Transcript of a Conference Call on the Staff Report of the 2014 Article IV Consultation with the Euro Area

July 17, 2014

Washington, D.C.
Monday, July 14, 2014

Mahmood Pradhan, Deputy Director, European Department, and Mission Chief for the Euro Area
Petya Koeva-Brooks, Advisor, European Department
Ángela Gaviria, Communications Department

MS. GAVIRIA: Hello, everyone. Welcome to this conference call on the staff report of the 2014 Article IV Consultation with the Euro Area. The staff report for this consultation along with a Survey story and a press release were posted under embargo on Friday in the Press Center. We also posted under embargo separately this morning a blog post on QE. It is not part of the documentation of the consultation, but it’s related, explanatory material on our policy recommendation. Now let me introduce the speakers. Mahmood Pradhan, who is Deputy Director in the European Department and has led the work for this consultation. And Petya Koeva-Brooks, Advisor in the European Department. They will make some initial remarks, and then they’ll be happy to take your questions.

MR. PRADHAN: Thank you, Angela. Good morning to everyone or good afternoon if you are somewhere else. I’ll start by highlighting some of the issues in this report before I take your questions.

The focus of this report is on two things: One, to acknowledge that there has been a recovery. A lot has been done. All the policy efforts have been sufficiently strong to begin the recovery, but there’s a lot more that needs to be done to strengthen that recovery.

Let me expand on that. The euro area, as you see from financial market sentiment, has been relatively stable. Confidence has returned. Financial market asset prices, sovereign yields, and borrowing costs have fallen fairly substantially. The recovery is underway, but in our view it is still very, very weak, and fragile. More needs to be done to strengthen the recovery.

Inflation is too low. It has been too low for a while, and for too long. This is a symptom of weak demand, and inflation is significantly below the ECB price stability objective.

Let me turn to the policy areas and what needs to be done to strengthen the recovery. The first is to support demand. Here we would focus mainly on what monetary policy can do because fiscal policy that spans across the euro area is broadly neutral. There’s clearly less fiscal drag than the prior year.

On fiscal policy, it’s a balance between those countries that have a little bit of fiscal space and a large number who don’t. It’s an issue of balancing debt sustainability with demand support. Our assessment and conclusion is that the current stance across the euro area is broadly appropriate.

On monetary policy, we very strongly welcome what the ECB has done recently. There are a whole range of measures which we think will lead to a substantial expansion of liquidity. These should be quite persuasive in convincing markets that the ECB intends to maintain a very accommodative stance for an extended period, and I think financial markets will really register that. In the event that inflation remains low for longer or, as we said in our concluding statement, if it remained stubbornly low, we think the ECB will need to do more, but we’ll come back to that later in your questions.

The second area to strengthen the recovery is to continue mending balance sheets, both in the public sector and the private sector. A very important part of this process is the banking union, on which we think there has been substantial progress. As part ofthis exercise. Later this year we will see the completion of the comprehensive assessment, the balance sheet assessment by the ECB, and we note in the report that banks have already been raising substantial amounts of capital ahead of the results of this asset quality review in the comprehensive assessment.

We urge the authorities to continue that effort to make sure the banks are proactive in raising capital and strengthening their balance sheets. We think the exercise is doing well. We await, like everyone else, the results.

The other supporting architecture around this is the resolution mechanism and resolution fund. We are pleased with the agreements that have been reached in setting them up. However, we do point out that this architecture still lacks the common fiscal backstop which we think will be needed in extreme crisis events.

On balance sheet repair, we also emphasize the need for repairing balance sheets of the private sector -- particularly the corporate sector, where the debt overhang in a number of countries is very high and is impeding the recovery.

The third issue to strengthen the recovery is to continue to advance structural reforms. Typically, we deal with a number of structural reforms in country-specific discussions in our bilateral Article IV consultations with individual euro area members.

Here in this report we look at structural reforms that can be advanced from the center. We highlight two particular areas: One is to develop capital markets in a way that reduces the dependence of the real economy on banks. Europe is a very bank-based financing system. A more diversified system would increase the resilience of the real economy when banks are under stress. In particular, you will see in the report that we have some supporting analytic work in the background papers that looks at expanding the market for securitization of assets. I will take specific questions on that later.

The second area where structural reforms can be advanced from the center is to deal with the very high unemployment, particularly youth unemployment. There is a lot of supporting work in this report on what to do about youth unemployment. We favor two areas: One is to reduce the tax wedge. Broadly speaking, that’s to make young people more competitive in the labor market. Secondly, to implement more targeted training programs, what we call the active labor market policy.

Those are the two structural reform areas -- capital markets and unemployment -- in the report. Let me finish off by talking about two things.

In this report, and in a background paper that you will see, we explore ways to simplify the fiscal governance framework. This is a more medium-term issue. We start with the premise that the current framework has become too complex. Some of the specific components of the current framework may not work very well with each other; there may be inconsistencies. There’s a broader issue here about making the framework credible. Because it is too complex, it is often difficult for outside observers to follow, and it could be simplified.

We say in the report that European officials could explore ways of simplifying it, but this is an ongoing discussion. I just want to emphasize that it’s not related to any current discussions about flexibility within the current framework, the Stability and Growth Pact.

Lastly, let me talk a little bit about what Angela mentioned in your material today. There is also a blog on QE -- Quantitative Easing -- that will be released at the same time. It’s an independent part of this. It’s not part of the consultation. What it shows is how quantitative easing, in our view, would work if and when it is necessary.

Let me emphasize again that the measures that the ECB has announced recently and is now implementing -- here I’m talking about the targeted funding, the negative interest rate, the forward guidance and the LTROs, and the sterilization and non-sterilization of its current SMP holding -- together as a package amount to a substantial expansion and a substantial increase in its accommodative stance.

The blog I mentioned is about if these measures do not materially change the inflation outlook and the ECB needs to do more. It explains how it could be done, and more importantly, how it would work.

Let me stop here, and I’d be happy to take your questions.

QUESTIONER: My question is about the development of the securitization market which you alluded to. Do you think that would amount to a substantial push to credit to the real economy? Would it be sufficient in scope to help in promoting more credit to the real economy in the euro zone?

My second question would be about the QE blog, which I haven’t had the chance to see, but could you give us some details on that? How do you think QE could work in the case of the euro area?

MR. PRADHAN: On securitization, just to give you a perspective, the market for securitized assets is very small in Europe. We would like to see -- and I think many European officials agree – a larger proportion of financing coming from capital markets rather than directly from banks. This would be a better system for the real economy; it would also be a more resilient system.

Specifically on your question: Would it expand credit to the real economy? I think this is a medium-term issue. Right now we’re looking at a small, securitized market of about €200 billion outside of mortgage bank securities. There are a number of hurdles to overcome to expand this market. Some of them come from regulations -- this has to do with risk weights. These could be changed quite quickly. This requires agreement among global regulators at the FSB.

There are other hurdles. They have to do with things like solvency frameworks, transparency. Normally, to give you an example, for securitized assets, investors who buy these assets would like to see all of the accounts of small and medium-sized enterprises; a track record for at least 3 years or so. Much of this transparency may not exist at this stage, so there is quite a lot to do.

To answer your question, it would not be an immediate way of expanding credit to the real economy. In this sense, we fully support the current strategy of the targeted LTRO at the ECB.

Your second question on the QE blog is quite general, so let me just say that what it does is explain how you could expand the central bank’s balance sheet, the ECB’s balance sheet, by purchasing assets. There are various ways of doing it, and it goes through how you might want to do it, what is a relatively neutral way to do it, and how it might work. What effect would it have on asset prices, and how would it raise inflation and inflation expectations. But let me emphasize again, that’s if and when it is necessary.

QUESTIONER: It’s just a follow-up on my previous question. Would QE work only if public assets were included or do you think it’s feasible excluding public assets or sovereign assets, as some people seem to think in the euro zone?

MR. PRADHAN: The blog also explains that QE, in principle, can work through the purchase of private assets or public assets. The objective of expanding the balance sheet would be achieved by either.

In the euro zone right now the size of these private asset markets is relatively small. You would need an expansion of these asset markets to engage in a QE program entirely through private assets. The blog explains that because these markets are small, right now a QE program of sufficient size and to be effective would need to be implemented through the purchase of sovereign assets or public assets, as you call them. Here we mean government bonds of the member countries.

Does that answer your question?

QUESTIONER: Yes, it does. Of course, there are other public sector issues, but I suppose that’s not a very large market either, like EIB or ESM or other European institutions’ assets.

MR. PRADHAN: You could include assets of the EIB or the ESM. In principle, they’re assets that are in the same market space, but these are not the assets we’re thinking of because they’re quite small these days. You would not purchase EIB assets because it’s a development bank. Their business model is different.

MR. MIRLY: Right.

MS. GAVIRIA: We end this conference call here. Thank you all for participating. Thank you, Mahmood. Goodbye.

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