Strengthening the European Financial Architecture IV Astana Economic Forum & The International Monetary System: New configuration of the economic and monetary power Astana May 3-4, 2011 Franz Nauschnigg Head, European Affairs and International Financial Organisations Division, Central Bank of Austria. The views expressed are only those of the author

Financial Crises - The Problem of market failure and Contagion Neoliberal paradigm after breakdown of Bretton Woods System - Trend of deregulation and privatization Market elements were incorporated even into financial regulation (Basel II) and accounting rules (mark-to-market), providing for strong pro cyclical effects. Large parts of the financial system without proper supervision. The number of financial crises increased dramatically – IMF 1970 – 2007, 124 banking, 208 currency, and 63 sovereign debt crises. Strong pro cyclical tendency of the financial sector leads to overshooting and boom/bust cycles. Contagion: Iceland – Hungary – CESEE region Greece – Ireland - Portugal – Spain Market failure in the Euro area - first under pricing and later overpricing of sovereign bond spreads.

Financial Crisis - The Problem of Overshooting Capital Flows Capital flows volatile even FDI - findings of UNCTAD working group after Asian crisis Iceland and CESEE region - massive overshooting of capital flows, first flooding of the countries with capital, later reversal. –Made possible by extensive liberalisation, financial deregulation and privatisation processes in Iceland and the Central European and South Eastern European (CESEE) Region. –The Nordic crisis (Finland, Norway and Sweden) in the early 1990s also result of rapid financial deregulation and liberalisation. Austria on the contrary followed a very gradual path and had no crisis. –Monetary policy during the boom – although restrictive - was undermined by carry trades and foreign currency loans increasing the vulnerability.

Capital Mobility and Banking Crises Quelle: Reinhart, Rogoff, This time is different 2009 EU, Euro area financially integrated, liberalised markets therefore vulnerable

Crises in CESEE region Contagion of markets following the collapse of Lehman Brothers and Iceland: –Iceland financial crisis in Q –Hungary financial crisis in Q –CESEE currencies under pressure Q (even of countries with strong fundamentals) –Euro Area banks and countries with large CESEE exposures under pressure in Q –Financial markets did not differentiate enough between countries –Strong speculative attacks against exchange rate in Latvia

Financial Crisis CESEE – Policy Actions EU/European Council March 2009: 1.EU Balance of payments (BOP) assistance increased to 50 bn € (after intense Austrian lobbying) 2.75 bn € EU contribution to IMF funding puts pressure on US to follow, later increased to up to 125 bn €. 3.Coordination Banking and Fiscal packages; New order in EU financial markets – regulation and supervision G 20 April 2009 strong increase IMF funding to 750 bn $, 250 bn $ SDR distribution Vienna Initiative – close cooperation on banking sector – home/host countries, IFIs to maintain private sector exposure EU and IMF support CESEE countries – when not in agreement usually EU prevailed – defence of FX rate in Latvia avoided contagion

EU crisis support for EU Countries outside Euro Area 50 bn.€ EU Medium-term financial assistance (balance of payment difficulties). ECB liquidity support for Western banks active in CESEE. Guarantees and recapitalisation by home countries of banks active in CESEE. Joint IFI Action plan: EBRD, EIB and World Bank Group 24,5 bn. € ( ) lending to business. European Economic Recovery Plan: Advance payments from EU structural funds. “Vienna Initiative”: Meetings international financial organisations (IMF, EBRD; EC, NCB, Supervisors home-host), international banks active in the country concerned Macro financial assistance for non EU countries

Crises in CESEE region – EU policy response sucessful

Crises in CESEE region – Austrian CDS Spreads temporarily reached unusual high levels

Assistance for Euro Area Members 1.May Euro area financial support for Greece bn. € - 80 bn Euro area bilateral loans, 30 bn IMF 2.May 2010 European Stabilisation Mechanism – 500 bn. € European Financial Stabilisation Mechanism (EFSM) - 60 bn € European Financial Stability Facility (EFSF) 440 bn € - temporary 3 years SPV in Luxemburg – Financing on capital markets with guaranties of Euro area countries Additional IMF financing up to 250 bn € 3.Eurosystem buys government bonds of affected Euro area countries on secondary market – Securities Market Programme to stabilise bond markets 83 bn € 4.EU/IMF rescue Ireland 85 bn. €, Portugal

EU financial regulation and assistance for Euro Area Members September 2010 new architecture for European financial supervision and better regulation of financial sector European System Risk Board (ESRB) March 2011 European Semester for fiscal consolidation and structural reform, Euro Plus pact for stronger economic policy cooperation for competiveness and convergence, EU 2020 strategy for jobs and growth Permanent European Stability Mechanism (ESM) with an effective lending capacity of € 500 bn

Conclusion Overall EU/Euro area crises management successful Stabilisation of CESEE, Greece, Ireland Good EU cooperation with the IMF - eases financing pressure on IMF resources, sets an example for other regions, taps IMF expertise, allows EU to influence IMF Programmes. Problems remain Non Euro area EU, CESEE countries Pro cyclical fiscal policies - room for countercyclical monetary policies limited Exchange rate volatility in countries with flexible exchange rates Pressures on some CESEE countries with fixed exchange rates could return Euro area countries High spreads for some Euro area countries government bonds – Greece, Portugal, Ireland, Spain. Imbalances in Euro Area, Germany – southern members

Proposed further Policy Actions 1.Introduction of a credit growth stabilisation tax (CGST) on all new private sector credit, to limit credit growth. Higher tax on foreign currency credits. Tax-receipts to flow into a cyclical stabilisation fund (CSF), used to finance countercyclical measure in recession. Allows restrictive fiscal policy in boom, as monetary policy given fully liberalized and integrated financial markets is undermined by capital inflows. 2.creation of an EUR 50 bn € EU facility for BOP and macro financial assistance for European Economic Area, EU candidates, EFTA and EU neighbouring countries. 3.Creation of an EU wide € bond market with - EFSM, EFSF, EU-BoP - bonds emitted and backed by the EU – up to 550 bn €. 4.Establishment of bilateral swap or repo facilities between the Eurosystem and the EU (and possibly other European central banks)

Conclusion Measures would strengthen European financial architecture, help stabilize financial markets, stimulate the economies and correct market failure throughout the EU. End Boom/Bust cycles and enable countercyclical policies in the recession Deepen European Integration with no cost for EU taxpayers Help countries in the early stages of a crisis and avoid that they develop into serious currency, solvency, or even sovereign debt crises with possible contagion effects on stronger EU economies