José Manuel González-Páramo: The ECB and the sovereign debt crisis
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the XXIV Moneda y Crédito Symposium, Madrid, 4 November
2011.
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1. Introduction
It is a great pleasure and honour for me to contribute to this year's 24th edition of the
Moneda y Crédito Symposium.
There is no doubt that advanced economies, not just the euro area, are currently facing a
period of exceptional economic and financial instability that requires swift, decisive and
credible action by all concerned institutions, each with its own responsibilities.
On 26 October the Heads of State and Government of the euro area agreed on a
comprehensive set of measures to restore confidence and address the current tensions in
financial markets. These measures include:
First, an agreement to secure the decline of Greek debt to a level equivalent to 120% of GDP
by 2020. This reduction will be partly achieved via a voluntary bond exchange involving a
50% nominal discount on notional Greek debt held by private investors. Euro area Member
States will also contribute up to 30 bn euro to the PSI package.
Second, a new EU-IMF multiannual programme financing up to 100 bn euro will be put in
place by the end of the year.
Third, a significant leveraging of existing EFSF resources via two different schemes in order
to increase the fund's ability to extend loans, finance bank recapitalisations and conduct
bond purchases in the primary and secondary markets. I will describe these schemes in a bit
more detail later on.
Fourth, a commitment to increase the capital position of banks to 9% of Core Tier 1 by the
end of June 2012 and to facilitate access to term-funding through a coordinated approach to
bank liability guarantees at the EU level.
Fifth, a strengthening of economic and fiscal coordination and surveillance and a
commitment to put in place a set of measures, going beyond and above the recently adopted
package on economic governance.
In the period ahead, it is of paramount importance that this agreement is applied rigorously
and quickly in all its dimensions.
Against this background, I would like to focus my intervention today - from my perspective as
a central banker - on the challenging environment for monetary policy created by the
ongoing euro area financial and sovereign debt crisis. In the first part of my speech I would
like to recall some of the main policy "failures" leading up to the present crisis and briefly
review the more recent policy actions undertaken by the ECB.
As the ECB has repeatedly stressed, the main responsibility for resolving this crisis lies with
governments and the financial sector. Euro area governments' unwillingness to adapt their
fiscal and competitiveness policies to the requirements of EMU very much lies at the heart of
the current "sovereign debt crisis". Excessive risk-taking by an over-leveraged and
inadequately regulated financial sector is, of course, the other source of the present "financial
turmoil". I will therefore focus the second part of my speech on a discussion of the main
reforms to the governance as well as the supervisory and regulatory frameworks that have
been undertaken at the European and international level in response to the crisis.
2. Fiscal imbalances and the monetary policy response to the crisis
Growing fiscal imbalances
The economic and financial crisis has led to a severe deterioration of public finances across
European countries. Governments which already had significant fiscal imbalances ahead of
the crisis exited from the recession with the highest deficit and debt-to-GDP ratios recorded
in times of peace. The aggregate fiscal balance of the euro area increased from an almost
balanced budget in 2000 to a deficit of around 6% of GDP in 2010. Furthermore, the euro
area's debt stood at more than 85% of GDP in 2010. Similar developments were also
recorded in other advanced economies, for example the US and Japan, likewise as a result
of the cyclical contraction as well as the adopted fiscal stimulus measures. However, it is
useful to consider that the consolidated fiscal position of the euro area remains - overall -
rather more favourable than that of the US and Japan. According to the Commission's spring
2011 forecast, the euro area deficit ratio is projected to decline to 3.5% of GDP by 2012 as
compared to the US and Japan where fiscal deficits are expected to stand at 8.6% and 9.8%,
respectively, in 2012. These forecasts are in line with those of the main international
organisations.
The interaction between government finances and the financial system
Despite ongoing fiscal consolidation efforts across euro area countries, negative feedback
loops between the financial sector and sovereigns are becoming more and more entrenched.
Although in some countries it was financial system stress that happened first and later
weighed on sovereign risk, in others the events took place in reverse order. Regardless of
the exact chronology of events, since mid-2010 we have progressively begun to see a very
close interaction between risks associated with the financial system and the sovereign.
There are several reasons behind the close interplay between these two risks. For a start,
the burden on governments caused by their implicit and/or explicit guarantees to the banking
sector, and the need to finance bank re-capitalisations with public funds, has certainly taken
its toll on public finances. In some cases this burden was compounded by the adoption,
earlier in the crisis, of discretionary fiscal stimulus measures and the parallel decline in
government revenues caused by the economic downturn. In countries where the emergence
of systemic risk originated in large fiscal imbalances, the deterioration of public finances
weighed negatively on the market pricing of government bonds from these countries. This, in
turn, had a negative impact on the balance sheets of banks that held these bonds in their
portfolios.
The difficulties faced by some governments in financing themselves in the market also
affected the ability of banks from these same countries to obtain financing in wholesale
markets. Rating agencies traditionally link the ratings they give to banks to the ratings of the
respective sovereigns. Moreover, markets link the interest rate at which banks are able to
issue debt in wholesale markets to the interest rate required from the respective sovereign.
This means that as soon as a government's rating begins to be downgraded and its funding
cost begin to rise the same occurs to banks from that country. Even in collateralised funding
markets, like for example, the interbank repo market, banks have grown increasingly averse
to lend to banks who use their own government's bonds as collateral whenever that
government is tainted by sovereign risk concerns.
Against the background of a deteriorating fiscal situation, market confidence in the
sustainability of public finances has been progressively eroded - though not just in the euro
area - and the growth outlook is now surrounded by downside risks.
Unsustainable government policies and the failure of governance
But let me be clear: Although the economic crisis significantly increased the burden on
government budgets, the true "failures" leading up to the current sovereign debt crisis lie with
the unsustainable fiscal and structural policies pursued by many of these governments
before the crisis and with the governance system of the euro area.
The EU's economic governance framework failed to prevent and correct unsustainable
national policies that contributed to the build-up of major imbalances in euro area countries.
This applies in particular to the weak implementation of policy recommendations, the
inadequacy of enforcement measures taken to discourage or correct deficit infringements,
and the insufficient recognition by national policy-makers of the need to ensure mutual
consistency between national policies in a monetary union, especially with regard to the
issue of competitiveness. Moreover, as I will elaborate in more detail later on, existing fiscal
rules have been weakened over time and procedures and measures that were put in place in
order to enhance economic policy coordination have not been implemented with sufficient
rigour.
Let us not forget that EMU is characterised by a high degree of economic and financial
integration among its members, which in normal times is obviously beneficial to all. Yet, in
times of crisis, close financial integration also means that unsustainable developments in one
member state can easily spread to other members perceived as vulnerable by the market.
The crisis has also made policymakers increasingly aware of the need to establish effective
macro-prudential surveillance frameworks which can provide a strengthened systemic
perspective to regulation and supervision and do not neglect the interactions within the
financial system, and their relation to the real economy. Against this background, the
European Systemic Risk Board (ESRB) was established at the beginning of 2011 and
entrusted with the responsibility for the macro-prudential oversight of the financial system of
the European Union. In addition to macro-prudential surveillance, strengthened fiscal and
macroeconomic surveillance remains essential for guarding against destabilising
crosscountry spillovers which might stem from a loss of confidence in the sustainability of national
policies.
The experience of the last few months has taught us that the possibility of market failures in
the financial sector can never be ruled out, including self-fulfilling trend dynamics in the
pricing of sovereign risk. Market failures are costly in a monetary union due to the potential
for contagion. The experience of euro area sovereign bond markets in recent years is rather
telling in this regard. Prior to the financial market tensions in autumn 2008, euro area
sovereign bond spreads were clustered in close proximity to each other, in spite of sizeable
cross-country differences in underlying fiscal and structural positions. This under-pricing of
sovereign risk and, ultimately, failure of market discipline in a period of tranquillity quickly
gave way to an abrupt and disorderly re-pricing of this same risk, without due regard to
different underlying fiscal and structural positions. The fact that market discipline had been
rudely awakened also meant that, in this environment of over-pricing of risk, a protracted
liquidity crisis has the potential to easily become a systemic threat to solvency and
sustainability if left unaddressed.
The ECB's response to the crisis
Central banks around the world, including the ECB, have reacted to the crisis in a swift and
decisive manner. Before discussing some of the measures the ECB has taken, let me briefly
discuss some more general principles that underlie the ECB's policy response.
The ECB reacted to the financial turmoil in full accordance with both its mandate and with
key principles of modern central banking practice. First of all, the ECB's policies were always
guided by its primary objective, which is to maintain price stability. However, we have learned
from the financial crisis that while price stability is certainly a necessary condition for financial
stability, it is not a sufficient one. The materialisation of systemic risk and financial instability
triggered deep recessions with great economic costs. These developments carried risks for
medium-term price stability which called for bold decisions by central banks around the
world.
With regard to the nature of the policy decisions we took, our monetary policy framework
distinguishes between monetary policy decisions, on the one hand, and the implementation
of the desired monetary policy stance through open market operations, on the other. This
facilitates the clear distinction between interest rate decisions taken to preserve price stability
and liquidity measures adopted in the course of implementing this stance. This distinction is
certainly useful under normal market conditions and has proven to be of great relevance in
periods of financial turbulence, albeit for somewhat different reasons.
In normal times, this so-called "separation principle" allows the central bank to fine-tune
operational procedures in order to steer short-term interest rates very close to the main
policy rate, without risking that those adjustments are regarded by observers as changes to
the monetary policy stance. In exceptional circumstances, when severe distortions in
financial markets emerge and the level of uncertainty is higher, a more non-standard liquidity
management by the central bank may be needed to prevent dysfunctional markets from
interfering with the effective transmission of the monetary policy stance. These non-standard
measures have to be conducted without compromising the central bank's main monetary
policy objective, which in the ECB's case, is price stability.
The "non-standard" measures implemented by the ECB have not introduced any distortion
into the general strategic monetary policy framework of the ECB and did not interfere with the
aforementioned "separation principle". On the contrary, "non-standard" measures should be
seen as complementary to rates policy in times of financial crisis.
As you know, with the start of the financial crisis in 2007 banks became significantly more
concerned about counterparty credit risk and liquidity risk. As a result banks also became
increasingly reticent to lend to each other in the interbank market. This meant that short-term
interest rates in the interbank market became disconnected from our main policy rate, the
rate in our main refinancing operations, because many banks could not access market
funding no matter what rate they were willing to pay for it. The ability of the ECB to influence
financing conditions in the economy by determining short-term money market rates was thus
seriously hampered.
In response to this situation, from August 2007 onwards, the ECB started to conduct
additional and special liquidity providing operations with the objective of ensuring that solvent
banks did not loose the ability to refinance themselves despite the fact that the interbank
market had become dysfunctional. After the collapse of Lehman Brothers in October 2008
the ECB began to conduct these operations under the fixed-rate full-allotment procedure
which allowed banks to determine through their own demand how much liquidity the
Eurosystem provided to the interbank market. The list of eligible collateral accepted by the
ECB in its refinancing operations was also expanded in order to allow banks to increase their
access to our operations if needed. The ECB also introduced refinancing operations for
longer maturities, including six month and one year maturities, so as to reduce the need for
banks to roll-over their funding over short periods of time in an uncertain liquidity
environment.
International cooperation with other major central banks has also allowed the ECB to provide
liquidity and alleviate tensions in funding markets for currencies other that the euro. The
swap arrangements with the US Federal Reserve, for example, have allowed us to conduct
fixed-rate full allotment tenders in US dollars. These operations became very important
following the collapse of Lehman. Demand in these operations declined in the course of
2010. Following the emergence of some signs of potential tensions in US dollar funding
markets in 2011, as a precautionary measure, the ECB recently decided to re-establish
84-day fixed-rate full allotment tenders in US dollars, in addition to the 7-days tenders.
In 2009 the ECB launched one of its most innovative non-standard measures, our first
Covered Bond Purchase Programme (CBPP1). Under this initiative the Eurosystem
purchased €60 billion worth of covered bonds between July 2009 and July 2010. This
initiative had four objectives: first, reducing money market term rates; second, easing funding
conditions for credit institutions and enterprises; third, encouraging credit institutions to
maintain or expand their lending to households and enterprises; and, fourth, improving
market liquidity in important segments of private debt securities markets. The Eurosystem
decided to target covered bonds because of the particular importance that this asset class
has for the financing of banks and the real economy in the euro area.
CBPP1 was very successful in restarting issuance activity in primary covered bond markets.
With the recent intensification of the sovereign debt crisis, however, covered bond markets
have again come under significant pressure. This is why at its meeting on the 6th of October,
the Governing Council decided to launch a second covered bond purchase programme,
CBPP2, that will consist of €40 billion worth of covered bond purchases within the year
starting in November 2011.
In addition to the aforementioned measures, after euro area sovereign bond markets became
increasingly dysfunctional the ECB launched its Securities Markets Programme (SMP) in
May 2010. The main purpose of this programme is to protect the functioning of the monetary
policy transmission mechanism by addressing the malfunctioning of certain key government
and private bond market segments. A key distinguishing feature of asset purchases made
under the SMP is that their liquidity impact has been sterilised through the conduct of weekly
liquidity absorbing operations. There has been no net injection of central bank liquidity to the
market as a consequence of these operations. The SMP and its objectives therefore remain
fundamentally different from quantitative easing.
Overall, the measures implemented in response to the financial crisis helped sustain financial
intermediation in the euro area by safeguarding the refinancing of solvent banks and
restoring confidence among financial market participants. This, in turn, helped preserve the
viability of the banking system and important segments of the financial market. These
measures were instrumental in supporting the availability of credit for households and
companies, in spite of the moderation in credit growth in a number of countries, and,
ultimately, they also contributed to maintaining price stability.
3. Institutional reforms in the euro area
Weaknesses in European economic governance
The success of monetary policy in containing the damage of the financial and sovereign debt
crisis should not obscure a more fundamental lesson that the experience of the past few
years teaches us: private and public sector imbalances may not only put at risk the
longerterm sustainability of public finances, but also have implications for financial stability and,
ultimately, monetary policy.
In Europe we have realised at a high cost that the governance to ensure fiscal soundness
and macro-economic stability was simply insufficient.
The fiscal policy framework suffered from weak implementation of the Stability and Growth
Pact (SGP), in particular after its reform in 2005. This was mainly due to two reasons:
First, at the national level, incentives for ensuring sound and sustainable fiscal positions have
been insufficient. Some Member States had already accumulated large fiscal imbalances in
"good times". The stability and convergence programmes were frequently poorly specified
and overly optimistic. Furthermore, Member States failed to adhere to medium-term
budgetary objectives and only slowly corrected excessive deficits. Future budgetary costs,
arising from ageing populations, were also not sufficiently addressed with the necessary
reforms.
Second, at the European level, the surveillance framework was never rigorously enforced.
Weak peer pressure among Member States translated into a reluctance to attach sufficient
importance to the joint responsibility for maintaining euro area stability. Allow me to remind
you that in 2003 Germany and France substantially contributed to a watering down of EU
budget rules. In 2003, they voted against proceeding with the excessive deficit procedure in
spite of breaking the 3% fiscal deficit ceiling. The lack of an automatic trigger in case of
noncompliance with the deficit rules left a great deal of discretion for the decision-making bodies
at the EU level. All participating parties were reluctant to enforce fiscal discipline in line with
the rules and procedures foreseen in the Stability and Growth Pact. In particular, financial
sanctions that were due to be applied for cases of persistent failure to correct excessive
deficits were never applied.
Apart from the weak fiscal surveillance mechanisms, the economic governance framework
also failed to prevent the emergence of large and persistent macroeconomic imbalances.
Some Member States experienced inflation rates permanently above the euro area average.
In these countries, increases in wage costs, significantly exceeded productivity gains and
this, in turn, led to a substantial rise in unit labour costs. As a consequence, competitiveness
was gradually eroded and risks of adverse spill-over effects from individual countries to the
euro area as a whole emerged.
The euro area's recent governance reforms
Against this background, on 28 September 2011 the European Parliament approved new
legislation aimed at addressing weaknesses in the existing economic governance framework
for co-ordinating fiscal and structural policies. I would like to share with you the ECB's
assessment of these reforms.
Let me say from the outset that the new legislation, consisting of six parts, the so-called
"Sixpack", is certainly a step in the right direction. The "Six-pack" consists of four proposals
aimed at strengthening the Stability and Growth Pact and the budgetary surveillance
framework, and two proposals which focus on monitoring and controlling macroeconomic
imbalances.
The key improvements in the EU surveillance framework include: (i) the strengthening of the
preventive arm of the Stability and Growth Pact, including through the introduction of earlier
and gradual sanctions and of an expenditure growth benchmark; (ii) making the government
debt criterion of the Maastricht Treaty operational; (iii) a new sanctions mechanism to
strengthen the enforcement of the rules for euro area countries, (iv) new minimum
requirements for the rules and procedures governing national budgetary frameworks and
finally (v) the introduction of a new Excessive Imbalances Procedure (EIP) for the prevention
and correction of macroeconomic imbalances.
The "Six-pack", however, falls short of the "quantum leap" that the ECB had long advocated
for the euro area. A major drawback is that the new governance package still leaves the
Council with too much room to apply discretion when deciding on the execution and
enforcement of the surveillance procedure. Another vital shortcoming relates to the large
amount of exceptions and relevant factors that need to be taken into account when it comes
to applying the excessive deficit procedure. This creates loopholes and could endanger the
transparency and therefore the accountability of the fiscal governance framework as a whole.
Looking ahead, the identification of the necessary reforms has to start from being clear about
what the ultimate objective is: the need to establish institutional arrangements which provide
credible incentives for sound fiscal and macroeconomic policies in a monetary union. In my
view, a more fundamental deepening of fiscal and economic policy surveillance is necessary
in the long run. This would involve a transfer of sovereignty to the European level of decision
making, which should have much stronger powers, and would also mean stricter constraints
on national budget policies.
This kind of reforms would require a comprehensive change to the EU Treaty but, above all,
an adequate mechanism to ensure their democratic legitimacy. Let me outline the ideal
cornerstones of such a governance reform. First, to ensure fiscal discipline, all planned
deficits of more than 3% of GDP and those in excess of a country's medium term objective
would need to be approved by all euro area governments. Second, past fiscal slippages
would be automatically corrected in upcoming budgets without any room for discretion via the
introduction of constitutional rules similar to the German "debt brake". Third, all Member
States would also agree to implement fines and sanctions in a quasi-automatic mode.
Finally, with the introduction in 2013 of a permanent crisis resolution mechanisms, the
European Stability Mechanism (ESM) - I shall come back later to a more detailed discussion
of the ESM -, those countries slipping over their macroeconomic adjustment programmes
would be placed under financial receivership.
The institutional arrangements at both national and supranational level would also have to be
strengthened. At the national level, independent budget offices would ensure reliable
forecasts - a prerequisite for sound planning and implementation of budgets. At the euro
area level this needs to be complemented by an independent entity with a clear mandate and
a strong institutional framework to assess the implementation of fiscal rules. For instance,
some form of European Budget Office or "EBO", which could potentially form the nucleus of
what could become over time, and in a gradual manner, a European Ministry of Finance.
Strong and independent institutions at the euro area and national levels serve to enhance
transparency. They bring the necessary pressure to bear to ensure the conduct of sound
policies and effectively counteract possible tendencies towards a lenient implementation of
fiscal rules at the level of individual member states.
In addition to the "Six-pack" in March 2011 the Heads of State or government of the euro
area agreed on a "Euro Plus Pact" to strengthen policy coordination in order to improve
competitiveness and convergence. Under this agreement euro area governments commit to
use a set of common indicators to regularly monitor each others progress in areas such as
labour-market reforms, reforms to wage-setting arrangements and reforms aimed at
improving the sustainability of pension, health care and social benefit systems. Governments
who signed the Euro Plus Pact also committed to translate the rules set out in the Stability
and Growth Pact into their national legislations. The reform of article 135 of the Spanish
constitution in August 2011, which for the first time introduced the principle of budgetary
stability into the fundamental law of the country, is a positive example of recent progress
made in this area.
The new architecture for financial supervision
But as I said earlier, in the lead up to the present crisis governments were not the only ones
to fail in their responsibilities. The functioning of our financial system also proved to have
important shortcomings.
To address these issues a new EU architecture in the area of financial supervision has
become operational in 2011. Let me recall that the EU institutional framework for financial
supervision is based on two pillars. The first pillar is the European Systemic Risk Board
(ESRB), which is the body responsible for macro-prudential supervision of the whole EU
financial system. According to the founding legislation, the ESRB has to act with the
logistical, analytical, statistical and administrative support of the ECB. Indeed, over the last
year the ECB has made a considerable effort to strengthen its analytical tools and models in
order to support the EU-wide risk assessment of the ESRB. The ESRB has just published its
first set of policy recommendations concerning lending in foreign currencies.
The second pillar is the European System of Financial Supervisors, including the national
supervisory authorities and the three European Supervisory Authorities (ESAs): the
European Banking Authority (EBA), the European Insurance and Occupational Pensions
Authority (EIOPA) and the European Securities and Markets Authority (ESMA). After an
initial "set-up" period, the three ESAs are already proving to be effective in steering the
coordinated efforts of the national supervisory authorities, for instance coordinating EU-wide
stress tests.
At the global level, significant progress has also been made on banking supervision. The
financial crisis clearly demonstrated the need to overhaul and complement the existing
international regulatory frameworks. Against this background, the G20 Leaders called for
broad regulatory reforms. As regards banking regulation, key elements of these reforms are
the new international capital and liquidity frameworks, which are commonly referred to as
"Basel III".
The new Basel III framework seeks to increase minimum capital requirements on banks,
enhance the ability of the regulatory framework to capture different sets of risks, introduce a
stricter definition of capital as well as entirely new concepts, such as a non-risk-based
leverage ratios and mandatory liquidity requirements. The implementation of Basel III is
expected to increase the resilience of the financial system and reduce the frequency of crises
in the future.
The main challenge that lies ahead is the timely and consistent implementation of the new
Basel III framework at the global level. The Basel Committee agreed to put in place a
comprehensive and robust review process covering all aspects of Basel III implementation.
In this context, I very much welcome the fact that the European Commission was one of the
first, at the international level, to take the initiative in actively implementing Basel III by
issuing a fully-fledged EU capital requirements regulation and directive on 20 July 2011. In
the coming months the ECB will issue its official Opinion on this regulation by the
Commission.
With the spill-over of the sovereign debt crisis to the situation of European banks, markets
have become increasingly worried about whether banks have sufficient capital buffers to
sustain losses stemming from sovereign risks. Market pressure for a front-loading of the
Basel III requirements has also become manifest. To address some of these concerns, on
the same day of the 26 October Euro Summit the EBA announced that it will require banks to
build an additional temporary capital buffer against their sovereign debt exposures to reflect
current market prices. In addition, as I already mentioned earlier, banks will be required to
establish a buffer such that their Core Tier 1 capital ratio reaches 9% by the end of June
2012.
Further progress in financial supervision is also needed in other areas like the oversight of
the shadow banking system and the treatment of systemically important financial institutions
(SIFIs). As regards these institutions, I would like to highlight that the efforts at euro-area and
EU levels to address the financial crisis are supported by the broader coordinated action of
all G20 countries to reform key elements of financial regulation. In this context, the recent
G20 meeting in Cannes was of crucial importance, as the G20 leaders endorsed a
comprehensive framework to reduce the risks posed by SIFIs, including strengthened
supervision, key attributes of effective resolution regimes, a framework for cross-border
cooperation and recovery and resolution planning as well as additional requirements to
absorb losses in the case of those banks classified as Global SIFIs. In addition to these
initiatives, initial recommendations and a work plan to strengthen the regulation and
oversight of the shadow banking system were also agreed upon.
The EFSF and ESM
This review of the main institutional, supervisory and regulatory initiatives that have been
undertaken in response to the crisis would not be complete without also mentioning the
creation of the permanent euro area crisis resolution mechanism.
As you know, on July 2013 the European Stability Mechanism (ESM) will take over the
functions that are currently performed by the European Financial Stability Facility (EFSF) and
the European Financial Stabilisation Mechanism (EFSM). Both the EFSF and the EFSM
were established in 2010 as temporary arrangements to tackle the urgent need to finance
governments in the euro area that had lost access to market financing as a result of the
sovereign debt crisis.
The main objective of the future ESM will be to provide financial assistance, subject to strict
conditionality, to euro area countries experiencing severe financing difficulties. As with the
EFSF, this assistance will predominantly take the form of loans known as ESM Stability
Support (ESS) loans. These loans will be granted conditional on agreement to and
com