04 November 2011

José Manuel González-Páramo: The ECB and the sovereign debt crisis

Mr González-Páramo spoke on the challenging environment for monetary policy created by the euro area financial and sovereign debt crisis. He mentioned some of the main policy “failures” leading up to the present crisis, and also reviewed recent policy actions undertaken by the ECB.

"As the ECB has repeatedly stressed, the main responsibility for resolving this crisis lies with governments and the financial sector. Euro area governments’ unwillingness to adapt their fiscal and competitiveness policies to the requirements of EMU very much lies at the heart of the current 'sovereign debt crisis'. Excessive risk-taking by an over-leveraged and inadequately regulated financial sector is, of course, the other source of the present 'financial turmoil'.

The interaction between government finances and the financial system

Regardless of the exact chronology of events, since mid-2010 we have progressively begun to see a very close interaction between risks associated with the financial system and the sovereign. There are several reasons behind the close interplay between these two risks. For a start, the burden on governments caused by their implicit and/or explicit guarantees to the banking sector, and the need to finance bank recapitalisations with public funds, has certainly taken its toll on public finances. In some cases this burden was compounded by the adoption, earlier in the crisis, of discretionary fiscal stimulus measures and the parallel decline in government revenues caused by the economic downturn. In countries where the emergence of systemic risk originated in large fiscal imbalances, the deterioration of public finances weighed negatively on the market pricing of government bonds from these countries. This, in turn, had a negative impact on the balance sheets of banks that held these bonds in their portfolios. The difficulties faced by some governments in financing themselves in the market also affected the ability of banks from these same countries to obtain financing in wholesale markets.

Unsustainable government policies and the failure of governance

The EU’s economic governance framework failed to prevent and correct unsustainable national policies that contributed to the build-up of major imbalances in euro area countries. This applies in particular to the weak implementation of policy recommendations, the inadequacy of enforcement measures taken to discourage or correct deficit infringements, and the insufficient recognition by national policy-makers of the need to ensure mutual consistency between national policies in a monetary union, especially with regard to the issue of competitiveness. Moreover, existing fiscal rules have been weakened over time and procedures and measures that were put in place in order to enhance economic policy coordination have not been implemented with sufficient rigour.

The ECB’s response to the crisis

The ECB reacted to the financial turmoil in full accordance with both its mandate and with key principles of modern central banking practice. First of all, the ECB’s policies were always guided by its primary objective, which is to maintain price stability. However, we have learned from the financial crisis that while price stability is certainly a necessary condition for financial stability, it is not a sufficient one. The materialisation of systemic risk and financial instability  triggered deep recessions with great economic costs. These developments carried risks for medium-term price stability which called for bold decisions by central banks around the world. The 'non-standard' measures implemented by the ECB have not introduced any  distortion into the general strategic monetary policy framework of the ECB and did not interfere with the aforementioned “separation principle”. On the contrary, 'non-standard' measures should be seen as complementary to rates policy in times of financial crisis.

From August 2007 onwards, the ECB started to conduct additional and special liquidity-providing operations with the objective of ensuring that solvent banks did not lose the ability to refinance themselves despite the fact that the interbank market had become dysfunctional. After the collapse of Lehman Brothers in October 2008, the ECB began to conduct these operations under the fixed-rate full-allotment procedure which allowed banks to determine through their own demand how much liquidity the Eurosystem provided to the interbank market. The list of eligible collateral accepted by the ECB in its refinancing operations was also expanded in order to allow banks to increase their access to our operations if needed. The ECB also introduced refinancing operations for longer maturities, including six-month and one-year maturities, so as to reduce the need for banks to roll over their funding over short periods of time in an uncertain liquidity environment.

The euro area’s recent governance reforms

On 28 September 2011, the European Parliament approved new legislation aimed at addressing weaknesses in the existing economic governance framework for co-ordinating fiscal and structural policies. The 'six-pack' falls short of the 'quantum leap' that the ECB had long advocated for the euro area. A major drawback is that the new governance package still leaves the Council with too much room to apply discretion when deciding on the execution and enforcement of the surveillance procedure. Another vital shortcoming relates to the large amount of exceptions and relevant factors that need to be taken into account when it comes to applying the excessive deficit procedure. This creates loopholes and could endanger the transparency and therefore the accountability of the fiscal governance framework as a whole.

The EFSF and ESM

The main objective of the future ESM will be to provide financial assistance, subject to strict conditionality, to euro area countries experiencing severe financing difficulties. As with the EFSF, this assistance will predominantly take the form of loans known as ESM Stability Support (ESS) loans. These loans will be granted conditional on agreement to and compliance with a strict macro-economic adjustment programme. The maturity of the ESS loans will depend on the nature of the imbalances and the beneficiary country’s prospects for regaining access to financial markets. The interest rate on the loans, which may be either fixed or variable, will reflect both the funding cost of the ESM and the need to avoid moral hazard behaviour by borrower countries. More recently, the Heads of State or Government of the euro area and EU institutions have formally announced their decision to entrust the EFSM/ESM with the power to finance the recapitalisation of financial institutions via loans to governments, including those of countries not under an EU/IMF programme. The ESM will also be able to intervene in the secondary government bond markets on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability, and on the basis of a decision by mutual agreement of the EFSF/ESM Member States, to avoid contagion."

Full speech

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