Benoît Coeuré: Lessons from East Asia for the euro area
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the Asia Europe Economic Forum on "Challenges and prospects for Asian and European
economies", Beijing, 28 October 2013.
* * *
I would like to thank Ine Van Robays for her contribution. I remain solely responsible for the opinions contained
herein.
Ladies and Gentlemen,
The global economic and financial crisis confronted the world economy not only with financial
turbulence, loss in output and social distress on a scale not seen since the Great
Depression. It also created a series of challenges for policy-makers. Across the euro area, it
exposed structural and institutional weaknesses that had remained hidden during the
preceding era, the "Great Moderation".
Times of crisis are times of hardship - but they are also times of change and opportunity.
This seems particularly true for Europe, where progress has often come in this way.
The Second World War was the impetus for the European Coal and Steel Community, which
was established to prevent another war between France and Germany. It formed the nucleus
of today's European Union. The demise of the Bretton Woods system in the 1970s was the
catalyst for a European single currency, which was eventually introduced in 1999.
I'll be talking today about the effects of the present crisis and the various challenges it has
presented for the euro area. I'll compare it with the East Asian crisis of 1997. In my view,
there are similarities that yield useful policy lessons for the euro area. But there are also
differences that need to be kept in mind.
What can we learn from the Asian crisis?
What are the parallels between the Asian crisis in 1997-1998 and the euro area crisis?
The economies of emerging Asia were characterised by buoyant growth and a brisk
expansion of credit (see Chart 1). This rise in debt was facilitated by considerable inflows of
foreign capital, which financed significant external deficits (see Chart 2). This led to growing
financial imbalances, and in particular to currency and maturity mismatches on the balance
sheets of local banks. In addition, the economic boom prevailing at that time was
accompanied by a loss of competitiveness of the region's export sector. Investors typically
under-priced potential risks as they had overly optimistic expectations of the medium-term
growth prospects. They did not identify systemic vulnerabilities such as the risk of sudden
stops in capital flows or of twin crises of the banking system and the balance of payments,
which eventually materialised.1
Except for currency mismatches, similar developments were evident in the euro area before
2009 - if not at the regional level, at least in those countries that later ran into financial
difficulties. It was widely believed that sudden stops in capital flows, not to mention twin
banking and balance of payments crises, could not happen in advanced economies.2 And yet
this is exactly what happened in Europe ten years after the Asian crisis (see Chart 2).
It seems therefore useful to look also at East Asia's response to its crisis and see what
lessons can be learned.
One lesson is that a deep and fundamental restructuring of the domestic financial
sector is necessary
Given the financial nature of the Asian crisis, this was a key element in resolving it.
Nonviable financial institutions were closed, viable institutions recapitalised and strengthened,
value-impaired assets dealt with and the corporate sector restructured, including through
foreign investment.3 These measures were implemented decisively. They were associated
with a painful adjustment process in the crisis countries but, at the same time, they made a
swift recovery possible.
This experience contrasts with Japan's experience in the late 1980s. Following the bursting
of Japan's asset bubble, there was by and large no rapid write-down of non-performing
assets. Due to the low profitability of banks, it was believed that an immediate write-off of bad
loans would prevent compliance with capital requirements. The recognition of losses was
postponed and, as a consequence, capital continued to be allocated to investments with
limited positive impact on Japan's long-term growth potential, which some have called
"zombie lending"4. Ultimately, this resulted in Japan's "lost decade", namely an extended
period of anaemic growth (see Chart 3).
A second lesson is that institutional and structural reforms are essential
Early in the crisis, emerging Asian economies strengthened prudential regulation and
supervision, together with bank governance and market transparency and discipline, in order
to prevent further instability and bring domestic standards closer to the international norms.5
Furthermore, they generally acknowledged that their economic "miracle" before the crisis
was not sustainable. It was driven by over-investment encouraged by Colbertist policies,
implicit government guarantees, and too often, opaqueness and political interference in
market mechanisms.6 As a result, at the macro level, growth was led by capital accumulation
in the wrong sectors and not by a rise in total factor productivity. In Paul Krugman's words,
the Asian miracle was "the fruit of perspiration, not of inspiration"7.
To address the root causes of the crisis, structural reforms aimed at improving governance
and challenging vested interests, both in public policy-making and in the corporate sector,
2
See FRBSF Economic Letter (2011). "Could We Have Learned from the Asian Financial Crisis of 1997-98?",
February 2011.
3
IMF
See Lindgren, C.-J. et al. (1999). "Financial Sector Crisis and Restructuring. Lessons from Asia",
Occasional
Paper, 188.
4
See Fukao, M. (2003). "Japan's Lost Decade and its Financial System", The World Economy, 26,
pp. 365-384, and Caballero, R., T. Hoshi and A. Kashyap (2008). "Zombie Lending and Depressed
Restructuring in Japan", American Economic Review, 98:5, pp. 1943-1977.
5
See footnote 4.
6
See Krugman, P. (1999). "What happened to Asia?", in Sato R. et al., Global Competition and Integration,
Càigēntán
Kluwer Academic Publishers, pp. 315-327. Already in 1590 Hong Zicheng's claimed that "water
that is clear has no fish."
7
See Krugman, P. (1994). "The Myth of Asia's Miracle", Foreign Affairs, 73:6 (1994: November/December).
were essential.8 The lesson to be learnt was that sustainable growth can only be achieved by
fostering an environment that encourages open markets, innovation and entrepreneurship.
A third lesson is that re-nationalisation and protectionism are not the solution to a
crisis
Indeed, there is empirical evidence that more open economies recover faster from the output
contraction that usually accompanies a sudden stop of capital.9 As such, the most open
Asian economies, such as Hong Kong and Singapore, were among the least severely
affected and fastest to recover from the Asian crisis.10 In other words, despite the attendant
risks, globalisation in trade is still the best way to achieve progress and economic
development, and open financial markets can support it provided they are backed by strong
prudential supervision. Open trade policies in the crisis helped Asian economies to benefit
from the upswing in global trade and growth towards the turn of the millennium (see Chart 4),
which in turn supported the post-crisis recovery.
However, while there may be lessons to learn, what are the important differences
between emerging Asia of the 1990s and the euro area today?
Emerging Asian economies had greater policy leeway than euro area countries in dealing
with their crises, in that they had flexible exchange rate regimes. Some might argue that this
makes it hard to say which part of the Asian experience is relevant for Europe. But I would
have a different interpretation: a lack of nominal exchange rate flexibility does not preclude
real exchange rate adjustment. Sharing a currency entails a fundamental trade-off. It brings
considerable microeconomic benefits but it creates responsibilities for participating countries.
They should run prudent policies to make asymmetric shocks less frequent, ensure that
relative prices can adjust if such a shock nevertheless occurs, and be prepared to insure
each other against extreme outcomes when the former mechanisms are not enough.
The conditions were unfortunately not met in the euro area. National policies were run on the
misguided assumption that countries, companies and households could borrow forever. In
more flexible
spite of needing markets with its single currency, Europe faced stronger
nominal rigidities than East Asia in labour and product markets.11 This limited the ability of
euro area countries to adjust to asymmetric shocks, especially as cross-border labour
mobility was low and public debt levels were already high. And finally, no mutual insurance
mechanism was in place.
But, and here comes the good news, unlike emerging Asia in the late 1990s, Europe had a
well-established regional political framework to address its crisis. The framework of
integration and cooperation among EU members is old and dense, building on the
experience gained with the European Monetary System12. This made it possible to create the
necessary instruments (the EFSF and ESM) for financial support for domestic adjustment
programmes to come mainly from within the Union, with the IMF focusing on monitoring
conditionality.
Some will remember the IMF Annual Meetings in 1997 in Hong Kong, when calls to create an
"Asian Monetary Fund" were judged incompatible with the IMF's universal mandate.13
Contrary to Asia in the late 1990s, Europe had the political infrastructure in place to sustain
the sharing of sovereignty that makes mutual insurance mechanisms possible. This is not to
say that all the discussions were easy, far from it, as might be expected in times of crisis.
Europe's sense of commonality was, and still is, under severe strain. But the political
framework was there to produce decisions, and most importantly, a legal framework was also
there to implement them.
The lesson from this is that regional integration, regional rule of law, and the sense of a
common project are sources of stability.14 In East Asia, things have moved on since the late
1990s, with the Chiang Mai Initiative multilateralisation. The G20 has taken stock of the
Asian and European experiences and acknowledged the relevance of regional financial
arrangements.
The road ahead for the euro area
Based on the lessons learnt from the Asian crisis, what are the main challenges we face in
the euro area? Let me consider them one by one.
Restructuring Europe's financial sector
To begin with, we need to reform Europe's financial sector.
We have, so to speak, come to a crossroads in Europe. In one direction lies the Japanese
experience, and in the other direction that of emerging East Asia. The authorities can either
choose between swiftly auditing and repairing the banking sector, which will help to restore
credit flows, or they can allow forbearance, which will harm the long-term prospects for our
economy.
I do not mean to downplay the significant restructuring and recapitalisation that has already
taken place in Europe. Since the onset of the global financial crisis, euro area banks have
raised around €225 billion of fresh capital and a further €275 billion has been injected by
governments, equivalent in total to more than 5% of euro area GDP. Today, the median Core
Tier 1 capital ratio of the largest euro area banks stands close to 12%. But there is some way
to go. To ensure that we take the right road, I see three responses as key.
The first is to carry out a comprehensive clean-up of the banking system so that the price
mechanism is no longer obscured by uncertainty about asset valuation and bank funding
models, and banks can free up balance sheet capacity to extend new loans.
The ECB will take up its supervisory responsibilities in about a year from now, and as part of
this we will conduct a comprehensive assessment of 128 significant credit institutions
covering 85% of euro area bank assets. We announced the details of this exercise on
Wednesday last week.15 It aims to increase transparency, to identify the necessary corrective
actions and to build confidence in the banking system.
With such steps, and provided that sources of capital are clearly identified, including public
backstops when private sources have been exhausted, I firmly believe we can put the
banking system on a sounder footing and enable it to support the economy's recovery.
The second response is to reduce financial fragmentation. Despite having a single market for
within
capital in Europe, liquidity is not fully fungible between and even cross-border banks.
This means that liquidity usage is not optimised - surpluses in some countries are not used
to fund deficits in others. The result is a greater divergence in bank funding costs and lending
rates than would be warranted by the underlying economic fundamentals, and euro area
companies being unable to tap a single pool of savings to fund their development.
The third response is to explore avenues for non-bank financing - that is, to develop debt
and equity capital markets in Europe. Around 75% of firms' external financing in the euro
area comes from banks, which makes the economy particularly vulnerable to crises that
spread through the banking system. Measures are being introduced in Europe to develop
capital markets for long-term financing and deepen markets for the securitisation of loans to
small and medium-sized enterprises.16
However, having a well-functioning financial sector is only one part of the story. To leave the
crisis behind us, we also have to ask: what in fact does that sector finance? Again, we can
learn from the Asian crisis: we need to foster growth and total factor productivity with new
business models.
Fostering growth: new business models
Due to its length and severity, the economic downturn has already caused a permanent loss
in output and a rise in structural unemployment, and we cannot rule out that the growth rate
of potential output has been affected too. To repair this damage, investment in both physical
and human capital has to be a key component of the recovery. Clearly, there is spare
capacity in the euro area economy. Total investment in the euro area is currently 17% lower
than it was in 2007. But some of this capacity is in sectors which will not be future engines of
growth - such as commercial real estate in some of the stressed countries. What we need is
investment in new business models that will raise total factor productivity and provide the
sources of future growth.
Politicians are not the best placed to decide what these business models will be. The market
economy will take care of that. The important thing is that we create an environment that
encourages innovation and entrepreneurship so that new models can emerge, and capital
and labour can be reallocated to a more efficient use. This is in the best interests of the
people of Europe, both as workers and as savers, beginning with those who have been hit
hardest by the crisis. It nevertheless implies changes at both national and European levels.
At national level, we need to prioritise public spending towards productivity-enhancing
investment, ensure that labour and goods market are flexible, cultivate a supportive
regulatory, judicial and educational environment, and open our economies to spur
competition and encourage the emergence of new actors.
Opaqueness and vested interests17 are not only defining features of developing economies.
Successful reform in European economies hinges on efforts to curb rent-seeking behaviours.
For example, doesn't the Single Supervisory Mechanism have the objective of freeing bank
supervision from national politics?
At European level, we need to provide a framework that supports and incentivises the
introduction of such national policies. This is the role of economic union in the euro area, the
"E" of EMU. I would stress, however, that economic union does not mean defining a single
economic model across all countries. On the contrary, its purpose is to create the conditions
for each country to identify and develop its comparative advantage. Paradoxically, it is only
difference
by encouraging - comparative advantage - that the euro area can achieve
convergence
- that is, a more even distribution of economic outcomes.
Avoiding re-nationalisation and protectionism
Let me finally address the third lesson learnt from East Asia. Europe needs to avoid
protectionist temptations and calls for re-nationalisation. Protectionism and
beggar-thyneighbour policies would lead to further losses of welfare at both European and global level.
Fortunately, there has been no significant surge in barriers to global trade in recent years
- unlike during the Great Depression - thanks to global and regional policy coordination.
These efforts remain important. Barriers to trade in goods and services cannot be raised
within Europe thanks to our Single Market and competition rules which are enshrined in
European laws, but the Single Market can be further enhanced.
Savings have been partly re-nationalised as a consequence of financial fragmentation. This
is a trend that, if left unchecked, can be fatal to the Single Market. Completing the Banking
Union is key to halt it, and I welcome EU leaders' resolve to swiftly agree on a Single
Resolution Mechanism.
Finally, Europe should remain open to the world. Further progress on bilateral or regional
free trade agreements, and cooperation in implementing the new financial regulatory
standards, are the best signal in this respect.
Conclusion
Let me draw to a close by re-emphasising that crises, despite their negative consequences,
can have positive effects. They can galvanise efforts and focus minds. They can drive
change and bring about progress. They can pave the way for innovative solutions. But to
secure these gains, cooperation across national borders is crucial, in other words, there must
be a willingness to work towards common goals and to learn from each other and resist
protectionism. This spirit will be essential to tackle the challenges still ahead of us, not only in
the euro area but also at a global level.
wēijī kiki
It is often claimed that the Chinese and Japanese word for crisis, or (危机 or 危機),
is made of the two characters meaning "danger" and "opportunity". While there can be no
wēi jī
doubt that means "danger", I would rather understand as meaning the critical moment
when things have to change - the ancient Greeks' kairos. This critical moment has now
arrived for Europe. Europe has emerged from the danger zone. It's time for us to get our act
together, to reform, and to grow.
Thank you very much for your attention.
Chart 1
Credit growth to the private sector in East Asia
and the euro area
(in percentage changes, year to year)
Chart 2
Current account balances in East Asia and the euro area
(in % of GDP, East Asia in 1996, euro area in 2008)
Chart 3
Real GDP growth in East Asia and Japan before,
during and after their crises
percentage, year to
(in year)
Chart 4
Export and Import volumes of goods and services in East Asia
(in percentage changes, year to year)
Sources: IMF WEO and Haver Analytics.