1 Philippe Moutot Deputy Director General Economics Euro area economy and enlargement at times of financial crisis Visit of the Dutch House of Representatives (Finance and Europe Committees) Frankfurt am Main, 21 September 2009

2 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

3 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit-strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

4 Turmoil started in 2007 in US as sub-prime crisis Intensification in autumn 2008 (Lehman Brothers) Functioning of money market seriously hampered Spill-over of financial stress to real economy  severe downward impact on economic growth The unfolding of the crisis

5 World real GDP growth Source: Eurostat. Latest observations: 2009 Q1.

6 Source: Eurostat. Latest observations: 2009 Q2. Euro area real GDP growth

7 Euro area real GDP growth: historical perspective Source: Eurostat. Latest observation: 2009 Q2.

8 Euro area industrial production: historical perspective Excluding construction production Source: Eurostat. Latest observation: 2009 Q2.

9 GDP growth forecasts / projections

10 Eurosystem staff projections for euro area growth Real GDP growth between -4.4% and -3.8% in 2009 and between -0.5% and 0.9% in 2010 Upwards revision of the range for both 2009 and 2010, reflecting the recent, more positive developments and information GDP expected to continue to stabilise in second half of 2009, before gradually recovering during 2010 Projected improvement mainly supported by revival of exports and positive effects of fiscal impulse on domestic demand

11 Risks to the growth outlook Risks are balanced and result from  Effects from the macroeconomic stimulus from various policy measures  Confidence improvement  Favourable developments in labour markets and foreign demand On the other hand  Stronger impact on the real economy from the turmoil in financial markets  Increases in oil and other commodity prices  Intensification of protectionist pressures  Adverse developments in the world economy from disorderly correction of global imbalances

12 Inflation Latest observation: August Sources: BIS, Eurostat and ECB calculations HICP, (percentage change compared to the previous year)

13 Source: Eurostat. Last observation: HICP August (percentage points, annual percentage changes) HICP inflation and contributions from energy and foods

14 Background slides Employment growth by sector (annual growth rates) Labour cost indicators (annual growth rates) Current labour market developments Source: Eurostat and ECB.

15 Euro area unemployment rate Percent of labour force Latest observation: July Source: Eurostat.

16 Sources: Reuters, Consensus Economics and ECB. 1 ECB’s Survey of Professional Forecasters Gathers expectations for euro area inflation, economic activity and unemployment from experts affiliated to financial or non-financial institutions based in the European Union. Latest observations: 20 August Inflation expectations (annual percentage change)

17 Survey based and market inflation expectations in the euro area Percent per annum Source: Reuters, Consensus, and ECB calculations. Latest observation: 15 September 2009.

18 HICP forecasts

19 Eurosystem staff projections for euro area inflation Price and cost expected to remain dampened in the wake of ongoing sluggish demand in the euro area and elsewhere Annual HICP inflation projected between 0.2% and 0.6% in 2009 and between 0.8% and 1.6% in 2010 Slight upward revision for both 2009 and 2010 compared with the June 2009 ECB staff projections, reflecting mainly upward revisions to energy prices

20 Risks to the inflation outlook Risks are broadly balanced and relate to  weak outlook for economic activity  higher than expected commodity prices  stronger than currently expected increases in indirect taxation and administered prices due to the need for fiscal consolidation in the coming years

21 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit-strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

22 Since the intensification of the financial crisis in autumn of 2008 … and against the background of rapidly receding inflationary pressures … … the ECB has taken a series of monetary policy and liquidity management measures … … unprecedented in nature, scope and timing Unprecedented response by the ECB to the crisis

23 ECB response: strong decline in ECB interest rates P ercentages per annum; daily data Source: ECB Last observations: 16 September 2009

24 ECB response to the crisis – enhanced credit support Primarily bank-based measures to enhance the flow of credit beyond the standard interest rate channel - Fixed-rate full allotment - Expansion of collateral - Longer-term liquidity provision - Liquidity provision in foreign currencies - Financial market support through purchases of covered bonds

25 Note: Breakdown of the sources of external financing of non-financial corporations, in percent, average 2004 – 2008 Source: ECB Monthly Bulletin, April 2009 Different role played by banks in funding firms in the euro area and the US

26 Breakdown of the financing of non- financial businesses in the US (4-quarter moving sum of transactions, in USD bn) Breakdown of the financing of non- financial corporations in the euro area (4-quarter moving sum of transactions, in EUR bn) Sources: Board of Governors of the Federal Reserve System and ECB Last observations: 2009 Q1 Different financial structures in euro area and the US

27 The Eurosystem’s balance sheet In millions, euro Source: ECB Last observations: End-of-August 2009

28 Loans to the private sector Annual percentage changes; adjusted for seasonal and calendar effects Source: ECB calculations. Latest observations: July 2009

29 MFI interest rates Annual percentage points Short-termLong-term Sources: ECB and Reuters. Latest observations: MFI interest rates: July 2009; money market rates: 9 September 2009 (average of daily data).

30 Spread between 12-Month EURIBOR/LIBOR and EONIA/OIS* ( percent p.a.) 12-Month EURIBOR/LIBOR ( percent p.a.) Sources: ECB, Bloomberg. Latest observations: 7 September * OIS: Overnight Index Swap rates Money market rates and spreads compared with those in other major currencies

31 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

32 The ECB has an exit strategy and is ready to act when the time comes No pre-determined sequence between the exit from non-standard measures and interest rate action  depends on the assessment of risks to price stability Key elements –Exit will be part of the ECB’s monetary policy strategy –ECB's non-standard measures were designed with exit considerations in mind –The ECB has full technical capability and institutional independence to start exit when needed –The ECB has established a track record for acting in a timely fashion The ECB’s exit strategy to unwind the various non-standard measures

33 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

34 Fiscal measures to stabilise financial markets Bank rescue plans in 14 countries, new bail-outs planned € 136 bn in capital injections and €1.9 trillion in loan guarantees EA governments committed 26% of GDP to rescue banks Action on the global front to tackle root problems European Economic Recovery Plan 16 fiscal stimulus plans, 1.1% of GDP in 2009, 0.8% in 2010 Extra budgetary measures and automatic stabilisers add up to an overall stimulus of about 4.7 % of GDP over 2009 and 2010 Action on structural reform priorities Fiscal measures

35 Main fiscal indicators for EU countries Source: AMECO Database, European Commission. DG-ECFIN. Spring 2009.

36 Source: Bloomberg, Datastream and ECB calculations. Last observation: 15 September Ten-year government bond spreads vis-à-vis Germany Daily data in basis points

37 A way back? Simulations of euro area government debt levels Debt simulations (2011 onwards): Assumptions: potential growth at 2.25%, starting values for 2010 given by the Commission forecast Scenario 0 (red): no-change-policy (constant primary deficit at 3.3% of GDP) Scenario I (blue, see previous slide): revenue ratio to GDP constant; real expenditures constant; in sum: consolidate by about 1 p.p. annually, deficit close to balance by 2016 Scenario II (purple): consolidate by only 0.5 p.p. annually, balanced budget reached by 2023

38 General principles for fiscal exit strategies Condition of banking sector primary criterion for phasing out of support to the financial sector Fiscal exit should start no later than the economic recovery Consolidation efforts should also take into account growth prospects, the size of deficits and debt and long-term sustainability Consolidation strategies should be in line with the Stability and Growth Pact Pace of consolidation must be maintained and stepped up in good times

39 Lessons to be drawn? (1) Make financial markets more effective by Stricter regulation of all financial market participants and products More adequate capital requirements and accounting rules Stronger international cooperation in financial oversight Appropriate time horizon for macro-economic policies Adjustment of banking models and remuneration systems Global management of global risks ?

40 Lessons to be drawn? (II) Moreover: Strengthen incentives that improve disciplining forces of competition Discourage “short-termism” and strengthen concept of liability and responsibility The value of monetary union has never been greater than during this financial crisis

41 Overview 1.Euro area economic activity and inflation 2.The monetary policy response to the crisis 3.The ECB‘s exit strategy 4.The fiscal policy response to the crisis 5.Euro area enlargement

42 Benefits of euro adoption a) For the individual country stable exchange rates in relation to most important trading partners reduced transaction/information costs credible framework for monetary policy and price stability = low risk premia and low long-term interest rates b) For the euro area completion of the internal market for goods, services, labour and capital

43 a) For the individual country differences in business cycles may lead to “suboptimal” interest rates in the national context and the emergence of local “bubbles”/ “crises” unless convergence is sustainable, a country can run into competitiveness problems without sufficient flexibility to adjust to changes in competitiveness/shocks - risks of protracted economic losses. b) For the euro area could affect the credibility of EMU in case of lack of convergence. Risks related to premature euro adoption

44 Source: Eurostat. Real GDP growth (annual percentage changes) The adjustment in the CEE Member States

45 The road to the euro Accession to the EU Entry into ERM II Assessment of convergence, formal decision on entry and conversion rate Adoption of the euro ERM II membership Optional: Pre-ERM II phase ERM II membership Technical preparations (as stipulated in the Treaty)

46 Convergence criteria There are four criteria for examining economic convergence Price stability Fiscal position (general government deficit and debt) Exchange rate Long-term interest rate In addition, “legal convergence” (i.e. compatibility of national legislation) is examined

47 Exchange Rate Mechanism II: main features Fixed but adjustable exchange rates vis-à-vis the euro Standard fluctuation band ±15% Central parity and fluctuation bands mutually agreed Both the ECB and the Member State concerned can trigger a review of the central parity

48 Considerations relating to ERM II entry Case-by-case assessment based on equal treatment Major policy adjustments (e.g. foreign exchange market and price liberalisation) to be undertaken prior to entry Need to follow credible fiscal consolidation path Labour and product markets need to be flexible in order to reduce the pressure on the exchange rate to adjust to shocks and changes in the economic environment The central rate should be close to the equilibrium value New members are asked to undertake policy commitments Exchange Rate Mechanism II (cont’d)

49 Length of participation Minimum two-years prior to a (positive) convergence examination No restrictions on length of participation beyond minimum period Length of participation should be assessed on the basis of what is most helpful to accompany the convergence process Exchange Rate Mechanism II (cont’d)

50 Formal enlargement process - role of the ECB Every second year, or at the request of a country, the ECB and the European Commission report on the state of convergence in their Convergence Reports Case-by-case examination based on the convergence criteria and the principle of equal treatment Based on such examinations and on a proposal by the Commission, the (ECOFIN) Council decides which countries fulfil the conditions needed for adopting the euro The Council will also decide the conversion rate at which the national currency will be replaced by the euro (based on a proposal by the Commission and after consulting the ECB)

51 Formal enlargement process – ECB Convergence Reports The Convergence Reports typically examine convergence in all Member States with derogation. Denmark and the United Kingdom have a special status in the Treaty. For these two countries, Convergence Reports only have to be provided if they so request.

52 Principles underlying the ECB’s convergence report Strict interpretation and application. All must be satisfied (no hierarchy). To be met on the basis of actual data. Consistent, transparent and simple application. To be achieved on a lasting basis (sustainability). Convergence criteria:

53 State of economic convergence – ERM II

54 Lessons to be drawn? (1) Make financial markets more effective by Stricter regulation of all financial market participants and products More adequate capital requirements and accounting rules Stronger international cooperation in financial oversight Appropriate time horizon for macro-economic policies Adjustment of banking models and remuneration systems Global management of global risks ?

55 Lessons to be drawn? (II) Moreover Strengthen incentives that improve disciplining forces of competition Discourage “short-termism” and strengthen concept of liability and responsibility The value of monetary union has never been greater than during this financial crisis