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. * * * 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

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,