Josef Bonnici: Reflections on the financial and economic challenges in
the euro area and beyond
Address by Professor Josef Bonnici, Governor of the Central Bank of Malta, at the
FinanceMalta's 5th Annual Conference "Malta's financial services industry - sustaining the
momentum", Mdina, 18 May 2012.
* * *
Ladies and gentlemen,
The euro area continues to face a number of unprecedented challenges. Bond and equity
markets have been highly volatile and the degree of uncertainty in financial markets has
increased. It can be said that Member States have largely recognised the gravity of the
situation and have already implemented or are in the process of implementing various major
reforms. These are generally directed at fiscal consolidation and the enhancement of
competitiveness and growth, and include significant labour market reforms, as in Spain, and
reform of the public administration, as in Italy. Ireland and Portugal are on track in the
implementation of their EU-IMF programmes.
But the tensions in the debt markets are clearly not over yet. Despite the efforts being made
by policy makers across the European Union, the sovereign debt crisis continues and its
ramifications are still uncertain. The recent rise in Spanish yields and the turbulence in
Greece are evidence of this.
The main problem is that fiscal consolidation has to be effected at a time of an economic
slowdown. Recessionary conditions slow down GDP growth and compound the difficulties
that are encountered in the reduction of the fiscal deficit and debt.
In this presentation I will cover various dimensions of the sovereign debt problem, and
conclude with some observations that are of particular relevance to Malta.
The effectiveness of monetary policy
In the wake of risk re-pricing by the markets, financial institutions have tended to unwind their
holdings of public and private sector debt. This can be seen in Chart 1, which shows the
resulting reduction in the leverage of Euro area financial institutions.
It is true that deleveraging reduces financial imbalances and corrects past excesses in the
banks' accumulation of assets. However, the process also slows down the return to normal
macroeconomic growth.
The assets-to-equity ratio in the euro area (shown as the blue line in Chart 1) stood at 14.9 in
March 2012, almost three percentage points below its peak of 18 in 2008. (By way of
comparison, the same ratio for Malta's domestic banks has been lower and more stable, as
can be seen from the red line. It stood at 10.1 in March, almost unchanged from 10.2 in
2008. I will come back to the Maltese situation later.)
The European Central Bank (ECB) has sought to avert a credit crunch and a bank funding
crisis via a number of measures, including the two 3-year Longer Term Refinancing
Operations (LTRO) launched last December and February. These have been provided on a
full allotment basis and at the average Marginal Refinancing Operations (MRO) rate over the
three year term.
These operations have helped to stabilise bank lending to the private sector as well as the
banks' holdings of government securities. However, the effectiveness of these operations
has been reduced, as banks have preferred to place a substantial part of the additional funds
with the ECB's deposit facility.
In fact, in Chart 2, the blue line shows the sharp increases in the volume of bank liquidity
provided by the ECB through its longer term operations over the course of the crisis. The red
line shows the increases in the volume of funds placed by the banks with the ECB deposit
facility. The inflow of funds into the ECB's deposit facility has neutralised a substantial part of
the added liquidity. This reflects a persisting lack of activity in the interbank market and a
hesitation on the part of the banks to provide more credit to households and businesses.
This accumulation of excess liquidity comes at a cost to the banks, currently amounting to
0.75% - the difference between the 1% MRO rate charged by the ECB on the LTRO and the
0.25% paid by the ECB at its deposit facility.
In a similar manner Chart 3 shows the path followed by various monetary aggregates during
the crisis. The monetary base - shown as the blue line - includes mainly bank deposits with
the central bank. The base consists of those central bank liabilities that form the foundation
for expansion of the money supply - M3, represented by the red line.
The sharp rise in the monetary base reflects the scale of the injected liquidity. On the other
hand, the banks' tendency to hold on to their liquidity has resulted in a growth rate in bank
loans (and investments) that is considerably slower than that of the monetary base. The
result is that the growth rates in bank loans (represented by the green line in the chart) as
well as in M3 have been substantially slower than that in the monetary base.
A return to a fully functioning monetary transmission process will increase the volume of
lending that would support the resumption of economic growth. This, however, remains a
challenging task while tensions continue in the sovereign debt markets.
Importance of a prudent fiscal policy
The creation of the euro reduced the cost of borrowing, as credit spreads narrowed and the
exchange rate risk on intra-euro area borrowing was eliminated.1 The reduced cost of
financing public as well as private debt led to higher government debt and private sector
leverage. With the benefit of hindsight, it is clear that the first seven years of the euro would
have been an ideal time for governments to engage in fiscal consolidation. Instead
2
imbalances and vulnerabilities were further aggravated.
In some Member States, institutional characteristics also played a major role. Seeking to
explain the sources of the Greek crisis, my former Greek colleague at the European Court of
Auditors, Ioannis Sarmas, has pointed to the lack of a culture of effectiveness that holds the
Greek government accountable for its policies.3 He also refers to the absence of an effective
internal control system in the Greek public sector, and to the lack of adequate powers in the
hands of the auditing authorities that would permit them to focus more on the efficient use of
public funds. While the auditing process scrutinises compatibility with the laws and
legislation, it pays insufficient attention to other important criteria like value-for-money and
effectiveness.
Fiscal consolidation across most of the euro area carries the risk of downward
macroeconomic adjustment. In today's circumstances, there is the danger of a negative
macroeconomic spiral. Weak economic growth leads to reduced government revenue that in
turn raises the deficit and debt ratios, and therefore may require further budgetary tightening
and austerity measures.
The higher the debt-to-GDP ratio, the more difficult it becomes to take corrective action,
especially during periods of slow economic growth. And the higher the debt ratio, the greater
the risk of a situation where the debt dynamics become unsustainable, such as when the
growth rate of the economy falls short of the interest rate paid on the debt.
At the same time, structural reforms are not easy or popular to implement, especially during
a slowdown or a recession. Structural measures include those that address the relative size
and effectiveness of the public sector and those that promote competition in resource as well
as in product markets.
It takes time for these competitiveness-enhancing measures to reap the so-called
macroeconomic dividends - including more rapid economic growth and faster employment
growth. As a result, the rapid correction of the excessive debt ratio, as demanded by financial
investors, often requires a sharp fiscal correction which leads to a slowdown in economic
activity. In other words, the distress caused by austerity measures is relatively immediate,
while the benefits need a longer period of time to materialize.
One has to recognise that in the current circumstances, the pursuit of a lower deficit by
financially stressed countries is inevitable and brings about a short term slowdown in the
economy. The issue that arises is whether it would be possible to alleviate the negative
effects on incomes and employment. Some of the impact may be alleviated through a
judicious mix of government spending and revenue options so as to reduce the depth and
duration of the slowdown. For example, an increased recourse to EU cohesion and solidarity
funds may help alleviate the structural adjustment necessary and make the economy of the
programme countries more competitive at the same time. Given the extent of the downturn is
some member states, this option is likely to require a strengthening of the EU budget which
in turn needs to be financed. However, not all member states are in a stressed environment,
and it may be possible to consider other financing options, especially where bond interest
rates in some member states are rather low, even below the inflation rate. EU level solidarity
and cohesion assistance may prove a crucial catalyst to the required structural changes.
One has to also keep in mind that governments are increasingly accountable not only to their
parliaments and electorates, but also to investors in the financial markets, and pressure from
the financial markets becomes more acute when a country is in financial distress.4 In
addition, financial markets take a very comprehensive view in their scrutiny of the
sustainability of a country's finances. Even compliance with the Maastricht criteria may not
be enough as there could be other imbalances that would undermine market confidence.
For example, in the case of Ireland prior to the financial crisis, the country was doing well
according to the Maastricht criteria. Government finances were quite healthy, with low public
debt and a low deficit to GDP ratio. The turning point came with the collapse of the housing
market starting in 2007. A drop in banks' share prices led to a deposit run on the banks. The
scale of the problem snowballed after the Irish government guaranteed all the obligations of
the largest banks. This transformed the house price crash into a sovereign debt crisis, with
the evaporation of the markets' confidence in Ireland's ability to honour its obligations. Irish
borrowing costs rose abruptly, requiring an EU/IMF bailout.
Strengthening governance
As I have already mentioned, the ECB played an important role in the policy response to the
crisis. In addition to the conventional interest rate tool, the ECB introduced a number of
nonstandard measures (such as the three-year LTROs that I mentioned earlier, and a reduction
in the required reserve ratio) to facilitate the transmission of monetary policy to the economy.
The events of the last few years have provided important lessons for the construction of a
whole new approach to European economic governance. The aim is to go beyond the
shortterm responses, such as the Greek bailouts, and tackle the problem before the situation has
become critical.
To provide better support where necessary, the European Financial Stability Fund will be
replaced by the European Stability Mechanism, which will be a permanent rescue fund with
added firepower and a stronger mandate.
In the medium term, it is also important to set up governance changes that first, limit
government deficits and debt, and second, protect national competitiveness.
On the subject of fiscal consolidation, there is a broad recognition across the EU that fiscal
governance has to be strengthened and that the Stability and Growth Pact should be
reinforced. The current thinking is that, to avert the recurrence of the crisis, fiscal
consolidation should be enshrined in the governance structure of every country. To this end,
the well-known Fiscal Compact obliges all euro area countries to run a structurally balanced
budget each year. Surveillance will be enhanced and the monitoring of economic policies will
also be comprehensive.
In particular, the problem of sustainable budget planning was addressed by introducing a
country-specific medium-term budgetary objective, which involves a cap on growth of public
expenditure that is in line with the medium-term rate of growth. The Fiscal Compact will also
accelerate the excessive deficit procedure by introducing sanctions when the debt and deficit
to GDP ratios are excessive.
Concerning the second issue (the enhancement of competitiveness), an excessive
imbalances procedure seeks to identify and correct macro-imbalances and shortfalls in
competitiveness. Preventive recommendations will be made to member countries at an early
stage in the formation of imbalances.
On the financial stability side, European authorities have strengthened the financial sector
surveillance framework. The European System of Financial Supervisors, which also includes
the European Systemic Risk Board (the ESRB), is a new supervisory architecture requiring
the National Supervisory Authorities to cooperate with the European Supervisory Authorities
in the identification and analysis of systemic risks. The objective of the ESRB is to address
one of the most important weaknesses identified during the financial crisis, as highlighted by
the de Larosière Report - the lack of an adequate pan-European monitoring, assessment
and mitigation of systemic risk.
In line with the ESRB recommendation to enhance macro-prudential governance in each
Member State, in the case of Malta, it is the intention to replace the current Standing
Committee by a joint committee on financial stability. This committee, which will include
representatives from the Central Bank of Malta and the Malta Financial Services Authority,
would be mandated to monitor and assess risks to financial stability. Its objective is to
formulate policy recommendations to the Boards of the two institutions, designed to
safeguard financial stability, strengthen resilience of the financial system and minimise
systemic risk.
The recently announced changes to the Depositor Compensation scheme are a welcome
change and help increase the resilience of the domestic banking sector. They are also in line
with the recommendations of the latest IMF report.
Given the importance of addressing the risks stemming from systemically important financial
institutions, it is necessary for regulators to reduce and if possible eliminate the prospect that
a systemically important financial institution would find itself in difficulties in the first place.
This consideration also brings up the need of supervising better shadow banking,5 which
consists of those parts of the financial system that are not visible to regulators and hence not
under their direct control and supervision.6
Basle III goes a significant way in narrowing the gaps in regulation that result from recourse
to shadow banking.7 It does so by incorporating off-balance sheet exposures in the leverage
ratio and by including in the liquidity, regulatory and supervisory standards a range of risks
stemming from shadow banking. Thus, stronger banking regulation and supervision will go a
long way towards containing the risks of the shadow banking sector.
The situation in Malta
I will now take a closer look at some key issues relating to the domestic economy and
financial system, particularly the fiscal situation, international competitiveness and financial
stability.
The outlook for the fiscal situation calls for continued vigilance and caution. Official
projections of the deficit ratio for 2012 and 2013 have been revised downward, remaining
below the Maastricht threshold of 3%. However debt forecasts have been generally revised
moderately upward, to levels projected above the 70% level in 2012 and 2013.
During the last decade, Malta's fiscal deficit ratio followed a mostly downward path from
levels that exceeded the euro area, as shown in Chart 4. The decline was interrupted during
two particular years - 2003 and 2008. Both were the result of one-off events.
The budget deficit ratio has fallen each year from the high of 4.6% reached in 2008. One also
notes that since 2009 the deficit ratio for Malta has been below the euro area's average,
though one has to keep in mind that the average for the euro area has been heavily
influenced by the high deficit levels in those Member States facing difficulties (Chart 4).
On the other hand, official forecasts of the debt ratio have been revised upward. With a
government debt ratio that is expected to exceed 70% in 2012 and 2013, it has become even
more important to bring this ratio down at a fast pace (Chart 5). A strong case can be made
for continued caution in Malta's fiscal policy and for further measures that would help to
ensure the achievement of the government's targets.
The recent IMF Article IV Report for 2012 acknowledges that "Malta has taken effective
action to correct its excessive deficit, shoring up confidence in Malta's public finances", but
also recommends a return to a fiscal balance in the medium term. One has to keep in mind
that low deficit and debt ratios leave more room for the application of countercyclical
measures in the event of an economic slowdown without breaching the European rules.
The optimal way to reduce the ratio of the deficit to GDP is through economic growth. In turn,
faster growth calls for improvements in productivity. In this respect, there needs to be a
greater degree of public awareness of the importance of productivity and competitiveness,
and a consensus on steps that can be taken with minimal social disruption to enhance the
country's international competitiveness.
As you know, competitiveness depends on the relationship between changes in productivity
and changes in costs, including wages. I have to note that unit labour costs (ULC), which are
based on the relationship between compensation and productivity, have generally moved in
line with those in the euro area. However, in recent quarters, Malta's unit labour costs have
pulled ahead of those in the euro area, as shown in Chart 6.
In this respect, the wage setting process and efficient labour market practices are of critical
importance. The fact that collective agreements in Malta are negotiated at the level of the
individual firm helps to ensure that wage growth is compatible with the realities of the
markets where the firm sells its products. Still, further steps could be taken to improve
productivity levels and increase the employment rate. Also, as I argued recently, COLA
increases should not be superimposed on wage increases agreed in collective agreements,
but should form part of the negotiation process, so as to ensure that firms are able to match
all wage increases with productivity increases. Faster productivity growth depends on many
factors, including investment, the infrastructure, the quality of the human resources and
hence the quality of the educational system and its ability to meet the skills requirements of a
growing economy. Measures that increase the employment rate could include further policies
that incentivise a higher female participation rate, as well as measures that facilitate more
flexible work conditions, including part-time employment.
A further requirement for economic growth is the smooth functioning of the financial system.
Particularly during these turbulent times, continued economic growth depends also on the
uninterrupted supply of credit by the financial sector to firms and households, and to that end
the stability of the financial system is essential.
It is important to note that although its rate of growth has declined, bank credit has continued
to increase in Malta, unlike the situation across the euro area, where widespread
deleveraging by financial institutions has led to a contraction in the volume of credit, as
shown in Chart 7.
The recent IMF report that I mentioned earlier noted the strong performance of Malta's
financial sector but also stressed the importance of strengthening the resilience of the sector.
The elevated levels of credit and concentration risks call for stronger financial buffers,
through higher provisioning and retention of profits. Such measures would strengthen the
banks' ability to absorb potential shocks and would also allow them to prepare themselves
for compliance with stricter Basel III regulatory requirements. On the positive side, credit risk
is being mitigated by prudent credit standards and cautious lending behaviour on the part of
the banks.
On the funding side, the resilience displayed by the banking system in the face of adverse
international conditions is explained by the business model that has been a traditional
characteristic of domestic banks, which rely strongly on retail deposits.
Another indication of the overall prudent bias of the Maltese domestic banks is evident in the
first chart presented earlier, which shows that leverage ratios of Maltese banks are
considerably lower than in euro area in general. While the euro area average has declined
on account of widespread deleveraging, the ratio remains significantly higher than the
Maltese ratio, which has been quite stable.
A further indication of the traditional funding model is the loan to deposit ratio, as shown in
Chart 8, which is significantly low when compared with the major economies.
This business model has served the domestic banking sector well. The traditional sources of
funding have proven to be very stable, including at a time of heightened tensions in the
international financial markets. While taking on the changes that are needed to remain
competitive and improve efficiency, the domestic banking sector must also continue to build
upon the strengths of the traditional model.
Among the many lessons that may be drawn from the experience of the international
financial crisis, one that stands out is the importance for each banking institution to keep a
prudent mix of dependable sources of funding, to limit the level of financial leverage and to
maintain a sound balance sheet.
Source: Central Bank of Malta; International Monetary Fund
Conclusion
In summary I would like to conclude by stressing the need for further efforts to maintain
international competitiveness and continued vigilance in the banking sector, in the context of
recurring uncertainty in international financial markets and in the world economy. With this in
mind, one has to acknowledge that although the relative performance of the Maltese
economy has been encouraging, the challenges ahead are to be treated seriously and with
caution.
A further lesson from recent experience is that fiscal prudence has to be a continuous
endeavour, especially in the light of the recent upward revisions in the public debt projections
for 2012 and 2013. Further fiscal consolidation becomes more challenging in an environment
of weak external demand. The choices that must be made between the various national
priorities have to be compatible with the economic and fiscal limits, and these limits can
become less constraining only through improved competitiveness and faster economic
growth.
Thank you for your attention