Lucas Papademos: European Central Bank's Annual Report 2007
Introductory statement by Mr Lucas Papademos, Vice-President of the European Central
Bank, to the Committee on Economic and Monetary Affairs of the European Parliament,
Strasbourg, 21 April 2008.
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Madam Chair,
Honourable members of the Committee on Economic and Monetary Affairs,
It is a great pleasure and privilege to present to you today the ECB's Annual Report 2007.
This presentation is a key pillar of the ECB's accountability relationship with the European
Parliament. In my introductory statement, I will first review economic and monetary
developments in 2007, summarise our current assessment of the macroeconomic outlook,
and explain our monetary policy decisions and operations. I will then briefly address fiscal
policies and structural reforms. Finally, I will focus on financial market conditions and
prospects and will conclude by discussing envisaged policy measures aimed at restoring
confidence and strengthening the resilience of the financial system.
Before doing so, I would like to highlight an important event: the third enlargement of the
euro area with the adoption of the euro by Cyprus and Malta on 1 January 2008. Thanks to
the meticulous preparations of all parties concerned, the changeover to the euro was very
smooth and efficient in both countries. The single currency was received with great
enthusiasm by the Cypriot and Maltese people and we warmly welcome them to the euro
area.
Economic and monetary developments
2007 was a very good year for the euro area in terms of economic activity. Real GDP grew
by 2.7%, mainly driven by domestic demand. Euro area exports also benefited from strong,
albeit moderating, global growth. However, in the second half of 2007, the outlook for
economic activity was clouded by unusually high uncertainty, stemming from the difficulty of
ascertaining the potential impact on the real economy of the financial turmoil that erupted in
August 2007. The balance of risks to the growth outlook tilted to the downside.
With regard to inflation, the year 2007 was characterised by a number of challenges. In the
euro area, average annual HICP inflation last year was 2.1%, that is, slightly above the
ECB's definition of price stability. However, in the last quarter of the year, annual inflation
rates rose sharply, reaching a peak of 3.1%, driven largely by substantial increases in oil and
food prices. Notwithstanding these price shocks, wage growth remained moderate and
medium to longer-term inflation expectations firmly anchored at levels consistent with price
stability. Nevertheless, risks to price stability over the medium term were clearly on the
upside in 2007 in view of the potential adverse impact of several factors, particularly possible
rises in commodity prices and the likelihood of second-round effects on the wage and
pricesetting.
Money and credit expansion remained very vigorous throughout 2007. In particular, bank
loans to non-financial corporations continued to grow at a robust pace in the second half of
the year, largely unaffected by the financial turmoil. The analysis of these developments
confirmed the Governing Council's assessment that upside risks to price stability prevailed.
To contain upside risks to price stability, the Governing Council raised the key ECB interest
rates by a total of 50 basis points in the first half of 2007, to 4%. Since the summer, the
Governing Council has kept the key ECB interest rates unchanged, in view of the unusually
high uncertainty surrounding the macroeconomic outlook as a result of the financial turmoil.
The latest information and analysis clearly confirm the Governing Council's assessment that
upside risks to price stability prevail over the medium term. Most importantly, there is a risk
that the current temporarily high annual inflation rates, which may persist for a rather
protracted period of time, could have second-round effects on wage and price-setting, in a
context of moderating but ongoing economic growth and continuing very vigorous money and
credit expansion.
Although global economic growth is moderating this year, it is expected to continue to
support euro area external demand, partly as a consequence of strong growth in emerging
market economies. Both investment and consumption should continue to contribute to
economic expansion as profitability has been sustained, credit growth remains robust and
employment conditions have improved. At the same time, this outlook for growth is
surrounded by unusually high uncertainty and downside risks, stemming in particular from
continuing financial market tensions, which may last longer than initially expected, from
further unanticipated rises in oil and food prices, which may dampen aggregate demand, and
from protectionist pressures.
Against this background, the Governing Council believes that the current monetary policy
stance will contribute to achieving price stability. As we have stressed, the firm anchoring of
medium to longer-term inflation expectations is of the highest priority to the Governing
Council. We remain strongly committed to preventing second-round effects and the
materialisation of upside risks to price stability over the medium term. Especially in a period
of heightened financial market volatility, such as the one we are experiencing at present, the
ECB's solid commitment to do what is necessary to preserve price stability over the medium
term can help to establish an environment of greater certainty for economic agents. Equally,
our manifest dedication to be active in the money markets when required to ensure their
orderly functioning can contribute to instilling confidence and dealing with stress in financial
markets.
Monetary policy and liquidity management
The Eurosystem has clearly distinguished between its decisions determining the monetary
policy stance to maintain price stability and its money market operations conducted in order
to implement this stance and provide liquidity to relieve pressures in interbank money
markets.
Three features of the Eurosystem's operational framework have been essential in supporting
the functioning of the euro area money market. First, a large set of counterparties has access
to the Eurosystem's refinancing operations. Second, a wide range of high-quality collateral is
eligible for Eurosystem operations. Third, the operations are of sufficient size to effectively
facilitate the redistribution of liquidity among banks.
The Eurosystem's operational framework has proved sufficiently flexible and effective in
dealing with the money market tensions caused by the financial market turmoil. The ECB has
adjusted the distribution of liquidity over the reserve maintenance period, without, however,
modifying the total average supply of bank reserves over the whole maintenance period. The
ECB has also conducted fine-tuning operations more frequently and lengthened the average
maturity of its open market operations. All these measures have allowed the ECB to keep
very short-term interest rates close to the policy rate and to contain potential spillover effects
to other segments of the financial markets and the real economy. In this way, the ECB has
contributed to safeguarding financial system stability and to mitigating macroeconomic
volatility.
Fiscal policies and structural reforms
Before I turn to financial market conditions, let me briefly address fiscal policy developments
and structural reforms. Last year, I noted during my presentation of the Annual Report that
the best time to repair the roof is when the sun is shining. A few countries did take advantage
of strong economic growth to improve their structural fiscal position. Some other countries,
however, did not capitalise on the good economic times to bring their fiscal house in order.
With clouds gathering on the economic horizon, these countries will have to proceed with
fiscal consolidation in line with the Stability and Growth Pact under potentially less favourable
economic conditions. Those Member States that have been more prudent may let automatic
stabilisers operate freely. In all countries, however, containing the share of public
expenditure in total national income and enhancing the quality of public finances should
receive greater attention.
Over the past decade, structural reforms in product and labour markets have paid off,
contributing to a strong and steady increase in employment in the euro area. Lower taxes on
labour, greater labour market flexibility and increased product market competition have
supported job creation and potential output growth. Further progress with structural reforms,
economic integration and cross-border competition are needed to address some countries'
diverging competitiveness positions and support the smooth functioning of the euro area
economy.
Financial stability and supervision
Since last summer, the global financial system has been undergoing a process of risk
repricing and balance-sheet deleveraging. This process, which is still ongoing, did not come
as a total surprise to us. Indeed, the ECB, in particular in its Financial Stability Review, as
well as other central banks and international institutions, had issued repeated warnings about
the potential underpricing of risks in a number of markets, including the US sub-prime
mortgage markets. For instance, in my speech before this Committee last year, I noted that
the unabated growth in the volume and complexity of new financial instruments could have
made these markets vulnerable to disruptive adjustments, as it was not always clear where
the risk exposures ultimately lay. But although we had pointed to the risks associated with
the accumulation of imbalances and had identified several vulnerabilities in the financial
system, it was difficult to foresee the specific nature and all the propagation channels of the
market turmoil, as well as its intensity and duration.
At the current juncture, the outlook for financial stability in the euro area continues to be
characterised by considerable uncertainty. The magnitude of the total valuation and income
losses facing the global financial system and their distribution across individual financial
institutions is uncertain, although several estimates have been made. It is also unclear what
the impact will be on the intermediation of credit to the household and corporate sectors.
Moreover, further tensions in structured credit markets cannot be excluded in view of the
ongoing weakness in the US housing market, and there is a risk of adverse developments in
the credit cycle.
All in all, the risks to euro area financial system stability have materially increased over the
past eight months. Looking ahead, the ongoing adjustment of global financial markets is
likely to last for some time, its interaction with the real economy could prove more
wideranging and the shock-absorption capacity of the euro area financial system could be further
tested. However, following a number of years of high profitability, the euro area banking
sector has a strengthened financial position to face credit-cycle pressures.
Authorities, at the EU and global levels, have taken measures to facilitate the adjustment of
financial markets and address the revealed weaknesses in the financial system. Private
sector initiatives have also been launched with the same objective. Further policy responses
are being prepared to restore confidence and to strengthen the resilience of the financial
system. The roadmap of objectives and actions agreed by the ECOFIN Council and the
recommendations of the Financial Stability Forum, strongly endorsed by the G7 finance
ministers and central bank governors, are consistent and converge to a very large extent.
What is essential is the effective and timely implementation of the recommendations and
envisaged actions. Let me highlight the importance of two major areas where prompt
implementation is warranted in order to restore confidence and improve market functioning.
First, improving transparency and enhancing valuation practices should be a top priority, as
the lack of adequate, relevant and timely information about risk exposures, valuations of
complex illiquid instruments, write-downs, and the ultimate holders of risk has contributed to
the loss of confidence and has impaired market functioning. Financial institutions are called
upon to make full and immediate disclosure of on and off-balance-sheet risk exposures and
losses, following the leading market practices as well as the guidance provided by
supervisors and accounting standard-setters. In the medium term, it is of the utmost
importance to converge towards best practices on risk valuation and disclosure in order to
facilitate the assessment of the risk profile of financial institutions by investors, markets and
public authorities.
Moreover, the turmoil highlighted the implications of the increased exposure of some banks
to complex financial instruments, which, unfortunately, was not always matched by a full
understanding of the inherent risks and their possible impact on banks' capital and liquidity
positions. This underscores the importance of having in place robust risk management
practices, including liquidity risk management, stress-testing and contingency funding plans.
The role and use of credit ratings should also be reassessed. Credit rating agencies should
expand the information provided on the risk characteristics of structured finance products
and differentiate their ratings by introducing a separate rating scale for such products.
Thankfully, a number of necessary improvements in rules, procedures and practices are
already in the pipeline. The Basel II framework is expected to improve transparency and
foster more sophisticated internal control and risk management systems. Supervisors will
monitor the effective implementation of the new framework to ensure that relevant
information is actually disclosed and that banks retain adequate capital and liquidity buffers,
commensurate to their risk profile, throughout the economic cycle. That said, the lessons
drawn from the financial turmoil also point to certain aspects of the framework that need to
be revisited, such as the treatment of exposures to structured finance products and to
offbalance-sheet vehicles.
The financial industry retains a primary responsibility and has strong incentives to promote
the smooth functioning of the financial system. It thus has to demonstrate its capacity to
implement actions regarding transparency, valuation and risk management practices so as to
finally turn the page on this difficult episode. Supervisors and central banks around the globe
will be monitoring very closely the adequacy of the actions taken by the financial industry to
restore market confidence. In this context, an appropriate balance needs to be struck
between market discipline and sound regulation that does not stifle financial innovation.
Finally, the experience of the turmoil also showed that EU arrangements for financial stability
should be enhanced. An important element of this process is the strengthening of the
cooperation and exchange of information between central banks and prudential supervisors
in both crisis prevention and crisis management. In situations of financial stress, enhanced
cooperation is important to allow both central banks and supervisory authorities to perform
their respective functions more effectively.
Payment and securities settlement systems
Before closing, I would like to say a few words on developments in the field of payment and
settlement systems, where the year 2007 was marked by major achievements. As you are
aware, the Eurosystem is engaged in four big projects to ensure well-functioning payment
and securities settlement systems in the euro area: TARGET2, TARGET2-Securities, the
update of the correspondent central banking model (CCBM2), and SEPA. In tandem with
these efforts to promote the integration of payment and settlement systems, the ESCB and
the Committee of European Securities Regulators are currently developing recommendations
to ensure the soundness and safety of the European post-trading sector.
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Ladies and gentlemen, the ECB places the greatest value on the fulfilment of its
accountability obligations. In last year's Resolution you made a number of suggestions to the
ECB and requested us to report back on the follow-up given to them. We carefully
considered these suggestions and I am pleased to inform you that in his letters of
transmission of this year's Annual Report to President Pöttering and to you, Madame Berès,
as Chair of this Committee, President Trichet has provided an overview of the follow-up
measures taken by the ECB.
I thank you for your attention. I am now at your disposal for questions.