25 April 2013

VP Rehn: Financial stability and EMU 2.0

In EMU, the interdependence between financial integration and financial stability has been a policy concern for long. Let me give you examples:

• While financial integration advanced in the EU and banks developed increasingly into cross-border financial institutions, supervision remained national. The unfortunate consequence was that crisis management capacity in the euro area was seriously challenged.

• When the crisis hit, national rescue measures for ailing banks threatened to undermine the level playing field in the single market for banking services. The application of state aid rules by the Commission developed into the key policy instrument to prevent this from happening.

• The sovereign debt crisis revealed that the evident home bias reinforced the adverse feedback loop between sovereign bond markets and bank funding markets. The process of financial integration halted and in some market segments even reversed.

• Today, financial fragmentation is holding back economic activity in vulnerable Member States. Yesterday's ECB Bank Lending Survey showed that overall pressures on lending have been somewhat receding in the first quarter of this year, but there is a heightened differentiation in lending standards according to risk. This seems to hurt most small and medium sized businesses, which in turn can be a drag on growth and the necessary reallocation of resources.

Policies have now been geared to actively address the linkages between financial integration and financial stability. We know that in the aftermath of a credit boom, the ensuing adjustment process is long and protracted, as the economy has to deleverage and credit conditions are tight. This weighs on consumption and investment. And in some countries this process is accompanied by unbearably high unemployment rates.

Quite often in such large balance sheet adjustment, which was also the experience of the Nordics in the 1990s, the boost for growth comes from the external side. Moreover, external adjustment, particularly of cost competitiveness, is also necessary in those cases where countries ran current account deficits for a long time and external debt is high.

Therefore, an essential contribution to financial stability is structural reforms that allow the necessary reallocation of economic resources in those economies towards trade-oriented activities. And several vulnerable countries have indeed been expanding exports.

Second, a necessary condition to restore financial stability and to address the negative feedback loop between the banks and their sovereign is restoring the health of the sovereign. Fiscal consolidation remains a necessary ingredient to our strategy. Here also, we have seen significant progress over the last years. For the euro area, public deficits have halved since 2010 and fall, on average, below 3 per cent of GDP this year.

The EU's economic policy aims at promoting sustainable economic growth and job creation and containing the increase in debt. To achieve these twin goals we encourage the balancing of public finances through a consistent fiscal policy by reducing structural deficits over the medium term. We have been clear that the pace of fiscal adjustment should take into account each country’s specific economic situation.

In line with this policy, the pace of fiscal consolidation is now slowing down in Europe. This year, the structural fiscal effort will be ¾ of a percentage point of GDP in the euro area – half of last year’s figure of 1.5 percentage points. The decisions leading to this reduction were made in 2012, in line with the Commission’s recommendations of last spring. By comparison, the United States is reducing its deficit by 1.75 percentage points this year, proportionally twice as much as in Europe.

This slowing down of the pace of fiscal consolidation has been made possible by three factors: first, by the increased credibility of fiscal policy which the euro area member states have achieved since 2011; second, by the decisive action the ECB has taken to stabilise the markets; and third, by the reform of EU economic governance, which provides an effective framework for a differentiated fiscal adjustment and the advancement of structural reforms.

Thanks to these factors, we have the room to make fiscal policy with a more medium-term view. This was not possible in 2010-2011, when several euro area countries were in danger of becoming insolvent or of falling into to the whirlpool of prohibitively high interest rates. At that time, many member states had to restore their policy credibility by difficult decisions to bring their public finances onto a sustainable path.

Third, we must address the financial sector itself. Much has been achieved, but much remains to be done. The single rule book for banks and other financial market actors has advanced considerably.

Today's Report gives convincing evidence. For example, in Europe we now have Basel III firmly in law, and we advanced the capital requirements already in a coordinated exercise in 2012...

It is therefore important to design prospective reforms by focusing on both objectives of ensuring financial stability and in parallel pursuing financial integration. Beyond this, it is equally crucial that the reforms will contribute to a more effective and robust functioning of EMU.

Full speech

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