Transcript of a Conference Call on the Staff Report of the 2013 Article IV Consultation with the Euro Area

July 25, 2013

Washington, D.C.
Thursday, July 25, 2013

Mahmood Pradhan, Deputy Director, European Department, and Mission Chief for the Euro Area
Petya Koeva-Brooks, Deputy mission Chief for the Euro Area
Ángela Gaviria, IMF Media Relations

MS. GAVIRIA: Hello, everyone. I'm Angela Gaviria, with the Communications Department of the IMF. Welcome to this conference call on the staff report of this year's Article IV Consultation with the Euro Area.

Let me introduce now the speakers. With me here are Mahmood Pradhan, who is Deputy Director in the European Department, and the Mission Chief for the Euro Area, and Petya Koeva-Brooks, who is the Deputy Mission Chief for the Euro Area.

Mahmood, will start with some brief points, and then they will be happy to take your questions.

MR. PRADHAN: Thank you very much. Good morning or good afternoon, everyone. I'll take a few minutes just to cover the highlights of this year's report that you now have.

First, let me start with taking stock of where we are. In this report, as you will see, we acknowledge substantial progress over the last year in addressing tail risks.

We're almost at the anniversary of President Draghi's "Whatever it takes" announcement last year, So let me take stock of what has been done since then. In addition to OMT, we have had substantial progress on building the banking union. Secondly, we have had the ESM become fully operational. Thirdly, we have had extension of maturities for official financing for some countries. And, finally, resolution of some difficult cases -- here, I'm thinking about Greece and Cyprus.

All of this, collectively, has led to an impressive degree of stabilization, where we see sovereign financing at a much more comfortable level now than a year ago. But we worry that the economic recovery across the euro area still remains elusive, and this weakness is now not only in the periphery but also in the core countries. Let me start by saying on the outlook that we see a mild recovery in the second half of the year, but very weak growth, and risks to growth still tilted to the downside.

So let me now turn to our key policy messages, what the euro area collectively needs to address.

First, we have focused very extensively in this report on financial fragmentation. And I want to treat this subject in two parts.

The first part is the health of banks. Across the euro area we see a very diverse picture. We see funding problems in banks in some countries. We see quite a strong perception of weakness -- and I want to emphasize "perception" -- in some banks, which is causing their funding costs to be high, and their ability to lend very weak.

That's also affecting the transmission of monetary policy. The ECB has maintained a very accommodative stance, but that is not being transmitted across the euro area, as I'm sure you're all familiar with.

Now, we think of addressing this problem in two ways. One is a structural problem, which is addressing the health of banks. And here, we are fully supportive of the euro area's efforts to strengthen banks. This involves, first, a balance sheet assessment to look at the health of banks, to look at the quality of their assets. Here we're talking about a realistic, transparent, and credible valuation of assets. And then identifying, through this process, the capital needs of banks. And, thirdly, having an ex ante plan of how these capital needs will be met.

To elaborate on that, we do not have a clear impression of where these capital needs are, whether they are concentrated in some countries, or they are spread across euro area banks. We suspect there's an element of both. But I want to say that the only way to know the real picture is to do this assessment. This assessment will be followed by stress tests which identify capital needs under various adverse macroeconomic scenarios, and then calls for how much capital various banks need.

I referred also to an ex ante plan. Here we're thinking that the euro area needs to have a plan of how these capital needs will be met. We would see the first recourse being the private markets, the private sector, and we think a credible assessment which involves a realistic valuation and dilution of existing shareholder’s stakes in banks is a necessary prerequisite to attract private capital. And, as I said, the first recourse should be private markets.

Secondly, there will be some countries which have sufficient fiscal space to provide public sector support for their banks’ capital needs.

And thirdly, in the final recourse should be the ESM. The ESM now has guidelines for direct recapitalization of banks.

I should emphasize here that when we think about capital needs for the program countries, the capital needs of banks are already, in some sense, allowed for within the program financing envelope. So the ESM will be the last resort. And, very helpfully, the ESM guidelines that have been finalized have now dealt with the issue of legacy assets: specifically, no assets will be excluded, and direct recapitalization can be done in a retroactive way.

Part of this fragmentation, as I mentioned earlier, is also impairing the transmission mechanism. And while restoring the health of banks will take time, we see a stronger role for the ECB.

So, to ask ourselves what more can the ECB do, we have suggested that they can provide liquidity support, both in a general sense -- and here we think of a longer-tenure LTRO. And also in a more targeted sense, to make sure that SMEs get credit, we could have a targeted LTRO, somewhat similar to the U.K.'s Funding for Lending scheme -- happy to elaborate on this during the question and answer session. That's what the ECB can do.

The third area of policy is, given what I said earlier about our outlook for relatively weak economic growth in the medium term, and the risks tilted to the downside, the euro area institutions providing stronger demand support. On fiscal policy and the European Commission's Excessive Deficit Procedure, we welcome in this report their extension of deadlines, allowing countries more time to meet their fiscal targets.

For the ECB, we still see a strong imperative to maintain a very accommodative stance. And, here, let me elaborate a little bit on their recent adoption of forward guidance. We see this forward guidance as part of a process. We think it started earlier with the fixed-rate full allotment, and then repeated assurances to the market that an accommodative stance would be maintained for an extended period.

However, in the current global environment of very volatile rates, some of this is not having as powerful an effect on money market interest rates in the euro area as we would like to see. Here, I'm referring to money market rates one year ahead, or two years ahead. Those rates are higher than what the monetary policy stance would indicate. And the ECB earlier this month, on July 4th, introduced a more specific form of forward guidance, yet it is not being as effective as they would like. So we would suggest that there is room to be more proactive on forward guidance, and perhaps more aggressive.

Finally, let me say that in this report we look at the fourth plank of the policy effort as structural reforms. Now, here, structural reforms, in many cases, are country-specific, and these are dealt within our individual Article IV Consultation reports on these countries.

But at the euro area level, the European Services Directive could play a strong role in completing the Single Market, liberalizing a lot of professions, a lot of the real sector economic activities. And these vary across countries, the various restrictions that currently exist.

The European Commission has produced, earlier this year, a very helpful and a very extensive report on this, identifying where the remaining reforms are, what needs to be done, and the bottlenecks, and also the potential economic benefits. We would urge this at the euro area level. This is the subject we treat in this report. And, as I said earlier, very specific structural reforms with regard to each of the member states are dealt with in the individual Article IV reports.

Let me stop there, and very happy to take your questions.

QUESTIONER: Two things: you seem to be leaning, in this report, really strongly on the ECB to do more. I was struck by this call for -- it seems to be a call for third-party oversight of the bank asset quality review. Does that indicate that you don't trust the ECB, or that you just think you need to anchor credibility by having somebody look over their shoulder? And, secondly, there's this graphic, it's sort of a line graph of political tension index, or something like that. And I'm wondering, is that just a straight correlation with the unemployment rate or is there some other measurement that's coming into play there that you're using?

MR. PRADHAN: On the third-party oversight, thank you very much for raising this point. I should have mentioned this in my remarks.

We think that an independent third-party involvement in these assessments is essential to make the process credible, and transparent. As you may be familiar with, in previous exercises -- we had a large stress-test exercise by the EBA a couple of years ago -- there was skepticism whether that truly reflected the state of the banks. This call is really meant to address that, because we would like something that settles, in a sense, in a credible way what the capital needs are, and it doesn't leave this perception problem or doubts about whether this exercise was adequate or not. And that's really what this third-party call is for.

It's not a view that the ECB is not credible. Turning to the details, this is, by the way, a massive exercise. This includes, in the first instance, all the banks that will come under the Single Supervision Mechanism of the ECB. So we're talking about large banks, and a large number of banks -- something in the order of 130. This is not something that can be done by one single institution, just purely from a resource point of view. It's not just, by the way, that the ECB will do it by itself. It will not. It will have to work with national supervisors across the 17 member states. So, what I would say is that the third-party involvement will be with the ECB, but also with the national supervisors.

On your second question, I'll ask my colleague Petya to answer.

MS. BROOKS: I assume you're referring to the chart on page 8. It's just a simple correlation between an index of political risk in Europe and the unemployment rate.

And, as always, we are careful not to infer causation from simple correlations. But I think in this particular case, one could make the argument that when the real economy gets in a very bad shape, and we have a high level of unemployment, this comes with mounting political and social tensions. These, in turn, can undermine the reform momentum, and the willingness of the euro area to move forward towards further integration.

QUESTIONER: I guess my question is how do you measure political risk? What is the IMF's official index of political risk?

MS. BROOKS: No, we actually use an external index. I'm happy to, after the call, give you the precise source. But this is not something that we define ourselves. We use external sources.

QUESTIONER: I want to ask about page 9, where you're talking about low demand -- isn't fiscal policy in the euro zone contractionary? Doesn't that make things worse? And I'm thinking, here, of the U.S. The Fund is critical of the U.S. fiscal contraction as not being particularly good policy. Isn't this contractionary fiscal policy within the zone a real problem?

MR. PRADHAN: It weighs on demand, and we recognize in this report that it weighs on growth, it is a drag. But the reality is that for a lot of countries there is very little fiscal space.

What we have called for -- and not only, by the way, in this year's report, but also, if you're familiar with last year's report – is a much slower pace of adjustment, especially where there is fiscal space. But many countries have been under financing pressures from the markets, and there is not much room.

The second point I would make is, again, not just this year but last year, we have emphasized that the fiscal adjustment effort should be defined and framed in terms of structural measures rather than nominal deficits. This is really a recognition that some of the fiscal problems, or some of the fiscal constraints that governments are facing, stem from lower growth, or the decline in revenues, and so on.

And a third point I would make is that while you are right that, in aggregate, the fiscal stance is contractionary, as the report highlights, the degree of that contractionary stance is falling now. So, it's not as contractionary as it was last year.

QUESTIONER: I was just hoping to ask your reaction to the ECB's latest decision to relax its collateral rules on asset-backed securities, and how this plays into how they can counter fragmentation and support demand?

MR. PRADHAN: Thank you for that question. It allows me to mention something I should have said at the start, which is that part of the ECB support, the targeted support I mentioned, is within the banking system. There are initiatives in the euro area with the EIB and the EU, to look at how more direct support can be provided to the SME sector. And this uses the EU structural funds, with the EIB taking on some risk. And, as you know, because the EIB, with its capital base, can borrow from the markets and do joint deals with the private sector, that has a potential of being a reasonably large amount of assistance.

Now, turning to your specific question, we welcome this move, because what it implies is that the ECB is willing to treat, as part of Eurosystem collateral, some of the risky tranches of asset-backed securities that are based on lending to the SME sector. This can be used in repo markets, and the ECB would provide liquidity against these tranches. So we strongly welcome this. It is another way the ECB can provide support.

And this can be –- this is an important point I want to emphasize, given what I said earlier about fragmentation, weak banks, the transmission mechanism, etc – this can be something that goes outside the banking system.

And, finally, let me say that, just to put it in context, corporate finance in the euro area is very heavily bank-based in comparison to other countries such as, for example, the U.S. So, to expand the ABS markets, and to use some of these ideas, like the EIB, and these institutions, is a very welcome move to diversify finance in the euro area. But we recognize that this is a capital market development issue, and will take some time.

QUESTIONER: Since we are coming up on a year, as you mentioned, of Draghi's speech, I just wanted to step back from a lot of the details and ask you whether or not, a year ago, when Draghi made this announcement and then followed it up with OMT, whether or not this is what you envisioned happening a year later. I mean, the impression I get from this report is that everything is kind of, on a real level, is kind of stuck. Credit isn't improving very fast, you know, wage and productivity levels have come down some, but aren't really changing as dramatically as perhaps might be needed. Everything is just kind of grinding along. And I'm wondering whether this is what you all expected, or whether or not it's just going a lot slower than you'd hoped.

MR. PRADHAN: I'll take your question in three parts.

The first is, as I said earlier, that the counterfactual without OMT would have been much worse. We don't know exactly what the counterfactual would be, but I want to emphasize how helpful OMT has been.

You know, there are lots of people who were talking about existential threats to the euro area. That’s a really important thing to address. So I think we should not take that lightly. I mean, that's a very strong contribution.

The second part is, yes, in terms of our assessment of the outlook, relative to a year ago, things look weaker. And as I said earlier in my remarks, the weakness has spread to the core, and the report analyzes that in detail.

The third part is a kind of subjective assessment. Look, they have embarked on some pretty big initiatives. If you stepped back a year ago, at the Leaders’ Summit, around the same time, they announced a plan to form a banking union. This is a very, very complex construct. You're starting from scratch. And if you look back over a year, a lot has been achieved in terms of the banking union.

Yes, there are difficult hurdles ahead, and as the report recognizes, the Single Resolution Mechanism is a difficult thing to establish, but it is necessary. Now, here we see a slower pace than we would have liked, but it's not slower than where you would have thought progress would be a year ago. The Commission has come out with a proposal that will be discussed in the Council and the European Parliament by the end of the year.

The important thing is that the Single Resolution Mechanism needs to be in place when the Single Supervision Mechanism is operative, is effective, which should be sometime next year.

So, yes, the euro area faces a very difficult, very challenging economic backdrop, but I do not think we should understate the amount of progress.

QUESTIONER: My question is about the banking union. What do you think is the main priority? You said the Single Resolution Mechanism. But, say, if you were to give a suggestion about something the euro zone should implement or do by the end of the year, what would that be? And what is the biggest hurdle that you see?

MR. PRADHAN: In terms of asking what is it that is causing financial market fragmentation, a really important part has already been done, and is going to be in place very soon -- and that's the Single Supervision Mechanism. I'll come back to the resolution part in a minute.

What we have observed in the euro area is what banks call "ring fencing," which is liquidity not being allowed to move across borders. Supervisors being very concerned about the health of their banks and their exposures, and so these exposures to other member countries have declined. Cross-border flows in the banking system have declined.

The Single Supervision Mechanism is intended to address that, to make sure that the supervisor does not restrict banks to keep liquidity within one member state. Now, the legislation for the Single Supervision Mechanism, should be approved in September, and then a year from then the ECB can be the effective single supervisor. I think that's very important progress by the end of the year.

The second part, in terms of resolution, is the Bank Recovery and Resolution Directive, which has been approved in principle, at the high level, and the details should be approved by the end of the year.

This is very important when it comes to what I mentioned earlier about identifying bank capital needs, and how to meet these capital needs, because there will be a need to bail-in private stakeholders. And a consistent framework for the EU, needs to be in place for that to happen. And that is also planned to be operational by the end of the year. It doesn't become operational, by the way, until 2018, except when the ESM is used for direct recapitalization. So for that, it would be earlier, and that would be sometime late 2014, early 2015, once the SSM is operational.

So those two things are important. And the resolution directive, the Bank Recovery and Resolution Directive is a prerequisite for the Single Resolution Mechanism because that's how resolution will work.

So, just to recap -- you asked about what's really important. It's very important that the SSM be finalized and that it be approved by September so that the ECB can begin to be the supervisor in September next year. And for the resolution framework -- i.e., the BRRD that I'm referring to -- be agreed on by the end of the year.

MS. GAVIRIA: Before we move to the next question, Petya would like to respond to a question asked earlier about the political risk index.

MS. BROOKS: Yes, we have the precise source now. It is the Political Risk Services Group, the International Country Risk Guide.

MS. GAVIRIA: Thank you, Petya. Next question?

QUESTIONER: I was wondering if we could talk more about what more the ECB could do. You mentioned, for example, something similar to the Funding for Lending scheme that the U.K. central bank does. Can we just talk, generally, what more can the ECB do about lending? And is further rate cuts, for example, part of that?

MR. PRADHAN: Let me start with things I've already touched on. We have called for changing the collateral framework and, particularly, reducing the haircuts for some of the assets that it accepts for liquidity provision. The additional credit claims is one, and we welcome the recent announcement that the collateral requirements on some of the lower rated assets, the haircuts on those, have been reduced. So that's very helpful. That essentially eases, if you like, the cost of funding for banks, or at least gives them more funding.

Also, the ECB could implement a longer-tenure LTRO. And that would essentially give more term funding for banks, for longer periods, and more certainty of funding.

Thirdly, in line with the example of the U.K. Funding for Lending scheme, given where interest rates are, and where private-sector borrowing costs are in some euro area countries -- i.e., relatively high -- in this report we say that a scheme similar to the U.K.’s would actually work in Europe because the advantages for banks to use this scheme, the incentives, would be substantial, which may not always have been the case in the U.K.

Lastly, you asked about monetary policy and interest rates. We think the ECB can take rates to negative levels. There are pros and cons -- and here, I'm talking about negative deposit rates. Right now, the deposit rate on excess balances at the ECB is zero. So if the rate on that was marginally negative, there would be --and this is a complete hypothetical -- if the excess liquidity, these balances at the ECB stayed at the same level, that would be the cost of the small negative rate from that.

But the benefits of negative rates would be, firstly, the lower cost of liquidity for a large number of euro area banks, especially in those countries under stress. Secondly, you could see a revival of the interbank market, which has been very dormant, at the zero lower bound, etc.

Thirdly, outside of the banking system, there could be substantial benefits in looking at yields in some of the countries under stress, where yields are quite high. This is really an argument by investors searching for yield.

But outside of all of this, in terms of the assessments of pros and cons, negative rates would also constitute a very, very strong form of forward guidance. And the objective here of forward guidance is to ensure that the ECB's policy rate, and its statements that it wants to maintain an accommodative monetary stance for an extended period, is credible in money markets, that it keeps one-year-forward rates, two-year-forward rates low, almost to the policy level. And that's the current challenge.

MS. GAVIRIA: Okay, thank you very much, all of you, for participating.


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