new debt reduction rule

• All EA MS (except the 3 countries under IMF/EU programme) committed to deficitsbelow the 3% of GDP threshold by 2013 at the latest

• A Fiscal Compact (intergovernmental Treaty) to enshrine balanced budget rules innational legislation with an automatic correction mechanismnational legislation with an automatic correction mechanism

Paying more attention to structural adjustment needs and growth

• Launch of a Macroeconomic Imbalances Procedure to monitor and address the• Launch of a Macroeconomic Imbalances Procedure to monitor and address thepotential build-up of unsustainable imbalances on the basis on an agreed set ofindicators (e.g. house prices, unit labour costs, credit growth)

• More ownership of the national (structural) reform programmes as a means to fosterimplementation of the Europe 2020 strategy

• Better targeted Community investments in growth

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ette ta geted Co u ty est e ts g o t

A broad-based crisis response: a more convergent approach to financial sector repair (2)

From soft coordination of the national responses to the initial phase of the post-Lehman crisis

• Pricing of national recapitalisation measures and bank funding guarantees aligned bythe Commission, with input from the ECB

A t i i th h ld f d it t d t l• Agreement on minimum thresholds for deposit guarantees and eventualharmonisation of levels (at EUR 100 000)

To a new EU supervisory framework

• European Systemic Risk Board coordinates (for first time) macro-prudentialsupervision at the EU level – can issue warnings on emerging systemic risks andmake recommendations for remedial action

• Three European Supervisory Authorities (for banking, insurance and securities &markets) improve coordination of micro-prudential supervision

• Commission pushing for harmonisation of national supervisory practices in the contextof the transposition of the Basel III framework in the EU

• EBA playing a central role in the organisation of EU regular stress test exercises (and

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p y g g g (the one-off capital exercise)

A broad-based crisis response: a better structured financial assistance framework (3)

From an urgent ad hoc response in the case of Greece

• Greek Loan Facility (GLF): EA MS provide EUR 80 bn in bilateral loans on an• Greek Loan Facility (GLF): EA MS provide EUR 80 bn in bilateral loans, on anintergovernmental basis, together with EUR 30 bn from the IMF

Via the creation of two temporary loan facilities of which currently 3 euro areacountries are benefitting

• European Financial Stabilisation Mechanism (EFSM): EU facility with lending capacityof EUR 60 bn backed by the EU Budget – currently EUR 22.5 bn committed to Irelandy g yand EUR 26 bn to Portugal. Expires mid-2013

• European Financial Stability Facility (EFSF): intergovernmental facility with lendingcapacity of EUR 440 bn backed by guarantees from EA MS – currently EUR 17.7 bncapacity of EUR 440 bn backed by guarantees from EA MS currently EUR 17.7 bncommitted to Ireland, EUR 26 bn to Portugal and EUR 144.6 bn for Greece. Expiresmid-2013

To the establishment of a permanent euro area mechanismTo the establishment of a permanent euro area mechanism

• European Stability Mechanism (ESM): established via an international treaty with alending capacity of EUR 500 bn, backed by paid-in and callable capital, and disposingf f l f ilit i t t

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of a range of loan facility instruments

A broad-based crisis response: a stronger governance framework (4)

A stronger preparatory structure for the Eurogroup

More independent analysis in the Commission and a stronger role for theCommissioner in charge of economic and monetary affairs

Structured involvement of the Commission and the ECB in exercising surveillanceover countries receiving financial assistance or experiencing financial tensions

A more stringently operating European Semester framework

More regular Euro Summits

9

Closer links between the EU/euro area and the national frameworks

The ECB’s crisis response – standard monetary policy for the euro area as a whole

Interest rate on the main refinancing operations (%, daily)

4.5

3.5

4.0

2.5

3.0

1.5

2.0

0 5

1.0

0.0

0.5

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Note: Last observation refers to 2 May 2012.Source: ECB.

10

The ECB’s crisis response – non-standard monetary policy action to address malfunctioning market segments

I. Interbank market

• Fixed-rate full allotment mode in all refinancing operations (since October 2008)Fixed rate full allotment mode in all refinancing operations (since October 2008)

• Lengthening the maturity of the refinancing operations (1, 3, 6, 12 and 36 months)

• Extending the list of eligible collateral (and not fully relying on rating agencies)g g ( y y g g g )

• Extending liquidity directly in foreign currencies (USD and CHF)

• Reducing reserve requirements

II. Covered bond market

• Objective: Easing of funding conditions and encouraging institutions to maintain orexpand lending, as well as supporting market liquidity in private debt security markets

• Covered Bond Purchase Programme 1 (CBPP1) EUR 60 bn purchased from July2009-July 2010; CBPP 2 under way for EUR 40 bn (until November 2012)y ; y ( )

III. Sovereign bond market

• Objective: to restore the monetary policy transmission mechanism

11

j y p y

• Securities Markets Programme (launched in May 2010)

Crisis response – International comparison

Evolution over time of the size of the central bank balance sheet (May 2006 = 100)

450

400

450US UK Japan euro area

300

350

200

250

100

150

502007 2008 2009 2010 2011 2012

Note: Last observation refers to30 April 2012.Source: ECB.

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Further scope for better preparing the euro area for future crises

I. Towards a closer economic union

• Better coordination of fiscal and structural policies in view of large potential spilloversBetter coordination of fiscal and structural policies in view of large potential spillovers

• Build and implement a more sophisticated system of sticks and carrots

II. Transferring cross-border financial sector competences to the euro area levelII. Transferring cross border financial sector competences to the euro area level

• Move towards a euro area deposit insurance corporation

• Build a special framework for the supervision of the euro area regionally systemicp p g y ybanking institutions

• Decrease the relative importance of the banking sector in providing market-based risksharing to the advantage of financial marketssharing to the advantage of financial markets

III. Enhancing the flexibility of the euro area regional financial arrangement

• Further develop the effectiveness of the tool box of the ESMFurther develop the effectiveness of the tool box of the ESM

• Further develop the collaboration between the global (IMF) and the regional (euroarea) surveillance and financial support mechanisms

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The euro area sovereign debt crisis: my seven lessons for the rest of the worldmy seven lessons for the rest of the world

I. Spillovers can be more important than one believes ex ante, hence collaborationis more useful than anticipated

II. Large countries have a systemic responsibility, not only because of the size oftheir potential spillovers, but also for making the system work credibly

III. Acting in a preventive manner is always better than waiting for the correctiveapproach to be applied; hence mutual surveillance is highly useful

IV Financing needs can be very large if adjustment needs are large or need to leadIV.Financing needs can be very large if adjustment needs are large or need to leadto results quickly

V. Trying to substitute for markets or trying to override them can both prove costly;guiding markets by assisting them in finding the right equilibrium is key

VI.Financial development and innovation can foster economic growth, but a too bigor too rapidly growing financial sector can become a danger for sustainableor too rapidly growing financial sector can become a danger for sustainablegrowth

VII.The morphing of financial problems into real economic ones and eventuallyb i li i l h ld b d ibl

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becoming political ones should be reversed as soon as possible