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Making the Most of the Euro|
First Deputy Managing Director
International Monetary Fund
"Banking on the Euro: Leap of Faith or Act of Folly?"
Royal Institute of International Affairs
London, February 25, 2002
Mr. Chairman, Ladies and Gentlemen.
It is a great pleasure to attend this conference, not just because of the variety and quality of the participants, but also because of its historic location here in Chatham House. William Gladstone, one of three prime ministers to make this building his home, once said of making speeches: "I absorb the vapor and return it as a flood". In Gladstone's case the flood would often continue for three or four hours unabated. Let me reassure you that my comments today will be a mere trickle by comparison.
One advantage of having just 20 minutes to speak is that I do not have adequate time to pronounce on the pros and cons of British entry into the single currency. That contentious task I will happily leave to other speakers. But whether Britain decides to embrace the Euro or not, it is in everyone's interest that monetary union is a lasting success, fostering growth, stability and job creation. A strong and prosperous European economy is essential to a strong and prosperous world economy.
What I would like to do today is to touch briefly on some of the macroeconomic and structural policy priorities that are necessary to help bring this about. I will then focus in a little more detail on the importance of a well-functioning capital market and banking system in promoting growth and stability within the Euro area.
2. Macroeconomic and Structural Policy Priorities
Let me begin though by acknowledging what a remarkable achievement monetary union has been to date. Europe's progress towards a single currency over the post-war period has been likened to the emotional rollercoaster of a television soap opera: every advance accompanied by inflated rhetoric about Europe's glorious future; every setback greeted with exaggerated predictions of conflict and disaster. But with the changeover to Euro notes and coins this year, the drama has successfully reached its season finale thanks to determined political leadership and economic convergence. The challenge now is to ensure that this positive political and economic momentum is maintained in the years to come and that monetary union delivers on its promise.
Fortunately, macroeconomic policy in the Euro area is built upon firm institutional foundations. Despite initial skepticism in some quarters, the European Central Bank has clearly established its independence and commitment to price stability. The ECB faced a difficult policy environment last year, with growth slowing and inflation above its target range. The ECB responded appropriately, lowering interest rates modestly to begin with and then responding more resolutely when September 11 unsettled financial markets and dealt a blow to business and consumer confidence.
We now appear to be at or near a turning point in global economic activity. This is always a particularly difficult juncture at which to set monetary policy. For now, the risks to medium-term price stability seem pretty evenly divided. If recovery proves sluggish, additional easing could be required. But the inflationary impact of an unexpectedly rapid recovery or a move away from wage moderation could argue for a touch on the brakes. For the time being, watchfulness is the key.
The ECB is supported and complemented by the commitment to sound fiscal policies embodied in the Stability and Growth Pact. As recently as 1995, the structural deficit of what would become the Euro area exceeded 4 percent of GDP. Five years later, it was less than 1 percent of GDP. This consolidation allowed Euro area countries to let headline deficits widen last year in response to the weakness of economic activity. Allowing the automatic stabilizers to work in this way was an appropriate response to help dampen the impact of the negative demand shocks that buffeted the region.
However, in some countries this loosening brought the overall deficit uncomfortably close to the 3 percent limit laid down in the Stability and Growth Pact. In January, the European Commission recommended to the Council that "early warnings" be issued to Germany and Portugal, but the Council decided not to do so in the light of fresh commitments to observe the fiscal targets set out in the pact. This reflected a delicate balance between the need to maintain the credibility of the fiscal framework on the one hand, and to support activity in a weak growth environment on the other.
The problem, fundamentally, was that fiscal consolidation during the upswing (while impressive) was not quite sufficient in some countries to allow the automatic stabilizers to work with room to spare. It will be essential to address this as the recovery gathers strength, especially in the key countries lagging in fiscal adjustment.
Macroeconomic policies focused on stability are a prerequisite for strong growth and job creation. But while they are necessary, they are not of course sufficient. The external weakness of the euro seems to reflect a number of factors, including the relative equity boom in the US, portfolio shifts, and a current account position that does not seem to have reacted in typical fashion to the depreciation. But the external weakness of the euro may also in part reflect a belief among market participants that productivity growth will remain lower in Europe than the US in the years to come. An important challenge for European policymakers will be to try to prove them wrong.
At the Lisbon Summit in March 2000, European leaders adopted the goal of creating over the next 10 years an economy with integrated, employment-generating, and smoothly-functioning markets. This will be important not only to boost productivity growth, but in particular to increase the economy's potential output by reducing structural unemployment. Progress to date has alas fallen short in a number of areas. We must hope that the creation of the euro — and now its physical manifestation in notes and coins — proves a spur to the area's longstanding structural reform agenda. If policymakers allow the loosening of exchange rate and current account disciplines to enervate the reform process, then all Europe's citizens will be the poorer for it.
Broader and deeper structural reform is required in a number of areas. For example, there is a broad consensus among economists that growth and job creation in Europe are hampered by labor market rigidities, by overstretched and expensive social security systems, and by subsidies that hinder efficiency and weaken fiscal positions. A study in the IMF's World Economic Outlook of October 1997 suggested that more rapid structural reform could deliver a growth premium of about 5½ percentage points over a 10 year period, helping reduce unemployment by 4 percentage points from a slow-reform baseline. To date, alas, this premium appears to have gone unclaimed.
Further reforming labor and product markets is unavoidable if the European economy is to achieve the productivity growth rates that it is capable of. The same is true of strengthening capital markets and banking systems, through which investment and innovation are financed. Let me talk briefly about this in a little more detail.
3. Reforming Capital Markets and Banking Systems
Monetary union has already had a significant impact on Europe's financial markets. As the Bank for International Settlements (among others) has noted, the introduction of the Euro has helped lower a number of technical, regulatory and psychological barriers that in the past have segmented Europe's financial markets along national lines. Borrowers now have a larger investor base to draw upon. And investors are able to allocate funds to a wider range of instruments and locations. As market participants have taken advantage of these opportunities, we have already seen a deepening of financial markets in the Euro area and increasing cross border activity.
The influence of the single currency has been most visible in bond markets, which were already relatively international in their focus prior to monetary union. At the end of 2000, the stock of euro area government securities was nearly on a par with the US Treasury market at around $2.8 trillion. And, significantly, a growing proportion of bonds issued by euro-area governments are being held by non-residents. Having said this, the multiplicity of issuers in the euro area, and their different credit ratings, limit the liquidity of the market. Greater coordination of release dates, maturities, coupon sizes and other technical features of bond issues could help address this weakness.
Bond issues denominated in euros have been even more popular among private borrowers, both inside and outside the euro area. Widening the range of investor portfolios that can be tapped with a single bond issue, monetary union has helped reduce the cost of capital market financing by allowing issues of greater size.
But issuance continues to be dominated by banks rather than companies, which suggests the market has not yet reached full maturity. The market for high-yield bonds also continues to be hampered by differences in national legal frameworks, for example regarding default and documentation issues.
Monetary union has had a less visible impact on European equity markets. Sectoral factors now appear to be growing in importance relative to national differences in determining equity prices in the euro area. But evolution towards a truly pan-European equity market has been hampered by slow progress in bridging the gaps between existing equity trading infrastructures. Ongoing consolidation of Europe's stock exchanges seems inevitable, but fraught with difficulty. Consolidating nationally focused clearing and settlement mechanisms is a important challenge.
In the money markets, Europe has gained an integrated interbank market, underpinned by the efficient functioning of new payment systems. But integration in the collateralized repo market has proceeded more slowly, with markets remaining largely national and unevenly developed. Partly this reflects different regulatory, legal and tax environments, as well as historical differences in market practices. As a result, for example, there is considerable legal uncertainty about the ownership of collateral in the case of default in a cross-border transaction.
To summarize, the deepening of European capital markets has been impressive, but uneven. In some segments, national legal traditions still stand in the way of creating a single capital market, with all the gains in liquidity and efficiency that could bring. The recent compromise struck between the European Parliament and Commission on the Lamfalussy Report holds out the welcome prospect of faster progress on regulatory harmonization. This could bring a single capital market much closer.
Notwithstanding the changes under way in the capital markets, Europe's financial system remains dominated by its banks — although they are feeling the competition ever more keenly. Consolidation within the banking system has been taking place, but to date largely within national borders. Profitability has been maintained by diversification, while operating costs have remained relatively high. As Europe's banking system becomes more concentrated, more integrated, and more capital market oriented over time, so this will pose important supervisory challenges.
Banking supervision remains organized along national lines, with the same true of the increasingly closely linked insurance sector. Decentralized supervision is helpful in detecting and monitoring slow-to-develop problems with individual institutions. But this approach may be less suited to the increasing capital market orientation of large, globally connected financial institutions where problems can arise and spread quickly, and where rapid intervention may be necessary to deal with problems. If supervision is not to be handled by a single euro-area body, then it is essential that information is exchanged efficiently between national supervisors, national central banks, and the ECB, which would ultimately have to provide liquidity in the event of a crisis. As the Brouwer Report made clear, if Europe is to maintain a decentralized supervisory regime, then it is vital that it operates as efficiently and seamlessly as possible.
Let me conclude by applauding once again the achievement of monetary union. Europe's leaders have overcome formidable obstacles in bringing it about. But if monetary union is to enjoy high levels of public confidence — and to be attractive to potential entrants — then it will have to be seen to contribute to greater economic stability and higher living standards for Europe's citizens. This means getting macroeconomic policy right and accelerating structural reform. No one should underestimate the magnitude of what has been achieved to date; but neither should anyone underestimate the magnitude of what remains to be done.
IMF EXTERNAL RELATIONS DEPARTMENT