Lucas Papademos: European Central Bank's Annual Report 2006
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, 23 April 2007.
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Madam Chair,
Honourable members of the Committee on Economic and Monetary Affairs,
It is a great privilege and pleasure for me to present to you today the ECB's Annual Report 2006. As
you know, this is a key aspect of the ECB's accountability obligations towards the European
Parliament and we welcome this opportunity to explain our policy decisions and report on our activities
to you. In my introductory remarks, I will first briefly review the economic and monetary developments
in 2006 and early 2007 and explain the reasons behind the monetary policy decisions that we have
taken. I would then like to address a number of policy issues examined in the Annual Report, including
issues pertaining to the stability and integration of Europe's financial system.
Before doing so, however, I would like to recall that on 1 January 2007 the euro area welcomed its
13th member, Slovenia. Accession to the euro area is rightly considered a tremendous success for
that country. Thanks to the diligent preparations of all parties concerned, the currency changeover
from the Slovenian tolar to the euro went very smoothly, to the great satisfaction of everybody
involved, especially the people of Slovenia.
Economic and monetary issues
Turning to economic and monetary issues, the euro area economy expanded at a robust pace in
2006: real GDP grew by 2.8% (on a working-day adjusted basis), compared to 1.5% in 2005. The
economic upswing was broad-based, with domestic demand being the main driver of economic
growth. Sizeable gains in corporate profits and an extended period of favourable financing conditions
supported investment growth. In addition, euro area exports continued to benefit from a solid and
broad-based global economic expansion. Labour market conditions in the euro area improved
significantly last year. Employment rose by more than 2 million, and the unemployment rate decreased
further to 7.5% in the fourth quarter of the year. The improvements in the labour market reflected both
the rebound in aggregate demand and the impact of labour market reforms in a number of euro area
countries.
As regards price developments, average annual HICP inflation was 2.2% in 2006, unchanged from
2005, and above the ECB's definition of price stability, i.e. below but close to 2%. Annual inflation
rates exhibited considerable volatility over the year, mainly as a result of developments in energy
prices. Overall, labour costs increased moderately and contributed to containing domestic inflationary
pressures in the euro area, although the situation varied greatly from country to country. Despite
significant inflationary shocks in 2006, and the fact that headline inflation was above 2% throughout
most of the year, longer-term inflation expectations remained anchored to price stability.
Nevertheless, risks to price stability remained clearly on the upside throughout 2006, on the basis of
the ECB's economic and monetary analyses. In addition to the possibility of further oil price increases,
several other risks were identified. These included: the risk of stronger-than-anticipated pass-through
of past rises in oil prices; additional increases in administered prices and indirect taxes beyond those
already announced; and, more fundamentally, the prospect of stronger-than-expected wage
developments and potential second-round effects in wage and price-setting behaviour.
The monetary analysis confirmed, by cross-checking, the assessment of upside risks to price stability.
Money and credit growth remained very robust during 2006, mainly reflecting the stimulative effects of
the low level of interest rates and the strength of economic activity. The persistent underlying rate of
monetary expansion since mid-2004 has resulted in the accumulation of a stock of liquidity which is
ample by all plausible measures. A broad-based and comprehensive analysis of these developments
pointed to upside risks to price stability over the medium to longer term.
To address the upside risks to price stability, the ECB's Governing Council adjusted the monetary
policy stance in 2006 by raising the key ECB interest rates gradually by a total of 125 basis points,
reaching the level of 3.50% by December 2006. On 8 March 2007 the Governing Council decided to
raise rates by another 25 basis points because it assessed that upside risks to price stability continued
to prevail.
The information which has become available since the last meeting of the Governing Council has lent
further support to the reasoning behind the decision to raise rates in March. It has also confirmed that
risks to the medium-term outlook for price stability remain on the upside. In addition to potential further
oil price increases, these risks relate primarily to stronger than currently expected wage developments
in an environment of robust growth in employment and activity. In order to sustain robust economic
growth and foster job creation, wage agreements should take into account productivity developments
as well as the price competitiveness positions and the prevailing high level of unemployment in many
economies.
Cross-checking the outcome of our economic analysis with that of our monetary analysis supports the
assessment that upside risks to price stability prevail over the medium to longer term. Accordingly, the
Governing Council will continue to monitor very closely all developments and ensure that risks to price
stability over the medium term do not materialise. Given the favourable economic environment, the
Governing Council is of the view that the ECB's monetary policy continues to be on the
accommodative side, with the key ECB interest rates moderate, money and credit growth vigorous and
liquidity abundant. Consequently, firm and timely action is warranted to ensure price stability over the
medium term.
It is precisely because the ECB has always acted in a firm and timely manner in the past years that
our monetary policy, with its medium-term orientation, has succeeded in solidly anchoring longer-term
inflation expectations at levels broadly consistent with price stability. As explained on various
occasions before, it is through the continued anchoring of inflation expectations that monetary policy
can make an ongoing contribution towards supporting sustainable economic growth and job creation
in the euro area.
Fiscal developments and structural reforms
Fiscal developments in euro area countries in 2006 turned out to be significantly better than
anticipated. However, this budgetary improvement was largely the result of buoyant tax revenues in an
environment of stronger-than-expected economic growth, offsetting in some cases
higher-thanplanned public expenditure. Against the background of the current economic "good times", it remains
essential to step up the pace of fiscal consolidation in 2007 and beyond, allowing unexpected tax
revenue to be fully allocated to deficit and debt reduction. After all, common sense dictates that "the
best time to repair the roof is when the sun is shining". It is important that all euro area countries
achieve their medium-term objective of a sound fiscal position as soon as possible, and by 2010 at the
latest. Furthermore, pro-cyclical fiscal policies should be avoided in all countries. It is vital to ensure
fiscal sustainability in view of ageing populations in order to support long-term growth and facilitate the
conduct of a stability-oriented monetary policy.
With regard to structural reforms, euro area countries have become increasingly aware in recent years
of the need to adjust to the challenges of increased global competition, ageing populations and
accelerating technological change. Countries should make the best use of the current "good times" to
make further progress on the path of economic reform, especially in view of the positive response of
the supply side of the economy to the reforms implemented over the past few years. Employment has
risen significantly, by more than 12 million people since the launch of the euro, and the unemployment
rate has steadily declined to the lowest level since 1993, although it is still unacceptably high.
Moreover, we have recently witnessed an increase in productivity growth. Although this seems to be
mainly associated with cyclical factors, there is some evidence that, in certain sectors of the European
economy, and in a number of euro area countries, efficiency gains of a structural or permanent nature
are being achieved. For the euro area as a whole, however, it is too early to reach definite
conclusions. In order to foster higher and sustained economic growth and job creation and enhance
the capacity of euro area countries to adjust to shocks, further reforms are needed that can contribute
to improving the efficiency, flexibility and adaptability of product, labour and financial markets.
Financial stability outlook
I would now like to address a number of issues concerning financial stability and integration in the euro
area. As you know, the ECB monitors and analyses risks to financial stability in order to assess the
financial system's shock-absorbing capacity. At the end of 2006, our assessment suggested that the
main scenario for euro area financial stability remained broadly favourable. Various considerations
underpinned this judgement, including: first, global economic activity was expected to remain robust
and become more evenly balanced; second, the credit quality of banks' key counterparties -
households and firms - generally remained high; and third, euro area banks' profitability was
anticipated to strengthen further, their solvency ratios comfortably exceeded regulatory requirements
and risk management methods had greatly improved. Against the background of the positive
macroeconomic outlook and benign financing conditions, and in the light of the latest information on
the euro area banks' performance, that assessment has been confirmed.
At the same time, several pre-existing sources of risk and vulnerability remain and some of them might
even have grown in importance. Among the vulnerabilities in financial markets, I would like to highlight
the following three: first, the low levels of long-term yields and credit spreads in some markets make
them vulnerable to a reappraisal of risks; second, unabated growth in the volume and complexity of
new financial instruments, combined with the increasing presence of lightly regulated and highly
leveraged financial institutions in the same markets could have made them vulnerable to disruptive
adjustments with possibly unforeseen consequences as it is not always clear where the risk exposures
ultimately lie; and third, rapid re-leveraging in some parts of the euro area corporate sector, partly
induced by a surge in leverage buy-out activity, makes a turn in the credit cycle increasingly probable.
The global financial market turbulence of late-February and early-March of this year vividly highlighted
the existence of some of these market vulnerabilities. It seems to have reflected an abrupt reappraisal
and re-pricing of risks in response to a combination of triggering events, especially a rising concern
about rapidly deteriorating credit quality in the US sub-prime mortgage market and, more generally,
increased uncertainty about the macroeconomic outlook in the United States. This temporary increase
in financial market volatility served to illustrate how an abrupt decline in risk appetite, when asset
prices may have departed from intrinsic values, can result in very sharp changes in asset valuations,
even when changes in the economic fundamentals are relatively small.
Looking ahead, in this context of what we have called "pricing for perfection" - in the sense that some
asset valuations appear to be based on highly optimistic expectations about future economic
outcomes and very low risk premia - some markets could continue to prove vulnerable to adverse
disturbances and changing market sentiment. Added to this, there is uncertainty about how markets
for innovative and complex financial instruments (in particular, structured credit derivatives) will
perform and how lightly regulated and highly leveraged financial institutions will behave in a more
challenging macrofinancial environment.
That said, financial innovation and the growth of alternative investment vehicles, such as hedge funds,
have had, in our assessment, an overall positive effect on financial markets in Europe, contributing
significantly to enhanced market liquidity and greater pricing efficiency, portfolio diversification and a
better distribution of risks within the financial system. However, hedge funds' activities are also
associated with potential operational and systemic risks. Moreover, the monitoring and management
of these risks by their counterparties and investors have become more complex. An appropriate level
of transparency is therefore important for effective market discipline and for the assessment and
management of risk by the counterparties of such institutions and by investors.
A final point I would like to stress with regard to the activities of the Eurosystem in the field of financial
stability concerns its ability to cope with a possible financial crisis affecting the euro area. To this end,
the Eurosystem carried out a comprehensive financial crisis simulation exercise in May 2006 which
confirmed its preparedness to deal with potentially systemic events that could affect the euro area's
financial system. This exercise also contributed to the enhancement of the existing arrangements for
managing financial crises.
European financial integration
Before closing, I would like to say a few words on European financial integration. A well-integrated
financial system in Europe is beneficial for the European economy for a number of important reasons:
it promotes economic growth by raising the economy's growth potential and adaptability; it enhances
the smooth and effective transmission of monetary policy impulses across the euro area; and it is
expected to positively affect financial and macroeconomic stability. Although intensified cross-border
financial links may imply potentially an increased risk of financial contagion, the improved risk-sharing
made possible by deeper and more integrated markets should contribute to a more balanced systemic
response of the economy to asymmetric shocks - which is, of course, of particular relevance for the
smooth functioning of Economic and Monetary Union. This is not a theoretical argument. The evidence
available for the United States shows that banking integration across the federal states has led to a
better alignment of business cycles and a reduction in the volatility of economic activity, employment
and personal income growth across the United States.
Given the importance of financial integration for the reasons I have mentioned, the ECB actively seeks
to promote this process through a variety of measures, for example the provision of central banking
services that foster integration and the regular monitoring and reporting on the progress of financial
integration with a view to enhancing knowledge and raising awareness of this process. In line with the
latter objective, the ECB launched in March a new annual publication entitled "Financial integration in
Europe", which provides, among other things, an overview of the main Eurosystem activities pursued
in 2006 that contributed to advancing European financial integration.
Thank you very much for your attention. I am now at your disposal for questions.