Peter Praet: Reforms and growth in the euro area
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Panel intervention "Fixing finance", The Economist's Lisbon Summit, Lisbon, 18 February
2014.
* * *
It is a great pleasure to be in Portugal today, where we are now seeing signs of a
stabilisation in the economy. Economic activity is recovering, the unemployment rate is falling
- although from very high levels - and the current account is in surplus. While it will take
years for the scars left by the crisis on the economy and society to fade, confidence has
been steadily improving during the recent months. Real GDP has been growing at positive
rates since the second quarter of 2013 and the most recent information from industrial
production, sales, and merchandise trade confirm that this trend is continuing.
Other euro area countries that have been hit hard by the crisis are also now beginning down
the recovery path, while financial markets have started a more benign pricing of sovereign
and private credit risk. All this is thanks to the progress that has been made in
macroeconomic, structural and financial repair since the onset of the financial crisis.
Especially since mid-2010, the start of the sovereign debt crisis, decisive action has been
taken at national and European levels.
In the first part of my remarks today, I would like to give an overview of the key measures
that have been taken in response to the crisis. My focus will be on the role played by the
ECB. Monetary policy has been critical to averting a more severe economic calamity.
But the ECB has also made a wider contribution: we have contributed actively to the debate
on the deepening of EMU and we have promoted progress toward the euro area's new
financial architecture, the Banking Union.
This work of strengthening the euro area is not complete, however. And this is where I would
like to focus the second part of my intervention. Specifically, I would like to ask: what further
steps are needed to embark on a path of robust growth, both in stressed and non-stressed
economies?
We know that achieving high sustainable growth will be indispensable to bring the
unemployment rate back to acceptable levels and to support debt sustainability. But for this
to happen, the euro area as a whole will need to persevere in its efforts to reform its
economic fabric. The process of structural reform is demanding - and it therefore requires
long-term commitment and strong ownership to be a success.
The starting point: the debt crisis and the emergence of financial fragmentation
Let me start by briefly reviewing the evolution of the crisis in the euro area.
Very broadly speaking, the crisis has had two main phases. The first phase began with the
bankruptcy filing of Lehman Brothers in September 2008. Here the euro area shared in a
global liquidity crunch that was largely imported from abroad. The second phase began in
May 2010 with a sovereign crisis that was localised in the euro area, and that was partially
exported to the world economy. This second phase was arguably the more pernicious for
monetary union.
The re-pricing of sovereign risk in the euro area spread from Greece to other vulnerable
economies, and from sovereign to private debt and vice versa. In the process, the liquidity
crunch morphed into a systemic crisis for the banking sectors of a number of member
countries, and for the integrity of monetary union as a whole. The traditional exposure of
banks in vulnerable countries to their own sovereign issuers became a quick carrier of
financial contagion as their sovereign bond holdings depreciated and eroded their capital in
the eyes of creditors.
This adverse sovereign-bank feedback loop interacted with existing vulnerabilities. Countries
with persistent competitiveness losses and associated large current account deficits - as
was the case of Portugal - were particularly sensitive to a reversal in external financing. This
was exacerbated by capital flight to core economies which started to deplete banks' deposits
in the most vulnerable countries. Concerns that systemic sovereign issuers may lose market
access fed fears that they may be forced to redeem their liabilities in a currency different
from the euro, and thus de facto leave the euro area. "Redenomination fears" became a new
source of market anxiety. There was a risk that such unwarranted concerns would become
self-fulfilling and the spectre of destructive tail scenarios was looming.
In this context, the process of financial integration, which had evolved at a rapid pace since
the inception of the euro, was partially reversed, giving way to fragmentation. Interbank
financial fragmentation per se was not a new phenomenon in the post-Lehman world.
However, during the most severe stages of the sovereign crisis the fractures across the euro
area were not idiosyncratic but systemic - that is, they ran along national borders. This
reversal of the integration process risked undoing one of the key benefits of the common
currency.
Fragmentation led to an impairment of the monetary policy transmission mechanism. The
monetary impulse that the ECB had swiftly introduced in response to the rising risks to price
stability was no longer transmitted uniformly throughout the entire euro area. While the ECB
had brought its official policy interest rates to historical lows, a number of countries were not
in a position to take advantage of monetary accommodation. Banks in those countries were
tightening credit conditions, running against the monetary policy intentions of the central
bank, with negative repercussions on access to finance, in particular for small and
mediumsized enterprises. This translated into a drag on the economic recovery.
As a result, the singleness of monetary policy was no longer ensured, posing significant
challenges to the ECB's policy conduct.
Fixing the monetary transmission mechanism and the elimination of tail risks
The ECB responded forcefully to these challenges with a number of standard and
nonstandard monetary policy measures. The main purpose of the non-standard measures was
to reduce financial fragmentation and restore an appropriate functioning of its monetary
policy across the euro area. In particular, the measures were geared towards removing two
sources of risk premia: bank funding risks and redenomination fears.
Higher funding risks for banks had been a symptom of the crisis ever since liquidity strains
had first emerged, almost overnight, in the summer of 2007. They had escalated to systemic
proportions after the Lehman demise.
Since the onset of the crisis, the ECB's mainstay response to this problem has been twofold:
a policy of unlimited provision of liquidity at fixed interest rates against eligible collateral in
the weekly main refinancing and longer-term operations, and an extension of maturity of the
liquidity operations from 3 months to up to 3 years. This dual approach to crisis management
has been reinforced by two further initiatives.
First, collateral rules have been adapted in various stages with a view to broadening the pool
of assets that banks could mobilise for Eurosystem liquidity provision. This process - which
has complemented the fixed-rate-full-allotment decision - has always balanced the need to
be supportive to our counterparties with the goal of exercising an appropriate degree of risk
control, and to protect our balance sheet. Incidentally, Portuguese banks have greatly
benefited from these measures. For instance, they were able to strengthen collateral buffers
by mobilising additional credit claims for the purpose of obtaining Eurosystem liquidity - and
more effectively than other banking systems in the euro area.
Second, the refinancing risk faced by euro area banks has been minimised by giving them
reassurance that monetary policy will remain accommodative for an extended period of time.
In the course of 2013, this reassurance has taken two forms: conditional forward guidance on
the level and direction of our policy rates in the future, and a pledge to maintain the
fixedrate-with-full-allotment policy for as long as needed and at least until mid-2015.
These measures proved powerful in addressing the funding risk faced by our counterparties
throughout the crisis, as evidenced, for example, by the significant decline in money market
term premia.
Addressing redenomination fear premia, however, is more alien to central banks, and
therefore required a new approach. The Outright Monetary Transactions (OMT) initiative was
the innovative instrument that we deployed to remove break-up fears from the market pricing
of sovereign credit risk, and promote more regular financial conditions. The initiative proved
an extremely effective instrument. It has not only reduced the fraction of sovereign spreads
that reflected compensation for the redenomination fears, but also contributed more
generally to the improvement in funding conditions for corporates, banks and individuals
across the euro area.
In sum, non-standard measures by the ECB have helped ease liquidity pressures for the
euro area in general, and continue to play a pivotal role in alleviating funding constraints for
Portuguese banks in particular. And we have seen consistent signs that banks in Portugal -
again, more visibly than within other stressed countries - are starting to pass the easing
stimulus onto their customers, that is, to firms and households.
Fixing the euro area economic and financial system
These monetary policy measures would have been less effective, had they not been flanked
by a serious drive toward financial reform. The key element of this ambitious reform agenda
has been the Banking Union. It is probably the most ambitious and encompassing reform of
the EU architecture since the institution of the single currency. The successful completion of
the Banking Union should help to address bank funding fragmentation in a more structural
way and give concrete support to credit supply conditions throughout the euro area.
Let me explain why.
With the creation of the Single Supervisory Mechanism (SSM) centred on the ECB, banks
will be subject to a homogeneous set of rules and procedures. This will make the standards
for prudential supervision in the euro area more comparable and evenly applied. As a
consequence, supervision should act as a source of integration rather than - as often was
the case in the past - an additional cause of fragmentation. But some preliminary steps are
needed before the SSM can operate in full. The first and most important precondition is full
information about the balance sheets of the euro area banking sector. This is why much of
2014 will be devoted to a comprehensive assessment of the conditions of our banking sector.
The Asset Quality Review (AQR) is a central building block in this assessment and a
precondition to restore confidence in the banking system of the euro area. Transparency
about banks' balance sheets will help revive private investors' interest in maintaining and
increasing exposures to euro area banks. Indeed, expectations of a serious comprehensive
assessment have already reinforced the positive trend in the financial markets. Looking
forward, the strengthening of bank funding positions - both on the equity and on the debt
side - that will result from the exercise will help support credit provision to productive sectors
with clear benefits for economic growth in the euro area.
The ECB is therefore also playing a role in the repair of the financial sector through its new
supervisory function. However, there are clear limits to what the ECB can and should do.
These limits are defined by the ECB mandate as enshrined in the Treaty. In that respect, the
strict separation between monetary and supervisory functions is instrumental in safeguarding
against potential conflicts of interest between these two functions.
Moreover, finishing the repair process requires actions in other policy areas. At the European
level, the most pressing is to complete the Banking Union. An effective Single Resolution
Mechanism is particularly important, as it will further reduce the sovereign-bank nexus and
thus work towards the elimination of fragmentation across national borders.
But fixing the financial system is not a sufficient condition for economy recovery. Healthy
banks can better intermediate between those who save and those who want to invest, and
are thereby necessary for future growth. Yet, proper framework conditions need to be in
place so that the right incentives to invest exist. For example, it is important that firms can
flexibly adjust to changing economic conditions, and that excessive rents in sheltered sectors
do not distort the allocation of capital. Creating such framework conditions is largely the
responsibility of national policies. Let me therefore now turn to the national dimension of the
reform process.
Improving sustainability and growth
At the time of the sovereign crisis, the most pressing preoccupation of national governments
was to repair public finances and restore the trust of financial markets. Therefore, fiscal
consolidation was necessarily their first priority, and the national reactions in this domain
were both forceful and effective.
Let me remind you of some key facts.
Between 2010 and 2013 Greece, Ireland, Portugal and Cyprus requested financial
assistance from the EU and the IMF. These programmes involved far-reaching economic
and financial policy adjustments. Other countries that had been hit by a confidence crisis,
such as Spain and Italy, chose to undertake similar corrections. Spain also requested ESM
programme for its financial sector.
As a result, structural fiscal balances (i.e. fiscal balances excluding the impact of the cycle
and one-off costs) improved significantly in all these countries. From 2010 to 2013 this
improvement was equal to about 15 percentage points in Greece, 6.5 percentage points in
Portugal, 6.0 percentage points in Spain, 5.5 percentage points in Ireland and
4.0 percentage points in Italy. Some of these adjustments are unparalleled in scale from a
historical perspective.
These fiscal corrections took place at a time when confidence had reached its lowest level,
private sector saving ratios were sharply increasing, banks had to deleverage and access to
finance by firms and households was impaired. The short-term costs in economic and social
terms were therefore high.
Yet, those costs were also elevated by the fact that most of the stressed countries had
entered the crisis with rigid institutions and economic structures. As a consequence, the
necessary adjustment of prices and costs to restore competitiveness was slow, which
exacerbated the negative impact on activity. Nominal rigidities increased the real cost of the
adjustment and the burden has often been borne by the more vulnerable members of
society.
A key complement to fiscal adjustment has therefore been structural reform. In several
countries a series of bold structural reforms have been implemented. In Portugal in
particular, the reform agenda has been broad-based and far-reaching. It has included public
administration, health and pension systems, education, judicial systems, competition
frameworks, industrial relations, labour markets, energy markets, network industries,
services sectors and regulated professions.
Some concrete examples of structural reforms
The overall approach to structural reforms in stressed countries has been to proceed in a
comprehensive manner. This is not only because certain reforms are mutually
complementary - for example, the competitiveness benefits of a labour market reform may
not materialise without accompanying product market reforms, as wages adjust but prices do
not - but also because an encompassing approach ensures that the burden of reform is
spread more fairly across society.
However, implementation obstacles to this approach have been significantly higher than
initially expected. In general, it has been easier to change institutions and rules in the labour
market than in product markets; it has been easier to change rules for "outsiders" than
denting the vested interests of established "insiders"; and it has been easier to increase
taxes rather than cutting expenditure. While these difficulties are in many cases gradually
being overcome, the process is far for completed. Still, one should not underestimate the
achievements so far.
Let me give you a few examples:
Looking at a well-established summary indicator of employment protection, the OECD index,
Portugal, Spain and Greece have recorded notable improvements in 2013. In these three
countries labour market institutions are currently assessed to be more flexible than in
Luxembourg, Italy, France, Germany, Belgium and the Netherlands. This should help
achieve a balance of employment protection that gives both stability - encouraging workers
to invest in firm-specific skills - and mobility - allowing for reallocation between productive
and non-productive sectors.1
These same countries have also introduced several measures to help connect wage levels
more closely with actual productivity developments. The link between collective bargaining
and economic conditions has been strengthened by the possibility for more firm-level
agreements. In Greece, wage floors have been significantly reduced to boost youth
employment creation; in Portugal, they have been frozen and overtime pay considerably
reduced. Wage indexation has become less prominent in Spain and in Cyprus it has been
abolished.
In all these countries the labour market reforms have started to have an impact on private
sector wages. Private sector compensation per employee has fallen significantly in Greece
since 2011, correcting what was an unsustainable increase prior to crisis, and it has also
started to adjust in Spain, Portugal and Cyprus in 2012-13. I fully recognise the difficulties
this process creates, yet this has to be set against the need for wages to adjust to reduce
unemployment and restore external competitiveness. We are expecting that that these
positive effects will dominate going forward and help employment to begin recovering in the
near future.
In parallel, all programme countries have strengthened their active labour market policies,
including by fostering traineeship programmes and dual-apprenticeship systems, also with
the support of EU funds. This is important, as having an adequate social safety net and job
search and retraining programmes can reduce unemployment duration and so lower the
long-term costs of an adjustment phase. There is also a fairness dimension: we should not
forget that some citizens paid high entry costs to enter previously closed professions, for
example by purchasing expensive licences, and may now need help transitioning to new
employment.
Product market reforms have generally aimed at improving competition in network industries
- energy, telecommunication, transport - and highly regulated professions, as well as
reducing administrative (licencing) burdens to wholesale and retail trade and provisions of
services. Such reforms have tended to face greater implementation obstacles than labour
market measures, partly owing to the micro or sector-specific dimension of the reform needs.
This has required policymakers to confront more concentrated opposition from vested
interests within the sector that is subject to reform.
However, among programme countries, Portugal has some impressive achievements to
show in terms improving product market functioning and economic framework conditions.
These have included the change of competition law and the regulatory framework, the reform
of the judicial system, and the reform of regulated professions and of the housing market.
Finally, programme targets for privatisation were achieved ahead of time.
Structural reforms need a long-term commitment
As I said at the start of my remarks, an improvement of the underlying prospects for these
economies has moved expectations. Perceptions about the sustainability of the recovery
path in Portugal, in particular, have been reflected in persistent improvements in confidence
and associated reductions in risk premia. Over time the economic and social pay-offs of
reforms will be high, in terms of higher wealth and employment. High and sustainable GDP
growth will in turn bring about improvements in fiscal positions and sizeable reductions in
debt-to-GDP ratios in the medium to long-run, contributing therefore to long-term debt
sustainability.
However, to reap these benefits implies a long-term commitment. The reform process is a
continuum. A reform that has just been legislated does nothing for the citizens of a country, if
it is not followed-up with effective implementation. Making sure that reforms transfer from the
statute book to the real economy requires painstaking monitoring, as well as a prompt
reaction in case outcomes deviate from expectations. When countries exit adjustment
programmes, such an orientation will help prove to markets that reforms have been
undertaken not only due to external pressure, but also out of a genuine recognition of their
benefits. This is the best way to ensure sustainable market access supported by a robust
growth outlook.
Recent empirical estimates based on the distance-to-frontier approach show the gains that
could still be achieved. In Portugal, closing the gap from best practices via a fast
implementation of product, labour and welfare state reforms would lead to an increase in
percapita GDP by 13.5% in 10 years.2 In these projections, not only the pace of implementation
matters, but also the degree of ambitiousness. If reforms target only a partial closure of the
gap vis-à-vis the best performers then of course the GDP gains will also be reduced.
All this points to the need to establish a clear link between notional reforms and actual
outcomes via an outcome-based accountability framework, which can increase or make
more effective the implementation process.
The need for structural reforms in all euro area countries
Despite difficulties, the impetus for reform has been strong in the stressed countries, while it
has been much weaker in the rest of the euro area. This is the natural outcome of a
crisisdriven reform process. However, the crisis has clearly shown that a strategy of postponing
reforms is self-defeating, as it contributed to the accumulation of imbalances and
vulnerabilities in good times and increased the cost of adjustment in bad times.
It is therefore crucial that the reform process is strengthened in all euro area countries, also
those not affected by the crisis. Research has shown that undertaking coordinated reforms in
all countries can boost GDP more than in a situation where each country acts alone.3 A more
widespread approach to reforms in all euro area countries can therefore contribute to a
stronger recovery in the stressed countries and in the euro area as a whole, through positive
supply and demand effects.
Conclusions
Let me conclude.
The euro area has come a long way in addressing its problems. The progress that has been
made is remarkable and covers a wide range of areas and actors. The ECB has been central
in stabilising the euro area economy, smoothing the adjustment process of the stressed
countries and restoring the proper functioning of the monetary transmission channel. At the
supra-national level, EU governance has been strengthened and, in particular, the Banking
Union is being established. And at national level, progress is ongoing towards restoring fiscal
soundness and driving forward structural reforms.
The pay-off from these reforms is becoming increasingly visible: in 2013, we already saw
signs of a turnaround in most euro area countries. In Portugal, real GDP has started its
recovery path, fiscal developments have been positive and the unemployment rate has
started to fall. And consumer and business confidence has been on an upward trend for
many months. A similar improvement in confidence has also occurred in other countries that
had been affected by the crisis. Expectations regarding incomes and employment are
steadily being upgraded. This is a sign that households and firms are starting to internalise
the benefits of the reforms implemented so far.
Looking ahead, the task of all euro area policymakers is to ensure that the improvement in
confidence will be validated by actual outcomes. If implementation of structural reforms is
pursued ambitiously and the reform momentum upheld, it seems likely that growth will
surprise on the upside in the coming years.