Peter Praet: Japan and the EU in the global economy - challenges and
opportunities
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the conference "Japan and the EU in the global economy - challenges and opportunities",
organised by Bruegel, the Graduate School of Economics, Kobe University, and Fondation
France-Japon de l'EHESS, Brussels, 7 October 2013.
* * *
I would like to thank Stephan Fahr, Georgi Krustev and Ana Lima for their contributions to this speech; all views
expressed remain mine.
Ladies and gentlemen,
It is a pleasure to be able to share some thoughts on the challenges and opportunities Japan
and Europe are facing in the global economy. Since the beginning of the financial crisis,
there has been no shortage of challenges along the road back to what I would call the
"normal functioning" of our economies.
One of the biggest challenges I see is still to be addressed: that of how to grow in an era of
deleveraging. Deleveraging can occur in an orderly fashion or it can be chaotic. It may drag
our economies down or it can place them on a stronger footing. Which of these will be the
case depends to a large extent on how we manage the process.
Today, I will focus my comments on the policy challenges faced by our two economies,
especially as regards how to manage the deleveraging process in the euro area, keeping in
mind the Japanese experience during the 1990s.
As witnessed in Japan, protracted and large-scale balance sheet adjustments can weaken
economic activity over a protracted period of time. Repairing the financial sector was an
important element in improving the Japanese economy. The lesson for the euro area
appears to be clear: the overhaul of the financial architecture - including the establishment of
a procedure for resolving failing banks - needs to be accomplished in its entirety; selective
mending will not be enough.
In my view, we should make use of the momentum offered by the crisis to turn these
challenges into opportunities - opportunities to put our economies on a sounder footing.
To underscore why I think that we need to address today's challenges in a comprehensive
manner and why institutions are crucial in achieving this, I will first briefly review the build-up
and adjustment of financial imbalances both in Japan and in Europe. Then I will elaborate on
how to manage the deleveraging process and the institutional changes to be implemented,
before touching upon the role monetary policy has to play.
Imbalances in Japan and the euro area
The Japanese experience provides important lessons as it demonstrates the difficulties of
emerging from a "balance sheet recession".1 With the euro area still battling the impact of the
financial crisis, an important question is: how does the current euro area economy compare
with the dynamics in Japan during the 1990s?2
Both episodes clearly share elements of a "balance sheet recession", where strong credit
expansion ends with a sharp correction in asset prices, thereby triggering the need for
significant balance sheet adjustment.
Yet, the scope of the required adjustment in the euro area when viewed at the
aggregate level differs markedly from that in Japan, even if some euro area countries
struggle with excessive leverage.
In Japan, the sharp fall in equity prices from the peak of 1989 led to losses of almost 80% in
the two decades that followed. Real estate prices also precipitated, with urban land prices
declining by about 40%. By comparison, at the euro area aggregate level, equity prices fell
by about 50% and have already rebounded from their post-Lehman trough, while residential
property prices have fallen by a mere 3% since their peak in 2008.
As for fiscal
Moreover, the levels of indebtedness across sectors clearly differ.
imbalances, the fiscal response in Japan meant an increase in public debt from 67% of GDP
at the start of the 1990s to about 240% in 2012. For the euro area as a whole, the increase
was much smaller, with aggregate debt increasing from below 70% in 2008 to 92% in 2012.
Obviously, the euro area aggregate figures mask the large heterogeneity among Member
States, where gross debt ranges from 10% of GDP in Estonia to 157% in Greece. This
notwithstanding, it goes without saying that general debt levels in European countries need
to decline, also in view of long-term demographic challenges.
Turning to private sector debt, Japan faced severe adjustment needs in the corporate sector,
with debt of non-financial corporations declining from 130% to 80% of GDP in the 15 years
that followed the peak in economic activity. In the euro area, the debt level of the aggregate
non-financial sector never reached the peaks seen in Japan and aggregate household
indebtedness is also comparatively lower in the euro area. However, in those euro area
countries which experienced housing bubbles, the household sectors have been facing much
stronger adjustment problems. Here, again, euro area averages mask significant
heterogeneity across Member States.
In fact, some euro area countries have seen strong capital inflows and unsustainable
debtfinanced economic expansion. This has not only brought the risk of reversal, as seen after
2008 when private capital inflows dried up and domestic demand collapsed, it has also led to
economic divergence within the euro area. Some countries have lost heavily in terms of
competitiveness relative to their peer euro area countries. Regaining this competitiveness will
indeed be a more gradual and tedious process.3
The credit-financed housing boom in countries like Ireland and Spain led to residential
property prices more than doubling in the seven years leading up to their peak. Since the
peak, adjustments in house prices appear to have been completed in Ireland, while those in
Spain are correcting more gradually. In both cases, the house price boom has left household
debt-to-income ratios in these countries far above their pre-crisis levels with only a slow
decline.
To summarise, while euro area aggregate dynamics appear different from those observed in
Japan at the beginning of the 1990s, some euro area countries do share some features that
are very similar to the Japanese experience in that a prolonged balance sheet adjustment is
underway.
Notwithstanding this cross-country heterogeneity, a common response was required from
monetary policy in the euro area to counter the initial fallout. The cuts in ECB policy rates
together with our non-standard measures were crucial to contain the risks to price stability
and to support the transmission of monetary policy across the currency area. While common
monetary policy has been successful, the crisis has shown that we need more solid common
institutions in other policy areas. In particular, a common monetary policy requires a common
regulatory framework for the financial sector to be able to adequately repair the financial
system, thereby securing a durable recovery in the euro area. The adverse impact of
"zombie banks" and the evergreening of loans in Japan serve as a stark warning signal.
Given the challenges ahead, we should not relax our efforts to put the euro area economies
on track to strong and sustainable growth. That way, we can turn the current challenges into
opportunities - as the title of today's event suggests. Further managing the deleveraging
process will be key, especially balancing the speed of adjustment and reforming euro area
governance. Let me elaborate on these two aspects in turn.
Managing the deleveraging process
To overcome debt overhangs, we have basically two options. We can consolidate or
restructure debt to address the nominal debt stock; or we can implement growth-enhancing
structural reforms that make our economies fitter to grow out of the debt burden. Or we could
opt for a combination of both. A third theoretically possible option allowing for higher inflation
to reduce the real value of the debt would go against the core mandate of central banks.
In recent years, we have seen some consolidation in Europe. As regards public finances,
euro area fiscal deficits exceeded 6% at the peak of the crisis in 2009 and 2010, but are
expected to fall below 3% this year, while primary budgets are even expected to post a
surplus of 0.2%.4 This adjustment strategy has brought with it painful cuts in our social models
and has not been without controversy.
In fact, some commentators and academics suggest that governments should continue
increasing deficits to support aggregate demand while the private sector is deleveraging.
They argue that parts of the private sector are debt-constraint and need to reduce their
leverage, while parts that are unconstrained are not increasing their leverage sufficiently.5 In
such an environment the role for government spending is to expand demand for funds, and
especially so when the nominal interest rate is constrained by the zero lower bound.6 I would
agree to this approach if the fiscal budget allowed for room for manoeuvre. But the recent
sovereign debt crisis has shown that fiscal space is very limited for many European
countries.
In Japan, the strategy of fiscal expansion has led to a situation in which gross
government debt levels now exceed 200% of GDP. The continued favourable financing
conditions appear to also be owed to the fact that more than 90% of Japanese government
bonds are held domestically. This situation can be seen as a special privilege for the
government. But the high exposure of banks to their domestic sovereign - in fact, Japanese
banks hold about 20% of their assets in domestic sovereign bonds - is not without risks,
especially in the event of sudden reversals in market confidence. Maintaining financial and
economic stability therefore requires a clear and long-term fiscal strategy to avoid
disruptions. This is true for Japan and Europe alike.
Debt consolidation is not limited to the public sector, however; it also applies to areas
of the private sector with excess leverage. Let me focus on the euro area financial sector.
While the ratio of financial sector liabilities to GDP has broadly stabilised, euro area large
and complex banking groups have steadily increased the median core Tier 1 ratio from 8.3%
in 2009 to above 11% in 2013.7
To strengthen their capital position banks have issued equity, converted hybrids, received
capital injections and raised the levels of retained earnings. The stronger capital positions
also mean that the relative share of debt in financing is reduced and substituted by more
equity, which should provide a better buffer against economic shocks. After all, debt is a
relatively inflexible form of financing as it requires repayments on time and in full.
But the stronger capital positions have also meant that banks have been shedding assets, a
process which depresses credit growth and puts a drag on the economy. In addition, as
households and non-financial corporations also reduce their indebtedness, they are
demanding less financing from banks. Taken together, we can expect that bloated balance
sheets will contract further.
It is important that this deleveraging process occurs in an orderly manner by
balancing the adjustment of assets and liabilities. Most of all, unnecessary fire sales
generating detrimental falls in asset prices and credit rationing for productive investments
need to be avoided. Throughout the crisis, the ECB has demonstrated its ability to actively
mitigate these effects by ensuring abundant funding to the banking sector through its liquidity
operations. But more is needed, especially regarding a more solid institutional framework to
repair balance sheets in a way that limits systemic risk and avoids damage to the real
economy.
The Japanese experience has shown the risks created when banks' balance sheet
problems are not recognised and addressed. Weakly capitalised banks initially extended
loans to insolvent firms to limit the recognition of losses in the short run. Indications of
evergreening became prominent as the share of loans to the construction sector continued
rising for years after the bubble had burst, despite the fact that this sector was adjusting and
needed to downsize. Write-offs on non-performing loans and necessary recapitalisations
were delayed and the financial sector remained highly vulnerable to shocks. But delayed
recognition was also facilitated by valuation standards that did not mark non-performing
loans to market, unlike much of the losses from securitised products in the recent crises. In
addition, the refusal of banks to foreclose on borrowers might have reflected a different
resolution culture and code of civility in Japan; namely, one that eschews the large turnover
of jobs and the frequent discharging of workers and avoids inducing a humiliating "loss of
face" for delinquent borrowers.8
For the real economy, the evergreening of loans implied a weakening of growth prospects.9
Potentially more efficient enterprises were denied financing, thereby hampering the natural
entry and exit of firms to the market place. Indeed, with the recession in Japan at the
beginning of the 1990s, entry rates of firms declined from their pre-crisis peak of above 7% to
a range of 4-5%, whereas firm exit rates remained subdued at their pre-crisis levels
throughout the 1990s.10
The lesson from this experience is to recognise non-performing loans in a timely manner and
have strong institutions in place to deal with the restructuring. This reduces uncertainty and
avoids adjustment delays. For the euro area, it is a call to move forward in completing the
banking union.
Supervision and resolution
Up until now, supervisory and resolution authorities have operated at the national level.
During the crisis this set-up has revealed pitfalls on three fronts. First, differences in
supervision maintain humps and hollows in the euro area playing field, thereby distorting
competition; second, differences in implicit state guarantees affect banks' funding conditions;
and third, differences in resolution frameworks - or a lack thereof - distort investor conditions
across jurisdictions.
The envisaged European banking union is meant to address these three pitfalls.
First, the single supervisory mechanism (SSM) will level the playing field in
supervision. Only a month ago, on 12 September, the European Parliament paved the way
for this truly European supervisory body. I hope that the Council will soon give its final
consent. The ECB will then take over supervision of euro area banks in the second half of
2014.
We will ensure that euro area banks are supervised in a consistent and stringent
manner. This implies impartial supervisory decisions across all Member States. We
are already in the midst of preparations to make sure we reach this goal. The ECB is
currently working on the methodological design for a comprehensive assessment. We will
communicate details on the exercise in the second half of October, but I can already say
today that the exercise will include a risk assessment and a balance sheet assessment. The
results of this exercise will form the basis for a stress test to be carried out by the European
Banking Authority in close collaboration with the ECB. In order to achieve its goal, this review
needs to be rigorous and stringent. For it to be credible, we need commitment on sound
backstops as a fall-back option for fulfilling capital needs.
In Japan, such a close inspection of bank balance sheets was carried out in 2002. It proved
to be an important step to recognising losses and cleaning balance sheets to eventually set
off a gradual recovery with credit expansion in Japan.
Second, one of the objectives of a European banking union is to delink banks from
their sovereigns. That also implies that bank funding costs will depend on the quality
of banks' assets, and not on the location of their headquarters. Achieving this would
mark a milestone in that it would establish a single capital market throughout Europe that
companies can tap into. A single capital market, in turn, provides better financing for
companies and eases productive investment, which will revitalise the European economies.
Ultimately, it will be decisive in ensuring that Europe avoids a repeat of Japan's "lost
decade", during which zombie banks poorly allocated financing across firms.
Third, orderly deleveraging in the euro area also requires that the restructuring and
resolution of individual banks will not endanger financial stability or put public
finances at risk. For this, the institutional framework needs to be solid. This is the rationale
behind the creation of a single system with a single resolution authority and single resolution
fund, in line with the proposal by the European Commission for a single resolution
mechanism. The resolution fund is to be entirely financed ex ante by the financial industry
itself so as to protect the European taxpayer. Still, until the fund is fully built up or for
exceptional circumstances, it should be able to obtain external funds via a backstop. Here,
the feasibility of a credit line from the European Stability Mechanism could be explored. Any
such backstop should be temporary in nature and compensated by ex post levies on the
banking sector ensuring that the fund is fiscally neutral over the medium term.
A banking union with these elements in place has the potential to delink banks and
sovereigns, not least by following an important principle: bail-in precedes bail-out. This will
ensure that shareholders and unsecured creditors according to the hierarchy of their claims
are the first to bear losses, not the taxpayers.
Monetary policy
Speaking in my capacity as a central banker, let me finally come to the role of monetary
policy in the deleveraging process.
To counter the risks from disorderly deleveraging, the swift cuts in ECB policy rates
and our non-standard measures were key. Fixed-rate full allotment and longer-term
refinancing operations stabilised financial markets early on and counteracted the risks from
fire sales by providing liquidity where it was most needed.
Equally, the ECB did not shy away from bold measures to curtail tail risks and to
restore the monetary policy transmission. Over the last year euro area financial
fragmentation has fallen significantly, capital flows have reverted to stressed countries and
financing costs for corporates have converged somewhat across countries.
These measures had the overarching purpose of ensuring price stability over the
medium term. For the euro area, this is not merely lip service to the primary objective stated
in the EU Treaty. It is, instead, the yardstick against which to measure the success of the
ECB policies and to build credibility. In fact, inflation expectations remained firmly anchored
throughout the crisis. By contrast, policy interest rates in Japan in the early 1990s remained
at higher levels for longer, which, together with a lack of reforms in other areas, contributed
to protracted economic weakness and falling prices. Eventually, inflation expectations
became unanchored and made stabilisation more difficult for monetary policy once it was at
the zero lower bound.
Some commentators would go further and argue that central banks should loosen the belt in
the deleveraging process to actively stoke high inflation.11 I disagree with this line of
reasoning. Although surprise inflation would reduce the real debt burden in the short run, it
would sow doubts about the central banks' ability and willingness to control inflation in the
longer run. Ultimately, it would undermine efforts to implement structural changes and
prudent policies.
However, as the Japanese experience has shown, monetary policy alone cannot place
the economy on a sustainable growth track. Bold monetary policy measures may be
effective in the short run, but they also bear the risk of reducing incentives for banks to
restructure balance sheets. We are aware of these risks.
Furthermore, even if central banks operate within their own specific circumstances and
mandates, the policy measures may lead to unintended spillovers to other countries. To
ensure that monetary policy is transmitted adequately to the economy and domestic
financing conditions are insulated from those prevailing in the global economy, sound
macroeconomic policies and strong domestic institutions are vital.
In addition, to place the economy back on track to sustainable growth, a medium-term fiscal
consolidation strategy as well as structural reforms with productive investment are essential;
these two elements combined with monetary policy form the three arrows identified by Prime
Minister Abe. Monetary policy can buy time to implement structural changes and ease the
deleveraging process, but it cannot cure the root causes of imbalances or be a substitute for
structural reforms.
Conclusion
Allow me to conclude.
Both our economies face large challenges to counter the risks from deleveraging. Preventing
disorderly deleveraging will remain key to limiting possible adverse effects on the economic
performance in the most indebted euro area countries. At the same time, repairing banks'
balance sheets and ensuring their soundness is a pre-condition for re-establishing adequate
financing of the economy. This is why the SSM, including the comprehensive assessment,
and the single resolution mechanism are crucial steps towards improving euro area
governance. The European institutional context may sometimes appear cumbersome, but
the progress made shows that Europe recognises problems and responds to them.
Nevertheless, even with these changes, solving a stock problem means addressing a
prolonged adjustment in flows in the future. We are all well aware that debt consolidation
alone weighs on economic activity just like a diet leaves one with the feeling of fatigue. The
deleveraging process will require time; we should not lose patience in the process.
Compared with past episodes, deleveraging has, in fact, become even more challenging.
The global dimension of deleveraging makes burden-shifting across countries impossible
and today's demographic trends are putting strain on our growth prospects. It is therefore
crucial to balance the consolidation across generations12.
Nonetheless, I reemphasise the need to complement the consolidation process with
structural changes in order to make our economies fitter. This involves reducing red tape to
ease business creation, streamlining governance of state-owned enterprises and reallocating
workers more flexibly from stagnating and declining industries to productive and expanding
ones. Structural reforms are not only required in the countries in the euro area, but have also
been recognised by Prime Minister Abe in his third arrow as essential to securing the
Japanese recovery over the long term.
Thank you for your attention.