18 May 2012

Josef Bonnici: Reflections on the financial and economic challenges in the euro area and beyond

Bonnici, Governor of the Central Bank of Malta, covered various dimensions of the sovereign debt problem, and also spoke about observations that are of particular relevance to Malta.

Importance of a prudent fiscal policy

Fiscal consolidation across most of the euro area carries the risk of downward macro-economic adjustment. In today’s circumstances, there is the danger of a negative macro-economic spiral. Weak economic growth leads to reduced government revenue that in turn raises the deficit and debt ratios, and therefore may require further budgetary tightening and austerity measures.

At the same time, structural reforms are not easy or popular to implement, especially during a slowdown or a recession. Structural measures include those that address the relative size and effectiveness of the public sector and those that promote competition in resource as well as in product markets.

One has to recognise that in the current circumstances, the pursuit of a lower deficit by financially stressed countries is inevitable and brings about a short-term slowdown in the economy. The issue that arises is whether it would be possible to alleviate the negative effects on incomes and employment. Some of the impact may be alleviated through a judicious mix of government spending and revenue options so as to reduce the depth and duration of the slowdown. However, not all Member States are in a stressed environment, and it may be possible to consider other financing options, especially where bond interest rates in some Member States are rather low, even below the inflation rate. EU level solidarity and cohesion assistance may prove a crucial catalyst to the required structural changes. One has to also keep in mind that governments are increasingly accountable not only to their parliaments and electorates, but also to investors in the financial markets, and pressure from the financial markets becomes more acute when a country is in financial distress. In addition, financial markets take a very comprehensive view in their scrutiny of the sustainability of a country’s finances.

Strengthening governance

There is a broad recognition across the EU that fiscal governance has to be strengthened and that the Stability and Growth Pact should be reinforced. The current thinking is that, to avert the recurrence of the crisis, fiscal consolidation should be enshrined in the governance structure of every country. To this end, the well-known Fiscal Compact obliges all euro area countries to run a structurally balanced budget each year. Surveillance will be enhanced and the monitoring of economic policies will also be comprehensive.

In particular, the problem of sustainable budget planning was addressed by introducing a country-specific medium-term budgetary objective, which involves a cap on growth of public expenditure that is in line with the medium-term rate of growth. The Fiscal Compact will also accelerate the excessive deficit procedure by introducing sanctions when the debt and deficit to GDP ratios are excessive.

On the financial stability side, European authorities have strengthened the financial sector surveillance framework. The European System of Financial Supervisors, which also includes the European Systemic Risk Board (the ESRB), is a new supervisory architecture requiring the National Supervisory Authorities to cooperate with the European Supervisory Authorities in the identification and analysis of systemic risks. The objective of the ESRB is to address one of the most important weaknesses identified during the financial crisis, as highlighted by the de Larosière Report – the lack of an adequate pan-European monitoring, assessment and mitigation of systemic risk.

In line with the ESRB recommendation to enhance macro-prudential governance in each Member State, in the case of Malta, it is the intention to replace the current Standing Committee by a joint committee on financial stability. This committee, which will include representatives from the Central Bank of Malta and the Malta Financial Services Authority, would be mandated to monitor and assess risks to financial stability. Its objective is to formulate policy recommendations to the Boards of the two institutions, designed to safeguard financial stability, strengthen resilience of the financial system and minimise systemic risk.

The recently announced changes to the Depositor Compensation scheme are a welcome change and help increase the resilience of the domestic banking sector. They are also in line with the recommendations of the latest IMF report.

The situation in Malta

The elevated levels of credit and concentration risks call for stronger financial buffers, through higher provisioning and retention of profits. Such measures would strengthen the banks’ ability to absorb potential shocks and would also allow them to prepare themselves for compliance with stricter Basel III regulatory requirements. On the positive side, credit risk is being mitigated by prudent credit standards and cautious lending behaviour on the part of the banks.

Full speech

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