José Manuel González-Páramo: Globalisation, macroeconomic stability
and monetary policy at a time of financial turmoil
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the FCAVN Seminar on "Globalisation in the XXI Century:
Challenges and Dilemmas", San Sebastián, 5 September 2008.
* * *
1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to be here in San Sebastián and I would like to thank the
organisers - Federación de Cajas de Ahorros Vasco-Navarras and, in particular Mr Pedro
Martínez de Alegría Pinedo - for giving me the opportunity to participate in this Seminar,
which continues what is by now a long tradition started in 1991.
Like in the past, the organisers have challenged us by choosing a very important but rather
"difficult" subject: the challenges and dilemmas that the financial globalisation process poses
for policy-makers, economic agents and the society at large.
Financial globalisation has potentially very significant implications for the welfare of our
economies, as the experience of the turmoil in international financial markets over the last
year shows. It is therefore very important that we improve our understanding of how financial
globalisation is changing the structure of our economies and the way they work. Therefore,
we should congratulate the organisers for promoting a public debate on this issue. In my
intervention today, I will focus on the relationship between financial globalisation and the
market turmoil that we have experienced since last year, and some of the lessons that we
have learned.
I would also like to use this opportunity to share with you some considerations about the euro
area economy. Therefore, in my intervention I will briefly discuss the state and the outlook for
economic growth and inflation in the euro area and their implications for monetary policy.
2. Different dimensions of globalisation
Globalisation is a catch-all term used to describe the growing interdependence of the
international economy via trade, production and financial market linkages over recent
decades. A number of key indicators of globalisation compiled by academic researchers and
international organisations (e.g. the size of international capital markets, portfolio investment
and FDI, trade openness, international competition, etc.) show that the current wave of
globalisation gained momentum at around the beginning of the 1980s and significantly
accelerated in the course of the 1990s.1
Understanding globalisation is very important for central banks since globalisation may - via
a number of channels - affect key elements of the monetary policy framework, such as the
inflation formation process and the monetary transmission mechanism.2 In particular,
changes in the structure and workings of the economy prompted by globalisation may alter
the relative importance of the various transmission channels of monetary policy impulses.3
This is indeed one of the major challenges posed by globalisation, to recall the theme of this
seminar.
The theme of the seminar is also the dilemmas arising from globalisation. The President of
the Federal Reserve Bank of Dallas, Richard Fisher, once remarked that "One cannot make
monetary policy without being aware of the forces of globalization acting upon our
economy".4 Yet, we still know relatively little about how globalisation has affected our
economies. This is partly because the current wave of globalisation is still fairly new. Thus,
its impact on the structure of the economy may yet to emerge in the data or may be hard to
discern using analytical tools, such as econometric models, based on regularities drawn from
the study of a less globalised world. Besides, over the last few decades, our economies have
also undergone other structural changes (for instance, in the monetary policy regime) that
may render it difficult to disentangle the specific effect of globalisation from those of changes
elsewhere in the economy.
At the same time, even in a globalised world, inflation remains a monetary phenomenon in
the long run and central banks retain their key role and responsibility in preserving price
stability. If anything, the commitment of central banks to price stability becomes even more
necessary since a solid anchoring of inflation expectations at levels consistent with price
stability is essential in a rapidly changing global economy, where inflation dynamics can be
affected in various ways and adverse shocks are more easily and rapidly transmitted across
countries.
One of the main sources of changes to the global economy during the current wave of
globalisation has been the acceleration in financial integration across countries, particularly
since the second half of the 1990s. While some researchers often point out that the current
level of openness of international capital markets is still lower than that prevailing before
World War I, there is no doubt that we live in a world in which advances in financial and
communications technology combined with regulatory and institutional changes have led to
international capital markets and financial institutions becoming more closely interrelated
than ever in the past.5
Growing financial integration among countries and regional areas is a potential source of
benefits, notably due to enhanced opportunities for international risk sharing. Indeed,
financial globalisation may provide countries with instruments to hedge against idiosyncratic
shocks in order to better smooth consumption smoothing, thereby yielding significant welfare
gains. In addition, larger integration into the international financial system may contribute to
the efficient functioning of the entire economy by providing additional financing at a
reasonable cost to domestic agents, by facilitating the transfer of technology from abroad
and by stimulating the performance of the domestic financial sector.
However, financial globalisation may also entail some risks. Increased international financial
integration is likely to lead to a larger sensitivity to external spillovers. Under more extreme
circumstances, the experience of some developing countries suggests that increased
integration into international financial system, if not accompanied by the establishment of
high-quality institutional and regulatory frameworks as well as sound macroeconomic
policies, may make countries more vulnerable to episodes of financial and macroeconomic
instability.
3. The financial turmoil
The episode of financial market turmoil that we have experienced since August 2007
provides a good illustration of how, in a globalised economy, an idiosyncratic shock can be
propagated more rapidly and through a variety of new channels to seemingly distant
countries and markets. Indeed, the turmoil originated in a relatively small segment of the US
economy - the sub-prime segment of the mortgage market - that has no obvious relationship
with the Eurosystem's sphere of interest. Yet, its quick propagation caused an increase in
volatility and a decline in liquidity in a variety of markets all around the world, including the
euro area market for inter-bank unsecured loans that represents a key component of the
money market and the starting point of the area-wide monetary transmission mechanism.
The decrease in liquidity was most obvious for the markets directly related to the core of the
current turmoil, namely the market for sub-prime mortgage-backed securities (MBSs).
However, since the start of the turmoil problems of illiquidity have spread further, affecting
other asset-backed securities (ABSs), asset-backed commercial paper (ABCP), and basically
all structured credit instruments, such as collateralised debt obligations (CDOs). Also the
liquidity in the secured non-government repurchase agreement (repo) markets was heavily
impacted, as many banks no longer wanted to accept the types of securities mentioned
above (MBSs, ABSs at large, and CDOs) as underlying collateral in repo transactions.
Another market segment that saw a partial (temporarily, even severe) deterioration of
liquidity conditions is the foreign exchange swap market, which is very important for banks
managing liquidity in different currencies. Occasionally, poor liquidity conditions have been
reported even in markets for securities historically regarded as very liquid and safe, such as
the market for bank covered bonds or, even, the government bonds of some developed
economies.
To understand, at least partly, how the disturbances in a fairly domestic-oriented part of the
US economy - a small segment of its housing market - could have spread across borders,
financial markets and institutions all around the world, we must bear in mind the increasing
importance of credit securitisation and the emergence of credit derivatives in global financial
markets. Credit securitisation essentially means to convert highly illiquid loans into liquid and
tradable securities that can be sold to investors. While the origination of bank loans remains
to a large extent level, financial globalisation has made the related securities available to
investors worldwide.
Some scholars have nevertheless challenged the recurrent claim that the current turmoil is
unprecedented.6 Indeed, past financial disturbances and crises have often had an
international dimension and cross-border financial contagion is certainly "no new thing under
the sun". However, a number of factors, including its speed of transmission and scope, set
the current episode of turmoil apart from previous experiences.
4. Policy responses
Let me briefly elaborate on the actions taken by the ECB to address the financial market
turbulences. In both "normal" and "turbulent" times, the primary objective of the Eurosystem's
open market operations is to keep the overnight rate as close as possible to the policy rate.
However, during the recent period of turbulence, open market operations have aimed also at
ensuring the continued access of solvent banks to liquidity, notably by contributing to
smoothening the impaired functioning of the money market. By doing so, the ECB has
intended to contribute to re-establishing confidence among market participants and to
safeguarding financial stability and the appropriate functioning of the monetary policy
transmission mechanism.
From the very first day of the financial market turmoil, in an environment of increased liquidity
risk and in response to banks' changed liquidity demand pattern, the ECB has achieved
these objectives in two different ways.
First, the Eurosystem has adjusted the distribution of liquidity supplied over the course of the
maintenance period, by frontloading the supply of liquidity at the beginning of the period and
reducing it later, so that the total amount of liquidity over an entire maintenance period has
remained unchanged.
Second, during the turmoil the Eurosystem has applied different open market procedures to
supply liquidity to the banking system. More specifically, the use of fine-tuning operations has
been more frequent than in "normal times" because of the unpredictability of liquidity
demand. In addition, the amount of refinancing provided via longer-term refinancing
operations with 3-month duration and, since April 2008, also with 6-month maturity has
increased significantly with a view to maintaining smooth conditions in the term money
market. At the same time, the amount of refinancing provided via the one-week main
refinancing operations has been reduced correspondingly, so that the total amount of
outstanding refinancing has remained unchanged.
Given the global nature of the financial turmoil, central banks have strengthened their
cooperation, first through enhanced information exchange and collective monitoring of
market developments and later on by coordinated steps to provide liquidity. Since December
2007, the ECB has, in cooperation with the US Federal Reserve and together with the Swiss
National Bank, been conducting several term auction facilities - the so-called TAF-operations
- to provide USD liquidity to euro area banks. In practice, through these operations the ECB
grants loans in USD to euro area banks, on behalf of the US Fed, with a maturity of 28 days
and, since August 2008, also of 84 days. These liquidity-providing operations do not have a
direct effect on euro liquidity conditions, but are conducted to address the availability of US
dollar funding for euro area banks and aim at improving global funding conditions.
As regards other central banks, in general their primary response to the market turmoil has
been to intervene to keep short-term money market rates near target rates, through more
active liquidity management. Moreover, central banks have aimed to ease the increasing
pressure in term money markets by: (1) increasing the viability of standing loan facilities as
backstop funding options; (2) boosting the share of longer-term operations in total refinancing
provided to banks; (3) expanding the range of acceptable collateral and eligible
counterparties, in those countries where it was needed; and (4) establishing security lending
facilities.7
4. Lessons from the turmoil
Whilst it is too early to make a definitive assessment, certain supervisory, regulatory and
operational issues can already be identified as warranting further attention or action.
Initiatives are already underway at the international and EU level to address these various
issues. Let me highlight some of them.
4.1 Lessons for supervisors and regulators
The recent episode of financial turmoil has reminded us that financial globalisation makes the
safeguarding of financial stability a more interdependent task, requiring effective coordinated
international action aimed at addressing financial system vulnerabilities.
Against this background, both the public and the private sector have undertaken a major
collective effort to identify measures needed to strengthen the resilience of the domestic and
international financial systems in the longer term in order to avoid the recurrence of similar
events in the future.
Particularly important in this respect is the report of the Financial Stability Forum (FSF) on
"Enhancing Market and Institutional Resilience" that has been fully endorsed by the
international community and acts as the main reference for the necessary improvements. In
this context, let me briefly recall some of the key areas in which the report has identified
room for improvement: (i) some aspects of the prudential framework, relating to capital and
liquidity risk as well as to banks' liquidity risk management practices; (ii) transparency,
including full disclosure of banks' exposures on structured products and off-balance sheet
vehicles; (iii) valuation standards, especially as regards marking-to-market illiquid assets; (iv)
market functioning, including possible conflicts of interest of credit rating agencies and their
role in rating structured finance instruments; and (v) authorities' responsiveness to risks and
arrangements for crisis management.
Having identified the main areas for intervention, the key issue is now to ensure the rapid
and effective implementation of the respective recommendations in the FSF report. In
particular, the short-term measures put forward by the FSF and endorsed by the G7 in April
this year represent immediate priorities and thus a time horizon of 100 days for their
implementation has been set. While a more thorough review of the progress in the
implementation of these recommendations is due for the G7 meeting in October, the results
of a preliminary assessment is encouraging. Indeed, progress has been observed in a
number of areas identified as requiring immediate action.
In addition, the recent market correction has exposed a number of more structural
weaknesses of the financial system that represent medium-term priorities for policy work.
Some of the topics of critical importance from a central banking perspective include: (1) to
ensure adequate transparency regarding financial markets, institutions and financial
instruments; (2) the effective and timely implementation of the new Basel II framework, after
revising detected shortcomings (for instance related to any pro-cyclical features of the
regulatory framework); (3) the growing importance and complexity of liquidity risk in more
market-based financial systems; (4) the enhancement of institutional arrangements for
crossborder cooperation among authorities, both at times of financial stress and in normal times.
Finally, I would like to highlight the importance of improving cooperation and the exchange of
information between supervisory authorities and central banks on financial stability issues.
The recent financial market turmoil has confirmed the importance of a smooth and efficient
relationship between the central banking and supervisory functions. In financial stress
situations, supervisory information remains essential for the effectiveness of the central
bank's financial stability assessments. Conversely, supervisors should benefit from the
systemic perspective of central banks when considering their actions vis-à-vis individual
institutions. This is the rationale behind the specific FSF recommendation to enhance the
interplay between central banks and supervisory authorities.
4.2 Lessons for the operational frameworks
The ability of the Eurosystem to respond to the challenges for monetary policy
implementation posed by the recent period of financial market volatility has to a large extent
depended on its collateral framework. Thanks to the broad range of assets eligible as
collateral - together with the large number of counterparties and the large size of its
refinancing operations - the Eurosystem has been able to step in effectively when
intermediation in inter-bank markets deteriorated, without the need to make changes to its
framework.
As a side effect of the broad range of assets accepted as collateral, the framework helped us
also during the turmoil to address liquidity squeezes in some markets, including the ABS
market, as it mitigated refinancing risks for asset classes that had become illiquid. This has
contributed to financial stability in the euro area. Other central banks may have had those
effects in mind when they initiated changes to their operational framework in the wake of the
turmoil, leading to a significant degree of convergence among the various frameworks.
Of course, the ability of the Eurosystem's operational framework to respond to the challenges
for monetary policy implementation posed by the recent period of financial market volatility
does not mean that there is no scope for further improvements and refinements to make it
even more effective. Regarding this point, the ECB yesterday announced some technical
refinements to its risk control framework for Eurosystem credit operations. These are the
result of a regular review of the framework, conducted on a biennial basis with the objective
of identifying possible improvements and ensuring that the Eurosystem remains adequately
protected against financial risks in the face of changes in financial markets and collateral use
practices.
The announced refinements are as follows:
First, some revisions are being introduced to the haircuts for credit institution debt
instruments and asset-backed securities. The first are increased by 5%, across all maturities,
while the haircut schedule for ABS is replaced by a unique haircut of 12% for all maturities
and coupon types. In addition, a valuation markdown of 5% is imposed on those ABS that
are priced theoretically.
Second, the ECB has extended the definition of "close links" between counterparty and
collateral. As you may know, the existence of such links, which are currently defined only in
terms of cross ownership of capital, would prevent a counterparty from using that collateral.
With the announced change, "close links", are extended to situations in which a counterparty
submits an ABS as collateral when it provides support to that ABS. Such support should not
be in the form of extensive liquidity support or in the form of a currency hedge.
Finally, we have placed more weight on the transparency of the credit assessments by
ratings agencies. Such assessments should be based on a public rating and, for ABSs,
publicly available credit-rating reports and quarterly rating reviews would be required.
These changes were deemed necessary as they reflect improvements in the methodological
framework, the assessment of market and liquidity risk characteristics of eligible assets, the
actual use of eligible assets by counterparties, and new developments in financial
instruments.
5. Monetary policy
The continuation of the financial market turbulences has increased the uncertainty
surrounding not only the implementation of monetary policy but also its formulation. Let me
now turn to our current assessment of the monetary policy stance. I should start by stressing
that, also in an increasingly globalised world, inflation is fundamentally and over the long
term a monetary phenomenon. Despite the many challenges which we face daily, euro area
monetary policy must remain focused on delivering price stability in the medium term, which
is essential for the efficient working of markets and the optimal allocation of resources.
Looking at the current inflation performance, there is no reason to be satisfied. Annual HICP
inflation has remained well above levels consistent with price stability since last autumn. This
is largely due to both the direct and the indirect effects of the sharp increases in commodity
prices, particularly oil and food prices, observed in recent quarters.
The inflation outlook is also a source of major concern. HICP inflation is expected to remain
above levels consistent with the ECB's quantitative definition of price stability for a rather
protracted period of time, and to moderate only in the course of next year. Consistent with
this outlook, the latest ECB Staff projections, released yesterday, show that annual HICP
inflation is expected to average between 3.4% and 3.6% in 2008, and between 2.3% and
2.9% next year. Projections from international organisations and private sector forecasters
depict a similar picture.
At our meeting yesterday, the members of the Governing Council concurred that risks to
price stability at the policy-relevant horizon remain on the upside. These risks mainly relate to
possible further increases in commodity prices or to the delayed effects of past price
increases. Besides, the possible emergence of broad-based second-round effects in price
and wage setting behaviour represents a source of acute concern. In addition, unanticipated
increases in indirect taxes and administered prices may aggravate the outlook for inflation.
In the current context of strong inflationary pressures, it is essential to maintain longer-term
inflation expectations solidly anchored at levels consistent with price stability and to avoid
that the current inflation rates become entrenched in private sector inflation expectations.
This is not only the task of the central bank. All parties, in both the private and the public
sector, can give a key contribution to maintaining price stability by abstaining from any
practices that may fuel broad-based second-round effects. In this sense, it is particularly
important that all parties concerned agree to abolish indexation schemes for nominal wages
in those countries where they still exist. Under the illusory pretence of preserving the
purchasing power of workers, these schemes risk turning temporary price shocks into
devastating inflationary wage-price spirals that ultimately undermine employment and
competitiveness to the detriment of those whom the schemes are supposed to protect.
Let me also briefly recall the Governing Council's current assessment of economic activity in
the euro area. The latest data indicate that, after recording a 0.2% decline on a quarterly
basis in the second quarter of 2008, the euro area economy is currently experiencing a
period of weak activity, reflecting the dampening impact of both domestic and external
factors. Nevertheless, we expect the current episode of weakness to be followed by a period
of gradual recovery. Consistent with this scenario, the ECB Staff projects average real GDP
growth to between 1.1% and 1.7% in 2008, and between 0.6% and 1.8% next year.
However, the uncertainty surrounding the outlook for growth in 2008 and 2009 is particularly
high, with risks predominantly on the downside. These downside risks mainly stem from
further unanticipated increases in energy and food prices, the continuing possibility that the
financial turmoil may have a more severe impact on the real economy than currently
anticipated, the potential for disorderly developments stemming from persisting global
imbalances and increasing protectionist pressures.
The monetary analysis has continued to confirm our view of prevailing upside risks to price
stability at medium to longer horizons. Although the growth of euro area broad monetary and
credit aggregates has recently moderated, the continued underlying strength of monetary
expansion signals the existence of upside risks to price stability over the medium term.
On the basis of its economic and monetary analyses, the Governing Council decided
yesterday to leave the ECB's key policy rate (the minimum bid rate of its main refinancing
operations) unchanged at 4.25%. It is our view that the current monetary policy stance will
contribute to achieving our primary objective of maintaining price stability in the medium
term.
The public at large should be confident that the members of the Governing Council are
resolutely determined to do whatever it will be necessary to fulfil the ECB's mandate of
delivering price stability in the medium term and to maintain expectations firmly anchored at
levels consistent with price stability. This is the best contribution that the ECB can provide in
order to preserve the purchasing power of citizens over the medium term and to support
sustainable growth and employment in the euro area.
Many thanks for your attention.