ANNUAL REPORT 2003 - European Central Bank · Annual Report 2003 3 FINANCIAL INTEGRATION 114 4 OVERSIGHT OF MARKET INFRASTRUCTURE120 4.1 Oversight of large-value euro payment systems

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ANNUAL REPORT2003

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© European Central Bank, 2004

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ISSN 1561-4573 (print)ISSN 1725-2865 (online)

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CONTENT SFOREWORD 10

CHAPTER 1ECONOMIC DEVELOPMENTS AND MONETARYPOLICY

1 MONETARY POLICY IN THE EURO AREA 161.1 Evaluation of the ECB’s monetary

policy strategy 161.2 Key ECB interest rates reached

historically low levels in 2003 21

2 MONETARY, FINANCIAL AND ECONOMICDEVELOPMENTS 252.1 Monetary and financial

developments 252.2 Price developments 422.3 Output, demand and labour market

developments 492.4 Fiscal developments 552.5 The global macroeconomic

environment, exchange rates andthe balance of payments 59

3 ECONOMIC AND MONETARY DEVELOPMENTSIN EU COUNTRIES OUTSIDE THE EUROAREA 65

CHAPTER 2CENTRAL BANK OPERATIONS AND ACTIVITIES

1 MONETARY POLICY OPERATIONS, FOREIGNEXCHANGE OPERATIONS AND INVESTMENTACTIVITIES 741.1 Monetary policy operations 741.2 Foreign exchange operations 841.3 Investment activities 84

2 PAYMENT AND SECURITIES SETTLEMENTSYSTEMS 862.1 The TARGET system 862.2 TARGET2 882.3 Use of eligible assets across

national borders 89

3 BANKNOTES AND COINS 923.1 The circulation of euro banknotes

and coins and the handling ofcurrency 92

3.2 Developments in euro banknotecounterfeits and counterfeitdeterrence 93

3.3 Banknote issuance and production 94

4 NEW AND IMPROVED STATISTICS 974.1 New statistics 974.2 The medium-term strategy

for statistics 984.3 Improvements in the institutional

and legal framework for statistics 98

5 ECONOMIC RESEARCH 1005.1 Research topics 1005.2 Research networks 1005.3 Macroeconomic modelling of

the euro area 1025.4 Conferences and visitor

programmes 102

6 OTHER TASKS AND ACTIVITIES 1036.1 Compliance with the prohibitions

of monetary financing andprivileged access 103

6.2 Advisory functions 1036.3 The administration of the

borrowing and lending operationsof the European Community 104

6.4 Reserve management services 104

CHAPTER 3FINANCIAL STABILITY AND INTEGRATION

1 FINANCIAL STABILITY 1081.1 Financial stability monitoring 1081.2 Cooperation in crisis situations 110

2 FINANCIAL REGULATION ANDSUPERVISION 1112.1 The Lamfalussy framework 1112.2 Banking 1112.3 Securities 1132.4 Other issues 113

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3 FINANCIAL INTEGRATION 114

4 OVERSIGHT OF MARKET INFRASTRUCTURE 1204.1 Oversight of large-value euro

payment systems andinfrastructure 120

4.2 Retail payment services 1224.3 Securities clearing and settlement

systems 123

CHAPTER 4EUROPEAN AND INTERNATIONAL ISSUES

1 EUROPEAN ISSUES 1281.1 Policy issues 1281.2 Institutional changes relating to

relevant European bodies 131

2 INTERNATIONAL ISSUES 1342.1 International monetary and

financial system 1342.2 Cooperation with countries

outside the EU 136

CHAPTER 5ACCOUNTABILITY

1 ACCOUNTABILITY VIS-À-VIS THEGENERAL PUBLIC 142

2 ACCOUNTABILITY VIS-À-VIS THEEUROPEAN PARLIAMENT 1442.1 Overview of relations with the

European Parliament in 2003 1442.2 Views of the ECB on selected

topics raised at meetingswith the European Parliament 144

CHAPTER 6EXTERNAL COMMUNICATION

1 COMMUNICATION POLICY 150

2 COMMUNICATION TOOLS 151

3 COMMUNICATION ISSUES IN 2003 152

CHAPTER 7ENLARGEMENT OF THE EUROPEAN UNION

1 KEY ECONOMIC AND FINANCIALDEVELOPMENTS AND POLICY ISSUES 1571.1 Economic developments 1571.2 Financial market developments

in the acceding countries 160

2 LEGAL DEVELOPMENTS 162

3 PREPARATIONS FOR ACCESSION 1633.1 Central bank operations 1633.2 Payment and settlement systems 1633.3 Banknotes 1643.4 Statistics 1643.5 IT infrastructure and applications 165

CHAPTER 8INSTITUTIONAL FRAMEWORK, ORGANISATIONAND ANNUAL ACCOUNTS

1 DECISION-MAKING BODIES ANDCORPORATE GOVERNANCE OF THE ECB 1681.1 The Eurosystem and the European

System of Central Banks 1681.2 The Governing Council 1691.3 The Executive Board 1721.4 The General Council 1741.5 ESCB committees and the Budget

Committee 1751.6 Corporate governance 176

2 ORGANISATIONAL DEVELOPMENTS 1782.1 Human resources 1782.2 Measures to strengthen the

functioning of the internalorganisation 179

2.3 New ECB Premises 180

3 ESCB SOCIAL DIALOGUE 182

4 ANNUAL ACCOUNTS OF THE ECB 183Balance Sheet as at 31 December 2003 184Profit and Loss Account for the yearending 31 December 2003 186Accounting policies 187Notes on the Balance Sheet 190

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Notes on the Profit and Loss Account 196Note on the Allocation of Losses 199Auditor’s report 201

5 CONSOLIDATED BALANCE SHEET OF THEEUROSYSTEM AS AT 31 DECEMBER 2003 202

ANNEXES

LEGAL INSTRUMENTS ADOPTED BY THEEUROPEAN CENTRAL BANK 206

OPINIONS ADOPTED BY THEEUROPEAN CENTRAL BANK 209

DOCUMENTS PUBLISHED BY THEEUROPEAN CENTRAL BANK SINCEJANUARY 2003 213

CHRONOLOGY OF MONETARY POLICYMEASURES OF THE EUROSYSTEM 217

GLOSSARY 219

LIST OF BOXES, TABLES AND CHARTS

BOXES1 Research related to the ECB’s monetary

policy strategy evaluation 202 The corporate debt securities market

in euro area countries 29Chart: Amounts outstanding of

euro-denominated debtsecurities issued by euro areanon-MFI corporations 30

3 Developments in the financial positionsof euro area households andnon-financial corporations 33Chart A: Debt of the private

non-financial sector 33Chart B: Net lending/borrowing position

of the private non-financialsector 33

4 Inflation differentials in the euroarea: potential causes and policyimplications 44Chart: Inflation dispersion in the

euro area 445 Progress with structural reforms in

euro area product and labour markets 506 The importance of comprehensive

reforms for sustainable public finances 587 Risk management related to the

provision of credit in monetary policyand payment systems operations 82

8 Best practices for market participantsinvolved in CCBM operations as agreedby the European Banking Federation,the European Savings Bank Groupand the European Association ofCo-operative Banks 90

9 Measures of financial marketintegration in the euro area 117

10 Research Network on capital marketsand financial integration in Europe 118

11 The excessive deficit procedure 13212 The ECB’s mission statement 153

TABLES1 Summary table of monetary variables 262 Sectoral shares of amounts outstanding

of debt securities issued by euro arearesidents 31

3 Financing and financial investment ofthe euro area non-financial sector 32

4 Price developments 425 Labour cost indicators 486 Composition of real GDP growth 497 Labour market developments 548 Fiscal positions in the euro area 569 Macroeconomic indicators for Denmark 6510 Macroeconomic indicators for Sweden 6811 Macroeconomic indicators for the

United Kingdom 6912 Payment traffic in TARGET 8713 Allocation of euro banknote production

in 2003 95


CHARTS1 Longer-term inflation expectations 182 ECB interest rates and the overnight

interest rate 223 M3 growth and the reference value 254 Estimates of the nominal and real

money gaps 265 Movements in M3 and its counterparts 276 Sectoral breakdown of debt securities

issuance by euro area residents 287 Debt financing of the non-financial

sector 318 Short-term interest rates in the

euro area market 369 Three-month EURIBOR futures rates

and implied volatility 3610 Long-term government bond yields 3711 Euro area long-term real bond yield

and break-even inflation rate 3812 Short-term MFI interest rates and

a short-term market rate 3913 Long-term MFI interest rates and

a long-term market rate 3914a Stock price indices 4014b Implied stock market volatility 4015 Breakdown of HICP inflation: main

sub-components 4316 Contributions to HICP

inflation from sub-components 4317 Breakdown of industrial producer

prices 4718 Sectoral compensation per employee 4819 Contributions to quarterly real GDP

growth 5220 Confidence indicators 5321 Exports of goods and industrial

production 5322 Unemployment 5523 Nominal and real effective euro

exchange rates 6224 Current account balance and its

components 6225 Extra-euro area exports, foreign demand

and nominal effective exchange rate 6326 Financial account 6327 Economic and financial indicators for

the non-euro area EU countries and theeuro area 66

28 Liquidity factors and the use ofstanding facilities in the euro areain 2003 75

29 Tier one eligible assets for Eurosystemcredit operations 80

30 Use of collateral in Eurosystemcredit operations 81

31 Cross-border collateral as a percentageof the total collateral provided to theEurosystem 91

32 Total value of banknotes in circulationbetween 2000 and 2003 92

33 Total number of euro banknotes incirculation between 2002 and 2003 92

34 Number of euro banknotes incirculation between 2002 and 2003 93

35 Release of ECB Working Papers 10036 ECB Working Paper series:

Journal of Economic Literatureclassification 101

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ABBR EV I AT I ON SCOUNTRIES

BE BelgiumDK DenmarkDE GermanyGR GreeceES SpainFR FranceIE IrelandIT ItalyLU LuxembourgNL NetherlandsAT AustriaPT PortugalFI FinlandSE SwedenUK United KingdomJP JapanUS United States

OTHERS

BIS Bank for International SettlementsBPM5 IMF Balance of Payments

Manual (5th edition)c.i.f. cost, insurance and freight at

the importer’s borderCPI Consumer Price IndexECB European Central BankECU European Currency UnitEEA European Economic AreaEER effective exchange rateEMI European Monetary InstituteEMU Economic and Monetary UnionESA 95 European System of Accounts 1995ESCB European System of Central BanksEU European UnionEUR eurof.o.b. free on board at the exporter’s borderGDP gross domestic productHICP Harmonised Index of Consumer PricesILO International Labour OrganizationIMF International Monetary FundMFIs monetary financial institutionsNCBs national central banksPPI Producer Price IndexULCM Unit Labour Costs in Manufacturing

In accordance with Community practice, the EUMember States and the accession countries arelisted in this Report using the alphabetical order ofthe country names in the national languages.


Artist: Hans VandekerckhoveTitle: Landschappeling, 2000Material: Oil on canvas, Format: 200 × 160 cm 14

Artist: José María SiciliaTitle: La luz que se apaga, 1997Material: Wax, oil and paper on wood, Format: 185 × 157 cm 72

Artist: Gerhard BalderTitle: Roter Nautilus, 1995Material: Oil on canvas, Format: 70 × 54 cm 106

Artist: Jens FängeTitle: Jugend, 2003Material: Oil on canvas, Format: 132 × 122 cm 126

Artist: Kyriakos MortarakosTitle: UntitledMaterial: Mixed media on canvas, Format: 220 × 320 cm 140

Artist: Gérard GarousteTitle: La duègne et le pénitent, 1998Material: Oil on canvas, Format: 195 × 160 cm 148

Artist: Árpád SzabadosTitle: Untitled, 1995Material: Mixed media on canvas, Format: 120 × 90 cm 154

Artist: Koen VermeuleTitle: Untitled (detail), 2002Material: Oil on canvas, Format: 210 × 210 cm 166

Since 1998 the ECB has organised a series of exhibitions entitled “Contemporary art from theMember States of the European Union”. Each exhibition aims to give ECB staff and visitors aninsight into the art scene of a particular EU country. Contemporary art has been chosen since itreflects the period when Monetary Union became reality.

Some of the artworks are purchased for the ECB’s art collection, which is to be expanded. Theeight pages which separate the chapters of this Annual Report show a selection of works fromthis collection.

FOREWORD


For most of last year, Wim Duisenberg was at thehelm of the ECB and I wish to pay tribute to him.Under his presidency, the EMI, the ECB and theNCBs successfully dealt with all the challengesthey had to meet: the changeover of all capitalmarkets and cashless transactions to the euro on4 January 1999, the century date change andthe cash changeover on 1 January 2002. TheEurosystem was perceived as a highly crediblecentral bank with a reliable policy and as a goodguardian of the currency, preserving pricestability and confidence in the euro. It is thislegacy of an efficient steering of the unitedEuropean monetary team that the other membersof the Executive Board of the ECB and I are keento preserve and reinforce in the years to come.

***

In December 2002 the Governing Council of theECB announced its decision to conduct acomprehensive evaluation of its monetarypolicy strategy in the first half of 2003. Sincethe inception of the ECB, the monetary policystrategy has provided a robust basis for internaldecision-making and a consistent frameworkfor external communication, thereby fostering

the ECB’s accountability. Indeed, there isevidence that since 1999 long-term inflationexpectations – which provide a measure of thecentral bank’s credibility – have remainedconsistent with the ECB’s definition of pricestability. Less uncertainty about future inflationhas helped to reduce the risk premia in interestrates, and thus real financing costs. It was onlynatural that, after more than four years ofexperience, the Governing Council wanted tolook back and reflect in a systematic way on theexperience gained and the comments made byexternal observers.

On 8 May 2003 the Governing Councilannounced the results of its evaluation of thestrategy. It confirmed the definition of pricestability that had been announced in October1998 as a year-on-year increase of below 2% inthe HICP for the euro area. At the same time,the Governing Council clarified that, in thepursuit of price stability within the definition, itaims to keep inflation rates below, but close to,2% over the medium term. The GoverningCouncil also confirmed that its monetary policydecisions would continue to be based on acomprehensive analysis of the risks to pricestability, comprising an economic analysis anda monetary analysis. The Governing Councilemphasised that, in seeking to make a unifiedjudgement of the risks to price stability, itwould continue to cross-check the informationgained from the thorough economic analysiswith the monetary analysis in a medium andlong-term perspective. To underscore thelonger-term nature of the reference value formonetary growth, the Governing Councildecided to no longer review the monetaryreference value on an annual basis. With itsconfirmation and clarification of the mainelements of its stability-oriented monetarypolicy concept, the Governing Council hasfurther improved the understanding of theECB’s strategy both in Europe and throughoutthe world.

***

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In the first half of 2003 economic activity wasvery weak in the wake both of the escalation ofgeopolitical tensions related to the situation inIraq and of the uncertainty prevailing infinancial markets. It was only as from thesummer of 2003 that economic confidence in theeuro area gradually improved and signs ofglobal economic recovery strengthened.Overall, real GDP growth in the euro area was0.4% in 2003, after 0.9% in 2002. Over recentmonths economic activity in the euro area hasincreased. The growth of euro area exports hasremained robust as a consequence of thedynamic expansion of the world economy. Inaddition, the conditions for a recovery indomestic demand are in place, not least as aconsequence of the low level of interest ratesand the generally favourable financingconditions. The disappointing performance ofreal GDP growth over recent years illustratesthe euro area economy’s lack of flexibility andresulting vulnerability to external shocks.While some progress has been made in thisrespect, as must be acknowledged andwelcomed, continued and very substantialefforts are still needed to implement thestructural reforms that will increaseemployment growth and labour participation,raise productivity and enhance the potential forgrowth in the euro area. In addition, against thebackground of demographic developments,corrective action is needed to ensure that healthcare and pension systems are sustainable in thelong run.

In 2003 annual inflation, as measured by theHICP, declined to 2.1% (from 2.3% in 2002).The persistence of inflation rates above 2% wasmainly caused by unexpected increases in somevolatile components of the HICP (such as oiland food prices in the second half of 2003), butincreases in indirect taxes and administeredprices in the course of 2003 also had someimpact. In a medium-term perspective,inflationary pressures in 2003 had beenexpected to develop in line with price stability.

The picture of a favourable outlook for pricestability was not jeopardised by the continued

strong monetary growth in 2003. Indeed, part ofthis strength was attributed to the high level ofeconomic and financial market uncertaintyprevailing during the first half of 2003, whichprompted portfolio shifts into safer, short-termliquid assets included in M3. The accumulationof excess liquidity was therefore not regardedas alarming; however, vigilance is required incase this high level of liquidity continues to beobserved when the recovery picks up pace.

In view of the moderation of inflationarypressures in the first half of 2003, the key ECBinterest rates were reduced by 25 basis points inMarch 2003, and by 50 basis points in June. Asa consequence, the minimum bid rate on themain refinancing operations reached thehistorically low level of 2.0%. These decisionswere in line with the aim of maintaininginflation rates below but close to 2% over themedium term. The very low levels of interestrates also provided some counterweight to thevarious factors that were having an adverseeffect on economic activity. In the second halfof 2003 the key ECB interest rates were leftunchanged, as the stance of monetary policywas considered appropriate to preserve pricestability over the medium term.

As regards fiscal policies, most Member Statesfailed to meet the targets set out in the stabilityprogrammes that had been submitted at the endof 2002 and the beginning of 2003. The averagefiscal deficit for the euro area increased from2.3% of GDP in 2002 to 2.7% of GDP in 2003.Moreover, the fiscal situation remained asource of concern in countries that had alreadyrecorded significant imbalances in 2002. On25 November the ECOFIN Council decidednot to act on the basis of the Commissionrecommendations regarding Germany andFrance, and agreed to hold the excessive deficitprocedures for these countries in abeyance. Thetwo countries concerned committed themselvesto correcting their excessive deficits as soon aspossible and by 2005 at the latest, while theCouncil indicated that it stood ready to take adecision under Article 104 (9) of the Treatyestablishing the European Community – thereby


triggering the excessive deficit procedure again– if these two countries should fail to meet theircommitments. Other countries that still facefiscal imbalances likewise need to makeprogress towards achieving budgetary positionsclose to balance or in surplus over the mediumterm.

It is crucial that confidence in the solidity bothof public finances and of the economicand institutional underpinnings of EMU bemaintained. In the view of the GoverningCouncil, all parties involved need to live up totheir responsibilities and commitments.Looking ahead, it is essential that fiscalconsolidation and structural reforms take root.This should also have positive effects in theshort term, as it may enhance public confidencein the credibility of the rules and long-termfiscal sustainability. Furthermore, reforms ofexpenditure and taxation, and a reprioritisationtowards productive expenditure, would fosterpotential output growth.

***

On 1 May 2004 ten further countries will bejoining the EU, and ten new central banks willbecome members of the ESCB. This majorpolitical and economic event, which istaking place only some 14 years after the fallof the Berlin Wall and 12 years afterthe signing of the Maastricht Treaty,demonstrates how fast history is moving. Intheir field of competence, the ECB and theNCBs, in cooperation with the central banks ofthe acceding countries, have carried out atremendous amount of preparatory work toensure a smooth integration of the accedingcountry central banks (ACCBs) into the ESCB.In order to cope with this challenge, the ECBhas recruited and is continuing to recruit newstaff, notably experts from the accedingcountries who will contribute – through theirknowledge and specific background – to theefficiency and dynamism of the ECB.Moreover, the governors of the ACCBs havebeen invited to participate in the meetings of theGeneral Council as observers since June 2003,

while experts from their institutions have beenparticipating with the same status in ESCBcommittees since April 2003.

The accession of ten new countries is a majorhistorical and institutional event for the EU,which induced the Europeans to prepare a newconstitutional design through the work of theConvention on the future of Europe. The ECBfollowed the work of the Convention and theintergovernmental conference very closely andcontributed to their deliberations on issues ofrelevance to the tasks and mandate of the ECBand the ESCB. The Governing Council of theECB has welcomed the draft Treaty establishinga Constitution for Europe (draft Constitution)in general, on the understanding that it wouldnot entail any changes to the substance of thetasks, mandate, status and legal regime ofthe ECB and the ESCB. The ECB’s mainrequest was to introduce a reference to “non-inflationary growth” or “price stability” inArticle I-3 (3) on the EU’s objectives. Such areference of proper prominence was lacking inthe text of the Convention. The ECB alsosuggested, in particular, recognising theindependence of the NCBs in Article I-29,introducing a reference to the widely recognisedterm “Eurosystem” in the draft Constitutionand adding an explicit reference to theresponsibilities of the ESCB in Article III-90on how the euro’s place in the internationalmonetary system should be ensured.

***

Turning to the organisation and functioning ofthe ECB, 2003 was a very challenging year forthe institution. At the end of the year the annualaccounts of the ECB showed a net loss of€477 million. This loss, which is mainly due towrite-downs of the euro value of the ECB’sholdings of US dollar-denominated assets,arises after account has been taken of all incomeearned by the ECB, including income on eurobanknotes in circulation, and of the release ofprovisions made in previous years againstexchange and interest rate risks, amounting to€2.6 billion. The depreciation of the US dollar

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Frankfurt am Main, March 2004

Jean-Claude Trichet

in the course of 2003 has resulted in substantialunrealised losses that are treated – inaccordance with the principle of prudence – asrealised losses and entered in the profit and lossaccount, whereas unrealised gains are posted torevaluation accounts. Furthermore, thehistorically low levels of interest ratesprevailing in 2003, and their evolution inrespect of both the ECB’s main reservecurrencies and the euro, have also led to areduction of its interest income, includingincome on the counterpart assets to banknotesin circulation.

At the end of 2003 the number of staffemployed by the ECB was 1,217, comparedwith 1,109 at the end of 2002. As from1 January 2003 all vacant positions wereopened to nationals of acceding countries, andthe ECB successfully launched recruitmentcampaigns aimed specifically at recruiting suchnationals as translators, lawyer-linguists andlegal counsels. 39 staff members from accedingcountries are currently employed on contractsof more than one year’s duration.

Since 1998 the ECB has grown steadily and thenumber of staff members has risensubstantially, creating a need to permanentlyimprove the functioning of the internalorganisation. In this context, the ExecutiveBoard decided to launch a number of staffsurveys on the issues of corporate principles,internal communications and organisationalperformance. On the basis of the survey results,the Executive Board decided to embark on aprocess of changes in management called “ECBin Motion”. Four project teams were establishedunder the guidance of a project office and theExecutive Board. In October 2003 the ExecutiveBoard approved a number of measures, mostof which should be ready for implementation byJuly 2004. Our aim is to improve thefunctioning and efficiency of the ECB, toenhance the management of human resourcesand to reinforce central banking values such asefficiency, impartiality, discretion and highethical standards among all staff. Thefundamental spirit of ECB in Motion is to apply

more fully, more comprehensively and moreefficiently the concept of the team to thedifferent aspects of the functioning of the ECB,whether through a better empowerment of staff,through more direct rewards for performance ofstaff or through reinforcement of an open andcooperative environment.

ArtistHans VandekerckhoveTitleLandschappeling, 2000MaterialOil on canvasFormat200 × 160 cm

CHAPTER 1

ECONOMICDEVELOPMENTS AND

MONETARY POLICY


1.1 EVALUATION OF THE ECB’S MONETARYPOLICY STRATEGY

After more than four years of conductingmonetary policy for the euro area, theGoverning Council of the ECB undertook athorough evaluation of the ECB’s monetarypolicy strategy in the first half of 2003 in orderto take stock of the experience accumulated thusfar. This evaluation took into account the publicdebate concerning the appropriate design ofmonetary policy and the results of a number oftechnical studies prepared by Eurosystem staffas background material for the evaluationexercise (see Box 1). On 8 May 2003 theGoverning Council announced the outcome ofits evaluation. That evaluation related to boththe quantification of the price stability objectiveof the ECB and the framework for analysing therisks to price stability.1

THE OBJECTIVE OF PRICE STABILITYIn October 1998 the Governing Council of theECB announced a quantitative definition of itsprice stability objective. That objective wasdefined as “a year-on-year increase in theHarmonised Index of Consumer Prices (HICP)for the euro area of below 2%”. By referring toan increase in the HICP of below 2%, thedefinition of price stability made it clear thatboth inflation and deflation are incompatiblewith price stability. The definition of pricestability did not specify an explicit lower boundfor inflation rates, reflecting uncertaintysurrounding the size of a potential measurementbias in the HICP and its possible variation overtime. The upper bound was set at a level clearlyabove zero in order to incorporate in thedefinition a safety margin to guard against therisks of deflation. At the same time, the upperbound of 2% was considered to be low enoughfor the benefits of price stability to be reaped.

The Governing Council also specified that“price stability is to be maintained over themedium term”. This reflected the recognitionthat monetary policy is not suited to controllingprices or fine-tuning economic developmentsover short periods of time.

1 MONE TARY PO L I C Y I N T H E E URO A R E AIn its announcement of 8 May 2003, theGoverning Council confirmed its definition ofprice stability. At the same time, it made clearthat, within that definition, it aims to maintainthe inflation rate below but close to 2% over themedium term.

In its quantification of the price stabilityobjective, the Governing Council againexplicitly took into consideration both the costsof inflation and the possible arguments fortolerating moderate positive inflation.

The costs associated with inflation are wellunderstood. Recent studies suggest that theymay actually be higher than previously thought,even in the case of moderate rates of inflation.In particular, inflation distorts the signallingfunction of relative price movements anddiverts resources away from productive usestowards activities directed at protectinginvestors against inflation. Furthermore,inflation amplifies the distortionary effects oftaxation and may increase uncertainty andthus risk premia, thereby hampering theaccumulation of capital in the economy. From aredistributional point of view, inflationincreases inequality, as it penalises the weakestgroups in society, which are less equipped toprotect themselves against the costs ofinflation. On these grounds, barring furtherconsiderations, there would seem to be a strongcase for literal price stability.

However, despite the significant costs ofinflation, a number of considerations alsosuggest that maintaining a moderate positiverate of inflation would be desirable. The firstargument concerns the presence of a zero lowerbound for nominal interest rates and the risks ofdeflation. The lower bound problem stems fromthe fact that a central bank cannot force nominalinterest rates to levels below zero. Any attemptto do so would probably fail, as the publicwould prefer to hold cash – which yields a zeronominal return – rather than lend or hold

1 See also the article entitled “The outcome of the ECB’s evaluationof its monetary policy strategy” in the June 2003 issue of the ECB’sMonthly Bulletin.

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deposits at a negative rate. In these conditions, aprotracted period of deflation caused by asequence of negative aggregate demand shocksmay limit the central bank’s ability to reducereal interest rates in order to stimulate demandand counteract deflationary pressures.Although alternative policy actions areavailable even when the interest rate is at zero, itis prudent to maintain a safety margin by aimingat a positive, but low, rate of inflation ratherthan at zero inflation.

The second argument for maintaining amoderate positive rate of inflation concerns thepossible presence of a measurement bias in theprice index, caused, for example, by a lack ofadequate adjustment for changes in quality.This would mean that aiming at a measuredinflation rate of zero could actually lead todeclining prices. Although the size of themeasurement bias in the euro area HICP isuncertain, available studies indicate that it islikely to be limited.

The third argument in favour of aiming for lowpositive inflation rates concerns the fact that apositive rate of change in the price level mayhave a beneficial effect in facilitating the realadjustment of the economy to various shocks inthe presence of downward nominal rigidities.These rigidities may stem from producers’ andworkers’ resistance to nominal reductionsin prices and wages. While the practicalimportance of downward nominal rigidities ishighly uncertain and the empirical evidence isnot conclusive, particularly for the euro area, itis crucial that structural reforms seek toincrease the flexibility of product and labourmarkets.

An additional consideration that might beput forward in favour of maintaining a lowpositive inflation rate in the medium termconcerns processes of real convergence amongheterogeneous regions in a currency union. Ifconvergence across regions in terms of incomeand productivity levels is incomplete, structuralinflation differentials may arise betweenregions to allow price (and income) levels in the

less developed areas to catch up with those inthe more mature economies within the union. Inthese circumstances, it has been argued thatmonetary policy should aim at a union-wideinflation rate high enough to prevent regionswith lower inflation rates from facing thesignificant costs associated with downwardnominal rigidities or entering protracted periodsof declining prices. While these considerationsare theoretically sound, in practice they can beaccommodated by a strategy that aims tomaintain the inflation rate below but close to 2%over the medium term, as clarified by theGoverning Council on 8 May. In fact, it shouldbe noted that the present degree of convergencein the euro area is relatively high and does notseem to pose a significant problem at the currentjuncture. In view of the accession process, theoverall relevance of this effect is also likely toremain limited in the future, given the smallweight of the acceding countries’ economies inan enlarged euro area. In addition, accedingcountries will have to fulfil the convergencecriteria in order to adopt the euro. This requiresthem to demonstrate that they have convergedsufficiently and in a sustainable way andto meet the conditions necessary to sustain alow inflation environment prior to the adoptionof the euro.

Regarding the index to be used for assessingwhether price stability has been achieved, theGoverning Council concluded that headlineHICP remains appropriate. It most closelyapproximates – in a harmonised fashion acrossthe countries of the euro area – the changes overtime in the price of a representative basket ofconsumer goods. It is a credible and reliablestatistic that helps to communicate, in atransparent manner, the ECB’s commitment tofull and effective protection against reductionsin the purchasing power of money.

It is sometimes argued that central banks shoulduse measures of “core” or “underlying”inflation to define their primary objective.These measures provide useful tools foranalysis, as they remove the more volatilecomponents and/or temporary factors from


headline inflation with a view to uncoveringmore fundamental trends in price movements.However, choosing a measure of underlyinginflation to define price stability would involvesignificant drawbacks from the point of view ofmonetary policy, particularly regarding the lossof transparency. Furthermore, it would berather arbitrary, as there is no singleuncontroversial method for determining suchmeasures. In any case, by defining the pricestability objective in terms of headline inflation,the ECB is in no way paying excessive attentionto short-term price developments in itsmonetary policy deliberations. The medium-term orientation of the ECB’s monetary policystrategy ensures that the Governing Councilduly discounts any short-term price volatilitywhen taking decisions.

In conclusion, the Governing Council’sdecision of 8 May 2003 reflects the positiveexperience with the quantification of the ECB’sprice stability objective and ensures fullcontinuity with the past conduct of its monetarypolicy. As Chart 1 shows, longer-term inflationexpectations in the euro area have been firmly

anchored at levels in line with the definition ofprice stability since January 1999, remainingwithin a range between 1.7% and 1.9%. This isa remarkable result given the considerableadverse price shocks that have hit the euro area.This firm anchoring of inflation expectationsallows the medium-term inflationary effect ofadverse price shocks to be contained, thusavoiding possibly strong monetary policyreactions to such shocks, which could in turnhave a negative effect on the variability ofoutput.

THE ANALYSIS OF RISKS TO PRICE STABILITYIn October 1998 the Governing Council of theECB announced that its approach to organising,evaluating and cross-checking the informationrelevant for assessing the risks to price stabilitywould be based on two analytical perspectives,which subsequently came to be known as the“two pillars” of the ECB’s monetary policystrategy. This framework is designed to ensurethat no policy-relevant information is neglectedin the formation of a comprehensive assessmentof the outlook for price stability. Within one ofthe two pillars, which gives a prominent role to

Chart 1 Longer-term inf lation expectations

(annual percentage changes)

Sources: Eurostat, Consensus Economics Forecasts, Survey of Professional Forecasters and ECB calculations.1) Longer-term inflation expectations are market inflation expectations at a horizon of six to ten years. Until December 2002 these wereconstructed as a weighted average of the f ive largest euro area countries, accounting for more than 80% of euro area GDP.

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Stage Three ofEMU

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HICP inflationlonger-term inflation expectations (Consensus Economics Forecasts) 1)

five-year ahead HICP inflation expectations (Survey of Professional Forecasters)upper bound of definition of price stability

19ECB

Annua l Repor t2003

money, a reference value for the growth rate ofa broad monetary aggregate consistent with theECB’s price stability objective has beenspecified.

On 8 May 2003 the Governing Councilannounced that its monetary policy decisionswould continue to be based on a comprehensiveanalysis of the risks to price stability made onthe basis of the two pillars. The two pillarswould henceforth be referred to as “economicanalysis” and “monetary analysis”. TheGoverning Council stated that, over time, bothforms of analysis had been deepened andextended as the availability of euro area datahad increased and technical tools had improved,and would continue to be developed in thefuture.

The Governing Council also clarified the way inwhich it integrates the indications stemmingfrom these two complementary types of analysisas it seeks to come to an overall judgementon the risks to price stability. In particular,the Governing Council indicated that themonetary analysis serves mainly as a meansof cross-checking, from a medium to long-term perspective, the short to medium-termindications derived from the economic analysis.

The economic analysis focuses mainly on theassessment of current economic and financialdevelopments and the implied short to medium-term risks to price stability from the perspectiveof the interplay between supply and demand ingoods, services and factor markets at thosehorizons. In this respect, due attention is paid tothe need to identify the nature of shocks hittingthe economy, their effects on cost and pricingbehaviour and the short to medium-termprospects for their propagation in the economy.

However, economic analysis in isolation fails tocapture the mechanisms by which monetaryfactors act over extended horizons and does notidentify the longer-term trends underlying pricedevelopments. There is therefore a need formonetary policy to explicitly take into accountthe information contained in the medium-term

trend in money growth, which is empiricallyclosely associated with the formation of pricesat more extended horizons.

The undisputed relationship between moneygrowth and inflation in the medium to long termprovides monetary policy with a firm andreliable nominal anchor beyond the horizonsconventionally adopted when constructinginflation forecasts on the basis of standardmacroeconomic models. In this sense, theECB’s approach constitutes a commitment toensuring that, while economic developments areresponded to as they unfold, the fundamentalfactor driving prices over extended horizons –the rate of money growth – is consistentlymonitored.

The ECB’s framework does not entail thepartitioning of the information set relevant forthe assessment of price prospects. Similarly, itdoes not allocate indicators rigidly to theeconomic analysis or the monetary analysis. Onthe contrary, it exploits all complementaritiesbetween relevant information variables in aconsistent manner.

In order to properly reflect the cross-checkingrole of monetary analysis in its communicationwith the public, the Governing Council alsodecided that the President’s IntroductoryStatement to the ECB’s monthly pressconferences would henceforth have a differentstructure, which would take into account theclarification of the ECB’s monetary policystrategy.

To underscore the longer-term nature of thereference value for monetary growth as abenchmark for the assessment of monetarydevelopments, the Governing Council decidedto no longer conduct a formal review of thereference value on an annual basis. However, italso decided to continue to assess theconditions and assumptions underlying thereference value and communicate any changesto the underlying assumptions as soon as theybecome necessary.


Box 1

RESEARCH RELATED TO THE ECB’S MONETARY POLICY STRATEGY EVALUATION

During the winter and spring of 2003 the Governing Council of the ECB conducted anevaluation of the ECB’s monetary policy strategy. Ten background studies were prepared byEurosystem staff, partly in consultation with external co-authors. The studies focused ontechnical issues which were considered relevant, such as the choice of the price index and theformat used to define price stability, the indicator properties of monetary aggregates and thestability of euro area money demand. The technical studies were made available on the ECB’swebsite immediately after the communication of the outcome of the strategy evaluation on 8 May2003. In November 2003 the ECB published a book, which brought together those studies.1

Concerning the choice of price index, one of the studies concluded that the HICP continues to bea valid yardstick for prices in the euro area, but that there is still some room for improvement inthe construction of the HICP. In particular, frequent re-basing of the national indices isimportant to ensure the accuracy and comparability of the HICP and to reduce substitution bias.Such bias occurs in a price index where it ignores the possibility that when prices of certainitems rise, individuals may choose to replace more expensive goods with cheaper ones whilestill achieving the same level of utility.

The issue of the format used to define price stability concerns the importance of announcing aspecific target, a range or a price stability objective formulated only in qualitative terms. Onestudy focused on this by analysing survey data on long-term inflation expectations in 15industrialised countries and found that these inflation expectations were well anchored in mostof the countries. When comparing the evidence as regards the different formats of inflationobjectives, the study concluded that the specific features of announcements have no visibleeffect on the ability to anchor inflation expectations.

An important topic that was analysed in two studies was the zero lower bound on nominalinterest rates and the risks of prolonged deflation or a deflationary spiral. Whereas some costsrelated to inflation are also incurred in periods of deflation, there are particularly seriousproblems which are specific to deflation and which indicate that it may be desirable to maintaina small positive inflation rate as a safety margin. Based on somewhat different theoreticalmodels, both studies of the zero lower bound issue concluded that the likelihood of the zerolower bound becoming binding did not represent a qualitatively important factor where theinflation objective was set at 1% or higher.

The decision by the Governing Council in 1998 to assign a prominent role to money was takenin recognition of the fact that inflation is a monetary phenomenon in the medium to long term.One of the background studies surveyed a large body of theoretical and empirical literature andconcluded that a systematic monitoring of monetary developments can help a central bank toidentify potentially destabilising shocks that would be difficult to detect using a real-sectormodel. Another study examined the potential for narrow money to improve forecasts of realGDP. Contrary to the findings for the United States, this study concluded that in the euro areaM1 has better and more robust forecasting properties than yield spreads. One study conducted

1 Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy, ECB, 2003.

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Annua l Repor t2003

CONCLUSIONWith its announcement of 8 May 2003 theGoverning Council confirmed and clarified theECB’s monetary policy strategy. TheGoverning Council’s statement that it aims tomaintain inflation rates below but close to 2% isfully consistent with the ECB’s price stabilitydefinition announced in October 1998 andreflects full continuity with the past conduct ofmonetary policy. At the same time, the changesto the presentation of the two-pillar framework,now referred to as “economic analysis” and“monetary analysis”, should help the public tounderstand more clearly the conduct ofmonetary policy.

1.2 KEY ECB INTEREST RATES REACHEDHISTORICALLY LOW LEVELS IN 2003

The economic environment in which monetarypolicy was conducted in the euro area during thefirst half of 2003 was surrounded byconsiderable uncertainty related to the highdegree of geopolitical tension in the MiddleEast and the associated turbulence in oil pricesand financial markets. While real GDP growthstagnated in the first half of the year, prospectsfor economic activity gradually brightened overthe summer following the end of the militaryoperations in Iraq and the normalisation infinancial market conditions. Overall, real GDPin the euro area increased by only 0.4% in 2003,a disappointing performance considering thatthe euro area had already recorded belowpotential real GDP growth in both 2001 and2002 (with annual growth rates of 1.6% and0.9% respectively).

Despite weak economic activity, annual HICPinflation slowed only very moderately, from2.3% on average in both 2001 and 2002 to 2.1%in 2003, thus remaining slightly above theupper limit of the ECB’s definition of pricestability. However, in 2003 the continuedsubdued pace of economic activity and thesignificant appreciation of the euro wereexpected to dampen inflationary pressures overthe medium term.

In line with the ECB’s monetary policystrategy, the Governing Council cross-checkedthe indications of risks to price stability derivedfrom the economic analysis with those from themonetary analysis. Although, partly as a resultof portfolio shifts, monetary growth remainedstrong in 2003 and there was a significantamount of excess liquidity which had builtup after mid-2001, inflationary risks wereconsidered to be low in view of the rathersubdued economic activity and moderate creditgrowth.

The Governing Council lowered the key ECBinterest rates in March and June 2003 by 25 and50 basis points respectively. These decisions,which followed a 50 basis point reductionin December 2002, reflected the overallassessment in the first half of the year thatmedium-term inflationary pressures weremoderating. These decisions put the minimumbid rate on the main refinancing operations atthe historically low level of 2.0% and theinterest rates on the marginal lending facilityand the deposit facility at 3.0% and 1.0%respectively (see Chart 2). In the second half of2003 these rates were kept unchanged, as theGoverning Council considered them to be

formal tests on both the short and long-term stability of broad money demand for the euro area.It concluded that the stability of neither the long nor short-term parameters of money demandcould be rejected. Another study reviewed the question of why broad money demand has beenmore stable in the euro area as a whole than in individual countries inside and outside the euroarea. Among other things, the study suggested that stability has been enhanced by aggregatingthe money demand of individual euro area countries.


compatible with the maintenance of pricestability over the medium term.

Turning to a more detailed analysis of monetarypolicy decisions in 2003, in the first fewmonths of the year the economic dataincreasingly supported the view that economicactivity would remain subdued and evolve moreweakly than had been expected in late 2002.Heightened geopolitical tensions in the MiddleEast sparked uncertainty about the economicoutlook, led to sharp rises in oil prices andcontributed to the increase in financial marketvolatility. In this environment, while the mostlikely scenario was one of a gradual increase inreal GDP growth starting in the second halfof 2003, risks were increasingly perceivedto be on the downside. The accumulatedmacroeconomic imbalances in major economicareas of the world outside the euro area addedto the uncertainty surrounding the global recovery.

HICP inflation remained above 2% in early2003, as increases in oil prices and rises inindirect taxes and administered pricesintroduced some upward price pressures. The

fact that the annual growth rates of the lessvolatile components of the HICP remainedrelatively high despite the subdued economicactivity, and the fact that nominal wage growthremained relatively strong despite the rise inunemployment and low productivity growthintroduced some concern as regards themedium-term outlook for price stability.

Overall, however, the economic analysisindicated in early 2003 that the most likelyoutcome was that inflation would finally falland eventually stabilise at a level below 2%over the medium term. The protracted period ofweak economic growth was increasingly seenas a factor that would eventually limit thepotential upward risks to price stability via itseffects on wage and price-setting behaviour. Inaddition, the appreciation of the euro, witnessedsince the spring of 2002, was expected todampen consumer price inflation over time.

Monetary growth continued to be strong inearly 2003, partly as a result of the high degreeof economic and financial market uncertainty,which continued to give rise to portfolio

Chart 2 ECB interest rates and the overnight interest rate

(percentages per annum; daily data)

Source: ECB.Note: The rate for main refinancing operations is the rate applicable to fixed rate tenders for operations settled before 28 June 2000.Thereafter, the rate reflects the minimum bid rate applicable to variable rate tenders.

marginal lending ratedeposit ratemain refinancing/minimum bid rateovernight interest rate (EONIA)marginal rate in main refinancing operations

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23ECB

Annua l Repor t2003

shifts into short-term liquid assets included inM3 and supported precautionary savings.Consequently, inflationary risks related tomonetary developments were considered to below. This assessment was supported by thecontinuing moderate rate of growth of loans tothe private sector, notably of loans to non-financial corporations.

On balance, the Governing Council expected thefactors dampening inflation over the mediumterm to prevail. Therefore, it decided on6 March 2003 to reduce the key ECB interestrates by 25 basis points, taking the minimumbid rate on the main refinancing operations to2.5%.

In the second quarter of 2003 it becameincreasingly clear that real economic activitywas weak and that the downside risks to thescenario of a recovery remained. The possibleeffects of the military operations in Iraq wereinitially difficult to assess. Despite theabatement of the geopolitical tensions in thecourse of the spring, it gradually becameevident that a strong recovery in confidence andeconomic activity was unlikely to materialise inthe near future. Concerns about the impact ofthe SARS virus also clouded the outlook foreconomic growth in East Asia. In addition,other downside risks remained, related to thepast accumulation of imbalances outside theeuro area and uncertainty about the extent of thefurther adjustment still needed in the euro areacorporate sector to enhance productivity andprofitability after the protracted period of weakgrowth and the large decline in stock prices.

Oil prices declined as the uncertainty related tothe outcome of the military operations in Iraqdiminished. In view of the economic situation andthe continued appreciation of the euro, there werereasons to expect in June 2003 that annual HICPinflation would reach levels comfortably below2% over the medium term. This overall picture forinflation was also reflected in the June 2003Eurosystem staff macroeconomic projections andin the forecasts of other international institutionsproduced in the second quarter of 2003.

Cross-checking the economic analysis with themonetary analysis, the strong M3 growthappeared increasingly to be related to the lowlevels of interest rates, as indicated by thestrong growth in the most liquid components ofM3. However, as a significant part of theaccumulated excess liquidity was related toportfolio shifts and precautionary moneydemand, the overall monetary situation wasassessed as being less of a concern for medium-term price developments, at least in a period ofsubdued economic activity.

Against this background, the GoverningCouncil decided on 5 June 2003 to reduce thekey ECB interest rates by 50 basis points. Thereduction was in line with the aim ofmaintaining inflation rates below, but close to,2% over the medium term and provided somecounterweight to the various factors adverselyaffecting economic activity.

During the second half of 2003 economicconfidence in the euro area first stabilised andthen gradually improved amid signs of a globaleconomic recovery. Uncertainty in stock marketsdeclined significantly, supporting the pick-up instock prices that had started in the secondquarter of the year. In this context, the likelihoodof a gradual economic upswing in the secondhalf of 2003, strengthening further in 2004,increased.

The recovery in global demand was the mainreason for the strong growth of euro areaexports, compensating for the lower externalprice competitiveness associated with thepronounced appreciation of the euro witnessedsince early 2002. In fact, in the secondhalf of 2003 euro area exports increasedsignificantly, after having declined in the firsthalf of 2003. Domestic demand remained weakin the second half of 2003. However, the lowlevel of interest rates and the generallyfavourable financing conditions, as well aspositive terms-of-trade effects from theappreciation of the euro, were expected tosupport private demand. In addition, ongoingadjustment efforts in the corporate sector aimed


at enhancing productivity and profitabilitysupported the expectation that businessinvestment would recover gradually. Overall,all available forecasts and projections producedin the second half of 2003, including theEurosystem staff macroeconomic projectionspublished in December, pointed to a continuedstrengthening of euro area real GDP growth in2004 and 2005.

The short-term downside risks to this scenarioof a gradual economic recovery declined duringthe second half of the year. At the end of 2003the Governing Council assessed these risks asbeing balanced. Over longer horizons, however,uncertainty remained in relation to thepersistence of external imbalances in someother regions of the world and their potentialeffect on the sustainability of global growth.

As regards prices, in the second half of 2003annual HICP inflation rates did not fall asquickly and strongly as previously expected.This was mainly a consequence of adverse foodprice developments and higher than expected oilprices after the end of the Iraq conflict, althoughthis latter effect was attenuated by theappreciation of the euro. In addition, increasesin indirect taxes and administered prices in late2003 and early 2004 affected inflation rates. InJanuary 2004 annual HICP inflation stood at1.9%.

Nevertheless, in the second half of 2003 andearly 2004 the Governing Council assessedthat the outlook for price stability beyond theshort term remained favourable. Given that theeconomic recovery was expected to be onlygradual, it was considered that moderate wagedevelopments in conjunction with a cyclicalrecovery in productivity would contain growthin unit labour costs. In addition, the renewedand significant appreciation of the euro wasexpected to continue contributing to subduedimport price developments, moderating – bothdirectly and indirectly – consumer priceinflation. In fact, in the course of 2003 the euroappreciated by around 11% in nominal effectiveterms. At the same time, the Governing Council

recognised that the outlook for price stabilityprevailing at the end of 2003 and in early 2004was conditional on a number of assumptionsrelating, inter alia, to global economic growth,oil prices, exchange rates, wage developmentsand fiscal measures. Furthermore, theGoverning Council felt that the indications ofincreasing long-term inflation expectationsfrom bond markets warranted close monitoring.With regard to monetary developments, M3growth moderated only slowly in the secondhalf of 2003. This indicated a rather gradualshift of portfolios away from monetary assetstowards longer-term financial assets outsideM3. In addition, the low level of interest ratescontributed to the continued strong growth ofvery liquid assets. At the same time, the annualrate of growth of loans to the private sectorincreased in the second half of 2003.

In early 2004 there remained significantly moreliquidity available in the euro area than wasneeded to finance non-inflationary growth. TheGoverning Council stressed that whether theaccumulated excess liquidity would translateinto inflationary pressures over the mediumterm depended very much on the extent to whichportfolio shifts were reversed and on the futurestrength of economic growth. Indeed, shouldexcess liquidity persist, it could lead toinflationary pressures over the medium term. Inthis context, the Governing Council emphasisedthat monetary developments needed to becarefully monitored.

Overall, in the second half of 2003 and early2004 the Governing Council of the ECBassessed the monetary policy stance as beingappropriate to maintain price stability over themedium term. As a consequence, the key ECBinterest rates were kept unchanged in thisperiod. At the same time, the GoverningCouncil made it clear that it would continue tocarefully monitor all developments that mightaffect its assessment of the risks to pricestability over the medium term.

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2.1 MONETARY AND FINANCIAL DEVELOPMENTS

M3 GROWTH REMAINED STRONGThe trend of high monetary growth in the euroarea, which started in mid-2001, continued in2003. The average annual growth rate of thebroad monetary aggregate M3 increased evenfurther, to 8.0%, from 7.2% in 2002 and 5.4%in 2001. However, the first and second halvesof the year showed diverging growth patterns.In the first two quarters annual M3 growthstrengthened further, reaching a peak of 8.5%in the second quarter. It then moderatedsomewhat, to stand at 7.6% in the fourth quarter(see Chart 3).

The continuing increase in M3 growth in thefirst half of 2003 reflected, to a large extent, avery strong liquidity preference on the part ofeuro area investors in response to high financialmarket and geopolitical uncertainties, the thenrather uncertain outlook for economic growthand employment, and a rather flat yield curve.Monetary growth was also fuelled by the lowlevel of interest rates.

In the second half of the year, monetary growthmoderated only slowly. The improvement infinancial market conditions and in the economicoutlook only gradually induced economicagents to return to longer-term financial assetsand reduce their precautionary savings. Inaddition, monetary growth continued to besupported by the low level of interest rates.

The strong M3 growth observed from mid-2001resulted in the accumulation of significantlymore liquidity in the euro area than neededto finance non-inflationary growth. This isillustrated by the sharp rise in the money gapmeasures in Chart 4, which show the cumulativedeviations of M3 growth from its referencevalue since the beginning of 1999.2 Both thenominal and the real money gaps continued toincrease steeply in 2003, and by the fourthquarter they stood at their highest level since thestart of Stage Three of EMU.3

2 MONE TARY, F I N ANC I A L AND E CONOM I CD E V E LOPMENT S

The main contribution to continued strongmonetary growth during 2003 came from themost liquid components, i.e. those which formthe narrow monetary aggregate M1 (seeTable 1). Among them, the persistently strongannual growth rate of currency in circulationreflected the fact that both residents and non-residents of the euro area continued to increasetheir currency holdings in 2003. As a result, inthe second half of the year the stock of currencyin circulation reached a level in line with thelong-term trend observed before the cashchangeover. The growth of overnight depositswas also pronounced in 2003, reflecting the lowopportunity costs of holding this type ofdeposit and, in the early part of the year, theclimate of high uncertainty.

2 The measure of the nominal money gap is the difference betweenthe actual level of M3 and the level of M3 that would have resultedfrom constant M3 growth at its reference value of 4½% sinceDecember 1998 (taken as the base period). The measure of thereal money gap is the difference between the actual level of M3deflated by the HICP and the deflated level of M3 that would haveresulted from constant nominal M3 growth at its reference valueof 4½% and HICP inflation in line with the ECB’s def inition ofprice stability, again using December 1998 as the base period.

3 It has to be kept in mind, however, that the choice of the baseperiod is to some extent arbitrary. Therefore, caution is warrantedwhen interpreting the level of these money gap measures.

Chart 3 M3 growth and the reference value

(annual percentage changes; adjusted for seasonal and calendareffects)

Source: ECB.

M3 (three-month centred moving average of the annual growth rate)M3 (annual growth rate)reference value (41/2%)

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The annual rate of growth of total short-termdeposits other than overnight deposits wasbroadly stable during 2003, at 5.0% on average.Economic agents reduced their funds held inshort-term time deposits (i.e. deposits with an

Table 1 Summary table of monetary variables

(annual percentage changes; annual and quarterly figures are averages; adjusted for seasonal and calendar effects)

Source: ECB.

2002 2003 2002 2003 2003 2003 2003 2004Q4 Q1 Q2 Q3 Q4 Jan.

M1 7.6 11.0 8.8 10.1 11.3 11.5 11.2 11.2Currency in circulation -11.8 32.2 12.9 39.1 35.7 29.6 26.2 25.0Overnight deposits 10.9 8.2 8.2 6.6 8.1 8.9 9.1 9.1

M2 - M1 (= other short-term deposits) 5.7 5.0 4.8 4.3 5.5 5.7 4.7 3.7Deposits with agreed maturity of up to andincluding two years 2.3 -1.0 1.5 0.4 0.0 -1.5 -3.2 -3.7Deposits redeemable at notice of up to andincluding three months 8.5 9.9 7.6 7.5 9.9 11.4 10.9 9.4

M2 6.6 8.0 6.7 7.1 8.3 8.5 7.9 7.4M3 - M2 (= marketable instruments) 11.3 8.4 8.5 10.5 9.8 7.4 6.0 1.1M3 7.2 8.0 7.0 7.6 8.5 8.3 7.6 6.4

Credit to euro area residents 4.5 5.1 4.1 4.2 4.8 5.4 5.9 5.9Credit to general government 1.6 4.3 2.0 2.1 3.5 4.9 6.6 6.2

Loans to general government -1.0 0.2 -1.2 -1.2 -0.4 1.0 1.5 1.4Credit to the private sector 5.3 5.3 4.7 4.8 5.1 5.5 5.7 5.8

Loans to the private sector 5.3 5.0 4.8 5.0 4.6 4.9 5.3 5.5Longer-term financial liabilities(excluding capital and reserves) 4.4 5.6 5.2 5.1 5.2 5.6 6.4 7.1

agreed maturity of up to and including twoyears), but holdings of short-term savingsdeposits (i.e. deposits redeemable at a period ofnotice of up to and including three months)increased substantially, in response to thegradual decline, in the first half of the year, ofthe typically positive spread between theinterest rates paid by MFIs on these types ofdeposit.

Finally, the annual growth rate of marketableinstruments fell to 8.4% in 2003, from 11.3% in2002. This decline, which occurred mainly inthe second half of 2003, suggests that economicagents slowly started to reduce theirinvestments in safe short-term assets includedin M3 as financial market uncertainty decreasedand the yield curve steepened.

Annual M3 growth declined further, to 6.4% inJanuary 2004, adding to the evidence that euroarea investors were gradually shifting thestructure of their portfolios towards longer-term and riskier financial assets outside M3. Atthe same time, the low level of interest ratescontinued to fuel the demand for monetaryassets.

Chart 4 Estimates of the nominal and realmoney gaps

(as percentages of the stock of M3; three-month centred movingaverages)

Source: ECB.Note: For details see footnote 2 above.

real money gapnominal money gap

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INCREASING GROWTH IN MFI CREDIT TO THEPRIVATE SECTORChart 5 provides an overview of the annualflows of M3 and its counterparts in theconsolidated balance sheet of the MFI sector.Increasing growth in M3 in the first half of2003 was mainly driven by a rise in the annualincrease of net external assets of the euro areaMFI sector and increasing growth in total creditgranted by MFIs to euro area residents, whilethe expansion of MFI longer-term financialliabilities (excluding capital and reserves)remained broadly stable in this period. In thesecond half of 2003 the moderation in M3growth was accompanied by an increase in thegrowth rate of MFI longer-term financialliabilities (excluding capital and reserves) and adecline in the annual increase of MFI netexternal assets. It appears that investors startedto again invest more in domestic and foreignlonger-term assets, as the yield curve steepenedand financial uncertainty lessened. However,the expansion of total MFI credit to euro arearesidents continued to increase.

Looking in more detail at credit developments,the annual growth rate of MFI credit to euroarea residents increased from 4.1% in the fourthquarter of 2002 to 5.9% in the last quarter of2003. This rise reflected the higher borrowingneeds of both the private and the governmentsector.

After declining between mid-2000 and the endof 2002, the annual growth of MFI loans to theprivate sector (accounting for 87% of MFIcredit to the private sector) was relatively stablein the first half of 2003, before picking up in thesecond half of the year. Particularly in the firsthalf, weak economic growth appears to havecounterbalanced the impact of the low banklending rates in the euro area. Thereafter, withthe economic outlook improving, the demandfor lending increased somewhat.

Seen from a long-term perspective, in 2003the average annual growth rate of loans tothe private sector was, in real terms, about1¼ percentage points below its long-term

average since 1980. However, compared withprevious periods of sustained weak economicactivity, loan dynamics remained relativelyrobust in 2003, reflecting the structurally lowerinterest rates prevailing since the introductionof the euro.

In 2003 the ECB introduced a quarterly banklending survey for the euro area. The surveyprovides information on demand and supplyconditions in the euro area credit markets and isdesigned to complement other statistics on MFIinterest rates and credit.4 At the beginning of2003 almost half of the participating banksreported that they were tightening financingconditions for loans to enterprises. In thecourse of the year, however, the number ofbanks reporting a tightening of creditconditions fell continuously, indicating acertain stabilisation of credit conditions in theeuro area. As regards lending to households,the number of banks reporting a tightening of

Chart 5 Movements in M3 and itscounterparts

(annual flows; end of period; EUR billions; adjusted for seasonaland calendar effects)

Source: ECB.M3 = 1 + 2 + 3 - 4 + 5

M3 Credit tothe private

sector (1)

Credit to general

government(2)

Net externalassets (3)

Longer-termfinancialliabilities

(excludingcapital and

reserves) (4)

Othercounterparts(includingcapital and

reserves) (5)

H2 2003H1 2003H2 2002H1 2002H2 2001

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4 See the article entitled “A bank lending survey for the euro area”in the April 2003 issue of the ECB’s Monthly Bulletin.


credit standards remained low throughout theyear, which may have supported a relativelyrobust expansion of loans (particularly thosefor house purchase) to households in 2003.

Credit to general government acceleratedsubstantially in the course of 2003. Thisdevelopment reflected the rise in generalgovernment budget deficits, which was largelylinked, in turn, to weak economic growth in theeuro area.

LIQUIDITY REMAINED AMPLEIn summary, annual M3 growth remainedstrong in 2003, despite the moderation observedin the second half of the year. As aconsequence, more liquidity has beenaccumulated in the euro area than needed tofinance non-inflationary economic growth.However, the inflationary risks related to thishigh excess liquidity were considered low,given that the ample liquidity resulted, to asignificant extent, from past portfolio shifts andthat economic activity remained weak. Therelatively moderate growth rate of MFI loans tothe private sector in 2003 supported thisassessment.

Looking ahead, should the unwinding of pastportfolio shifts not gain momentum, there is arisk that once economic activity strengthenssignificantly the excess liquidity could translateinto spending and lead to inflationary pressuresin the medium term. For this reason, theGoverning Council has repeatedly emphasisedthe need to monitor monetary developmentsclosely.

ISSUANCE OF DEBT SECURITIES RISINGIn 2003 the market for debt securities issued byeuro area residents grew at a slightly higherpace than in 2002. The annual growth rate of theamount outstanding of debt securities increasedto 7.3% at the end of 2003, compared with 6.3%at the end of 2002. The higher overall growthwas largely driven by developments inthe market for long-term debt securities, whichrepresented 90.5% of the total amountoutstanding of debt securities issued by euro

area residents at the end of 2003. Grossissuance by euro area residents of euro-denominated debt securities accounted foraround 94% of issuance in all currencies in2003. The euro also remained an attractivecurrency for international issuers, with theamount outstanding of euro-denominated debtsecurities issued by non-residents of the euroarea increasing by 17.4% during 2003, ascompared with 12.9% during 2002.

As regards resident issuers, the annual growthrate of debt securities issued by the generalgovernment increased from 5.0% at the end of2002 to 5.5% at the end of 2003 (see Chart 6).This was primarily due to an increase inissuance activity by the central government sub-sector, from 4.1% at the end of 2002 to 4.7% atthe end of 2003. The annual growth rate of debtsecurities issued by the other government sub-sector, which primarily comprises local and

Chart 6 Sectoral breakdown of debtsecurit ies issuance by euro area residents


Source: ECB.Note: Growth rates are based on financial transactions and arecorrected for reclassifications, revaluations, exchange ratevariations and other changes that do not arise from transactions.

totalmonetary financial institutionsnon-monetary financial corporationsnon-financial corporationsgeneral government

2000 2001 2002 20030

5

10

15

20

25

30

35

40

0

5

10

15

20

25

30

35

40

29ECB

Annua l Repor t2003

Box 2

THE CORPORATE DEBT SECURITIES MARKET IN EURO AREA COUNTRIES

A broad and deep corporate debt securities market opens up a viable alternative avenue offinance for corporations. This could have important implications for economic developments. Afirm’s decision to issue securities is primarily driven by its need for funding, and its choice ofinstrument involves a number of considerations, including taxes, bankruptcy and other costs.

For the purposes of this box, the corporate sector includes non-financial corporations and non-monetary financial corporations and excludes MFIs. Non-monetary financial corporationsinclude insurance corporations and other financial intermediaries. The bulk of debt securitiesissuance by non-monetary financial corporations is, however, carried out by what are known asspecial financing vehicles. These are institutions which engage in financial activities, the mainpurpose of which is to raise money on behalf of a third party, such as a credit institution, a non-financial corporation, an investment fund or the general government. Such vehicles can belegally owned by the companies to which they are providing funds or can be without capitallinks to those companies, and can be established to facilitate a particular financial transaction. Inthe latter case, they are known as special purpose vehicles (SPVs). SPVs act as a conduit for thesole purpose of channelling funds from lenders to borrowers. They are precluded from engagingin activities other than the transaction for which they were established and they immunise theinvestor against the potential bankruptcy of the original owner of the assets (originator).1

The average annual growth rate of euro-denominated debt securities issuance by the corporatesector has largely outpaced the average annual growth in euro-denominated debt securitiesissued by all sectors considered together since the start of Stage Three of EMU. The amountoutstanding of euro-denominated debt securities issued by non-financial corporations hasgrown at an average annual rate of 14% since January 1999, which is significantly higher thanthe 2% average annual growth rate for this sector during Stage Two of EMU. The same is truefor euro-denominated debt securities issued by non-monetary financial corporations, theaverage annual growth rate of which has stood at 37% since January 1999, compared with 11%during Stage Two of EMU. Today’s corporate debt securities market in the euro area hasbroadened to include a variety of issuers, from various economic sectors, with diverse financingneeds and of variable credit standing. What used to be a corporate debt securities market limitedto borrowers rated AA or higher has been able to accommodate a broadening spectrum of creditratings. At the same time, the spectrum of economic sectors has broadened. Although non-financial debt securities issuance activity was dominated by the telecommunications, media andtechnology sector in 2000 and 2001, by 2003 this sector’s share of issuance activity hadreturned to the levels seen before the introduction of the single currency.

Although growth in the corporate debt securities market has been very strong at the euro arealevel in the last three years (see Chart 6 in the main text), the trend towards increasing direct

1 For more detailed information on securitisation, see the box in the article entitled “Recent developments in financial structures of theeuro area” in the October 2003 issue of the ECB’s Monthly Bulletin, pp. 47-49.


Amounts outstanding of euro-denominated debtsecurities issued by euro area non-MFI corporations

(as percentages of national GDP, end-December 2003)

Sources: ECB and Eurostat.Notes: The available ECB securities issues statistics arecurrently not harmonised at the euro area level, giving rise todifferences in the data across countries. ECB securities issuesstatistics for amounts outstanding of debt securities issued bynon-MFI corporations resident in Ireland and Luxembourg arenot available. Data for GDP refer to 2002.

non-financial corporationsnon-monetary financial corporations

0

20

40

60

80

100

0

20

40

60

80

100

1 2 3 4 5 6 7 8 9 10 11

1 Belgium2 Germany3 Greece4 Spain

5 France6 Italy7 The Netherlands8 Austria

9 Portugal10 Finland11 Euro area

access to this market is anything but uniformacross euro area countries.2 The chart showsthat the market for debt securities issued bynon-financial corporations is relatively welldeveloped in France, which accounted formore than half of the amount outstandingof such securities at the end of 2003. Thecorporate debt securities markets in Portugal,Finland, the Netherlands and Belgium are alsorelatively well developed. The cross-countrydifferences are, however, to some extentaccounted for by the fact that part of thecorporate debt securities issues have beencompleted through financial subsidiaries.

In the euro area, the rapid growth of corporatebond issuance since 1999 has generally beenclosely linked to the wave of mergers andacquisitions, which may in part explain whyfinancing through debt securities issuancediffers quite significantly across the euro areaeconomies. Another reason why corporate bond issuance is used to differing degrees acrosseuro area countries is that the institutional and fiscal frameworks and other historicallydetermined characteristics shaping the financial structure differ widely from one country toanother.

The differences across euro area countries are even more pronounced in the case of the marketfor debt securities issued by non-monetary financial corporations (see the chart). According toECB statistics, the most important market for these securities in terms of GDP is theNetherlands, followed by Italy and Spain somewhat behind. The Netherlands accounted foraround 60% of the amount outstanding of euro-denominated debt securities issued by non-monetary financial corporations at the end of 2003. The situation prevailing in the Netherlandsis to some extent attributable to taxation factors. The actual ultimate beneficiaries in many casesare residents of other euro area countries, which use special financing institutions in theNetherlands only as a dedicated financing vehicle. The domestic activity in the Netherlands isprimarily driven by the securitisation of mortgage loans granted by MFIs.3 These mortgage-backed securities, where the borrower or originator (e.g. the MFI) sells the loans to an SPV, arenot the same as covered bonds, which are debt securities backed by loans that remain on thebalance sheet of the borrower or issuer (e.g. the MFI). The latter are also known as Pfandbrief-style products. All in all, as is the case for debt securities issued by non-financial corporations,institutional, fiscal and historical factors largely explain the differences in the importance ofdebt securities issued by non-monetary financial corporations in the various euro areaeconomies.

2 See “Report on financial structures”, ECB, 2002.3 See “Growing importance of securitisation and special purpose vehicles (SPVs)”, De Nederlandsche Bank Statistical Bulletin,

December 2003, pp. 31-35.

31ECB

Annua l Repor t2003

regional governments, decreased to 21.9% atthe end of 2003 (from 28.0% at the end of2002). The relatively high issuance activity inboth government sub-sectors reflects lessfavourable budgetary developments in generaland ongoing strong borrowing requirementsoutside central government in particular.

The annual growth rate of debt securities issuedby MFIs increased from 5.4% at the end of 2002to 6.2% at the end of 2003. By contrast, theannual growth rate of debt securities issued bynon-financial corporations increased sharply to9.8% at the end of 2003, from 3.5% at the end of2002. The annual growth rate of debt securitiesissued by non-monetary financial corporationswas 23.3% at the end of 2003, compared with25.4% at the end of 2002. The strong overallissuance activity by the private non-MFI sectorwas supported by a further improvement infinancing conditions and improved businessconfidence in the course of 2003 (see Box 2).The sharp increase in the growth rate of debtsecurities issued by non-financial corporationsin the course of 2003 has to be seen against thebackground of subdued issuance activity duringthe second half of 2002, when many companiesmade efforts to reduce short-term liabilities inorder to protect themselves from financialturbulence. Underlying the strong rebound inissuance activity in 2003 were increases in theannual growth rates of both short and long-termdebt securities.

As a consequence of these developments, theproportion of debt securities outstanding issued

by non-monetary financial and non-financialcorporations in the total amount outstanding ofdebt securities issued by euro area residentscontinued to increase, to 14.5% at the end of2003, from 13.4% at the end of 2002. This wasin line with the trend of an increasing non-MFIcorporate sector share in total debt securitiesissuance that had prevailed over previous years(see Table 2). Mirroring this evolution in 2003was a decrease in the share of the MFI sector, to38.0% at the end of 2003, whereas the share ofthe general government sector in the stock ofdebt securities decreased to 47.5%.

1998 1999 2000 2001 2002 2003

MFIs 37.2 38.6 39.0 38.6 38.4 38.0Non-MFI corporations 8.1 9.5 11.2 12.9 13.4 14.5

Non-monetary financial corporations 3.1 4.2 5.1 6.1 6.9 7.8Non-financial corporations 4.9 5.3 6.1 6.8 6.6 6.7

General government 54.7 51.9 49.8 48.5 48.1 47.5Central government 53.1 50.3 48.1 46.7 45.9 45.0Other general government 1.7 1.6 1.6 1.8 2.2 2.5

Table 2 Sectoral shares of amounts outstanding of debt securit ies issued by euro arearesidents(as percentages; end of period)

Source: ECB.

Chart 7 Debt f inancing of the non-f inancialsector


Source: ECB.Note: For details, see Table 3.

householdsnon-financial corporationsgeneral government

0.0

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6.0

8.0

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14.0

16.0

1999 2000 2001 2002 20030.0

2.0

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8.0

10.0

12.0

14.0

16.0


OVERALL FINANCING OF THE NON-FINANCIALSECTOR IN THE EURO AREA RECOVEREDThe annual growth rate of financing of the euroarea non-financial sector5 recovered somewhatduring 2003 (see Table 3). In particular, theannual growth rate of debt financing isestimated to have increased to 5¾% in thefourth quarter of 2003, whereas that of

financing via quoted shares is estimated to haveremained at a low level. These developmentsmirror a very favourable cost of debt financingand a relatively high cost of equity financing.

Outstanding amountas a percentage Annual growth rates (end of period) 2)

of (sector)financing/financial 2000 2001 2002 2003 2003 2003 2003

investment 1) Q1 Q2 Q3 Q4 2)

FinancingNon-financial sector 100 6.2 4.5 3.9 4.3 4.7 5.0 5

Debt financing 3) 84.7 7.3 5.6 4.7 5.3 5.6 5.8 5 ¾of which: short-term debt financing 15.0 11.5 5.4 2.1 5.2 7.1 6.5 5of which: long-term debt financing 69.7 6.4 5.6 5.3 5.3 5.2 5.6 5 ¾

Households 3), 4) 23.2 7.4 5.7 6.6 6.6 6.3 7.0 7 ¼of which: short-term debt financing 7.3 6.3 -0.7 1.9 1.0 -1.0 -1.3 -1 ½of which: long-term debt financing 92.7 7.5 6.3 7.0 7.1 7.0 7.7 8

Non-financial corporations 43.4 8.4 5.1 2.5 2.9 3.3 3.5 3 ¼Debt financing 3) 64.8 14.6 8.8 3.9 4.9 5.1 4.9 4 ¾

of which: short-term debt financing 19.3 20.6 4.7 -2.5 0.4 3.9 3.0 3of which: long-term debt financing 45.5 11.8 10.9 7.0 7.0 5.6 5.7 5 ½

Quoted shares 35.2 3.4 1.5 0.7 0.4 0.8 1.0 ¾

General government 3) 33.4 1.9 2.8 4.1 4.8 5.5 5.7 5 ¼of which: short-term debt financing 14.8 -1.9 9.5 11.6 16.5 16.2 15.7 11 ¼of which: long-term debt financing 85.2 2.5 1.8 2.9 3.0 3.7 4.0 4 ¼

Financial investment 100 6.0 4.6 4.4 4.5 5.0 5.1 .of which: short-term financial investment 5) 43.1 3.8 5.8 5.3 5.3 5.9 5.4 .of which: long-term financial investment 6) 55.7 7.2 4.3 4.0 4.0 4.1 4.5 .

Currency and deposits 37.9 3.4 4.6 4.9 5.9 6.5 6.7 .Securities other than shares 13.3 9.2 7.7 4.2 0.7 -0.7 -1.8 .Mutual fund shares 12.2 6.2 5.6 4.3 5.3 6.8 6.7 .

of which: mutual fund shares excludingmoney market fund shares 9.6 7.0 3.7 3.1 4.2 5.6 6.3 .

of which: money market fund shares 2.7 0.1 21.1 11.3 11.2 12.9 8.7 .Quoted shares 12.2 6.1 -0.4 1.0 1.6 2.4 3.3 .Insurance technical reserves 24.4 8.5 7.2 6.5 6.4 6.5 6.5 .

Table 3 Financing and f inancial investment of the euro area non-f inancial sector

Source: ECB.1) As at the end of the third quarter of 2003. Figures may not add up due to rounding.2) Figures for the most recent quarter shown in the table have been estimated on the basis of transactions reported in money and bankingstatistics and securities issues statistics.3) Debt financing includes loans, debt securities issued, pension fund reserves of non-financial corporations and deposit liabilities ofcentral government. Short-term debt financing (with an original maturity of up to one year) includes short-term loans, short-term debtsecurities issued and deposit liabilities of central government. Long-term debt financing (with an original maturity of over one year)includes long-term loans, long-term debt securities issued and pension fund reserves of non-financial corporations.4) Including non-profit institutions serving households.5) Short-term financial investment includes currency and deposits (excluding central government deposits), short-term debt securitiesand money market fund shares. Owing to the exclusion of central government deposits, short-term and long-term financial investment donot add up to 100%. When interpreting these figures, it should be kept in mind that both short-term and long-term deposits are includedin short-term financial investment.6) Long-term financial investment includes long-term debt securities, mutual fund shares excluding money market fund shares, quotedshares and insurance and pension products.

5 The non-financial sector comprises households (includingnon-profit organisations serving households), non-financialcorporations and general government.

33ECB

Annua l Repor t2003

Box 3

DEVELOPMENTS IN THE FINANCIAL POSITION OF EURO AREA HOUSEHOLDS AND NON-FINANCIALCORPORATIONS

Between the mid-1990s and 2000 the indebtedness of the euro area private non-financial sectorincreased substantially, leading to relatively high debt-to-GDP ratios, particularly in the case ofnon-financial corporations. Chart A illustrates these developments.

As can be seen from Chart B below, non-financial corporations had a rising need for externalfinance in the second half of the 1990s as their net borrowing or financing gap (i.e. the gapbetween firms’ income – gross saving plus capital transfers – and gross capital expenditure)increased. In addition, non-financial corporations’ financing needs rose on account of large netpurchases of financial assets as a consequence of the buoyant merger and acquisition activityover that period. Subsequently, the deterioration of their financial position in conjunction witha less favourable economic and financial market environment raised some concerns about thevulnerability of the non-financial corporate sector. However, when assessing the sustainabilityof current debt levels, the interest payment burden also needs to be taken into account. In fact,owing to the significant and sustained decline in the cost of debt financing over the 1990s, non-financial corporations’ interest payments in relation to GDP have remained broadly stable since1996.

Since 2001 non-financial corporations have adjusted their balance sheets in order to graduallyreduce financial imbalances. Restructuring and cost-cutting measures as well as reductions in

Chart A Debt of the private non-f inancialsector

(as percentages of GDP)

Source: ECB.Notes: Debt refers to the sum of loans and debt securities andpension fund reserves in the case of non-financial corporations.Data for the last quarter of 2003 have been estimated on thebasis of transactions reported in money and banking statisticsand in securities issues statistics.Compared with the annual data, quarterly debt-to-GDP ratiosare somewhat lower, mainly because loans granted by the non-financial sector and by banks outside the euro area are notincluded. For a comparison with annual figures, see Chart 4 inthe article entitled “Developments in private sector balancesheets in the euro area and the United States” in the February2004 issue of the ECB’s Monthly Bulletin.

40.0

45.0

50.0

55.0

60.0

65.0

70.0

1998 1999 2000 2001 2002 200340.0

45.0

50.0

55.0

60.0

65.0

70.0

householdsnon-financial corporations

Chart B Net lending/borrowing position ofthe private non-f inancial sector

(as percentages of GDP)

Source: ECB.Notes: Annual data. The net lending/borrowing position isdefined as gross saving plus capital transfers minus gross capitalexpenditure. Data for 2003 were not available at the date ofpublication.

-4.0-3.0

-2.0-1.00.01.0

2.03.04.0

5.06.0

1995 1996 1997 1998 1999 2000 2001 2002-4.0-3.0

-2.0-1.00.01.0

2.03.04.0

5.06.0

householdsnon-financial corporations


both real and financial investments have resulted in a decline in the growth of financing and agradual rebound in the generation of internal funds. As a consequence, the financing gap of euroarea non-financial corporations gradually declined from a level of 3.5% of GDP in 2000 to 0.8%in 2002, and is estimated to have remained broadly stable in 2003. At the same time, the debt-to-GDP ratio grew at a slower pace from 2001 onwards, and has stabilised more recently. Takingdue account, to the extent possible, of accounting differences, the level of indebtedness of euroarea non-financial corporations in 2003 was broadly similar to that of the United States andbelow that of the United Kingdom and Japan.1

Since 2001 there has been an overall improvement in the financial position of euro area non-financial corporations. This is also reflected in the more positive perception of risks in thissector from the end of 2002 onwards, as illustrated by the significant decline in corporate bondspreads. Nevertheless, additional efforts to increase profitability and to improve balance sheetpositions may still be needed in some corporate sectors.

With regard to the financial position of euro area households, their indebtedness has risencontinuously since the second half of the 1990s, reflecting, in particular, strong growth inhousing investment. Favourable financing conditions resulting from a considerable decline inmortgage interest rates fuelled the demand for housing loans and supported strong rises inhouse prices in some euro area countries. At the same time, developments in house pricesbolstered the need for larger loans to purchase a house, while also resulting in wealth gains andhigher collateral values. Notwithstanding the upward trend in household debt ratios, the interestpayment burden on households measured as a percentage of GDP remained below the levelsobserved in the early 1990s because of the strong decline in the cost of debt financing. Inaddition, comparing household debt ratios across major industrialised countries, euro areahouseholds are significantly less indebted than households in the United States, the UnitedKingdom and Japan.1

Owing to a recovery in the household saving ratio since 2001 in the context of high economicuncertainty (especially in relation to employment), the net lending of the euro area householdsector has risen. In 2002 it stood at levels slightly lower than those seen in the mid-1990s (seeChart B) and is estimated to have stabilised in 2003. Consequently, the financial position ofeuro area households appears relatively sound, although in some euro area countries some risksmay exist in connection with rapid rises in house prices.

1 See the article entitled “Developments in private sector balance sheets in the euro area and the United States” in the February 2004issue of the ECB’s Monthly Bulletin.

Household demand for debt financingcontinued to expand strongly in the course of2003, despite weak economic growth (seeChart 7). This was related to ongoing robustdemand for loans for house purchase, supportedby a further rise – particularly in some countries– in residential property prices and by the lowlevel of mortgage lending rates. The annualgrowth rate of short-term debt financing

gradually declined, to reach negative territory inthe second quarter of 2003.

The annual growth rate of debt financing ofnon-financial corporations recovered somewhatin the first half of 2003, mainly in connectionwith short-term debt financing growth. Bycontrast, in the second half of the year theannual growth rate of debt financing of non-

35ECB

Annua l Repor t2003

financial corporations remained broadly stable.Overall, developments in debt financing of non-financial corporations have led to a broadlystable debt-to-GDP ratio of the sector in recentyears (see Chart A in Box 3).

By contrast with the relatively robust growth ofdebt financing, the annual growth rate of quotedshares issued by non-financial corporationsremained subdued in 2003. However, there wasa slight recovery in the course of the year linkedto a rise in stock prices, which tends to lowerthe cost of equity financing.

Finally, the annual growth rate of debtfinancing of general government rose duringmost of 2003, owing largely to weak economicgrowth putting strains on government finances.

ONGOING RELUCTANCE OF THE NON-FINANCIALSECTOR TO INVEST IN SHARESThe annual growth rate of financial investmentof the non-financial sector recovered somewhatduring the first three quarters of 2003. In thefirst two quarters this was mainly driven by arise in short-term financial investment growth,reflecting the then prevailing preference ofeconomic agents for safe and liquid assets. Inthe third quarter, however, the annual growthrate of short-term financial investment declinedsomewhat in connection with the steepening ofthe yield curve and receding financial marketuncertainty.

Long-term financial investment growthremained broadly stable in the first half of 2003and rose in the third quarter. At the same time,the annual growth rate of investment in long-term debt securities fell in the first half of theyear and remained subdued thereafter. The fallwas probably related to the low level of interestrates, periods of relatively high bond marketvolatility and, from the second quarter onwards,a recovery in stock prices, which increasedthe relative attractiveness of equity over bondinvestments. The annual growth rate ofinvestment in mutual fund shares (excludingmoney market fund shares) increasedconsiderably during the first three quarters of

2003. Investment in quoted shares by the non-financial sector also recovered, although theannual growth rate remained subdued comparedwith the late 1990s. This points to ongoing,albeit declining, caution on the part of economicagents with regard to shares, following thelosses made on equity holdings from early 2000onwards.

MARKET INTEREST RATES AT VERY LOW LEVELSIn line with the decisions of the GoverningCouncil to reduce the key ECB interest rates inMarch and June 2003, money market interestrates decreased in the first half of the year,continuing the downward trend that started inmid-May 2002. After the reduction of the keyECB rates in June 2003 the downward trend inmoney market rates came to a halt. Moneymarket interest rates at longer maturitiessubsequently rose in an environment in whichthe prospect of an economic recovery becamemore certain.

The market had broadly expected the reductionsin key ECB interest rates in the first half of2003. Longer-term money market interest ratesfell early in the year against a backdrop ofsubdued economic growth and the appreciationof the exchange rate of the euro, which led toexpectations of a decline in inflationarypressures. The slope of the money market yieldcurve, as measured by the difference betweenthe twelve-month and one-month EURIBOR,remained broadly unchanged at negative valuesin the first half of 2003, as money market ratesat different maturities declined by similaramounts (see Chart 8).

In mid-2003 the downward trend in moneymarket rates started to reverse as pessimismsubsided and market expectations graduallyshifted towards an economic recovery in theeuro area in an environment in which moreliquidity was available than needed to supportnon-inflationary growth. Towards the end ofthe year, part of the increase in money marketrates was reversed, as the appreciation of theeuro dampened expectations of future increasesin short-term interest rates. The one-month and


Chart 8 Short-term interest rates in theeuro area market

(percentages per annum; percentage points; daily data)

Source: Reuters.

one-month EURIBOR (left-hand scale)twelve-month EURIBOR (left-hand scale)spread between twelve-month and one-month EURIBOR (right-hand scale)

Q3 Q4 Q1 Q2 Q3 Q4 Q12002 2003

1.5

2.0

2.5

3.0

3.5

4.0

-0.6

-0.3

0.0

0.3

0.6

twelve-month EURIBOR stood at 2.10% and2.31% respectively at the end of 2003,significantly lower than at end-2002 butsomewhat higher than in mid-2003.

In the first two months of 2004 EURIBORinterest rates at longer maturities declinedslightly, as market participants expected short-term interest rates during the course of 2004 toremain at lower levels than previouslyanticipated. On 27 February 2004 the one-month and twelve-month EURIBOR stood at2.05% and 2.09% respectively.

Following the gradual reduction of economic,financial and geopolitical tensions towards theend of the first half of 2003, the impliedvolatility derived from options on three-monthEURIBOR futures contracts declined

substantially. The low implied volatility in mid-2003 indicated that market participants attacheda very low degree of uncertainty to future short-term interest rates at that point in time (seeChart 9). After remaining stable at relativelylow levels for several months, implied volatilityrebounded slightly towards the end of 2003 butremained well below the levels prevailing a yearearlier.

At the very short end of the money market, formost of 2003 the overnight interest rate, asmeasured by the EONIA, fluctuated slightlyabove the level of the minimum bid rate on theEurosystem’s main refinancing operations. Thespread between the EONIA and the minimumbid rate increased slightly during the summermonths, but it subsequently normalised in thecourse of September and October amid

Chart 9 Three-month EURIBOR futures ratesand impl ied volat i l i ty

(percentages per annum; basis points; daily data)

Sources: Bloomberg, Reuters and ECB calculations.Note: Implied volatility with constant six months to maturity isobtained from an interpolation of the term curve of impliedvolatility derived from options on three-month EURIBOR futures(see also the box entitled “Measures of implied volatility derivedfrom options on short-term interest rate futures” in the May 2002issue of the ECB’s Monthly Bulletin).

Q3 Q4 Q1 Q2 Q3 Q4 Q12002 2003

1.5

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3.0

3.5

4.0

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5.0

20.0

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60.0

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120.0

three-month EURIBOR futures maturing in December 2003 (left-hand scale)three-month EURIBOR futures maturing in March 2004 (left-hand scale)implied volatility with constant six months to maturity(right-hand scale)

37ECB

Annua l Repor t2003

comfortable liquidity conditions in the moneymarket (see Chapter 2, Section 1.1).

PRONOUNCED FLUCTUATIONS IN BOND MARKETSTHROUGHOUT 2003Global bond markets were characterised bypronounced yield fluctuations in 2003, withbond yields in the major economies followingbroadly similar patterns. The volatility resultedfrom market participants’ changing perceptionsabout the outlook for economic growth,inflation and the related monetary policy stance.Particularly during the first quarter of the year,uncertainties related to geopolitical tensionsplayed an important role, as the high level ofrisk aversion triggered portfolio flows fromequity to bond markets. The weakening of theseuncertainties, as well as clear indications of arecovery in the major economies, prompted apartial reversal of these flows later in the year.All in all, ten-year government bond yields inthe euro area and the United States increased byaround 10 and 50 basis points respectively in2003 and stood at around 4.3% at the end ofthe year in both cases (see Chart 10). Thedifferential between US and euro area long-termbond yields hovered around zero throughout thelast few weeks of the year, whereas it had beenin negative territory for most of the year untilthen.

In the United States, government bond yieldsdeclined during the first half of the year,continuing the trend that started in 2002. Thesedevelopments reflected market participants’more pessimistic perceptions about the short tomedium-term outlook for economic activityamid tensions stemming from geopoliticaluncertainty and disappointing macroeconomicdata. In addition, bond yields declined as aresult of investors’ increasing concern aboutthe risk of deflationary tendencies in the USeconomy. Consequently, ten-year governmentbond yields reached historically low levels of3.1% by mid-June. The rebound in bond yieldswhich started thereafter was mainly driven byupward revisions of market participants’expectations for economic growth and inflation,but may also have been related to their mounting

Chart 10 Long-term government bond yields

(percentages per annum; daily data)

Source: Reuters.Note: Long-term government bond yields refer to ten-year bondsor to the closest available bond maturity. From 1 January 2001euro area data include Greece.

1998 1999 2000 2001 2002 20030.0

1.0

2.0

3.0

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5.0

6.0

7.0

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1.0

2.0

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7.0

euro areaUnited StatesJapan

concerns regarding the sustainability of thehigh fiscal and current account deficits in theUnited States. Hedging strategies of UShousing agencies may have strengthened boththe downward trend in US bond yields and thestrong rebound over the summer. Despite thisstrong rebound, long-term bond yields in theUnited States ended the year at relatively lowlevels, partly reflecting perceptions amongmarket participants that the Federal Reservewould keep short-term interest rates at very lowlevels for a considerable period.

Market participants’ uncertainty regardingfuture bond yield movements in the US marketremained relatively high throughout the year.This is suggested by the implied volatility onten-year US Treasury futures, which reachedfairly high levels from a historical perspective,in particular during the summer. Theuncertainty seemed to reflect – to some extent –


the ongoing debate among market participantsover the sustainability of very low long-termbond yields in the United States.

In Japan, long-term bond yields broadlyfollowed the same pattern as in the UnitedStates and the euro area, albeit remaining atmuch lower levels. In the first half of 2003Japanese ten-year bond yields reachedhistorical lows (around 0.4% in mid-June),reflecting investors’ growing pessimism aboutthe outlook for the Japanese economy. Marketparticipants’ concerns stemmed from the strongappreciation of the yen vis-à-vis the US dollar –which was perceived as negatively affectingJapanese exporters – as well as from the effectsof the SARS epidemic. Ten-year bond yieldsrebounded sharply during the third quarter andthen stabilised at the end of the year, to reach1.4% on 31 December, which was close to thelevels last seen at the beginning of 2002.Expectations of a swifter economic recovery, aswell as portfolio shifts from bonds to stocks,contributed to a rise in long-term bond yieldsduring the second half of the year.

In the euro area, bond market developments in2003 to a large extent mirrored those in theUnited States, although euro area bond yieldsfluctuated somewhat less. In the first half of2003 market participants gradually became lessoptimistic about growth prospects, whichpushed long-term interest rates lower. Thehigh degree of uncertainty surrounding thegeopolitical situation was reflected in anincrease in market participants’ risk aversionand thus prompted “flight-to-safety” flowsfrom the stock to the bond market. From mid-June onwards euro area bond yields began torise, although less markedly than in the UnitedStates. These developments reflected marketparticipants’ upward revisions with regard toexpected economic growth and – to some extent– upward revisions of inflation expectations.Indeed, the break-even inflation rate, measuredas the difference between the yields on ten-yearnominal and index-linked bonds, increasedsomewhat after mid-June, although this waspartly also due to technical factors (see

Chart 11 Euro area long-term real bondyield and break-even inf lat ion rate

(as percentages; daily data)

Sources: Reuters, French Treasury and ISMA.Note: The euro area real bond yields are derived from themarket prices of French government bonds which are indexed tothe euro area HICP (excluding tobacco prices) and whichmature in 2012. The methods used to compute the break-eveninflation rate were outlined on page 16 of the February 2002issue of the ECB’s Monthly Bulletin.

Chart 11). The degree of uncertainty prevailingin euro area bond markets changed little overallin 2003 according to developments in impliedbond market volatility. Moreover, and bycontrast with the situation in the United States,implied bond market volatility in the euro areawas, in general, not particularly high in 2003.

Financing conditions in euro area corporate bondmarkets improved significantly in the first part ofthe year and remained very favourable until theend of 2003. The relative cost of financing forBBB-rated corporations, for example, asmeasured by the differential between the yields onbonds issued by such corporations andcomparable government bonds, declinedmarkedly – by around 150 basis points – in2003 and stood at around 80 basis pointsat the end of the year, which wasvery low by historical standards. Thesedevelopments in financing conditions areattributable to an improved outlook for corporatecredit risk as perceived by investors and to a

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q12002 2003

0.0

1.0

2.0

3.0

4.0

0.0

1.0

2.0

3.0

4.0

break-even inflation ratereal bond yield

39ECB

Annua l Repor t2003

Chart 12 Short-term MFI interest rates anda short-term market rate

(percentages per annum; rates on new business)

Source: ECB.1) Include loans to non-financial corporations over €1 millionwith a floating rate or with up to one year initial rate fixation.2) Include deposits from households redeemable at notice of upto three months.3) Include deposits from households with an agreed maturity ofup to one year.

Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.2003

three-month money market rate (left-hand scale)short-term loans to non-financial corporations 1)

(left-hand scale)overdrafts to households (right-hand scale)overnight deposits from non-financial corporations(left-hand scale)short-term savings deposits from households 2)

(left-hand scale)short-term time deposits from households 3)

(left-hand scale)

0.0

1.0

2.0

3.0

4.0 8.0

9.0

10.0

11.0

Chart 13 Long-term MFI interest rates anda long-term market rate

(percentages per annum; rates on new business)

Source: ECB.1) Include loans to non-financial corporations over €1 millionwith over five years’ initial rate fixation.2) Include loans to households with over five and up to ten years’initial rate fixation.3) Include deposits from households with an agreed maturity ofover two years.

Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.2003

2.0

3.0

4.0

5.0

6.0

2.0

3.0

4.0

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6.0

five-year government bond yieldslong-term loans to non-financial corporations 1)

long-term loans for house purchase 2)

long-term time deposits from households 3)

stronger preference for higher-yielding assets onthe part of investors, reflecting the historicallylow levels of risk-free interest rates.

In early 2004 long-term bond yields declinedsomewhat in all major markets. Between theend of December 2003 and 27 February 2004ten-year government bond yields in the euro areaand in the United States fell by around 20 and25 basis points respectively. The yield spreadbetween BBB-rated corporate bonds andcomparable government bonds in the euroarea remained broadly unchanged over this period.

MFI INTEREST RATES BROADLY FOLLOWEDMARKET RATESShort-term MFI interest rates6 declined during thefirst half of 2003 and stabilised thereafter (see

Chart 12). Between January and December therates on short-term savings deposits byhouseholds (i.e. redeemable at a period of noticeof up to three months) and overnight deposits bynon-financial corporations both declined byaround 30 basis points, to 2.0% and 0.9%respectively. Short-term lending rates alsodeclined, although to varying degrees,depending on the borrower type. From thebeginning of 2003 short-term lending ratesto non-financial corporations (i.e. loans over€1 million with a floating rate or with an initial

6 The ECB released euro area MFI interest rate statistics for thefirst time in December 2003, which cover the period from January2003 onwards. They replaced the previously published euro arearetail interest rate statistics, which were produced on the basis ofnational interest rate statistics which already existed before 1999.The new MFI interest rate statistics are harmonised and thusgenerally comparable across countries.


rate fixation of up to one year) declined byaround 60 basis points, to 3.1% in December,while the rates on bank overdrafts to householdsdecreased only slightly, by around 20 basispoints, to 9.7%. These developments in short-term MFI interest rates took place against thebackground of a decrease of around 70 basispoints in the three-month money market rate in2003. The pass-through of the marked drop inmarket rates to short-term bank interest rates wasbroadly in line with the historical pattern, inparticular the fact that rates on overnight depositsand on typical short-term savings deposits tend toadjust particularly slowly to changes in market rates.

Long-term MFI interest rates on new businessdeclined during the first half of 2003 butrebounded from August onwards, broadlyreflecting the pattern in comparable governmentbond yields (see Chart 13). For the entire year,the rates on loans to households for house

purchase with over five and up to ten years’initial rate fixation and on long-term loansto non-financial corporations (loans over€1 million with over five years’ initial ratefixation) decreased by around 35 and 30 basispoints, to 5.0% and 4.3% respectively. Thus,general developments in long-term MFI interestrates were another indication of the veryfavourable financing conditions that prevailedthroughout 2003. As regards long-term MFIdeposit interest rates, rates on long-termdeposits by households (i.e. with an agreedmaturity of over two years) fell by around80 basis points between January and December2003, to around 2.4%.

GLOBAL STOCK PRICES INCREASED STRONGLY IN2003Putting an end to the downward correction thatcommenced in March 2000, stock prices in themajor markets rose strongly in 2003, recording

Chart 14 (a) Stock price indices

(index: 1 January 1998 = 100; daily data)

Source: Reuters.Note: The Dow Jones EURO STOXX broad index for the euroarea, the Standard & Poor’s 500 for the United States and theNikkei 225 for Japan. From 1 January 2001 onwards euro areadata also include Greece.

Chart 14 (b) Implied stock marketvo lat i l i ty

(percentages per annum; ten-day moving average of daily data)

Source: Bloomberg.Notes: The implied volatility series reflects the expectedstandard deviation of percentage stock price changes over aperiod of up to three months, as implied in the prices of optionson stock price indices. The equity indices to which the impliedvolatilities refer are the Dow Jones EURO STOXX for the euroarea, the Standard & Poor’s 500 for the United States and theNikkei 225 for Japan.

1998 1999 2000 2001 2002 200310

20

30

40

50

60

10

20

30

40

50

60


1998 1999 2000 2001 2002 200340

60

80

100

120

140

160

180

200

220

40

60

80

100

120

140

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200

220


41ECB

Annua l Repor t2003

their first annual increases since 1999 (seeChart 14a). Increasing stock prices wereaccompanied by significant drops in impliedstock market volatility, which is a measure ofmarket participants’ degree of uncertainty (seeChart 14b).

In general, developments in broad stock marketindices in the United States, Japan and the euroarea followed similar patterns in the course of2003. Up to mid-March stock prices declined inthese markets on account of investors’ morepessimistic outlook for the global economy,increased uncertainty and risk aversion. All ofthese factors appeared to be closely related tointensified geopolitical tensions and theprospects of war in Iraq. The apparent global“flight” from equities was also spurred byincreased concerns about corporate earningsquality in the wake of repeated accountingscandals. For the rest of the year stock prices inthe major markets followed a solid upwardtrend. Initially, the stock market rebound wasset in motion by the normalisation of marketconditions resulting from market participants’fading uncertainty at the outset of the militaryoperations in Iraq. In the second half of theyear stock prices were further bolstered bycontinuously improving corporate earnings,abating stock market uncertainty and a brighteroutlook for the world economy.

Overall, between end-2002 and end-2003, stockprices in the United States, as measured by theStandard & Poor’s 500 index, increased by26%. In Japan, stock prices, as measured by theNikkei 225 index, increased by 24%, while inthe euro area the Dow Jones EURO STOXXindex gained 18% over the same period.

In the United States, the strong increases instock prices in 2003 might have also beenbolstered by the economic stimulus packagepassed by the US congress at end-May,including a reduction in dividend and capitalgains taxation rates. The improved corporateoutlook was corroborated by corporate earningsreports that, for most of 2003, exceededexpectations. While the better than expected

earnings figures seemed mainly to reflectsuccessful cost-cutting measures in the firsthalf of 2003, they were further supported by therecovery in general business activity during thesecond half of 2003.

In Japan, stock prices declined during the firstfour months of 2003, following marketconcerns about non-performing loans in theJapanese banking sector that continued tonegatively affect stock prices. In addition, thestock prices of export-oriented firms wereadversely affected by the strengthening of theJapanese yen vis-à-vis the US dollar. Later,between April and mid-September 2003,Japanese stock markets rebounded stronglyagainst the background of improved economicdata and sounder corporate earnings reports,and possibly also as a result of spillover effectsfrom the US stock market. From mid-Septemberonwards stock prices broadly stabilised.

In the euro area, stock price developments tendedto be strongly synchronised with movements inUS stock markets. As with the United States, theoverall rise in euro area stock prices reflecteddeclining stock market uncertainty together with amarket perception of a more favourable economicand corporate outlook. As regards the sectoralbreakdown, the general increase in euro areastock markets was mainly driven by thetechnology, financial and consumer cyclicalsectors, which had seen proportionally largerdeclines during 2002. In addition, in the financialsector, the improvement of financial marketconditions after March 2003 together with cost-cutting efforts and lower loan loss provisionsseemed to have a positive impact on theprofitability of banks.

In the period from end-2003 to 27 February 2004the Dow Jones EURO STOXX index, theStandard & Poor’s 500 index and theNikkei 225 index increased further, by 5%,3% and 3% respectively. These increases seemedto reflect further indications of improvedcorporate profitability, lower long-term interestrates and further declines in stock marketuncertainty.


2.2 PRICE DEVELOPMENTS

Despite subdued economic activity and theappreciation of the euro, overall HICP inflationin the euro area averaged 2.1% in 2003, whichwas only 0.2 percentage point lower than in theprevious two years (see Table 4). The mainreason for the decrease with respect to 2002was lower average year-on-year growth ratesin non-energy industrial goods and servicesprices, which also allowed for a decline in theaverage growth rate of the HICP excludingunprocessed food and energy to 2.0% from2.5% in 2002. In this context, the pattern ofoverall HICP movements throughout 2003reflected developments in the more volatile sub-components: energy and unprocessed foodprices. Cost pressures were subdued over 2003as producer prices showed moderate growthrates and nominal labour cost growth levelledoff. However, the decline in labour productivitygrowth in the context of weak economic activityled to an increase in the growth rate of unitlabour costs in the first half of 2003.

In January 2004 overall HICP inflation fell to1.9%, down 0.1 percentage point comparedwith December 2003. This was mainly due tostrong base effects in energy and tobaccoprices, partly offset by the upward impact from

administered prices and indirect tax changes.The year-on-year rate of change of the HICPexcluding energy and unprocessed food pricesremained unchanged at 1.9%.

HEADLINE INFLATION REFLECTEDDEVELOPMENTS IN THE MORE VOLATILECOMPONENTSOverall HICP inflation followed a rather erraticpattern over 2003 as a whole (see Chart 15).Headline inflation rose in early 2003, asgeopolitical uncertainties related to the war inIraq pushed up energy prices. Once thesegeopolitical uncertainties had lessened, and asthe euro continued to appreciate against the USdollar, the contribution of energy developmentseased and headline inflation resumed itsdownward trend to reach 1.8% in May, thelowest rate of increase in three years. In thesecond half of the year, however, headlineinflation hovered around 2%, mainly reflectingtwo opposing influences. On the one hand,there was a rising contribution from food prices– unprocessed food prices rose as a result of thesummer heatwave in Europe, while increases intobacco taxation also pushed up processed foodprices. On the other hand, the contribution fromenergy prices declined with respect to the firsthalf of the year as a result of the euroappreciation, which attenuated the effects of the

2001 2002 2003 2002 2003 2003 2003 2003 2003 2004Q4 Q1 Q2 Q3 Q4 Dec. Jan.

HICP and its componentsOverall index 2.3 2.3 2.1 2.3 2.3 1.9 2.0 2.0 2.0 1.9

Energy 2.2 -0.6 3.0 2.9 7.0 1.5 2.1 1.6 1.8 -0.4Processed food 2.9 3.1 3.3 2.6 3.1 3.3 3.1 3.8 3.8 3.3Unprocessed food 7.0 3.1 2.1 1.6 0.1 1.5 3.4 3.6 3.2 2.9Non-energy industrial goods 0.9 1.5 0.8 1.2 0.7 0.9 0.7 0.8 0.7 0.6Services 2.5 3.1 2.5 3.1 2.7 2.6 2.4 2.4 2.3 2.5

Other price and cost indicatorsIndustrial producer prices 1) 2.1 -0.1 1.6 1.2 2.4 1.5 1.2 1.1 1.0 0.3Oil prices (EUR per barrel) 2) 27.8 26.5 25.1 26.5 28.4 22.7 25.1 24.5 24.0 24.2Commodity prices 3) -8.1 -0.9 -4.5 5.6 -3.2 -7.9 -5.8 -1.2 -0.2 5.1

Table 4 Price developments

(annual percentage changes, unless otherwise indicated)

Sources: Eurostat, Thomson Financial Datastream and HWWA (Hamburg Institute of International Economics).1) Excluding construction.2) Brent Blend (for one-month forward delivery).3) Excluding energy. In euro.

43ECB

Annua l Repor t2003

Chart 15 Breakdown of HICP inflation: mainsub-components

(annual percentage changes; monthly data)

Source: Eurostat.

total HICP (left-hand scale)unprocessed food (right-hand scale)energy (right-hand scale)

total HICP excl. energy and unprocessed foodprocessed foodnon-energy industrial goodsservices

1999 2000 2001 2002 2003-2

0

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1999 2000 2001 2002 2003-2

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rise in US dollar-denominated oil prices (seeChart 16).

In 2003 headline inflation was particularlyresilient to the subdued economic activity and,despite some direct impact via energy prices, tothe appreciation of the euro. This was also truefor the HICP excluding energy and unprocessedfood.

Processed food prices in 2003 were mainlyinfluenced by increases in tobacco prices as aresult of increases in indirect taxation in somecountries both in the first few months of theyear and, especially, in the latter part of theyear. This translated into a contribution of this

main sub-component to overall inflation ofaround 0.4 percentage point.

Services prices growth in 2003 showed agradual decline from the fairly high levelreached in 2002. The year-on-year rate ofgrowth of services prices followed a downwardtrend during the course of the year, reaching2.3% in December, which was around0.7 percentage point lower than in December2002. As a result, the contribution of servicesprice growth to overall inflation declined toaround 1.0 percentage point, which wasnonetheless almost half of the observed HICPinflation rate for most of 2003. By contrast, theannual rate of inflation of non-energy industrial

Chart 16 Contributions to HICP inflationfrom sub-components

(annual percentage point contributions; monthly data)

Source: Eurostat.

overall indexservicesnon-energy industrial goodsprocessed foodunprocessed foodenergy

Q1 Q2 Q3 Q42002 2003

-0.5

0.0

0.5

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1.5

2.0

2.5

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-0.5

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3.0


Box 4

INFLATION DIFFERENTIALS IN THE EURO AREA: POTENTIAL CAUSES AND POLICY IMPLICATIONS

The diversity of inflation developments among the euro area countries – as captured by variousdispersion indicators – declined significantly over the 1990s. Following the start of Stage Threeof EMU in 1999, inflation dispersion continued to decline, reaching its lowest level in thesecond half of 1999. However, it then picked up modestly until early 2001. Since then, inflationdispersion in the euro area has remained broadly stable, before declining again during 2003 tolevels close to those seen in the second half of 1999. All in all, the extent of inflation dispersionobserved at present in the euro area is not notably different from that in the United States.

Notwithstanding the currently low level, by historical standards, of inflation dispersion in theeuro area, the euro area has witnessed relatively persistent inflation differentials over the pastfour years. With the exception of Belgium, France, Luxembourg and Finland, all euro areacountries have experienced inflation persistently either above or below the euro area averagesince 19991. In particular, five countries (Greece, Spain, Ireland, the Netherlands and Portugal)have experienced relatively large and persistently positive inflation differentials vis-à-vis theeuro area, which however have started to narrow since 2002 in Portugal and in the course of2003 in Spain, Greece and Ireland. In the Netherlands, meanwhile, the inflation differential vis-à-vis the euro area has actually turned negative recently. By contrast, Germany and Austria haveobserved persistently negative inflation differentials. This box briefly reviews the potentialcauses and the policy implications of inflation dispersion in the euro area.2

1 Based on annual average inflation rates in 1999-2003.2 For a more detailed analysis and discussion of inflation differentials in the euro area see the ECB report entitled “Inflation differentials

in the euro area: potential causes and policy implications”, published on the ECB’s website (www.ecb.int) on 30 September 2003.

Inf lation dispersion in the euro area

(standard deviation in percentage points)

Source: Eurostat.

0.0

1.0

2.0

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5.0

6.0

7.0

0.0

1.0

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5.0

6.0

7.0

Stage Two of EMU Stage Three of EMU

weighted standard deviation unweighted standard deviation

Stage One of EMU

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

45ECB

Annua l Repor t2003

Potential causes

With respect to the inflation differentials observed in the euro area, it needs to be stressed thatthe single monetary policy implied a regime shift, the effects of which on price formationprocesses would take several years to unfold. In particular, the move to Stage Three led tostrong declines in interest rates in Ireland, Portugal and Spain and later in Greece, i.e. incountries where inflation rates had been systematically above the euro area average before themid-1990s. In most of the other euro area countries, these nominal convergence effects wereconsiderably less sizeable. However, the equilibrating effect of changes in nationalcompetitiveness triggered by inflation differentials is likely to limit the size and persistence ofinflation differences emanating from the adjustment to the new monetary regime. In this respect,countries with below-average inflation rates should benefit from a gain in competitiveness andalso, in the short term, from the relatively smaller adverse effect of inflation on real disposableincome and real wealth. Meanwhile, other things being equal, countries with above averageinflation rates should suffer from competitiveness losses and larger negative effects of inflationon real income and wealth.

In addition to the special effects related to the start of Stage Three, a combination of temporaryand more persistent factors on inflation developments seems to have caused the observedinflation differentials. As for the temporary factors, one-off domestic policy measures, such aschanges in administered prices and indirect tax measures, have varied across countries and havethus contributed to the inflation differentials. However, these measures do not seem to haveaccounted for much of the observed inflation differentials since the start of Stage Three and areunlikely to play a larger role unless domestic policy measures increasingly diverge across euroarea countries in the future. Moreover, differences in the speed of implementing structuralreforms across countries may temporarily translate into higher inflation differentials. Differentlevels of exposure to external shocks – because of national discrepancies in the degree ofopenness concerning extra-euro area trade and oil dependency – also appear to contribute, albeittemporarily, to inflation differentials.

Furthermore, there is a relationship between cyclical positions and inflation rates: euro areacountries with above average inflation rates have seen the strongest average growth rates indomestic demand, alongside relatively large positive output gaps. The opposite applies to theeuro area countries with below average inflation rates. Cross-country differences in the fiscalpolicy stance may have also played a role in explaining inflation differentials, notably incountries like Greece and Ireland, where fiscal policies have been relatively expansionary in thelast few years.

Finally, with regard to more persistent factors, inflation differentials in Greece, Ireland,Portugal and, to a lesser extent, Spain may have been partially caused by price level and incomeconvergence and/or what are known as Balassa-Samuelson (BS) effects3. Conversely, low

3 The BS effect explains that prices of non-tradable goods normally rise faster than prices in the tradable goods sector becauseproductivity growth is normally lower in the non-tradable goods sector. As wages in the tradable goods sector are driven up byproductivity growth, wages in the non-tradable sector will tend to increase as well. As the latter wage increases are not matched byproductivity gains, labour costs and prices will increase faster in the non-tradable goods sector. With prices in the tradable goodssector set internationally, countries with high productivity growth differences between sectors will tend to see a larger increase in theoverall price index.


productivity growth differentials between the tradable and non-tradable goods sectors inGermany may have contributed to lower than average inflation in that country. However, theobserved inflation differentials among some euro area countries have been significantly largerthan would be implied by the BS model, according to available estimates. Other structuralfactors, such as wage and price rigidities or differing degrees of competition in key domesticmarkets, may also have contributed to the observed inflation differentials and their persistence.In this respect, empirical studies show that the relative degree of market competition seems to bean important parameter in explaining the size and volatility of relative price responses to shocksacross euro area countries. In any event, the continuation of the convergence process among theeuro area countries should lead to a decline in inflation dispersion owing to price level andincome convergence in the long run. However, given the current heterogeneity of nationaleconomic structures and countries’ exposure to idiosyncratic shocks, it is likely that somedifferences in inflation rates will continue to exist in the future.

Policy implications

Since the start of Stage Three it has no longer been possible to deal with regional economicimbalances and (asymmetric) shocks in the euro area countries using monetary policy. On thecontrary, the single monetary policy of the ECB can only be geared towards the objective ofprice stability for the euro area as a whole. Just as in any monetary union, inflation differentialswithin the euro area reflect different regional price dynamics and adjustments in relative pricesand, as such, cannot be addressed by the single monetary policy. At the same time, the ECB’smonetary policy strategy attributes a secondary role to unavoidable inflation differentials whencalibrating the safety margin for admissible inflation in the euro area, since their existence mighthave implications for lower-inflation regions. Moreover, inflation differentials remain animportant communication challenge for the ECB since monetary policy is often discussed fromthe viewpoint of national inflation rates and its implications for national economic policies.

Large and persistent inflation differentials may justify national remedies in some countries inorder to prevent undue losses in competitiveness. National economic policies, such as fiscal andstructural policies, need to be adjusted to counteract persistent and potentially damaginginflation differentials. Structural reforms, particularly measures aimed at removing nominalwage and price rigidities and leading to a more diversified wage-setting process withinindividual euro area countries, can speed up the wage and price adjustments necessary to dealwith shocks, including a more synchronised response of national prices to shocks. Suchpolicies would, in turn, lower the likelihood of persistent inflation differentials in the euro area.Finally, given its considerable time-lags, fiscal policy may be ill-suited to fine-tuning inflationdevelopments in the short run, although it may be used to address inflation differentials over thelonger term, particularly if a country experiences persistently positive inflation differentials.

goods remained roughly constant at around0.8% throughout 2003, approximately half therate of increase recorded in 2002, leading toa contribution to overall inflation of around0.2 percentage point.

Inflation dispersion in the euro area declinedduring 2003 after having remained broadlystable over the previous two years. Box 4reviews and analyses the potential explanationsfor the observed inflation differentials in theeuro area.

47ECB

Annua l Repor t2003

Public perception of past inflation, as measuredby the European Commission’s qualitativeindicator of perceived inflation over the past 12months, showed a gradual decline in the firsthalf of 2003. However, this decline wasinterrupted in the summer as unprocessed foodprices rose as a result of the heatwave inEurope. This gives some support to the viewthat consumers’ inflation perceptions arelargely influenced by developments infrequently purchased items, which mostlybelong to the out-of-pocket expenditurecategory. This also helps to explain thesomewhat volatile pattern of inflationperceptions. In the second half of 2003consumers’ inflation perceptions seemed tohave stabilised at fairly high levels by historicalstandards. By contrast, throughout 2003consumers’ inflation expectations for the next12 months remained at very low levels byhistorical standards.

MODERATE PRICE PRESSURES AT THE PRODUCERLEVELThe annual rate of growth in total industrialproducer prices (excluding construction)declined in the course of 2003, reflecting theeffects of the appreciation of the euro exchangerate counterbalancing those of higher oil andnon-oil commodity prices (see Chart 17). Thisled to an annual average increase in producerprices of 1.6% in 2003. Weak economicconditions may have also prevented firms fromincreasing producer prices for most of the year.

The pattern followed by the annual rate ofgrowth of overall producer prices in 2003 waslargely the result of developments in energyand intermediate goods prices. Reflectingdevelopments in oil prices, the annual rate ofchange in industrial energy prices increased inthe first few months of the year but easedthereafter, supported by the moderation ofoil prices and the appreciation of the euro. Theannual rate of growth in intermediate goodsprices, which averaged 0.8% in 2003 as awhole, was higher in the first half of the yearand declined in the second half as the impact ofthe exchange rate appreciation worked through.

Chart 17 Breakdown of industrial producerprices

(annual percentage changes; monthly data)

Source: Eurostat.

industry excluding construction (right-hand scale)intermediate goods (right-hand scale)capital goods (right-hand scale)consumer goods (right-hand scale)energy (left-hand scale)

1999 2000 2001 2002 2003-12

-8

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0

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16

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24

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-4

-2

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8

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12

As usual, the two other main components ofoverall producer prices, capital goods andconsumer goods prices, displayed much morestability in their year-on-year rates of growth.This suggests that the weak demand conditionsmay have prevented firms from passing onincreases in energy and intermediate goodsprices in early 2003 to later production stages.The annual average growth rates in consumergoods and capital goods prices were 1.1% and0.4% respectively.

NOMINAL LABOUR COST GROWTH LEVELLED OFFIN 2003The gradual upward movement observed in therates of growth of euro area-wide labour andwage cost indicators since 1999 levelled off atthe beginning of 2003 (see Table 5).

Growth in compensation per employee showeda decline in the second half of 2002 andremained roughly unchanged in the first threequarters of 2003.


Available information on compensation peremployee shows some noticeable differences atthe sectoral level in the first three quarters of2003. The rate of growth in the constructionsector rose in the first half of 2003 and easedthereafter, while in industry excludingconstruction there seemed to be a gradualdecline over the year as a whole. As forservices, growth in compensation per employeeseemed to stabilise in 2003 for the sector as awhole. However, some counterbalancingeffects were observed within sub-sectors: theincrease in market-related services (whichinclude trade, hotels and restaurants, financeand business services) in the first two quarterseased in the third quarter, whereas the growthrate in non market-related services increased inthe third quarter. These developments suggestthat the lower rates of growth in industrialactivity may be behind the decline in labour costgrowth in industry during the first threequarters of 2003. Labour cost developmentsin services may also help to explain someresilience of services prices over the year as awhole, given the higher share of labour costs inthe services sector.

The rate of growth of negotiated wages fell in2003 compared with 2002, and gross monthlyearnings appeared to follow a similar trend. Anoticeable moderation in labour cost growthwas also observed when measured on the basisof hours worked, as the growth rate of hourlylabour costs in the first three quarters of 2003were lower than the average growth in 2001 and2002.

Given that growth in compensation peremployee was roughly unchanged in the firstthree quarters of the year, the lowerproductivity growth in the second and thirdquarters of 2003 led to an increase in unitlabour costs from 2.0% year on year in the firstquarter to 2.7% in the second and 2.4% in thethird. Profit mark-up developments, as proxiedby the gap between the annual rates of growth inthe GDP deflator and unit labour costs,indicated that the delayed recovery in economicactivity in the euro area continued to exertpressure on profits. However, in the secondhalf of 2003 some improvement in productivitygrowth helped to moderate unit labour costgrowth.

Chart 18 Sectoral compensation peremployee

(annual percentage changes; quarterly data)

Sources: Eurostat and ECB calculations.

industry excl. constructionconstructionservices

1999 2000 2001 2002 20030.0

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5.0

2001 2002 2003 2002 2003 2003 2003 2003Q4 Q1 Q2 Q3 Q4

Negotiated wages 2.6 2.7 2.4 2.7 2.7 2.4 2.5 2.2Total hourly labour costs 3.3 3.5 . 3.5 3.1 3.2 2.9 .Gross monthly earnings 2.9 3.0 . 3.1 2.9 2.8 2.6 .Compensation per employee 2.8 2.6 . 2.5 2.6 2.7 2.6 .Labour productivity 0.2 0.4 . 0.9 0.6 0.0 0.2 .Unit labour costs 2.6 2.2 . 1.6 2.0 2.7 2.4 .

Table 5 Labour cost indicators


Sources: Eurostat, national data and ECB calculations.

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Annua l Repor t2003

Annual rates 1) Quarterly rates 2)

2001 2002 2003 2002 2003 2003 2003 2003 2002 2003 2003 2003 2003Q4 Q1 Q2 Q3 Q4 Q4 Q1 Q2 Q3 Q4

Real gross domestic product 1.6 0.9 0.4 1.1 0.7 0.1 0.3 0.6 0.0 0.0 -0.1 0.4 0.3of which:Domestic demand 1.0 0.3 1.0 0.9 1.3 1.0 0.5 1.3 0.3 0.4 0.1 -0.2 1.0

Private consumption 1.7 0.1 1.0 0.6 1.3 1.0 0.9 0.7 0.3 0.4 0.0 0.2 0.1Government consumption 2.5 2.9 1.9 2.2 1.9 1.7 1.8 2.3 0.1 0.5 0.6 0.6 0.6Gross fixed capital formation -0.3 -2.8 -1.2 -1.6 -1.9 -0.8 -1.2 -0.8 0.3 -0.9 -0.4 -0.2 0.6Changes in inventories 3), 4) -0.5 0.2 0.3 0.5 0.5 0.2 -0.1 0.5 0.0 0.2 0.1 -0.4 0.7

Net exports 3) 0.7 0.6 -0.6 0.2 -0.5 -0.8 -0.2 -0.6 -0.2 -0.4 -0.2 0.6 -0.7Exports 5) 3.4 1.5 0.0 3.6 1.9 -1.5 -0.5 0.1 -0.4 -1.5 -0.9 2.3 0.2Imports 5) 1.7 -0.1 1.5 3.3 3.6 0.8 0.0 1.8 0.3 -0.6 -0.4 0.8 2.1

Real gross value addedof which:

Industry excl. construction 0.5 0.2 -0.1 1.4 0.7 -1.0 -0.6 0.7 -0.6 0.3 -0.8 0.5 0.7Construction -0.6 -1.1 -0.8 -1.5 -2.0 -0.4 -0.4 -0.4 0.0 -0.6 0.1 0.0 0.1Purely market-related services 6) 3.1 1.1 0.7 1.1 0.9 0.4 0.9 0.6 0.2 -0.1 0.1 0.7 -0.1

Table 6 Composition of real GDP growth

(percentage changes, unless otherwise indicated; seasonally adjusted)

Sources: Eurostat and ECB calculations.1) Annual rates: percentage change compared with the same period a year earlier.2) Quarterly rates: percentage change compared with the previous quarter.3) As a contribution to real GDP growth; in percentage points.4) Including acquisitions less disposals of valuables.5) Exports and imports cover goods and services and include internal cross-border trade in the euro area. Intra-euro area trade is notcancelled out in import and export f igures used in national accounts. Consequently, these data are not fully comparable with balance ofpayments data.6) Includes trade, transport, repairs, hotels and restaurants, communication, finance, business services, real estate and renting services.

2.3 OUTPUT, DEMAND AND LABOUR MARKETDEVELOPMENTS

RECOVERY IN ACTIVITY DURING 2003Economic activity in the euro area picked up inthe second half of 2003, having generallystagnated since the fourth quarter of 2002 (seeTable 6). However, earlier expectations forgrowth in 2003 as a whole had to be scaledback. Real GDP grew by 0.4%, slowing furtherfrom a rate of growth of 0.9% in 2002 andremaining below the trend rate of growth inpotential output for the third successive year. Inaddition, labour market developments weresubdued throughout the year. This lacklustreperformance emphasised the need to enhancethe euro area’s structural flexibility andresilience to shocks. Box 5 reviews theprogress made with the EU’s reform agenda.

At the start of 2003 a number of factors, suchas the continued subdued activity in theworld economy, were contributing to weak

economic conditions. Moreover, the decline inbusiness and consumer confidence wasreinforced by the high degree of uncertainty inthe run-up to the Iraq war. Towards the middleof the year the geopolitical uncertaintygradually dissipated, giving rise to growingconfidence and a pick-up in activity driven byforeign demand.

EXPORTS TRIGGERING RECOVERY ON THEEXPENDITURE SIDEThe pick-up in activity in the second halfof 2003 reflected the positive effects ofimproving foreign demand on euro area exports.However, this impact was dampened by theappreciation of the euro. The contribution toquarter-on-quarter growth from net exports,which had turned positive in the third quarter,turned negative again in the fourth quarterin the face of strong import growth (seeChart 19). In 2003 as a whole net exportsmade a negative contribution to growth of0.6 percentage point.


Box 5

PROGRESS WITH STRUCTURAL REFORMS IN EURO AREA PRODUCT AND LABOUR MARKETS

Structural reforms in product and labour markets are essential to enhance the euro area’seconomic growth potential and facilitate adjustment to economic change. Measures to raise thepotential rate of economic growth are all the more important in view of the downward impactthat population ageing is likely to have on labour supply. In March 2000 the Lisbon EuropeanCouncil focused on the importance of modernising the regulatory framework and introduced anambitious reform agenda aimed at making the EU the most competitive and dynamic knowledge-based economy in the world by 2010. This box briefly reviews the progress made inimplementing the EU’s reform agenda over recent years and particularly in 2003.

The EU monitors and evaluates the functioning of product markets as part of the “Cardiffprocess”, whereas labour market reform is assessed within the “Luxembourg process”. Bothprocesses examine reforms in each of the different countries and provide input into the BroadEconomic Policy Guidelines (BEPGs), which define overarching priorities for various fields ofeconomic policy. These priorities then form the basis of policy recommendations which aremade for each EU Member State.1

In the field of labour markets, the BEPGs for the period 2003-05 stress the need to: (i) improvethe combined incentive effects of taxes and benefits in order to make work pay, (ii) ensureefficient, active labour market policies targeted towards the most disadvantaged groups,(iii) promote a more flexible organisation of work and review employment contract regulations,(iv) facilitate geographical and occupational mobility and (v) ensure that wage bargainingsystems allow wages to reflect productivity.

A number of countries have implemented reforms in their tax/benefits system in order to reducenon-wage labour costs and encourage labour supply. Tax rates have decreased for incomes atthe bottom and the middle of the distribution; employees’ and employers’ social securitycontributions have been reduced, particularly for the low-paid. Moreover, progress has beenmade in increasing the participation rate among people at the margin of the labour market. SomeMember States have strengthened the role of temporary work agencies, and some obstacles topart-time work have been removed.

All in all, most EU countries introduced labour market reforms in 2003. However, alsoconsidering the still high level of structural unemployment, reforms seem to lag behind what isimplied in government announcements. Limited progress has been made in attracting morepeople into the labour market, investing in human capital accumulation, and increasing theadaptability of both workers and enterprises to changing macroeconomic conditions. Measuresaimed at reducing long-term unemployment through retraining, as well as improving theemployability of low-skilled and older workers, can be seen as priority areas for reforms.Moreover, further reforms are needed to encourage labour mobility by improving the

1 Council Recommendation of 26 June 2003 on the broad guidelines of the economic policies of the Member States and the Community.The 2003 BEPGs were adopted for the period 2003-05.

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transferability of pensions and healthcare rights as well as by allowing wage differentiationaccording to local, regional and sectoral differences in productivity.

The structural reform agenda for product markets covers a wide range of areas. Among otherthings, the BEPGs urge Member States to foster competition in goods and services markets by(i) transposing Internal Market directives more quickly into national legislation, (ii) furtheropening up public procurement, (iii) giving adequate powers and resources to competitionand regulatory authorities and ensuring their independence, (iv) reducing state aid and(v) encouraging market entry and effective competition in network industries.

After many years of continuous progress, the percentage of EU Internal Market legislationwhich Member States had not yet transposed into national law (known as the “transpositiondeficit”) started to increase in 2002, and the deterioration continued in 2003. The EuropeanCommission has taken several initiatives to improve the functioning of the Internal Market.There are, nevertheless, still some significant barriers to this, particularly in the services sector.Many of these barriers appear to be due to national regulations, for example administrativeprocedures for setting up subsidiaries in other euro area countries. As far as the reinforcementof competition is concerned, there are indications that many euro area countries have taken stepsto improve the efficiency and transparency of public procurement procedures. In addition, somecountries have increased the powers of their competition and regulatory authorities. Moreover,over recent years the trend towards reducing and redirecting state aid seems to have continued,although it still plays an important role in some sectors, such as transport. Euro area countrieshave continued to implement regulatory reforms in network industries, albeit to varyingdegrees. Nevertheless, effective competition in these previously sheltered sectors could beincreased further.

To sum up, the pace of reform continued to be rather slow in 2003. This adds to the concernthat the EU may not be able to achieve the Lisbon targets unless Member States vigourously stepup their efforts. Besides offering long-term growth benefits, renewed momentum in the processof structural reform would foster consumer and investor confidence, thus also entailing someshorter-term stimulus to growth.

Changes in the contribution to growth fromdomestic demand over the course of 2003 werelargely explained by developments in inventorychanges. The restocking in the first half of theyear, which followed a two-year period ofdepleting inventories, was possibly induced byuncertainty regarding the supply of importedintermediate goods and unexpected declines indemand associated with the war in Iraq. Thisinventory build-up was partly unwound inthe third quarter but resumed in the final quarterof the year. The contribution to real GDPgrowth from inventory changes in 2003 was0.3 percentage point, slightly higher than in theprevious year.

Final domestic demand (i.e. excluding changesin inventories) remained subdued for most of2003, with only a slight pick-up in the secondhalf of the year. Its overall contribution to realGDP growth in 2003 was 0.7 percentage point.Developments in fixed capital formation andprivate consumption diverged over the courseof the year. Fixed capital formation declined inthe first three quarters, but the pace of declinegradually became slower and in the fourthquarter fixed capital formation recovered topositive rates of growth. By contrast, privateconsumption grew at a rate of 0.4% quarter onquarter in early 2003 but almost stagnated forthe remainder of the year.


A common factor having a negative impact onfixed capital formation and private consumptionin the first half of 2003 was the uncertaintyassociated with the war in Iraq and the outlookfor the economy in its aftermath. This meantthat households were hesitant to make majorpurchases and firms were reluctant to expandtheir production capacities. It also concealedthe fact that the underlying conditions forconsumption and investment were relativelyfavourable. In particular, the low level ofinterest rates alleviated the debt servicingburden of households and firms. Moreover, theterms-of-trade gains associated with theappreciation of the euro increased real incomein the domestic economy.

The uncertainty about the general economicoutlook coincided with ongoing efforts bycorporations to consolidate their balancesheets. In this context improvements inprofitability may have been used for furtherde-leveraging rather than capital spending.Continued uncertainty about labour marketprospects and job security may have led

households to adjust their saving according toprecautionary motives rather than to supportconsumption. In a number of countries thediscussions on implementing reforms to socialsecurity and health systems may have added tohousehold uncertainty and fuelled the motivefor precautionary saving. With clearer signs ofan upturn in economic activity in the secondhalf of the year, firms became less hesitant toinvest, although households’ consumptionspending remained subdued.

INDUSTRY DRIVING RECOVERY ON THE OUTPUTSIDEBoth industry and market services contributedto the recovery in output in the course of 2003,but the contribution from industry wasstronger. Output in purely market-relatedservices, as measured by real value added,picked up somewhat earlier than in industry(excluding construction). This was broadly inline with the observation that servicesconfidence had started to improve in the secondquarter of 2003, whereas industrial confidencehad started to improve in the third quarter (seeChart 20). However, developments diverged inthe final quarter of the year, with output inindustry accelerating further and output inmarket services declining somewhat.

When comparing the average rate of outputgrowth in 2003 with the rates in previous yearsand over the business cycle, the performance ofthe services sector was relatively weak. Growthin real value added in market services was0.7%, declining further compared with theprevious two years and reaching a lower levelthan in the recession of 1993. By contrast,growth in industry (excluding construction)was -0.1%, somewhat lower than in theprevious two years but in line with the rates ofgrowth typically observed during economicdownturns.

The pick-up in industrial activity in the secondhalf of 2003 largely reflected the recovery inexports of goods, consistent with thepronounced cyclical sensitivity of production ineuro area countries to external developments.

Chart 19 Contributions to quarterly realGDP growth

(quarterly percentage point contributions; seasonally adjusted)

Sources: Eurostat and ECB calculations.1) Percentage change compared with the previous quarter.

real GDP 1)

domestic demandnet exports

2000 2001 2002 2003-1.0

-0.5

0.0

0.5

1.0

1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

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Annua l Repor t2003

Both intra- and extra-euro area exports appearto have provided impulses for the pick-up inindustrial production (excluding construction)in the second half of 2003 (see Chart 21).

LESS DISPERSION IN OUTPUT GROWTH ACROSSCOUNTRIESVarious dispersion measures indicate that thedivergence of real GDP growth rates declinedamong euro area countries in 2003. Reflectingin part the global economic slowdown, annualaverage real GDP growth decreased in mosteuro area countries in 2003 compared with theyear before, except for Belgium, Spain andGreece, where growth increased moderately; inItaly growth remained virtually unchanged.

EMPLOYMENT LARGELY STABLE DURING 2003In some contrast with overall output, the levelof euro area employment appears to haveremained broadly stable throughout 2003 (seeTable 7). This was also the case for most of

2002. The national data available for thefourth quarter of 2003 suggest that annualaverage growth in total employment was around0.1-0.2% in 2003. Employment thus provedmore resilient than might have been expectedgiven the protracted period of subduedeconomic activity. However, while employmentremained largely stable, the data available fromlabour force surveys suggest that hours workedper employed person have declined relativelystrongly in the past few years and thusaccounted for much of the labour marketadjustment that is typically associated withan economic slowdown. To some extent thiswould contrast with developments observedin previous economic slowdowns, whereemployment rather than hours bore the brunt ofthe adjustment.

Adjustments in hours worked per employedperson might partly reflect increased labourmarket flexibility, for example by allowing the

Chart 20 Confidence indicators

(percentage balances)

Sources: European Commission Business and Consumer Surveys.Note: All data are seasonally adjusted. Data shown arecalculated as deviations from the average over the period sinceJanuary 1985 for consumer and industrial confidence, and sinceApril 1995 for services confidence.

consumer confidenceindustrial confidenceservices confidence

1998 1999 2000 2001 2002 2003-30

-25

-20

-15

-10

-5

0

5

10

15

20

-30

-25

-20

-15

-10

-5

0

5

10

15

20

Chart 21 Exports of goods and industrialproduction

(volumes; seasonally adjusted)

Sources: Eurostat and ECB calculations.Note: Data shown are calculated as three-month on three-monthpercentage changes.

1997 1998 1999 2000 2001 2002 2003

extra-euro area exportsintra-euro area exportsindustrial production excluding construction

-6

-4

-2

0

2

4

6

-6

-4

-2

0

2

4

6


2001 2002 2003 2001 2001 2002 2002 2002 2002 2003 2003 2003 2003Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Labour force 0.9 0.9 . 0.8 0.8 0.9 0.9 0.9 0.7 0.6 0.6 0.5 .

Employment 1.4 0.4 . 1.2 0.8 0.7 0.5 0.4 0.2 0.1 0.1 0.2 .Agriculture 1) -0.8 -2.1 . -1.1 -1.5 -2.4 -2.1 -2.0 -2.0 -2.2 -1.9 -1.5 .Industry 2) 0.4 -1.3 . 0.1 -0.4 -1.0 -1.2 -1.4 -1.6 -1.5 -1.4 -1.5 .– excl. construction 0.3 -1.4 . 0.0 -0.5 -1.1 -1.3 -1.4 -1.8 -1.8 -1.9 -1.9 .– construction 0.4 -0.9 . 0.4 -0.1 -0.7 -0.8 -1.2 -1.0 -0.8 0.1 -0.2 .Services 3) 1.9 1.3 . 1.7 1.5 1.6 1.4 1.2 1.1 0.8 0.8 0.9 .

Rates of unemployment 4)

Total 8.0 8.4 8.8 8.0 8.1 8.2 8.3 8.5 8.6 8.7 8.8 8.8 8.8Under 25 years 15.7 16.2 16.8 15.7 15.8 16.0 16.2 16.3 16.4 16.8 16.8 16.7 16.725 years and over 7.0 7.4 7.7 7.0 7.1 7.2 7.3 7.4 7.6 7.7 7.8 7.8 7.8

Table 7 Labour market developments

(annual percentage changes and percentages)

Sources: Eurostat and ECB calculations.1) Also includes f ishing, hunting and forestry.2) Includes manufacturing, construction, mining and quarrying, electricity, gas and water supply.3) Excludes extra-territorial bodies and organisations.4) Percentage of the labour force.

working time to be calculated and scheduledover full years rather than weeks or months, orby increased recourse to part-time jobs. Stableemployment during 2003 implies that, measuredper person employed, improvements inaggregate labour productivity only emerged inthe second half of the year when activity startedto pick up. Measured per hour worked, gains inlabour productivity might fade out morequickly, given that the previous downwardadjustment in average hours worked is likely tobe reversed as the recovery unfolds.

The broadly unchanged level of totalemployment in the course of 2003 concealsopposite developments in industry and services.In the first three quarters of 2003 employmentdeclined in industry, but this was offset by netjob creation in services. However, in bothindustry and services average employmentgrowth in 2003 was most likely lower than in2002. Moreover, data from labour force surveyssuggest that the adjustment in labour inputs viahours worked per employed person featured inboth sectors.

RISE IN UNEMPLOYMENT RATE CAME TO A HALTIN 2003The rise in the euro area unemployment raterecorded since early 2001 came to a halt in the

spring of 2003, with the rate remainingunchanged at 8.8% for the rest of the year. Onaverage, the unemployment rate was 0.4percentage point higher in 2003 than in 2002.This rise was broadly spread over the individualage groups and genders, although the gapbetween the unemployment rate for thosebelow 25 and that for persons aged 25 andabove rose somewhat further, while the gapbetween the unemployment rates for women andmen continued to decline.

Most euro area countries suffered an increasein the unemployment rate between 2002 and2003, with the exception of Greece and Italy,where unemployment declined, and Finlandand Spain, which observed a broadly constantunemployment rate. All in all, the degree ofdispersion in unemployment rates declinedamong euro area countries in 2003. However, insome countries, the unemployment figuresrecorded for 2003 partly reflect outflows fromthe official statistics due to changes in therecording of unemployed persons and/or as aconsequence of labour market reforms.

While the euro area-wide rate of unemploymentwas broadly stable in the course of 2003, thenumber of unemployed increased somewhatfurther for most of the year. In December the

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Annua l Repor t2003

Chart 22 Unemployment

(monthly data; seasonally adjusted)

Source: Eurostat.Note: Data refer to the Euro 12 (including periods prior to 2001).1) Annual changes are not seasonally adjusted.

annual change in millions (left-hand scale) 1)

% of the labour force (right-hand scale)

1994 1996 1998 2000 2002-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

was mainly attributable to the operation ofautomatic stabilisers in a macroeconomicenvironment which was considerably lessfavourable than anticipated. Most Member Statesfailed to meet the targets set out in the stabilityprogrammes that were submitted at the end of2002 and the beginning of 2003. On average,targets were missed by nearly 1.0% of GDP.

Fiscal developments remained a source ofconcern in countries that had already recordedsignificant fiscal deficits in 2002. Deficits inGermany and France were close to or above 4%of GDP in 2003, while Portugal recorded adeficit close to 3% of GDP in spite of theimplementation of large-scale temporarymeasures. The general government deficit in theNetherlands was 3% of GDP in 2003.

On the spending side, in 2003 the euro arearatio of government expenditure to GDPincreased compared with 2002, with persistentupward pressure on current outlays largelyoriginating from higher unemploymentexpenditure and related social transfers.Interest expenditure declined slightly in 2003.On the revenue side, slow tax revenue growth in2003 can mainly be accounted for by theweakness in economic activity and by otherunexpected shortfalls in tax revenues.

Unfavourable budgetary developmentsadversely affected the average government debtratio. After several years of uninterrupted,albeit moderate, decline, the euro area debt-to-GDP ratio increased to 70.4% in 2003. Thisworsening reflects the protracted deteriorationof the primary surplus and the moderate growthof nominal GDP. In 2003 the debt ratioexceeded 60% of GDP in France, while inGermany and Austria it remained above thatreference value and in Belgium, Greece andItaly it stood above 100% of GDP.

The fiscal stance in the euro area was broadlyneutral in 2003, when measured by the changein the cyclically adjusted primary balanceaccording to European Commission estimates.This reflects the control of cyclically adjusted

total number of unemployed was 12.3 million,an increase of around 270,000 personscompared with one year earlier (see Chart 22).With a broadly stable level of employment, therise in the number of unemployed reflectscontinued growth in the labour force. However,labour force growth in 2003 was somewhatlower than in the previous year. The rise in theunemployment rate and a further fall in thevacancy rate most likely discouraged labourmarket participation, for example by delayingentry into the labour market.

2.4 FISCAL DEVELOPMENTS

BUDGET BALANCES DETERIORATED FURTHER IN2003The euro area fiscal balance deteriorated in2003 for the third year in a row. The latestavailable data from Eurostat show an averagedeficit of 2.7% of GDP in 2003, against 2.3% in2002 (see Table 8). The marked deterioration


primary expenditure and the increases inindirect taxes and social security contributionrates in some countries, which broadlycompensated for the implementation ofadditional cuts in personal income taxation inseveral Member States.

THE EUROPEAN FISCAL FRAMEWORK AT RISKOn 25 November 2003 the ECOFIN Councildecided not to act on the basis of the EuropeanCommission’s recommendations in respect ofGermany and France and to hold the excessivedeficit procedure for these countries inabeyance. In its conclusions, the ECOFINCouncil recommended that France achieve areduction of 0.8% of GDP in its cyclicallyadjusted deficit in 2004 and a reduction of atleast 0.6% in 2005 in order to bring the deficit

below 3% of GDP by 2005 at the latest. At thesame time, the ECOFIN Council recommendedthat Germany reduce its cyclically adjusteddeficit by 0.6% of GDP in 2004 and by atleast 0.5% in 2005 in order to bring the deficitbelow 3% of GDP by 2005 at the latest(see Chapter 4). The ECOFIN Council’sdecision has led to uncertainty on the futureimplementation of the rules governing fiscalpolicy in euro area countries. It also sets aprecedent of a lax implementation of theexcessive deficit procedure that could weakenincentives for consolidation in the future.

It is essential that confidence in the solidity ofthe institutional underpinnings of EMU bemaintained. Germany and France now have tolive up to their responsibilities and to honour

General government surplus (+) / deficit (-)

2000 2001 2002 2003

Euro area -0.9 -1.7 -2.3 -2.7Belgium 0.2 0.4 0.1 0.2Germany -1.2 -2.8 -3.5 -3.9Greece -2.0 -2.0 -1.4 -1.7Spain -1.0 -0.4 0.0 0.3France -1.4 -1.6 -3.3 -4.1Ireland 4.4 1.1 -0.4 0.2Italy -1.8 -2.6 -2.3 -2.4Luxembourg 6.3 6.3 2.7 -0.1Netherlands 1.5 0.0 -1.9 -3.0Austria -1.9 0.2 -0.2 -1.1Portugal -3.2 -4.4 -2.7 -2.8Finland 7.1 5.2 4.3 2.3

General government gross debt

2000 2001 2002 2003

Euro area 70.4 69.4 69.2 70.4Belgium 109.1 108.1 105.8 100.5Germany 60.2 59.4 60.8 64.2Greece 106.2 106.9 104.7 102.4Spain 61.2 57.5 54.6 50.8France 57.2 56.8 58.6 63.0Ireland 38.4 36.1 32.3 32.0Italy 111.2 110.6 108.0 106.2Luxembourg 5.5 5.5 5.7 4.9Netherlands 55.9 52.9 52.6 54.8Austria 67.0 67.1 66.6 65.0Portugal 53.3 55.6 58.1 59.4Finland 44.6 43.9 42.6 45.3

Table 8 Fiscal posit ions in the euro area

(as a percentage of GDP)

Sources: Eurostat and ECB calculations.Note: Data are based on the excessive deficit procedure definition. Budget balances exclude proceeds from the sale of UMTS licences.

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Annua l Repor t2003

their commitment to correct their excessivedeficits as soon as possible and by 2005 at thelatest. Countries that still face fiscal imbalancesalso need to make progress towards achievingbudgetary positions close to balance or insurplus over the medium term, by reducing theirunderlying deficit by at least 0.5% of GDP peryear.

The implementation of sound fiscal policies isin the interest of all countries. Close-to-balanceor in-surplus budgetary positions create roomfor the free play of automatic stabilisers, whichfacilitates the smoothing of economic businesscycles. Sound public finances also helpindividual countries to cope with the budgetaryimpact of population ageing by reducing publicdebt ratios. Lack of discipline, on the otherhand, increases the uncertainty surrounding thefuture soundness of public finances, thushindering the long-term decision-making ofeconomic agents. It may also create externalitiesthat could negatively affect other MemberStates.

According to the stability programmessubmitted at the end of 2003 and the beginningof 2004, the euro area deficit is expected todecline by 0.3 percentage point in 2004 to 2.4%of GDP. Consolidation effects stemming fromexpenditure restraint, the fall in interestpayments and the gradual recovery in economicactivity should outweigh the expansionaryeffects associated with tax cuts in a number ofcountries. The cyclically adjusted balance in theeuro area is forecast to improve in 2004.Deficits in Germany and France are expected todecrease but stay above 3% of GDP in 2004.According to the ECOFIN Council opinions,the adjustment path in France’s stabilityprogramme seems insufficient to eliminate theexcessive deficit by 2005, while Germany’sadjustment path may also be insufficient tocorrect the excessive deficit by that year.Moreover, based on the Commission’scalculations, as reported in the ECOFINCouncil opinions, Greece, Italy and Portugalseem unlikely to reduce their cyclically adjusteddeficit by at least 0.5% of GDP in 2004.

STRUCTURAL REFORM OF PUBLIC FINANCESREMAINS VITALThe pension reforms implemented or envisagedin some countries will improve the long-termsustainability of public finances. However, thesignificant ageing of the European populationwill make further adjustments necessary (seeBox 6). Fiscal consolidation should be part of acredible medium-term reform package. Thecombination of consolidation and structuralreforms may counteract the negative short-termdemand effects of budget retrenchment byenhancing the credibility of euro areagovernments and public confidence in theirability to adhere to the agreed rules and toensure long-term fiscal sustainability.

Structural reforms on the expenditure sideare particularly important. To promote thequality of public finances, expenditurepriorities should be shifted towards productiveexpenditures fostering potential output growth.The reduction of overall expenditurecommitments will create scope for a declinein the tax burden, thereby contributing toeconomic growth.


Box 6

THE IMPORTANCE OF COMPREHENSIVE REFORMS FOR SUSTAINABLE PUBLIC FINANCES

To ensure long-term fiscal sustainability, euro area countries need to implement substantialfiscal and other reforms.

Population ageing and fiscal sustainability

One of the most important risks to fiscal sustainability in the euro area economies arises frompopulation ageing. Eurostat projects that the old-age dependency ratio, i.e. the population aged65 years and older as a proportion of the population aged 15 to 64, will rise from about 25% in2000 to more than 50% in 2050. This demographic shift will put pressure on public finances bypushing up old age-related expenditure, in particular in public pensions and health, as well aslong-term care. Public pension systems in Europe are mostly based on the pay-as-you-goprinciple. As current contributions finance current expenditure, the rising number of pensionerswill put these systems under strain. Healthcare expenditure is set to rise, as the demand forhealth services tends to increase in old age. Past experience suggests that technicaldevelopments may also contribute to rising health expenditure.

A recent study commissioned by the ECOFIN Council and carried out by the Working Group onAgeing of the Economic Policy Committee1 has projected that in most euro area countries, theincrease in public pension expenditure due to population ageing will be between 3 and 6percentage points of GDP by 2050. A further 2 to 4 percentage points of GDP could relate to arise in health and long-term care expenditure.

The EU strategy for addressing the ageing problem

In light of the need for comprehensive reforms, the EU agreed in 2001 on a three-prongedstrategy to tackle the pressures of population ageing. This strategy was first set out in the 2001Broad Economic Policy Guidelines and prescribes: (i) measures to raise employment rates,(ii) a rapid reduction in government debt and (iii) further reforms of pension and health systems,including a greater reliance on funding. The EU fiscal framework provided by the Treatyestablishing the European Community and the Stability and Growth Pact also addresses thefiscal challenges of population ageing by demanding medium-term budgetary positions close tobalance or in surplus and by setting limits on deficit and debt levels.

Current policies

Current fiscal policies in the euro area present a mixed picture as regards action taken to enhancesustainability. First, while the approaches taken to pension and health reform point in the rightdirection, the planned measures will generally not suffice to ensure the sustainability of thosesystems, and further changes are necessary. The thrust of most of the pension reform efforts isto raise effective retirement ages, e.g. by creating incentives to stay in the workforce and byincreasing the contribution periods required to acquire full pension entitlements. Efforts in the

1 The study is available from the website of the European Commission’s Directorate General for Economic and Financial Affairs atwww.europa.eu.int/comm/economy_finance/epc_en.htm.

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health sector tend to focus on restraining short-term expenditure growth, for instance by raisingawareness of the cost of medical treatments by increasing patient co-payments. Second, thecurrent high fiscal deficits are, to a large extent, of a structural nature. This means that on top ofmeeting the fiscal requirements imposed by the projected demographic changes, the countries inquestion will need to pursue ambitious structural consolidation policies to achieve a soundbudgetary position.

2.5 THE GLOBAL MACROECONOMICENVIRONMENT, EXCHANGE RATES AND THEBALANCE OF PAYMENTS

WORLD ECONOMIC RECOVERY GAINEDMOMENTUM IN 2003Following a period of uncertainty in the firsthalf of 2003 – relating mainly to geopoliticaltensions, terrorist threats, the SARS epidemicand deflationary fears – the recovery of theworld economy gained momentum in the secondhalf of the year. By the end of 2003 the upswinghad broadened and strengthened, driven mainlyby growth dynamics in the United States andAsia. While private consumption andexpansionary economic policies supported thegradual upturn in global economic activity,business investment, in particular, remainedrelatively muted in some industrialisedcountries owing to overcapacity and the degreeof corporate indebtedness. Inflationarypressures remained relatively low, given thestrong growth in productivity, particularly inthe United States, and the continuing significantovercapacity. Imbalances persisted throughout2003. Most notably, the US current accountdeficit rose further, notwithstanding theconsiderable depreciation of the US dollar.

In the United States, the recovery broadened in2003 with GDP growth amounting to 3.1%, upfrom 2.2% in 2002. In early 2003 highgeopolitical uncertainty in the run-up to the Iraqwar undermined investors’ and consumers’confidence, thereby contributing to a delay inthe US economic recovery. However, economicactivity rebounded in the second quarter asthese geopolitical uncertainties receded, leadingto a significant strengthening of growth in thesecond half of the year. Household spendingremained resilient and contributed substantially

to GDP growth. Real private consumption grewby 3.1% in 2003, experiencing a large surgeespecially over the summer months. Animportant factor driving household spendingwas the effect of tax cuts, which helped tomaintain growth in disposable income (4.3%in 2003 compared with 5.2% the year before).Further support came from mortgagerefinancing activity during the first half of theyear. All these factors together outweighed thenegative impact of low confidence and theunfavourable employment situation onhousehold spending until the third quarter. Inthe context of a strong housing market andhistorically low mortgage rates, real residentialinvestment accelerated vigorously to 5.2% in2003.

One notable source of weakness through muchof 2003 was a receding labour market, though inthe third quarter some signs of improvement inlabour market conditions emerged. Privatepayroll employment contracted significantlyduring the first half of 2003 and then picked upmoderately. The unemployment rate started todecline in the summer after reaching a peak of6.4% in June, falling to 5.6% in January 2004,an improvement partly due to a slowdown in thelabour force.

After two years of contraction, businessinvestment grew by 4.3% in 2003. Followingthe initial rebound in the second quarter,business investment growth increasedthroughout the rest of the year, reachingannualised double-digit numbers. The recoveryin capital expenditure relied on favourablefinancing conditions, rising profits and strongdemand prospects. This recovery was stillnarrowly based, since it was concentratedin hardware and software expenditure. With


regard to trade, growth in import volumesoutpaced that in exports in 2003, in line with thehigher growth of domestic demand in the UnitedStates than in its main trading partner countries.Accordingly, the current account deficitincreased to more than 5% of GDP for 2003,reflecting, to a large extent, public sectorimbalances.

Consumer price inflation and producer priceinflation in the United States increased in 2003.However, correcting for the impact of energyprices, inflationary pressures remainedgenerally weak in the course of the year owingto low capacity utilisation rates and strongproductivity growth. Inflation, as measured bythe consumer and producer price indices,increased to 2.3% and 3.2% respectively in2003, up from 1.6% and -1.3% in 2002.Excluding food and energy, consumer priceinflation was 1.4% in 2003, down from 2.4% in2002, and producer price inflation (excludingfood and energy) remained subdued.

Interest rates remained at historical lows in2003. The Federal Open Market Committee(FOMC) of the Federal Reserve Systemreduced the target for the federal funds rateby 25 basis points in June 2003, to 1%. Theaccompanying statement of the FOMC meetingsup to December stated that policyaccommodation would be maintained for a“considerable period” given the risks of anunwelcome fall in inflation. At the January2004 meeting, however, this statement wasreplaced by the reference to a “patient”approach by the FOMC in terms of removingpolicy accommodation. Fiscal policy was stillmarkedly expansionary in 2003, with thefederal budget deficit increasing to 3.5% ofGDP in the fiscal year 2003, from 1.5% of GDPin the fiscal year 2002. This resulted mostnotably from discretionary budgetary measuresand, to a lesser extent, from the automaticresponse of the budget to the business cycle.

In Japan, real economic activity expandedthroughout 2003, supported by exports andprivate investment. After some initial

weakening of the export momentum, exportgrowth increased in the second half of the year.In particular, exports to non-Japan Asiaexhibited strong growth, with China accountingfor more than half of the overall increase inexports in 2003. Against the background ofhistorically low inventory levels, the exportgrowth translated into a pick-up in industrialproduction in the second half of the year, withparticularly strong gains in the export-orientedgeneral and electrical machinery sectors.Private non-residential investment spendingexpanded strongly, supported by a recovery infirms’ profits and some structural improvementsin corporate balance sheets. Reflecting continuedweaknesses in the labour market and the incomesituation, private consumption spending wasrelatively sluggish. Owing to continued effortsto achieve medium-term fiscal consolidation,government spending contracted, reflectinglarge declines in public investment outlays.

Deflationary pressures eased somewhat in2003. The CPI declined on average by 0.3%,compared with a decline of 0.9% in 2002. TheBank of Japan raised its target range for theoutstanding balance of the current accounts heldat the Bank of Japan from JPY 15-20 trillion atthe beginning of 2003 to JPY 30-35 trillion inJanuary 2004. In addition, the Bank of Japandecided to purchase asset-backed securities fora limited time, with the objective of promotingthe smooth financing of small and medium-sized enterprises.

Non-Japan Asia’s economic performance wasrobust in 2003, consolidating the recovery in2002. The region proved to be fairly resilient tosome adverse shocks, including the geopoliticaluncertainties (namely, the Iraq war and tensionin North Korea) and the SARS epidemic.Strong output growth stemmed from theconfluence of different factors. First, foreigndemand benefited from an improvement in theglobal economy and the depreciation ofeffective exchange rates, as evidenced by thebrisk pace of export activity in many countriesof the region. Second, domestic demand – whiledecelerating markedly in the second quarter as a

61ECB

Annua l Repor t2003

result of the SARS outbreak – later grew morethan initially expected. At the country level,China has remained by far the region’s fastest-growing economy, with GDP expanding by9.1% in 2003.

In the EU acceding countries, output growthremained resilient in 2003 despite the weakexternal environment. Real GDP growth wasmainly driven by private consumption and netexports, while investments also showed signsof strength in some countries. Fiscal positionscontinued to deteriorate in several countries,posing serious challenges to the sustainabilityof public finances. Average HICP inflation inthe acceding countries as a whole remainedclose to 2%, although sizeable differencesprevailed at the country level (see Chapter 7 forfurther details).

In Latin America, there were some signs ofoverall economic improvement in 2003 asArgentina experienced a strong rebound fromthe previous year’s crisis. Among the region’stwo largest countries, Brazil’s GDP contractedand Mexico recorded rather sluggish outputgrowth. The Brazilian economy exhibitednegative growth on a year-on-year basis overthe last three quarters of 2003, largely as aresult of a downturn in domestic demanddespite a slight decline in financing costs. Themain drag on the Mexican economy was themanufacturing sector, whose exports havelagged behind the recovery in the United States.

Brent crude oil prices averaged USD 28.9 perbarrel in 2003, 15.4 % higher than the previousyear. The increase was the result of supplydisruptions, pent-up demand, low inventory levelsand geopolitical tensions. Non-oil commodityprices also strengthened considerably in 2003owing to a pick-up in global economic activity. Inparticular, Chinese demand for raw materials hada strong impact on commodities markets.

EURO EXPERIENCED STRONG APPRECIATION IN2003In 2003 the euro continued its appreciationagainst major currencies. This was most

pronounced against the US dollar and severalAsian currencies, reflecting their formal orinformal peg to the US dollar. The euro alsostrengthened against the Japanese yen, thepound sterling and the Swiss franc, albeit to alesser extent, while it weakened against theAustralian dollar.

In the first half of 2003 these developmentstook place against the background of relativelyhigh economic and geopolitical uncertainty. Theupward pressure on the euro was temporarilysuspended in the summer amid positivelyrevised market expectations about the economicrecovery in major partner countries. Towardsthe end of 2003 the euro experienced renewedgains as market analysts became increasinglyconcerned about global external imbalances.Overall, at the end of 2003 the nominal effectiveexchange rate of the euro was almost 11%higher than at the beginning of the year andnearly 17% above its average level in 2002.

In the first two months of 2004 the effectiveexchange rate of the euro did not appreciatefurther. The developments in euro exchangerates over this period seem to have beenaffected by a combination of factors pointing indifferent directions, including market reactionsto the communiqué issued by the G7 in earlyFebruary 2004 on exchange rate movements.On 27 February 2004, the cut-off date for thisAnnual Report, the nominal effective exchangerate of the euro had appreciated by 3.8%compared with the average for 2003.

The real effective exchange rates of the euro,which take into account developments in priceand unit labour cost differentials between theeuro area and its main partner countries, trackedthe nominal index fairly closely and stood, inthe fourth quarter of 2003, somewhat abovetheir levels in the first quarter of 1999 (seeChart 23).

In 2003 the strengthening of the euro wasparticularly strong against the US dollar, whichfaced broad-based depreciation pressures. In thefirst months of the year, uncertainty generated by


rising geopolitical tensions and their likelyeffects on the global economic outlook seem tohave weighed on the US currency. Moreover, anumber of weaker than expected economic datareleases for the United States, the widening ofthe US current account deficit and a deterioratingfiscal position were identified by marketparticipants as additional negative factorsaffecting the US dollar in the first half of 2003.Over the summer months the US dollar stabilisedamid firming market expectations aboutimproving prospects for US economic growth.Towards the end of the year, however, marketconcerns over the financing of the US currentaccount deficit seemed to overshadow thesepositive factors, thereby exerting reneweddownward pressure on the US currency. On30 December 2003 the euro stood at USD 1.25,which was roughly 19½% stronger than at thebeginning of the year and more than 32% aboveits average level in 2002. On 27 February 2004the euro was quoted at USD 1.24, i.e. 9.8%stronger than the 2003 average.

Against the Japanese yen, the euro showed apattern similar to the one against the US dollaruntil September 2003. The developments in the

Japanese yen seem to have been mainly relatedto evidence of an improvement in economicactivity in Japan together with the foreignexchange market interventions by the Japaneseauthorities in an attempt to stabilise the yenagainst the US dollar. In the aftermath of the G7meeting in Dubai – where it was stated thatmore flexibility in exchange rates was desirableto promote smooth and widespread adjustmentsin the financial system based on marketmechanisms – the yen came temporarily understrong and broad-based appreciation pressure.At the end of 2003 the euro was quoted at JPY133.7, 7.5% higher than at the beginning of theyear and more than 13% above the 2002average. On 27 February 2004 the euro traded atJPY 135.6, 3.6% above its average in 2003.

Turning to other European currencies, the euroexperienced an appreciation against thepound sterling, the Swiss franc and, moresubstantially, the Norwegian krone, while itwas broadly unchanged against the Swedishkrona and the Danish krone. The lattercontinued to fluctuate in a very narrow rangeclose to its central parity in the exchange ratemechanism II (ERM II).

Chart 24 Current account balance and itscomponents

(EUR billions; 12-month cumulated seasonally adjusted)

Source: ECB.

currentaccount

services currenttransfers

goods income-100

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200320022001

Chart 23 Nominal and real ef fective euroexchange rates 1)

(monthly/quarterly data; index: 1999 Q1 = 100)

Source: ECB.1) An upward movement of the index represents an appreciationof the euro. In the case of the ULCM-based real EER, the latestobservation is for the third quarter of 2003 and is partly based onestimates.

1994 1996 1998 2000 200280

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nominalreal, CPIreal, PPIreal, ULCM

63ECB

Annua l Repor t2003

7 Here exports and imports always refer to extra-euro area trade.8 The breakdown of trade flows into volumes and prices is based on

External Trade Statistics, prices being proxied by unit valueindices. Owing to differences in definition, coverage and time ofrecording, trade data (as compiled by Eurostat) are not fullycomparable with the goods item in the balance of paymentsstatistics compiled by the ECB.

Chart 25 Extra-euro area exports, foreigndemand and nominal effective exchangerate(index: 2000 = 100)

Sources: Eurostat and ECB calculations based on Eurostat data.Note: The latest observation refers to the third quarter of 2003.

2001 2002 200390

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extra-euro area export volumesextra-euro area export unit value indexnominal effective exchange rateeuro area foreign demand

CURRENT ACCOUNT SURPLUS DECREASED IN2003In 2003 the euro area current account surplusfell to €28.1 billion (0.4% of GDP), from €67.1billion in 2002 (0.9% of GDP). The fallstemmed mainly from a €20.6 billion drop in thegoods surplus and a €16.0 billion rise in theincome deficit, while the current transfersdeficit also increased. These developments wereonly partly offset by a small rise in the servicessurplus (see Chart 24). As imports of goodsremained broadly unchanged in 2003 relative toa year earlier, the reduction in the goods surplusresulted from a fall in the value of euro areagoods exports (by 2.2%) over the same period.7

The increase in the income deficit stemmedmostly from a reduction in income credits. Theappreciation of the euro in 2003 largelyexplains this development, as the value ofincome credits received in foreign currencies islower when expressed in euro.

A better understanding of export developmentscan be obtained through a breakdown of thevalue of euro area goods exports into volumes

and prices – based on External Trade Statisticsdata until the third quarter of 2003. Such abreakdown suggests that, compared with 2002average levels, the fall in the value of exports inthe first three quarters of 2003 stemmed from adecrease in export prices.8 Euro area exporterslowered their prices in euro in an attempt tooffset the loss in price competitivenessresulting from the appreciation of the euro (seeChart 25). Meanwhile, export volumes declinedin the first half of 2003 and subsequentlyrecovered in the third quarter. Sluggish foreigndemand and the impact of the appreciation of theeuro contributed to the initial fall in euro areaexport volumes, while the strong pick-up inforeign demand in the third quarter of 2003seems to have been the key explanatory factorbehind their recovery. Overall, in the first threequarters of 2003 export volumes were slightly

Chart 26 Financial account

(EUR billions)

Source: ECB.

net directinvestment

net portfolioinvestment

in debt instruments

net portfolioinvestmentin equities

combined net direct investment

and portfolioinvestment

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above their average in 2002, although theyincreased less strongly than foreign demand,thereby pointing to a loss in euro area exportmarket share.

NET OUTFLOWS IN COMBINED DIRECT ANDPORTFOLIO INVESTMENT IN 2003In the financial account, combined direct andportfolio investment experienced net outflowsof €9.3 billion in 2003, compared with netinflows of €61.9 billion in 2002 (see Chart 26).This development largely reflected lowernet inflows in portfolio investment (by€91.6 billion), which were only partlycounterbalanced by declining net outflows indirect investment (by €20.3 billion) over thesame period.

Transactions in debt instruments mainlydominated developments in net portfolioinvestment flows. More specifically, afterrecording net inflows of €52.8 billion in 2002,net investment in debt instruments turnednegative in 2003 – showing net outflows of€27.4 billion (see Chart 26). This reflectedprimarily a sizeable switch in money marketinstruments from net inflows to net outflows,as foreign investors seem to have begunre-allocating their international portfolio infavour of riskier assets, particularly in thesecond half of 2003. The improvement in theglobal economic outlook over this period – alsoevidenced by the solid performance in globalequity markets – is likely to have been the maindriving factor behind this development. At thesame time, net inflows in bonds and notes alsodeclined somewhat in 2003 compared with ayear earlier. However, much of this declinereflected disinvestment by non-residents ineuro area bonds and notes that took place inJuly and August of 2003 amid expectations ofcapital losses as a result of a rise in long-termbond yields.

Both euro area direct investment and portfolioinvestment in equity securities moved, overall,towards a balanced position in 2003. Much ofthis related to economic and geopoliticaluncertainty stemming from the war in Iraq and

the SARS epidemic that adversely affectedinvestment decisions in the first half of the year(see Chart 26). As uncertainty receded andequity prices rebounded, cross-border activityin portfolio equity securities first stabilised andthen gradually began to rise. Similarly, in thesecond half of 2003 euro area direct investmentabroad also started a gradual recovery in thelight of an improved global as well as domesticeconomic outlook, while foreign directinvestment in the euro area remained subdued.

65ECB

Annua l Repor t2003

The Eurosystem and the NCBs of the non-euroarea EU countries cooperate closely in thecontext of the General Council of the ECB. Aregular review of macroeconomic conditionsand monetary and exchange rate policies formsan integral part of the coordination exercisebetween the Eurosystem and the three NCBs notcurrently participating in the single monetarypolicy. Although these NCBs conduct theirmonetary policies within different institutionaland operational frameworks, the ultimate goalof monetary policy for all of them is themaintenance of price stability.

DENMARK

The Danish economy slowed in 2003, with thereal GDP growth rate falling to 0.0%, downfrom 1.0% in 2002 (see Table 9). In the firsthalf of 2003 domestic demand, most notablyinvestment, remained subdued. However,domestic demand picked up again during the

3 E CONOM I C AND MONE TARY D E V E LOPMENT S I NEU COUNTR I E S OU T S I D E T H E E URO A R E A

remainder of the year in line with increasingconsumer and industrial confidence. The upturnin private consumption was supported by lowinterest rates, the introduction of instalment-free mortgages, higher real disposable incomeand housing wealth. As a result of sluggishforeign demand, export growth declinedin comparison with the previous year.Accordingly, imports grew slightly faster thanexports in 2003. Over the same period theunemployment rate increased to 5.6%.

Annual inflation decreased to 2.0% in 2003 (seeChart 27). This development was due mainly tocuts in indirect taxes (a reduction in exciseduties on alcohol, tobacco and soft drinks) andlow energy prices resulting from thedepreciation of the dollar. The decline ininflation was also supported by price falls ininsurance and communications. Unit labourcosts increased slightly in 2003, as wageincreases were accompanied by slightly lowerproductivity growth.

1999 2000 2001 2002 2003 2003 2003 2003 2003Q1 Q2 Q3 Q4

Real GDP 2.6 2.8 1.6 1.0 0.0 1.4 -1.2 -0.4 0.3Contribution to real GDP growth: 1)

Real domestic demand including stocks 0.1 2.4 1.0 1.8 0.1 1.3 -1.5 -0.7 1.4Net exports 2.6 0.5 0.6 -0.8 -0.1 0.1 0.3 0.3 -1.1

HICP 2.1 2.7 2.3 2.4 2.0 2.8 2.2 1.6 1.3Compensation per employee 3.6 3.5 4.7 3.4 3.6 3.2 3.6 3.7 3.9Unit labour costs, whole economy 2.4 1.4 3.7 2.0 2.2 0.5 3.0 2.7 2.7Import deflator (goods and services) -2.4 6.8 0.5 -3.2 -1.9 -2.9 -2.4 -1.2 -1.1

Current plus new capital account (% of GDP) 2) 1.8 1.5 3.1 2.6 2.8 2.3 2.8 4.5 1.7

Total employment 1.2 0.5 0.4 -0.6 -1.4 -1.5 -1.8 -1.4 -0.8Unemployment rate (% of labour force) 4.8 4.4 4.3 4.6 5.6 5.2 5.6 5.8 6.0

Fiscal balance (% of GDP) 3), 4) 3.3 2.6 3.1 1.7 1.5 . . . .Consolidated gross debt (% of GDP) 3) 55.8 50.1 47.8 47.2 45.0 . . . .

Three-month interest rate (% per annum) 5) 3.3 4.9 4.6 3.5 2.4 2.8 2.4 2.1 2.2Ten-year government bond yield (% per annum) 5) 4.9 5.6 5.1 5.1 4.3 4.3 4.1 4.3 4.5Exchange rate against the euro 5) 7.44 7.45 7.45 7.43 7.43 7.43 7.42 7.43 7.44

Table 9 Macroeconomic indicators for Denmark


Sources: Eurostat, European Commission, national data and ECB calculations.1) Percentage points.2) Quarterly figures are neither seasonally adjusted nor working day adjusted.3) Consistent with the Maastricht Treaty definition.4) General government surplus (+)/deficit (-).5) Average of period values.


Chart 27 Economic and financial indicators for the non-euro area EU countries and theeuro area

Sources: ECB and Eurostat.1) For the non-euro area EU countries: three-month interbank rates; for the euro area: three-month EURIBOR.2) Long-term government bond yields: ten-year bonds or closest available bond maturity.

Real GDP growth(annual percentage changes)

HICP inflation(annual percentage changes)

Short-term interest rate spreadvis-à-vis the euro area 1)

(in basis points)

Long-term interest rate spreadvis-à-vis the euro area 2)

(in basis points)

euro areaDenmarkSwedenUnited Kingdom

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67ECB

Annua l Repor t2003

The general government fiscal surplusdecreased from 1.7% of GDP in 2002 to 1.5%of GDP in 2003. This was partly attributable tolower tax revenues and higher unemploymentbenefits paid to households on account of thecyclical downturn. Government debt declinedfrom 47.2% of GDP to 45.0%. According to theupdated Convergence Programme, publicfinances in Denmark are expected to remainsound, with general government surplusesprojected to reach 1.3% and 1.8% of GDPin 2004 and 2005 respectively. Compared withthe previous update of the ConvergenceProgramme, the decline in projected surplusescan be attributed mainly to the phasing-in ofincome tax reductions in accordance with the2003 Tax Agreement. The gross debt ratio isprojected to fall to 41.2% of GDP in 2004 andto 38.7% in 2005.

Denmark is currently the only countryparticipating in ERM II. It continues to pursue afixed exchange rate policy vis-à-vis the euro,with a narrow band of ±2.25% around itsERM II central rate of DKK 7.46038 against theeuro. Developments in key official and short-term market interest rates should primarily beseen against the background of the ECB’sinterest rate decisions and developments in theexchange rate of the krone against the euro.During 2003 the Danish krone remained veryclose to its central parity in ERM II, holding alevel marginally above its central rate. Foreignexchange reserves peaked in June 2003 beforedeclining slightly towards the end of the year.The strength of the krone was due mainly torelatively low inflation and a considerablebalance of payments surplus.

In 2003 Danmarks Nationalbank reduced itslending rate three times, lowering it to 2.15%where it stood at the end of the year. During thecourse of the year the spread over the minimumbid rate on the Eurosystem’s main refinancingoperations declined to 15 basis points, while thespread between Danish and euro area short-termmarket rates narrowed to around 5 basis points

(see Chart 27). Danish long-term bond yieldsincreased, fluctuating around an average of4.3%.

SWEDEN

Real GDP growth in Sweden slowed somewhatin 2003, to 1.6%, compared with 2.1% in 2002(see Table 10 and Chart 27). With the effects ofearlier tax cuts levelling off and uncertaintyremaining high owing to geopolitical events,private consumption and investment growthremained subdued in the first half of 2003. Inaddition, a public sector strike negativelyaffected real GDP growth in the second quarterof the year. Private consumption strengthenedagain in the second half of 2003, in line withincreasing consumer confidence, whileinvestment and industrial production remainedsubdued. Exports were relatively strongthroughout the year and net exports contributedto real GDP growth, albeit not quite as much asin the previous year. Employment declinedslightly in 2003, while the total number ofhours worked declined more significantly, as in2002. This led to relatively strong increases inlabour productivity (especially if measured byhours worked) and, combined with moderatewage growth, to a subdued development of unitlabour costs. The unemployment rate increasedin the second half of the year to stand at around6% of the labour force.

Inflation rates, as measured by the HICP, theCPI and UND1X,9 rose to above 3% in early2003 (see Chart 27), reflecting increases inenergy prices resulting from low water suppliesin the production of hydroelectric power andrising oil prices. As these price increases were

9 UND1X is defined as the CPI excluding interest expenditure anddirect effects of altered indirect taxes and subsidies. In Swedenheadline CPI is the target variable of monetary policy. As transientfactors have had an impact on the inflation forecast in recentyears, monetary policy decisions have in practice been based onan assessment of UND1X or, as was the case in 2003, on UND1Xexcluding energy.


1999 2000 2001 2002 2003 2003 2003 2003 2003Q1 Q2 Q3 Q4

Real GDP 4.6 4.3 0.9 2.1 1.6 1.8 0.6 1.7 2.3Contribution to real GDP growth: 1)

Real domestic demand including stocks 3.0 3.3 -0.2 0.7 0.7 2.1 0.3 -0.1 0.6Net exports 1.5 1.1 1.1 1.4 0.9 -0.3 0.3 1.8 1.7

HICP 0.6 1.3 2.7 2.0 2.3 2.9 2.1 2.3 1.9Compensation per employee 1.3 7.4 4.5 2.2 . 1.8 1.7 2.8 .Unit labour costs, whole economy -1.0 5.4 5.6 0.2 . -0.4 1.2 0.9 .Import deflator (goods and services) 1.1 4.9 4.1 0.0 -2.0 0.0 -2.5 -3.2 -2.5

Current plus new capital account (% of GDP) 2) 2.6 3.8 3.8 4.3 5.4 5.4 4.6 6.2 5.5

Total employment 2.2 2.2 2.0 0.1 -0.2 -0.3 0.1 -0.3 -0.6Unemployment rate (% of labour force) 6.7 5.6 4.9 4.9 5.6 5.3 5.5 5.6 6.0

Fiscal balance (% of GDP) 3), 4) 2.5 5.1 2.8 0.0 0.7 . . . .Consolidated gross debt (% of GDP) 3) 62.7 52.8 54.4 52.6 51.8 . . . .

Three-month interest rate (% per annum)5) 3.3 4.1 4.1 4.3 3.2 3.8 3.4 2.9 2.9Ten-year government bond yield (% per annum)5) 5.0 5.4 5.1 5.3 4.6 4.6 4.4 4.6 4.9Exchange rate against the euro5) 8.81 8.45 9.25 9.16 9.12 9.18 9.14 9.17 9.01

Table 10 Macroeconomic indicators for Sweden


Sources: Eurostat, European Commission, national data and ECB calculations.1) Percentage points.2) Quarterly figures are neither seasonally adjusted nor working day adjusted.3) Consistent with the Maastricht Treaty definition.4) General government surplus (+)/deficit (-).5) Average of period values.

only temporary, inflation decelerated rapidly toaround 2% in mid-2003. While the CPIcontinued to decelerate thereafter, the HICP andUND1X remained close to 2%. This was mainlythe result of declining interest expenditure,included in the CPI but not in the HICP orUND1X. On average, annual HICP inflationwas 2.3% in 2003, up from 2.0% in 2002, whilethe CPI rose by 2.1%, compared with 2.4% in2002.

The general government fiscal surplusimproved from 0.0% of GDP in 2002 to 0.7%of GDP in 2003. The debt-to-GDP ratiodecreased slightly from 52.6% in 2002 to 51.8%in 2003. According to the updated ConvergenceProgramme, public finances in Swedenare expected to remain sound. Generalgovernment surpluses are projected to reach0.4% and 1.2% of GDP in 2004 and 2005respectively. The development indicatessome deviation in relation to the Swedish fiscalrule that a surplus of around 2% is to bemaintained over the business cycle. The gross

debt ratio is expected to decline to 51.5% in2004 and to 50.0% in 2005.

Sveriges Riksbank operates under a flexibleexchange rate regime with the objective ofmonetary policy expressed as an explicitinflation target of a 2% annual increase in theCPI, with a tolerance margin of ±1 percentagepoint. In 2003 Sveriges Riksbank reduced therepo rate by a total of 1 percentage point to2.75%. This came against a background of arisk of undershooting the inflation target of 2%following prospects of weaker external demandand decelerating utilisation of domesticresources. On 5 February 2004 SverigesRiksbank reduced the repo rate further by0.25 percentage point in the context of expectedlower domestic and international costpressures. The spread between short-termmarket interest rates in Sweden and the euroarea was broadly stable in the first half of 2003,at around 100 basis points, although it declinedto around 70 basis points in the second half ofthe year (see Chart 27). Long-term interest rates

69ECB

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1999 2000 2001 2002 2003 2003 2003 2003 2003Q1 Q2 Q3 Q4

Real GDP 2.8 3.8 2.1 1.7 2.3 2.0 2.3 2.3 2.8Contribution to real GDP growth: 1)

Real domestic demand including stocks 4.2 4.1 3.0 3.4 2.8 2.8 2.8 3.1 2.6Net exports -1.4 -0.3 -0.9 -1.7 -0.5 -0.8 -0.5 -0.8 0.2

HICP 1.3 0.8 1.2 1.3 1.4 1.5 1.3 1.4 1.3Compensation per employee 4.6 5.8 5.0 3.3 . 3.3 4.3 4.7 .Unit labour costs, whole economy 3.1 3.1 3.6 2.4 . 2.4 2.9 3.4 .Import deflator (goods and services) -1.2 3.1 0.1 -2.1 . -1.2 -0.1 1.3 .

Current plus new capital account (% of GDP) 2) -2.6 -2.4 -2.2 -1.6 . -0.2 -3.5 -2.6 .

Total employment 1.3 1.1 0.8 0.7 . 1.1 0.9 1.1 .Unemployment rate (% of labour force) 5.9 5.4 5.0 5.1 . 5.0 5.0 4.9 .

Fiscal balance (% of GDP) 3), 4) 1.1 3.8 0.7 -1.6 -3.2 . . . .Consolidated gross debt (% of GDP) 3) 45.0 42.1 38.9 38.5 39.8 . . . .

Three-month interest rate (% per annum)5) 5.4 6.1 5.0 4.0 3.7 3.7 3.6 3.5 3.9Ten-year government bond yield (% per annum)6) 5.0 5.3 5.0 4.9 4.6 4.3 4.4 4.6 5.0Exchange rate against the euro 7) 0.66 0.61 0.62 0.63 0.69 0.67 0.70 0.70 0.70

Table 11 Macroeconomic indicators for the United Kingdom


Sources: Eurostat, European Commission, national data and ECB calculations.1) Percentage points.2) Quarterly figures are neither seasonally adjusted nor working day adjusted.3) Calendar year estimates. Consistent with the Maastricht Treaty definition.4) Calendar year estimates. General government surplus (+)/deficit (-).5) Average of period values. Three-month sterling interbank deposits.6) Average of period values. Source: BIS.7) Average of period values.

reflected developments in international bondmarkets, and the differential with the euro areawidened slightly to stand at around 50 basispoints at the end of 2003. The krona fluctuatedaround SEK 9.2 per euro until September 2003,before strengthening somewhat to aroundSEK 9 per euro. These developments possiblystemmed from receding uncertainty followingthe outcome of the referendum of14 September on the adoption of the euro andthe fact that the outlook for growth remainedrelatively favourable.

UNITED KINGDOM

Average real GDP growth in the UnitedKingdom picked up in 2003, rising to 2.3%,compared with 1.7% in 2002 (see Table 11). Inearly 2003 the economy was affected byuncertainty associated with the conflict in theMiddle East, high oil prices and volatility infinancial markets, which undermined

confidence. Later in 2003 these uncertaintiesdiminished and financial markets started torecover, supporting a pick-up in economicactivity. As in previous years, growth wasdriven mainly by domestic demand, whereas netforeign trade made a negative contribution toreal GDP growth.

Growth in real household consumption easedto 2.9% in 2003 as a result of reduced gains inreal disposable income, moderating house priceincreases and slower rises in household wealth.At the same time, credit growth was strong andthe housing market remained more resilient thanhad been generally expected. Public spendinggrowth accelerated to 3.6%, up from 3.3% in2002. Gross fixed capital formation increasedby 2.6%, somewhat more than in 2002.Business investment was held back by financialrestructuring in the corporate sector and bythe fact that there was little sign of pressureson physical capacity. Notwithstanding theimprovement in price competitiveness, the


decline in exports seen in 2002 continued in2003, with exports falling by 0.5%. Thisdecline was associated with sluggish foreigndemand. Despite a slowdown in import growthin 2003, foreign trade made a negativecontribution to real GDP growth for the eighthyear in a row. The labour market proved ratherresilient, with unemployment remaining broadlyflat at 5.0%. Total employment expanded at arate similar to that recorded in 2002, helped by astrong increase in the number of jobs in thepublic sector.

Inflation pressures remained subdued in 2003.HICP inflation, which averaged 1.4% in 2003,was broadly stable compared with the previousyear. RPIX inflation, which averaged 2.8% in2003, was considerably higher than HICPinflation, partly reflecting the inclusion of thestrongly increasing housing cost component inthe RPIX.10 Both domestic and external costpressures remained subdued in 2003. Annualgrowth in unit labour costs in the economy as awhole was somewhat higher than in theprevious year, although it remained moderate.Import prices increased only slightly, despitethe depreciation of the pound during the firsthalf of the year.

After recording a deficit of 1.6% of GDP in2002, the general government balancedeteriorated further, reaching 3.2% of GDP in2003. This decline can be attributed mainly tothe expansionary fiscal stance reflecting highprimary public expenditure and shortfalls inrevenue related to changes in the composition ofGDP. As a result, the debt-to-GDP ratioincreased from 38.5% in 2002 to 39.8% in2003. The updated Convergence Programmetargets budgetary deficits of 3.3% and 2.6% ofGDP in 2003/04 and 2004/05 respectively. Thegross debt ratio is expected to increase from39.3% of GDP in 2003/04 to 40.2% in2004/05.

The Bank of England conducts monetary policywithin a flexible exchange rate regime with anexplicit and symmetric inflation target. In June2003 the government announced its decision to

postpone a referendum on the adoption of theeuro, based on the evaluation of the Treasury’sfive economic tests, which concluded that therewas still insufficient convergence andflexibility to cope with potential problemsinside EMU. To help ensure that inflationexpectations remain in line with those of theeuro area, the UK Government announced anew inflation target in December 2003,redefining it in terms of the HICP (referred toas the CPI in the United Kingdom) instead ofthe previously used national RPIX index. Thenew inflation target is defined as a 12-monthincrease of 2% in the HICP.

In 2003 the Bank of England changed itsofficial repo rate on three occasions. On both6 February and 10 July the rate was reducedby 0.25 percentage point, leaving it at 3.5%,while on 6 November the rate was raised bythe same amount to 3.75%. On 5 February 2004the repo rate was increased by 0.25 percentagepoint to 4%. The decisions to raise the repo ratewere taken against the background of astrengthening economic outlook, strong creditgrowth and a resilient housing market. TheBank of England expected these developmentsto put gradual upward pressure on futureinflation. Both the short and long-term interestrate differentials vis-à-vis the euro areaincreased in the course of 2003, reflecting therelatively rapid improvement in the economicoutlook and rising inflation expectations (seeChart 27). Following a depreciation during thefirst half of 2003, the pound’s exchange rateagainst the euro fluctuated around GBP 0.70until the end of the year.

10 The RPIX is defined as the Retail Price Index excludingmortgage interest payments.

ArtistJosé María SiciliaTitleLa luz que se apaga, 1997MaterialWax, oil and paperon woodFormat185 × 157 cm

CHAPTER 2

CENTRAL BANKOPERATIONS

AND ACTIVIT IES


1.1 MONETARY POLICY OPERATIONS

One of the pivotal tasks carried out through theEurosystem is the implementation of themonetary policy of the euro area. For thispurpose the Eurosystem has at its disposal anoperational framework of monetary policyinstruments and procedures.1

Based on an assessment of the liquidityconditions in the market and the needs of thebanking sector, the ECB manages the liquiditysituation in the euro area through its mainrefinancing operations (MROs), longer-termrefinancing operations (LTROs) and, wherenecessary, its fine-tuning operations.Counterparties can use the standing facilities(i.e. the marginal lending facility and thedeposit facility) to obtain overnight liquidityfrom, or make overnight deposits with, theNCBs. The Eurosystem requires creditinstitutions to hold minimum reserves onaccounts with the NCBs. All Eurosystem creditoperations have to be covered by adequatecollateral provided by counterparties. Due tothe importance of the money market for theimplementation of monetary policy, theEurosystem closely follows developments inthis market.2

In 2003 the Eurosystem’s operationalframework for monetary policy continued tofunction well, providing stable money marketconditions with low volatility for short-termmarket interest rates and a clear signalling ofthe monetary policy stance.

ASSESSMENT OF THE LIQUIDITY CONDITIONSThe ECB’s liquidity management relies on thedaily assessment of the liquidity conditions inthe euro area banking system to determine theliquidity needs of the system and thus thevolume of liquidity to be allotted in the weeklyMROs, and potentially through the conduct ofother open market operations such as fine-tuning and structural operations. The liquidityneeds of the banking system are defined by thesum of reserve requirements imposed on banks,funds held in excess of these requirements on

1 MONE TARY PO L I C Y O P E R AT I ON S , F O R E I GNEXCHANGE O P ER AT I ON S AND I N V E S TMENTA C T I V I T I E S

credit institutions’ current accounts with theirNCBs (excess reserves) and autonomousfactors. The latter are a set of items on theEurosystem’s balance sheet which have animpact on banks’ liquidity needs but are notunder the direct control of the liquiditymanagement of the ECB (e.g. banknotes incirculation, government deposits and netforeign assets).

In 2003 the daily liquidity needs of the euroarea banking system amounted to €241.5 billionon average, an increase of 24% compared with2002. On average, reserve requirements stoodat €130.9 billion, broadly unchanged comparedwith 2002. Excess reserves amounted to€0.7 billion, which was also similar to 2002.Autonomous factors, by contrast, increasedsubstantially, absorbing liquidity of €109.9billion, almost twice as much as in 2002 (see theupper panel of Chart 28). This was the result ofthe strong increase in banknotes in circulation,which to a large extent still reflected thecatching-up process following the temporaryfall around the cash changeover.

To help credit institutions prepare their bids inthe MROs, the ECB continued to publish on theannouncement day of the weekly MRO aforecast of the average autonomous factorscovering the period from the announcement dayto the day preceding the settlement of thesubsequent MRO. The absolute differencebetween the forecast and the actual outcomewas, on average, €1.4 billion in 2003, comparedwith €1.8 billion in 2002 and €1.9 billionin 2001, providing some evidence of animprovement in forecasts over recent years.3

1 A detailed description of the operational framework can befound in the ECB publication entitled “The implementation ofmonetary policy in the euro area: General documentation onEurosystem monetary policy instruments and procedures”,February 2004.

2 Money Market Study 2002, ECB, November 2003 and MoneyMarket Study 2003, ECB, January 2004.

3 Among the autonomous factors, government deposits held withNCBs were the most volatile factor in 2003. The volatility ofthese deposits, measured by the standard deviation of the dailychanges, amounted to €4.2 billion, against €3.9 billion in 2002.The volatility of banknotes in circulation was €1.3 billion in2003, compared with €6.7 billion in 2002.

75ECB

Annua l Repor t2003

Chart 28 Liquidity factors and the use of standing faci l it ies in the euro area in 2003

(EUR billions)

Liquidity factors

60

80

100

120

140

160

180

200

60

80

100

120

140

160

180

200

-10

-5

0

5

10

-10

-5

0

5

10

current accountsrequired reservesautonomous factors

23 December: 11.6

Standing facilities

marginal lending facilitydeposit facility

Dec.Nov.Oct.Sep.Aug.JulyJuneMayApr.Mar.Feb.Jan.

Dec.Nov.Oct.Sep.Aug.July

2003

2003

JuneMayApr.Mar.Feb.Jan.

Source: ECB.


MAIN REFINANCING OPERATIONSThe MROs are the most important open marketoperations conducted by the Eurosystem. Theyare regular liquidity-providing operations witha weekly frequency and normally have amaturity of two weeks (from 9 March 2004 theyhave a maturity of one week; see the sectionbelow on the review of the operationalframework). They play a pivotal role in steeringinterest rates, managing the liquidity situationin the market and signalling the stance ofmonetary policy through the level of theminimum bid rate. They also provide the bulk ofrefinancing to the banking system.

In 2003 the allotment volumes in MROs rangedfrom €38.0 billion to €150.0 billion, withan average volume of €95.9 billion. Theoutstanding liquidity provided through MROsamounted on average to €194.4 billion, whichrepresented 81% of the overall net liquiditysupplied by the Eurosystem through openmarket operations. As in 2002, MROs wereconducted as variable rate tenders with aminimum bid rate following the multiple rateauction procedure. According to this procedure,the bids with the highest interest rate aresatisfied first until the pre-defined allottedamount is exhausted. The lowest rate at whichfunds are allotted is the marginal rate. Bids atthe marginal rate are allotted pro rata.4

The marginal rate and the weighted average rateare usually higher than the minimum bid rate.The average spread between the marginal rateand the minimum bid rate was broadlyunchanged at 4.7 basis points, compared with4.8 basis points in 2002. The average spreadbetween the weighted average rate and themarginal rate stood at 1.5 basis points,compared with 1.4 basis points in 2002. Suchnarrow spreads show the high degree ofhomogeneity and precision among creditinstitutions in forecasting the allotmentoutcome as well as the tender rates. Thepercentage of bids which were satisfied in eachMRO ranged between 36% and 100%,averaging 74% over the period under review,

compared with a range of 19% to 100% and anaverage of 60% in 2002.

The Eurosystem’s operational framework formonetary policy was subject to only a fewepisodes of limited tension. These occurredmainly in relation to the three underbiddingepisodes in which the total amount of bidssubmitted by credit institutions fell short of theamount needed by them to allow for a smoothfulfilment of reserve requirements. On 3 Marchand 3 June 2003 underbidding occurredimmediately prior to Governing Councilmeetings at which bidders expected a decisionto lower the key ECB interest rates. These casesof underbidding resulted in tight liquidityconditions which temporarily drove up short-term market interest rates. By contrast, theunderbidding episode of 25 November did notoccur in an environment of expectations of aninterest rate decrease. The underbidding cameas a surprise to the bidders themselves, asrevealed by the fact that the weighted averagerate was 2.02%, i.e. two basis points higherthan the marginal rate (which was equal to theminimum bid rate). If underbidding had beenwidely expected by the market, bids would havebeen clustered at the minimum bid rate, thusresulting in a weighted average rate of 2.00%.

Finally, over the summer, a relatively highspread between the EONIA (euro overnightindex average) and the minimum bid rate wasobserved. In reaction to this, the ECB decidedto provide the banking system for some timewith slightly more liquidity than needed, whichhelped to bring the spread back down to morenormal levels in the autumn.

LONGER-TERM REFINANCING OPERATIONSThe LTROs are liquidity-providing operationswith a monthly frequency and a maturityof normally three months. They provide

4 The “pro rata” system works as follows: the total amount allottedat the marginal rate is divided by the total amount of bids at themarginal rate to give the percentage of bids satisfied. Eachindividual bidder’s bid amount at the marginal rate is multipliedby this percentage to obtain the amount it is allotted.

77ECB

Annua l Repor t2003

counterparties with additional longer-termrefinancing. In contrast to the MROs, theLTROs are not conducted with the intention ofsteering the liquidity situation or signalling themonetary policy stance. The Eurosystem acts asa rate-taker since LTROs are conducted as purevariable rate tenders with a pre-announcedallotment volume. The Eurosystem conducted12 LTROs in 2003, each having apre-announced allotment volume of €15 billion.In January 2004 the volume was increased to€25 billion. On average in 2003, LTROsamounted to 19% of the total net liquidityprovided through open market operations. As inprevious years, the dispersion of bids in LTROswas slightly higher than in MROs. On averageover the year, the weighted average rateexceeded the marginal rate by 1.7 basis points,compared with 1.9 basis points in 2002. Thepercentage of bids which were satisfied in eachLTRO in 2003 ranged between 42% and 60%,averaging 51%, compared with a range of 36%to 72%, averaging 50%, in 2002.

OTHER OPERATIONSOn 23 May 2003 the Eurosystem conducted aliquidity-absorbing fine-tuning operation inorder to restore balanced liquidity conditions.The large recourse to the marginal lendingfacility on the preceding two days had led tolooser conditions on the last day of themaintenance period and to a decline in theovernight rate. The fine-tuning operation wasconducted as a collection of fixed-term depositswith a fixed rate of 2.50% (which was theminimum bid rate in MROs at that time),overnight maturity and a pre-announcedintended allotment amount of €5 billion. Ofmore than 100 eligible counterparties, 12participated, and bids corresponded to anamount of €3.9 billion, all of which wasallotted. The reserve maintenance period endedsmoothly with a small net recourse to thedeposit facility of €0.6 billion.

STANDING FACILITIESThe two standing facilities offered by theEurosystem, i.e. the marginal lending facilityand the deposit facility, aim to provide andabsorb overnight liquidity, signal the generalstance of monetary policy and bound overnightmarket interest rates by setting an upper and alower limit for those rates. In 2003 the width ofthe interest rate corridor determined by the twostanding facilities remained unchanged at 200basis points, centred around the minimum bidrate of the MROs.

There are normally two reasons for creditinstitutions to have recourse to the standingfacilities:

– Recourse to standing facilities may arise in thecase of aggregate liquidity imbalances, i.e. ifthe banking system as a whole has either toolittle or too much liquidity relative to theaggregate reserve requirements. Aggregaterecourse normally takes place only towards theend of the maintenance period, when thebanking system must settle its position againstany accumulated aggregate liquidityimbalances via recourse to the standingfacilities. The bigger spikes in the recourse tostanding facilities during 2003 shown in thelower panel of Chart 28 mostly reflect theoffsetting of such aggregate imbalances.

– Unexpected payment flows betweenindividual banks at the end of the day, whenthe money market is no longer liquid, maytrigger individual recourse to the standingfacilities. Individual recourse is normallyspread fairly evenly across the maintenanceperiod. Individual recourse may becomesubstantial on days when payment systemcomponents fail, such as on 3 July 2003,when recourse to the marginal lendingfacility was €7.7 billion.

In 2003 the total average daily recourse tothe marginal lending facility amounted to


€269 million, while total average daily recourseto the deposit facility amounted to €242 million.On the assumption that the aggregate recoursetakes place on the last day of the maintenanceperiod while individual recourse takes place inthe remainder of the period, these amounts maybe broken down into €49 million aggregaterecourse and €221 million individual recoursefor the marginal lending facility, and €107million aggregate recourse and €135 millionindividual recourse for the deposit facility.

Total recourse to the standing facilities in 2003remained at the low levels of the previous year,indicating the good quality of the forecasts ofthe autonomous factors and the high efficiencyof the interbank market.

PARTICIPATION OF CREDIT INSTITUTIONS INMONETARY POLICY OPERATIONSThe Eurosystem’s monetary policy frameworkcontinued to enable a broad range of creditinstitutions to participate in monetary policyoperations. Of the 6,593 euro area creditinstitutions which were subject to minimumreserves at the end of 2003 (a change of -5%compared with the previous year), 2,149 (-7%)were eligible to participate in open marketoperations, 3,083 (-5%) were eligible to use thedeposit facility and 2,629 (-8%) were eligible touse the marginal lending facility.

In 2003 the average number of creditinstitutions participating in the MROs andLTROs continued the declining trend which hadstarted in mid-2000. In 2003 the averagenumber of bidders in the MROs was 267,compared with 307 in 2002. Similarly, thenumber of banks participating in the LTROs fellfrom 186 in 2002 to 133 in 2003. This trendseems to be the result of a combination ofvarious factors, such as the competitiveness ofthe interbank market, the consolidation of thebanking sector and the centralisation of treasurymanagement in banking groups. There is nosign that this continuous decline in MRO andLTRO participation has jeopardised the smoothallocation of central bank liquidity within theeuro area banking system. The Eurosystem

continued to have more counterparties in itsopen market operations than any other centralbank in the world.

MINIMUM RESERVE SYSTEMThe Eurosystem’s minimum reserve systemapplies to credit institutions in the euro area andprimarily pursues the aims of stabilising moneymarket interest rates and creating (or enlarging)a structural liquidity shortage. The reserverequirement of each institution is determined inrelation to elements of its balance sheet. Theaveraging provision, which allows creditinstitutions to fulfil their reserve requirementson average over the one-month reservemaintenance period5, helps to dampen theimpact of temporary liquidity shocks on short-term interest rates.

In 2003 reserve requirements represented 54%of the total liquidity needs of the euro areabanking system. The average level of aggregatereserve requirements held by credit institutionsin the euro area was €130.9 billion in 2003,representing a small increase of around€1 billion compared with 2002. Reserverequirements ranged from €128.9 billion inthe maintenance period ending on 23 March 2003to €132.1 billion in the maintenance periodending on 23 August 2003.

Banks’ current account holdings coveringreserve requirements fluctuated between€89.1 billion and €181.2 billion in the course ofthe year, indicating that a substantial furtherbuffer against unexpected aggregate liquiditywithdrawals was always available (see theupper panel of Chart 28). Mainly owing to theaveraging provision of the minimum reservesystem, and taking into account the lowfrequency of open market operations, thevolatility of the EONIA continued to be low in2003 by international standards. The standarddeviation of daily changes in the EONIA was14 basis points, 2 basis points higher than in2002.

5 From 10 March 2004 a reserve maintenance period no longerlasts one calendar month, but instead varies in length.

79ECB

Annua l Repor t2003

During 2003 an average of 19 cases of non-compliance with the obligation to hold minimumreserves were reported per reserve maintenanceperiod, compared with 28 in 2002. The averagedaily shortfall amounted to €6.7 million,compared with €10.5 million in 2002. 58% ofthe cases led to relatively small penalties ofbelow €500. There were, however, seven verylarge infringements, which led to fines inexcess of €10,000.

REVIEW OF THE OPERATIONAL FRAMEWORKIn reaction to some occasional disturbancesrecorded in previous years, the GoverningCouncil decided in January 2003 to amend someof the features of the Eurosystem’s operationalframework with effect from March 2004:

– to modify the timing of the reservemaintenance period so that it always starts onthe settlement day of the MRO following theGoverning Council meeting at which themonthly assessment of the monetary policystance is scheduled. Furthermore, as arule, the implementation of changes tothe standing facility rates is aligned withthe start of the new reserve maintenanceperiod;

– to shorten the maturity of the MROs fromtwo weeks to one week.

Combining both these measures will help toremove market expectations of interest ratechanges during any given maintenance period,given that changes in the key ECB interest rateswill only apply, in general, to the forthcomingreserve maintenance period and that liquidityconditions will no longer spill over from onereserve maintenance period to the next.Consequently, within a maintenance period, themarket overnight rate should no longer beaffected by rate change expectations. Hence,given the generally neutral liquiditymanagement policy of the ECB, the overnightrate should remain close to the minimum bidrate. This should eventually prevent speculativeconsiderations from disrupting the bidding ofcredit institutions in MROs. The measures will

thus help to stabilise the conditions in whichbidding takes place.

Owing to technical and legal lead times, it wasdecided that the changes would not enter intoforce until 10 March 2004.6 To help creditinstitutions to achieve a smooth implementationof the changes to the operational framework formonetary policy, an extended transitionalminimum reserve maintenance period (from24 January to 9 March 2004) was agreed.

ELIGIBLE ASSETS FOR MONETARY POLICYOPERATIONSThe Statute of the ESCB requires that allEurosystem credit operations be covered byadequate collateral. The collateral frameworkof the Eurosystem is designed to protect theEurosystem against incurring losses in itsmonetary policy and payment systemsoperations (see Box 7). It ensures the equaltreatment of counterparties and enhancesoperational efficiency.

In order to take account of existing differencesin the financial structure of euro area countries,assets eligible for Eurosystem credit operationsinclude a large number of different instruments.A distinction is made between two categories ofassets eligible for these credit operations: “tierone” and “tier two”. This distinction has nobearing on their eligibility for the various typesof Eurosystem monetary policy operations,except that tier two assets are not normallyexpected to be used by the Eurosystem inoutright transactions (not conducted at present).Tier one consists of marketable debtinstruments fulfilling uniform eligibility criteriaspecified by the ECB. Tier two consists ofassets which are of particular importance fornational financial markets and banking systemsand for which eligibility criteria have beenestablished by the NCBs, subject to minimum

6 A new Regulation (ECB/2003/9) on the application of minimumreserves was adopted on 12 September 2003 (OJ L 250,2.10.2003, p. 10). A revised version of the document entitled“The single monetary policy in the euro area: Generaldocumentation on Eurosystem monetary policy instruments andprocedures” (see footnote 1) applies from 8 March 2004.


eligibility criteria established by the ECB. Tiertwo assets may be marketable or non-marketable debt instruments or they may beequities.

A substantial part of tier one assets is made upof government securities (assets issued bycentral, regional and local governments) and ofPfandbrief-style securities which are issued bycredit institutions and backed by residentialmortgages or by public sector debt. At the endof 2003 government and Pfandbrief-stylesecurities represented 57% and 31%respectively of the total tier one assets. Othertypes of asset included in tier one are privatesector securities (i.e. uncovered bonds issuedby credit institutions, bonds issued bycorporations and asset-backed securities otherthan Pfandbrief-style securities) and securitiesissued by international and supranationalinstitutions (which accounted for less than 2%at the end of 2003). In particular, the value of

Chart 29 Tier one el ig ible assets for Eurosystem credit operations 1)

(end-of-month data; EUR billions)

Source: ECB.1) Securities issued by international and supranational institutions are not included.2) This category includes Pfandbrief-style securities and uncovered bonds issued by credit institutions.

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec.0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

governmentcredit institutions 2)

corporations

1999 20012000 2002 2003

eligible bonds issued by corporations followeda continuously increasing trend in 2003.

Tier two consists of marketable assets andnon-marketable debt instruments such as bankloans, trade bills and mortgage-backed promissorynotes listed by some NCBs in that category.

The total value of tier one assets eligible ascollateral for Eurosystem credit operations was€7 trillion at the end of 2003, compared with€6.6 trillion at the end of 2002 (see Chart 29).Overall, tier one assets accounted for anoverwhelming proportion of eligible assets (96%at the end of 2003). The total value of marketabletier two assets remained stable, standing at€261 billion at the end of 2003, compared with€265 billion in 2002. (The absolute amount of eligiblenon-marketable tier two assets is not available.)

All Eurosystem credit operations are based onunderlying assets provided by counterparties in

81ECB

Annua l Repor t2003

the form of either a transfer of ownership ofassets (earmarking system) or a pledge grantedover relevant assets (pooling system).

The total value of marketable assets put forwardby counterparties as collateral for Eurosystemcredit operations was around €750 billion at theend of 2003, compared with just over €700billion at the end of 2002 (see Chart 30).7

Overall, the share of debt instruments issuedby credit institutions in the total amount ofmarketable assets put forward at the end of 2003remained stable at 51%, compared with 52% atthe end of the previous year. Governmentsecurities were similarly stable, standing ataround 38%. A continuously increasing pathwas observed for the share of corporate bonds,from 4% (end-2002) to 6% (end-2003). Theshare of non-marketable bank loans has beenrelatively stable at around 4% of all assets putforward during the past five years.

Chart 30 Use of col lateral in Eurosystem credit operations

(end-of-month data; EUR billions)

Source: ECB.

Eurosystem counterparties may use eligibleassets on a cross-border basis, i.e. they canobtain funds from the NCB of the country inwhich they are established by making use ofassets located in another euro area country. Theshare of cross-border collateral in totalcollateral put forward by counterparties forEurosystem credit operations continued toincrease, from 33% at the end of 2002 to 40% atthe end of 2003. This increase involved alltypes of assets, but particularly those issued bycredit institutions and corporations (for moredetails see Section 2.3 of this chapter).

7 The total amount of collateral deposited by counterparties inpooling systems was around €650 billion (end-2003), comparedwith approximately €600 billion at the end of 2002. With regardto earmarking systems, where it is possible to identify theindividual transaction for which the underlying assets are used,the total amount used by counterparties for Eurosystem creditoperations (monetary policy operations and intraday creditneeds) was €107 billion at the end of 2003, compared with €115billion at the end of 2002.

0

100

200

300

400

500

600

700

800

Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec. Mar. June Sep. Dec.0

100

200

300

400

500

600

700

800

governmentcredit institutionscorporateother

1999 2000 2001 2002 2003


Box 7

RISK MANAGEMENT RELATED TO THE PROVISION OF CREDIT IN MONETARY POLICY AND PAYMENTSYSTEMS OPERATIONS

In policy operations (i.e. monetary policy or payment systems credit operations), when theEurosystem enters into a transaction with a counterparty, it incurs the risk that the counterpartymay be unable to meet its credit obligations. This credit risk is mitigated by the requirement thatthe counterparty provide adequate collateral to guarantee the credit provided.

The framework for managing the risks associated with the Eurosystem’s policy operations hasthree main components, namely the risk control of collateral, valuation principles and the creditrisk assessment of collateral.

In the context of risk control of collateral, a new haircut schedule was finalised in 2003. Thenew haircut schedule aims to better differentiate between collateral types on the basis of theirperceived liquidity risk characteristics. The classification of collateral into liquidity groups isbased on the examination of different liquidity indicators, such as yield curve differentialsbetween bonds issued by issuer groups of the same credit quality, effective supply and averageissue size as well as the bid-ask spread type of indicators. The classification of issuer segmentsinto groups of varying levels of liquidity is then reflected in the level of risk controls orhaircuts.

The new tier one risk controls apply as of March 2004. The main changes are as follows:

– Tier one assets are classified in four liquidity categories and each category is assigned aspecific haircut schedule:

Category I Category II Category III Category IV

Central government Local and regional Traditional Pfandbrief- Asset-backed securitiesdebt instruments government debt style debt instruments

instruments

Debt instruments issued Jumbo Pfandbrief-style Credit institution debtby central banks debt instruments instruments

Agency debt Debt instruments issuedinstruments by corporate and other

issuers

Supranational debtinstruments

– The maturity sectors of the haircut schedules have been chosen in such a way as to achieve aneven distribution of outstanding volumes across sectors. The new maturity sectors are0-1 year, 1-3 years, 3-5 years, 5-7 years, 7-10 years and >10 years. The application of initialmargins has been discontinued and trigger levels used in margin calls reduced from 1.0% to0.5%. In order to guarantee coherence between the new valuation haircut schedules for tier

83ECB

Annua l Repor t2003

one eligible assets and those for tier two eligible assets, the latter have also been modified totake into account both the discontinuation of initial margins and the new maturity sectors.

– The valuation haircuts applied to tier two assets reflect the specific risks associated withthese assets and are at least as stringent as the haircuts applied to tier one assets. The fourdifferent haircut groups for tier two assets, reflecting differences in their intrinsiccharacteristics and liquidity, have been maintained: equities, marketable debt instrumentswith limited liquidity, debt instruments with restricted liquidity and special features, andnon-marketable debt instruments.

The management and publication of thecomplete list of assets eligible for Eurosystemcredit operations are handled centrally at theECB, where the Eligible Assets Database iskept. The NCBs submit information to the ECBon eligible assets issued in their respectivenational markets. Assets are only consideredeligible for Eurosystem credit operations whenthey appear in the list updated on a dailybasis on the ECB’s website (www.ecb.int). In2003 the Eurosystem enhanced the quality,efficiency and reliability of the service providedto its counterparties and also modified thecontent of the list of eligible assets, providingadditional information on the issuer groupand the asset types in line with the new riskcontrol framework applied from March 2004(see Box 7).

THE SINGLE LIST OF COLLATERALDuring the first five years of Stage Threeof EMU, a large amount of collateralencompassing a wide range of assets wasavailable to counterparties for collateralisingEurosystem monetary policy and intraday creditoperations. However, the heterogeneity of theassets included in the tier two lists of differenteuro area NCBs may not ensure a level playing-field for counterparties and may somewhatdecrease the transparency of the collateralframework. The Eurosystem is thereforeinvestigating whether and how thisheterogeneity could be reduced and under whatconditions the two tiers of assets could bemerged in order to obtain a single list.

In June 2003 the Eurosystem launched a publicconsultation inviting market participants tosubmit their views on possible changes to theEurosystem’s collateral framework. The basicidea put forward to market participants was togradually move from a two-tier system to asingle list. The assets already accepted ascollateral by the Eurosystem under tier onewould be part of the single list. The maincategories of currently eligible tier two assetswere reviewed with a view to their potentialinclusion in the single list. In addition, a newcategory of assets to be made eligible wasinvestigated, namely euro-denominated debtinstruments issued in the EEA by issuersestablished in non-EEA G10 countries.

Replies were received from various interestedparties, including individual banks,associations of market participants andsome national and supranational bankingassociations. Almost all replies supported theproposal to replace the two-tier system with asingle list of eligible collateral. Support for thereform is largely based on the desire toestablish a harmonised collateral frameworkthat enhances the level playing-field betweeneligible counterparties. Market participantsargued that the new collateral policy shouldfavour greater availability of eligible assetsbecause of the increased use of collateral in themarket, e.g. in secured lending and repomarkets, and for the purposes of ContinuousLinked Settlement (CLS) (see Section 4 ofChapter 3). Some market participants


highlighted the need to make eligible in thewhole euro area all categories of assetscurrently accepted in tier two by only someNCBs. Some of them also mentioned additionalcategories of assets that they would welcome aseligible (e.g. more “foreign” assets such as debtinstruments denominated in foreign currencies).

The Eurosystem is aware that the revisedcollateral framework (if and when decided) willrequire gradual implementation over a numberof years. This will be necessary in the light ofthe required adaptation of operational systemsand procedures, both of the Eurosystem’scentral banks and of counterparties, as well aslegislative adjustments to be made in somecountries.

MARKET CONTACT GROUPSThe ECB continued to use the Money MarketContact Group (MMCG) and the ForeignExchange Contact Group (FXCG), bothestablished in 1999, as well as the OperationsManagers Group (OMG), established in 2002,as fora for discussing market developments,structural market issues and trading practices aswell as operational issues related to moneymarket and foreign exchange settlement.Among the issues discussed with marketparticipants in the MMCG in 2003 were thoserelated to the 2002 review of the euro moneymarket, the European repo market, the ACIinitiative on the Short-Term European Paper(STEP) project (see Section 3 of Chapter 3) andthe ECB’s consultation on the Eurosystem’scollateral framework. The FXCG discussedissues such as the progress of the recentlyestablished CLS, developments in e-commerceand a possible review of market practices.

1.2 FOREIGN EXCHANGE OPERATIONS

In 2003 the ECB did not conduct anyinterventions in the foreign exchange market.

The standing agreement between the ECB andthe IMF, signed in April 2001, to facilitate theinitiation of special drawing rights (SDR)

transactions by the IMF on behalf of the ECBwith other SDR holders was activated on oneoccasion in 2003.

1.3 INVESTMENT ACTIVITIES

FOREIGN RESERVE MANAGEMENTThe aim of the management of the ECB’sforeign reserves is to ensure that, at any givenpoint in time, the ECB has an adequate amountof liquid resources at its disposal for anyforeign exchange intervention, if and when theGoverning Council decides that intervention isnecessary. Liquidity and security are thereforethe basic requirements for the investment of theECB’s foreign reserves. Subject to theseconstraints, the ECB’s foreign reserves aremanaged in such a way as to maximise theirreturn. A set of rules and procedures – knownas a Chinese wall – have been established toprevent inside information, for instanceoriginating from the areas responsiblefor monetary policy implementation, fromreaching the areas responsible for themanagement of the ECB’s foreign reserves andown funds portfolio.

At the end of 2003 the ECB’s net foreignreserve assets amounted to €38.3 billion,compared with €43.2 billion at the end of 2002.The change in the size of the foreign reserveportfolio during 2003 reflects the interestincome earned and the change in the marketvalue of the assets in the portfolio, as a result ofthe depreciation of the US dollar. The ECB canmake further calls on the euro area NCBs’foreign reserve assets under the conditionsdefined in secondary Community legislation8.

The ECB’s foreign reserves mainly consist ofUS dollars but also include Japanese yen, goldand SDRs. The currency distribution, which isdefined by the Governing Council, is basedon optimal currency allocation studies and

8 Council Regulation (EC) No 1010/2000 of 8 May 2000concerning further calls of foreign reserve assets by theEuropean Central Bank (OJ L 115, 16.5.2000, p. 2).

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prospective operational needs, and theGoverning Council may change it when itdeems appropriate. In line with the CentralBank Gold Agreement of 26 September 1999,renewed on 8 March 2004, the ECB’s goldassets are not managed actively.

OWN FUNDS MANAGEMENTThe subscribed capital and general accountingreserve of the ECB form the basis of the ECB’sown funds portfolio. The purpose of the ownfunds portfolio is to provide the ECB with areserve to meet possible losses. The objectiveof portfolio management is to generate returnsover the long term in excess of the average mainrefinancing rate of the ECB.

At the end of 2003 the ECB’s own fundsportfolio amounted to €5.9 billion, comparedwith €5.6 billion at the end of 2002. The changein the size of the own funds portfolio during2003 reflects the interest income earned andthe change in the market value of the assets inthe portfolio. In 2003 further possiblediversification opportunities were examinedwith the aim of improving the total return on theown funds portfolio.

RISK MANAGEMENT ISSUESThe ECB’s risk management function measures,monitors and reports all risks resulting fromfinancial operations undertaken by the ECBdirectly or by the 12 NCBs of the Eurosystemon behalf of the ECB. The framework formanaging the risks associated with themanagement of the ECB’s foreign reserves andthe ECB’s own funds has three key interrelatedcomponents: (i) risk management measurementand compliance, (ii) the analysis and reportingof investment performance and (iii) theanalytical framework for asset allocation.

The ECB’s exposure to market, credit andliquidity risk is measured and compliance withagreed limits verified on a daily basis. In 2003no serious breaches occurred. The monitoringof compliance in 2003 focused increasingly onensuring the correct liquidity profile ofinvestments. Liquidity limits for the ECB’s

foreign reserves were formally introduced toensure that adequate amounts of assets are heldin cash or highly liquid securities. Clearprocedures are in place for reporting anddealing with any breaches of these or otherlimits. 2003 also saw improvements to theprocedures to verify the accuracy of the dailymark-to-market prices (the prices of securities,recorded on a daily basis and used for valuationpurposes).

The measurement and analysis of theperformance of all the relevant investmentportfolios forms a large part of the riskmanagement work. The current framework has24 separate portfolios for foreign reservemanagement alone, as each of the euro areaNCBs manages two portfolios of the ECB’sforeign reserves. Techniques to attributeperformance – i.e. to identify the sources ofportfolio returns in relation to the investmentbenchmarks set by the ECB – were furtherdeveloped in 2003 in order to provide usefulfeedback for portfolio managers. Aggregatingthese data over longer periods also allows moredetailed conclusions to be drawn. This analysisof overall performance as well as the relativeperformance of portfolios against the relevantbenchmark can also be useful for the decision-making bodies in deciding on any modificationof the overall investment framework.

Asset allocation is the process of dividinginvestments among different kinds of asset tooptimise, on the basis of the institution’s goals,the trade-off between risk and reward. The keyfactor influencing the return on the investmentportfolios is the asset allocation of the ECB’sstrategic benchmarks. These are designed toreflect the ECB’s long-term risk-returnpreferences. In 2003 the ECB developed aneconometric model to derive expected returnsfor the setting of benchmarks. In addition,several alternative optimisation techniques wereused to enhance the robustness of the analysis.


The provision of payment and securitiessettlement facilities is one of the Eurosystem’smain instruments for carrying out its task ofpromoting the smooth operation of paymentsystems. To fulfil its statutory task, theEurosystem has created the TARGET9 system, areal-time gross settlement (RTGS) system forvery large payments in euro. Payments throughTARGET are settled in the books of centralbanks, in central bank money, which greatlyminimises the risk of failures with criticalsystemic consequences for the entire financialsystem. TARGET has been subject toenhancements over the past few years, andplans are under way to develop a second-generation system, TARGET2.

On the securities settlement side, theEurosystem and the market offer variouschannels to facilitate the use of collateral acrossnational borders. The use of these channels isincreasing with the growing integration of EUmarkets.

2.1 THE TARGET SYSTEM

The present TARGET system is built on the 15national payment systems of the EU. It alsoincludes the payment mechanism of the ECB,the EPM, and an interlinking mechanism thatenables the processing of cross-borderpayments. In 2003 TARGET contributedfurther to the integration of the euro moneymarket and, because the Eurosystem’s creditoperations are processed via this system,continued to play an important role in thesmooth implementation of the single monetarypolicy. On account of its real-time settlementservice in central bank money and its broadmarket coverage, the TARGET system attracts avariety of other payments.

TARGET functioned smoothly and successfullyin 2003, and continued its trend of settlingincreasingly more large-value euro payments inline with the Eurosystem’s policy objective topromote settlement in central bank money. In2003 87% of the total turnover of large-value

2 PAYMENT AND S E CUR I T I E S S E T T L EMENTS Y S T EM S

payments in euro was executed via TARGET.TARGET is available for all credit transfers ineuro between banks in an EU Member State(intra-Member State traffic) and between banksin different EU Member States (inter-MemberState traffic), including those that have not yetadopted the euro. In 2003 there were 3,351participants in TARGET. 43,450 bank branchesworldwide can be addressed through TARGET.

TARGET OPERATIONSTARGET processed a daily average of 261,208payments with a total value of €1,650 billion aday in 2003. Compared with 2002, this is anincrease of 3% in volume and 6% in value.

Out of the total TARGET traffic in 2003, inter-Member State traffic represented 33% in termsof value and 23% in terms of volume, comparedwith 31% and 21% respectively in 2002. Of theTARGET inter-Member State traffic, 95% interms of value and 52% in terms of volume wereinterbank payments, the remainder beingcustomer payments. The average value of aninter-Member State interbank payment was€17 million, and the average value of aninter-Member State customer payment was€0.8 million. Further information is providedin Table 12.

In 2003 the overall availability of TARGET,i.e. the possibility for participants to useTARGET during its business hours withoutincident, reached 99.79%. The TARGETInformation System (TIS) was enhanced in2003 so that TARGET users can be providedwith more detailed and timely information in theevent of an incident.

9 TARGET stands for Trans-European Automated Real-timeGross settlement Express Transfer.

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PROVISIONS FOR SYSTEMICALLY IMPORTANTPAYMENTS IN TARGETOwing to the specific role the TARGET systemplays in the market and the broad marketcoverage it provides, suitable protection againsta wide range of threats is essential forthe smooth functioning of the system.Consequently, security issues need to beproperly addressed within the TARGETenvironment. A methodology for assessing therisk situation has been in place since thedevelopment phase of the TARGET system. In2003 the existing risk management process wasrevised substantially. The new TARGET RiskManagement Framework is based oninternational standards.

In abnormal circumstances it is of utmostimportance that systemically importantpayments, i.e. those that could cause a systemicrisk if not processed immediately, be carriedout without delay. Established TARGETcontingency measures have been furtherenhanced to ensure that this is the case. In 2003a number of trials among central banks

(sometimes involving commercial banks)verified the operability and interoperability ofall contingency measures alongside the wholeTARGET payment processing chain.

As a result, the Eurosystem is today betterpositioned to ensure that payment systems andfinancial markets can continue to functionsmoothly in a crisis situation.

OTHER CHANGESChanges in the communication network ofSWIFT, such as the SWIFTNet FIN migration,are mandatory for the entire user community.The components of TARGET may implementthe changes at their own pace, but must havecompleted the changeover by the end of 2004.

NIGHT-TIME SETTLEMENT FACILITIESIn 2003 the Eurosystem responded to a marketmove in securities settlement systems (SSSs)towards settling transfers of financialinstruments during the night, in what are knownas overnight settlement cycles. In thesesettlement cycles, SSS operators bring forwardto the previous night some of the activities thatwould typically occur on the following businessday. However, the value date for those trades isthe following business day. Overnightsettlement has the advantage that SSSparticipants can have certainty with regard totheir actual positions in cash and securities, andcan operate on this basis at the start of daytimeoperations.

Meeting a specific market request, theGoverning Council has approved a model whichsupports the cross-border settlement of thepayment legs of overnight settlement cycles incentral bank money for participants establishedoutside the country of the system in which theyparticipate. The model would be implementedonly by interested NCBs on a voluntary basis.The solution developed by the Eurosystemrelies on bilateral guarantees between euro areacentral banks. These guarantees involve theNCB of the country where the system is locatedand the NCBs of participants who areestablished outside that country. The bilateral

ChangeVolume 2002 2003 (%)

OverallTotal 64,519,000 66,608,000 3Daily average 253,016 261,208 3Intra-Member StateTotal 50,785,315 51,354,924 1Daily average 199,158 201,392 1Inter-Member StateTotal 13,733,685 15,253,076 11Daily average 53,858 59,816 11

Value Change(EUR billions) 2002 2003 (%)

OverallTotal 395,635 420,749 6Daily average 1,552 1,650 6Intra-Member StateTotal 271,914 283,871 4Daily average 1,066 1,113 4Inter-Member StateTotal 123,721 136,878 11Daily average 485 537 11

Table 12 Payment traf f ic in TARGET 1)

Source: ECB.1) 255 operating days in 2002 and 2003.


guarantees between NCBs make it possible forparticipants to use their central bank reservebalances at their home central bank forovernight settlement in an SSS outside theirhome country.

RELATIONS WITH TARGET USERS AND RTGSOPERATORS OF OTHER CURRENCY AREASThe ESCB maintains close relations withTARGET users so as to ensure that their needsare given due consideration and receive anappropriate response. As in previous years,regular meetings were held in 2003 between theEU central banks and the national TARGETuser groups. In addition, joint meetings of theTARGET Management Working Group(TMWG) of the ESCB and the TARGETWorking Group (TWG) of the Europeanbanking industry were held to discuss TARGEToperational issues. Strategic issues wereaddressed in the Contact Group on EuroPayments Strategy (COGEPS), a forum inwhich the senior management of commercialand central banks is represented.

The Eurosystem, as operator of one of thelargest RTGS systems in the world, maintainsclose contacts with the RTGS operators of othercurrency areas. Increasing interrelations,e.g. due to Continuous Linked Settlement (CLS)operations, have created the need for commondiscussions on operational issues.

2.2 TARGET2

The current structure of TARGET was decidedon in 1994 and was based on the principles ofminimum harmonisation and interconnection ofexisting infrastructures. This was the best wayof ensuring that the system would beoperational from the very start of EMU.However, in view of increasing financialintegration within the euro area and the fact thatthe business needs of TARGET users arebecoming even more similar, the system needsto be enhanced.

On 24 October 2002 the Governing Council setout the principles which have since guided thepreparation of the TARGET2 system. The newsystem must (i) provide an extensivelyharmonised service level, (ii) apply a singleTARGET-wide price structure to theseharmonised services and (iii) guarantee cost-effectiveness. At the same time, the NCBs willremain responsible for the accounts of, andbusiness relations with, credit institutions intheir respective Member States. As regards thetechnical infrastructure of TARGET2, centralbanks will be able to share a technical platform,the single shared platform (SSP), supportingthe RTGS services that they offer to theirbanks.

The planning for the TARGET2 project isdivided into three main phases: the pre-projectphase, the project phase, and the testing andtrial operations phase. 2003 was dedicated tothe pre-project phase, in which three main workstreams have to be addressed before technicaldevelopment work can start in the course of2004. The first work stream is the definition ofthe core features and functions offered byTARGET2 (e.g. payment processing andsettlement services, interface issues, liquiditymanagement, information services, businesscontinuity and security). The second workstream on cost and pricing issues consistsmainly of the finalisation of a common costmethodology for TARGET2. The third workstream focuses on issues specifically related tothe SSP.

As a first step in the definition of the corefeatures and functions of TARGET2, theEurosystem launched a public consultation inDecember 2002 to collect the views of the entirecommunity of TARGET users on the approachto be chosen for TARGET2 as well as on itsservice level.10 A summary of all replies,together with the individual contributions, wasmade available on the ECB’s website on 14 July2003.11 All respondents welcomed the

10 “TARGET2: principles and structure”, ECB, December 2002.11 “Summary of comments received on TARGET2: principles and

structure”, ECB, July 2003.

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Eurosystem’s initiative to improve thefunctionality and performance of TARGET. Thebanking industry also stressed the importanceof users being involved in the TARGET2project.

The ESCB will continue to consult the bankingcommunity on relevant TARGET2 issuesthroughout the project. In addition, thecontributions received in the publicconsultation have served as a basis fordetermining the features and functions ofTARGET2. Current preparations are alsofocused on ensuring the full compliance of thefuture TARGET2 system with the CorePrinciples for Systemically Important PaymentSystems12, which were adopted as minimumstandards by the Governing Council.

With regard to the second work stream, acommon cost methodology for TARGET2 to beapplied by all central banks had to bedeveloped. It will serve as the basis for thedetermination of the single TARGET2-wideprice structure and will also be used to establishwhether the cost recovery requirement has beencomplied with.

As for the third work stream, which focuses onissues related to the SSP, the ECB hascoordinated the discussions between the centralbanks interested in participating in the SSP. TheEurosystem has started to address issues relatedto the governance structure and financing of theSSP. The Banca d’Italia, the Banque de Franceand the Deutsche Bundesbank have launched ajoint initiative for the development of the SSP.

In addition to these three work streams, anadequate project organisation will have to beestablished in 2004 to ensure both the effectiveorganisation of the development work in theproject phase and an appropriate level ofinvolvement of, and control by, all centralbanks that intend to participate in the SSP.Preparations at the ESCB level aim to startTARGET2 operations on 2 January 2007.However, this deadline is very tight and will be

subject to a further feasibility analysis at a laterstage in the pre-project phase.

2.3 USE OF ELIGIBLE ASSETS ACROSS NATIONALBORDERS

Eligible assets may be used across nationalborders to collateralise all types of Eurosystemcredit operations by means of the correspondentcentral banking model (CCBM) or througheligible links between EU SSSs. The CCBM isprovided by the Eurosystem, while eligiblelinks are a market-led solution.

The amount of cross-border collateral held bythe Eurosystem increased from €234 billion inDecember 2002 to €305 billion in December2003. Overall, at the end of 2003 cross-bordercollateral represented 40% of the total collateralprovided to the Eurosystem. This is a clearindication of the increasing integration offinancial markets in the euro area. As a result ofthis process, counterparties are increasinglyinclined to hold in their portfolio assets locatedin another euro area country.

THE CORRESPONDENT CENTRAL BANKING MODELThe CCBM has remained the main channelfor transferring cross-border collateral andhas been enhanced further. Eurosystemcounterparties may use eligible assets on across-border basis, i.e. they can obtain fundsfrom the NCB of the country in which they areestablished by making use of assets locatedin another euro area country.13 The CCBMaccounted for 34% of the total collateralprovided to the Eurosystem. Assets held incustody through the CCBM increased from€195 billion at the end of 2002 to €259 billion atthe end of 2003.

12 Report of the Committee on Payment and Settlement Systems on“Core Principles for Systemically Important Payment Systems”,BIS, January 2001.

13 For more details, see Chapter 6.6.1 of “The implementation ofmonetary policy in the euro area: General documentation onEurosystem monetary policy instruments and procedures”, ECB,February 2004.


In order to improve the service level providedby the CCBM, the Governing Council decidedat the end of 2002 that, as of January 2004,NCBs would perform internal CCBMprocedures within an hour, provided thatcounterparties (and their custodians) submittheir instructions correctly. However, deviation

Box 8

BEST PRACTICES FOR MARKET PARTICIPANTS INVOLVED IN CCBM OPERATIONS AS AGREED BY THEEUROPEAN BANKING FEDERATION, THE EUROPEAN SAVINGS BANK GROUP AND THE EUROPEANASSOCIATION OF CO-OPERATIVE BANKS

1. Custodians shall ensure that their customers are informed of their rules/procedures forCCBM-related instructions. These rules/procedures shall be based, to the largest extentpossible, on the official local market practices. Customers must abide by these rules/procedures to ensure a swift and efficient processing of their instructions.

2. Whenever possible, the processing of CCBM instructions should rely on automaticprocedures. In this respect, electronic communication channels between custodians and theircustomers shall be used to the largest extent possible and instructions shall be based on ISO15022 standards.

3. Under normal circumstances and on a best effort basis, custodians shall submit theircustomers’ CCBM-related instructions to the local SSS within 30 minutes of their receiptprovided that the instructions are complete and correct, and that the customer has thesecurities to be delivered.

4. Custodian deadlines for same-day processing of their customers’ CCBM-related instructionsshall be 30 minutes before the deadline of the relevant local SSS (see the regularly updatedcountry tables on the ECB’s website at http://www.ecb.int). However, as good practice,customers are encouraged to submit their instructions well in advance of the custodian’sdeadline in order to avoid building up instruction queues and to provide the custodian withsufficient time to react to mistakes or unforeseen problems.

5. Market participants shall ensure that information is readily available to their customers toenable them to monitor the status of their CCBM instructions.

6. Custodians shall agree with their customers on solutions for recognising and prioritising(when necessary) CCBM-related instructions. These solutions should be based on ISO15022 standards where available.

7. Provided that there are ways for custodians to recognise CCBM instructions as such, theyshall inform their customers, on a best effort basis, of settlement problems within 15 minutesof their discovery.

from this one-hour benchmark will be toleratedin certain circumstances, for instance in the caseof peak traffic.

As custodian banks often play an important rolein the CCBM processing chain by delivering thecollateral on behalf of the counterpart, the major

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European credit sector associations (theEuropean Banking Federation, the EuropeanSavings Bank Group and the EuropeanAssociation of Co-operative Banks) haveestablished “best practices” for custodian banksinvolved in CCBM transactions. These providemarket participants with guidelines foroptimising the efficiency of the CCBM. Thebest practices, presented in Box 8, apply as ofJanuary 2004.

ELIGIBLE LINKS BETWEEN NATIONALSECURITIES SETTLEMENT SYSTEMSNational SSSs can be linked by means ofcontractual and operational arrangements to allowthe cross-border transfer of assets betweensystems.14 Once securities have been transferredvia such links to another SSS, they can be usedthrough local procedures in the same way as anydomestic collateral. 66 links are currentlyavailable to counterparties, of which only alimited number are actively used. Furthermore,these links only cover part of the euro area, and nonew links were presented for assessment in 2003.Collateral held through links increased from €38billion in December 2002 to €46 billion inDecember 2003, but represented only 6% of thetotal collateral, cross-border and domestic, heldby the Eurosystem.

14 For more details, see Chapter 6.6.2 of “The implementation ofmonetary policy in the euro area: General documentation onEurosystem monetary policy instruments and procedures”, ECB,February 2004.

Chart 31 Cross-border col lateral as apercentage of the total col lateral providedto the Eurosystem

0

5

10

15

20

25

30

35

0

5

10

15

20

25

30

35

1999 2000 2001 2002 2003

linksCCBM

Source: ECB.


3.1 THE CIRCULATION OF EURO BANKNOTESAND COINS AND THE HANDLING OFCURRENCY

DEMAND FOR EURO BANKNOTES AND COINSThe substantial increase in euro banknotes incirculation which was observed throughout2002 after the initial cash changeover periodcontinued during 2003. Between January andDecember 2003, the value of euro banknotes incirculation increased by 21.7%, from €358.5billion to €436.2 billion. Only in January 2003did the value of euro banknotes in circulationdecrease markedly, by 5.3% compared withDecember 2002, due to the reduced cash needsof economic agents after the turn of the year inline with the normal annual cycle. In Februarythe value of euro banknotes in circulationpicked up again, rising constantly at an averagemonthly growth rate of around 2.1% during therest of the year. The increase in demand for eurobanknotes is a result of their increased use bothas a store of value and as a parallel currency incountries outside the euro area. Statisticalanalyses have revealed that as at end-December2003 some 9% of the value of euro banknotes incirculation was held by non-euro area residents.

The number of euro banknotes in circulation alsorose markedly, by 10.1%, in 2003. Following adrop of 8.6%, from 8.2 billion to 7.5 billionbanknotes, in January 2003, the number rose

3 BANKNOTE S AND CO I N Smoderately throughout the year, with seasonalpeaks around the summer and towards the end ofthe year, when a level of 9.0 billion banknoteswas reached. Chart 32 shows the development ofnational banknotes and euro banknotes incirculation in terms of value from 2000 to 2003,while Chart 33 shows the development in terms ofvolume in 2002 and 2003.

No significant shifts between individualbanknote denominations occurred in 2003, as canbe seen in Chart 34. A closer look at thedevelopment of the annual growth rates for theindividual denominations reveals significantgrowth for the higher banknote denominations.The increase in the issuance of €500 banknoteswas strongest, with the number in circulationrising from 167 million to 238 million in 2003, anannual growth rate of 42.5%. The number of €50,€100 and €200 banknotes in circulation alsoincreased significantly, with annual growth ratesof 19.0%, 20.3% and 12.1% respectively, whilethe increase in the lower-value banknotes wasmoderate: 2.3% for the €5 banknote, 2.5% for the€10 banknote and 4.0% for the €20 banknote.

A lasting upswing in the demand for euro coinswas observed in all euro area countries fromJanuary 2003 onwards, resulting in an increasein the value of coins in circulation of 13.7%,from €12.4 billion to €14.1 billion as atend-December 2003. The number of coins in

Chart 32 Total value of banknotes incirculation between 2000 and 2003

(EUR billions)

Source: ECB.

national banknoteseuro banknotes

450400350300250200150100

500

450400350300250200150100500

Jan. June Nov. Apr. Mar. Aug. Jan. July Dec.Oct.2000 2001 2002 2003

Chart 33 Total number of euro banknotes incirculation between 2002 and 2003

(billions)

Source: ECB.

10

8

6

4

2

0

10

8

6

4

2

0Jan. May Aug. Dec. Apr. Aug. Dec.

2002 2003

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circulation increased by 9.1 billion in the courseof the year, from 39.9 billion to 49.0 billioncoins by the end of 2003. The significant risewas mainly due to the increased demand forlow-value coins, i.e. 1 cent, 2 cent and 5 centcoins, which accounted for more than two-thirds of this increase. This can be explained byhoarding and the relatively high loss rates forthese denominations.

BANKNOTE HANDLING BY THE EUROSYSTEMBanknotes returned to the NCBs are fullyauthenticated and quality checked withsophisticated banknote-processing machines toestablish whether they are fit for further use.Between January and December 2003 thenumber of euro banknotes crossing NCBs’counters totalled 57.8 billion, with a face valueof €1,744 billion, consisting of 28.5 billionbanknotes deposited and 29.3 billion withdrawnby credit institutions and other clients. Some2.7 billion banknotes needed to be destroyedbecause they were unfit for further use. Thisproportion is generally in line with NCBs’experience with the legacy banknotes after asimilar period from their launch.

3.2 DEVELOPMENTS IN EURO BANKNOTECOUNTERFEITS AND COUNTERFEITDETERRENCE

EURO BANKNOTE COUNTERFEITSIn 2002, when the euro banknotes were new, thelevel of counterfeiting was exceptionally low.This was partly because of the sophisticatedsecurity elements in the euro banknotes, butalso because counterfeiters had not had much timeto adjust to the new banknotes. In 2003, thebanknotes’ second year of use, the number ofcounterfeits detected was inevitably higherthan in the previous year. The total number ofcounterfeits received by National AnalysisCentres (NACs)15 during 2003 was 551,287. Theeuro remains a well protected currency. However,the reproduction technology available tocounterfeiters gets better and cheaper over time.In addition, the euro is a widely used internationalcurrency, which makes it more prone tocounterfeiting. Overall, the counterfeiting rate didnot show a steady increase in 2003, but there weresome seasonal fluctuations coinciding withperiods of high circulation of genuine banknotes,namely the Christmas and summer holidayseasons.

15 Centres established in each EU Member State for the initialanalysis of counterfeit euro banknotes at the national level.

Chart 34 Number of euro banknotes in circulation between 2002 and 2003

(millions)

Source: ECB.

0

500

1,000

1,500

2,000

2,500

3,000

0

500

1,000

1,500

2,000

2,500

3,000

0

100

200

300

400

500

600700

800

900

Jan. Mar. May July Sep. Nov. Jan. Apr. June Aug. Oct. Dec.0

100

200

300

400

500

600700

800

900

€500€200 €100

€50€20€10€5

2002 2003

Jan. Mar. May July Sep. Nov. Jan. Apr. June Aug. Oct. Dec.

2002 2003


The distribution of counterfeiting across thedenominations was as follows:

16 Cash-recycling machines are stand-alone, customer-operateddevices capable of receiving, processing and dispensingbanknotes.

ENSURING THE FUTURE INTEGRITY OF THE EUROBANKNOTESSecurity features “age” from the moment ofissue. As counterfeiters’ awareness of aninitially sound security feature increases, sodoes the risk of that feature being reproduced.The euro, as other world currencies,experienced this phenomenon after its launchand increasingly during 2003. This threatincreases as other banknote design authoritiesadopt the euro as a technical standard and optfor similar security features. Therefore, theresearch and development (R&D) of newsecurity features play an important role inensuring the future integrity of euro banknotes.In the pursuit of new security features thatrepresent a paradigm change in the longer term,the Eurosystem has developed a methodology toassess and fund R&D proposals on the widestpossible basis. The research on new securityfeatures is supplemented by developmentprogrammes that bridge the gap betweenresearch and production.

3.3 BANKNOTE ISSUANCE AND PRODUCTION

THE EUROSYSTEM’S ROLE IN THE CASH CYCLEThe Governing Council has on variousoccasions underlined the importance of a levelplaying-field for cash services. A number ofmeasures have already been taken with a view tocontributing to a fair competitive environment.In 2002 a common Eurosystem fee policy wasimplemented for the cash transactions ofprofessional clients at NCB counters and acommon approach to opening hours anddebiting/crediting rules for cash services atNCB counters was also defined. In addition,terms of reference for the use of cash-recyclingmachines16 in the euro area were published. In2003 a common procedure for testing suchmachines was established. Tests conductedaccording to this common procedure at any euroarea NCB are valid in all euro area countries.The test procedures set a high standard for these

€5 €10 €20 €50

Quantity 2,733 5,476 152,061 321,623Percentage 0.5 1.0 27.6 58.3

€100 €200 €500 Total

Quantity 53,668 14,776 950 551,286Percentage 9.7 2.7 0.2 100.0

Although the €50 banknote remains thecounterfeiters’ favourite target, by comparisonwith last year there has been a significant shiftaway from the €50 towards the €20 banknote.

The media have drawn attention to the existenceof high-quality counterfeits, but the number ofsuch counterfeits is extremely small and the“feel-look-tilt” test for counterfeits remainssufficient to detect almost all cases.

COUNTERFEIT DETERRENCEIn addition to the cooperation agreementconcluded with Europol during 2002, the ECBconcluded similar agreements in 2003 withInterpol and with several acceding countrycentral banks (ACCBs). The ECB and the NCBshave also been active in training cash-handlingprofessionals, both in the EU and beyond,in recognising and handling counterfeitbanknotes.

The Counterfeit Analysis Centre at the ECB andthe NACs collaborate with the police in thefight against counterfeiting, and techniciansfrom the NACs provide, upon request, legalauthorities with expert advice and technicalreports.

Furthermore, the Eurosystem has increased itscontribution to the global cooperation oncounterfeit deterrence under the auspices of theG10 governors. The ECB has developed atechnical support structure called the“International Counterfeit Deterrence Centre”(ICDC) for the international community. TheICDC updates the threat analysis throughcontinuous evaluation of new reproductionequipment and counterfeit deterrence systems.

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machines concerning the retention ofcounterfeit/suspected banknotes and theseparation of unfit banknotes in order tocontribute to the high quality of the banknotesin circulation. Due attention has also been paidto the feasibility and technical capabilities ofsuch machines. Several manufacturers havealready successfully completed these tests, thuscontributing to high standards for banknoteprocessing and recycling. In addition to themeasures already in place, the Eurosystemcontinues to discuss further aspects of the cashcycle with the objective of ensuring a smoothand efficient supply of cash and maintaining theintegrity of the euro banknotes.

The ECB and the European Commission jointlyorganise biannual meetings in which matters ofinterest related to the use of cash are addressed.Participants include representatives from thebanking industry, from consumer and retailgroups, as well as from the vending-machineand cash-in-transit industries. The ECB alsoparticipates, as an observer, in the CashWorking Group under the umbrella of theEuropean Payments Council, which has beenestablished by the European Credit SectorAssociations and the major banks.

PRODUCTION ARRANGEMENTS AND FUTUREBANKNOTE PRODUCTIONIn April 2001 the Governing Council decidedthat in the following few years production ofeuro banknotes would take place in accordancewith a decentralised production scenario withpooling. This means that each euro area NCB isresponsible for the procurement of an allocatedshare of the total requirement for selecteddenominations. Table 13 gives an overview ofthe allocation of the production to the NCBsaccording to this model.

The total production requirements for 2003amounted to 3.1 billion banknotes (4.8 billionin 2002).

Significant work has been undertaken todevelop a future banknote procurement policy.The Governing Council has carried out a

thorough analysis of whether tender proceduresmight be applied in the medium term for theprocurement of raw materials and theproduction of euro banknotes. The GoverningCouncil has decided that a common Eurosystemcompetitive approach with tendering will befully implemented by 2012 at the latest. TheNCBs with in-house/public printing works willbe allowed to opt out of this common approach.

SUPPORT FOR THE PRODUCTION OF EURO COINSThe Member States are responsible for theproduction of euro coins. The ECB continued toact as an independent assessor of the quality ofminted coins. This included the continuedsupport and maintenance of a common qualitymanagement system in all mints producing eurocoins. The production of coins in 2003 was4.8 billion (6.2 billion in 2002).

SECOND SERIES OF EURO BANKNOTESThe main aim of upgrading currency designs isto keep pace with technical developments inorder to make sure that the banknotes have acontinually high level of protection againstcounterfeiting, while containing securityfeatures that the public can recognise.Banknote-issuing authorities therefore tend togradually upgrade banknotes after a few yearsof circulation. In line with this practice, theECB has started planning a second series ofeuro banknotes, which will take several years toproduce and issue.

Denomination Quantity (millions NCB commissioningof banknotes) production

€5 110 FR€10 999.1 DE, GR, IE, AT€20 1,071.1 FR, ES, NL, PT, DE€50 657 IT, BE, ES, NL€100 122 IT, FI€200 133 DE, LU€500 0 1)

Total 3,092.2

Table 13 Allocation of euro banknoteproduction in 2003

Source: ECB.1) The logistical stocks of €500 banknotes resulting from thelaunch production were deemed to be sufficient to cover theneeds for 2003.


An issue date for the second series of eurobanknotes has not yet been defined, but it isexpected to be towards the end of this decade.The banknotes will be issued denomination bydenomination, with certain intervals betweenreleases, so that it will take several years beforeall denominations have been introduced. Thedesign of the second series will be based on the“ages and styles” theme of the current series inorder to signal continuity.

VERY LOW-DENOMINATION BANKNOTESSince the completion of the cash changeover,there have been suggestions that it would beuseful to introduce very low-denominationbanknotes, i.e. of €1 and/or €2. It has beenargued that in some countries the populationwas accustomed to using low-value banknoteswith their former currencies and has found itdifficult to adapt to the comparably highbanknote/coin boundary between the €2 coinand €5 banknote. It has also been argued thatconsumers tend to associate coins with lowvalues.

The Governing Council has agreed to reassessthe possible issuance of very low-denominationbanknotes in autumn 2004, when moreexperience regarding the use of euro banknotesand coins has been gained, both inside andoutside the euro area.

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The ECB, assisted by the NCBs, collects a widerange of statistics which enable the ESCB tofulfil its tasks. As in previous years, theprovision of statistics proceeded smoothly in2003. However, the ECB and the NCBsconsider that further improvements of thestatistics are still necessary.

In 2003 numerous efforts were made to improvethe availability and quality of statistics forthe euro area, while aiming to minimise thereporting burden on reporting entities. Progresshas also been made with regard to the statisticswhich are used intensively by the ECB andwhich are collected and compiled by theEuropean Commission (Eurostat) and thenational statistical institutes (NSIs).

4.1 NEW STATISTICS

In December 2003 the ECB published newharmonised statistics on the interest rates ofmonetary financial institutions (MFIs). Thesenew statistics cover 45 indicators of euro areainterest rates applied by MFIs to their depositand lending business vis-à-vis households andnon-financial corporations (see also Section 2.1of Chapter 1). The monthly interest ratestatistics cover both outstanding amounts andnew business. They provide a comprehensiveand harmonised picture of the level of interestrates applied by MFIs, how they change overtime and the business volumes associated withthese rates. The requirements for MFI interestrate statistics are laid down in Regulation ECB/2001/18. All information, including the manualon MFI interest rates and methodological notes,is available on the ECB’s website.

Since September 2003 the ECB has publishedadditional details on monetary aggregates andtheir counterparts. Seasonally adjustedestimates now cover the whole consolidatedbalance sheet of the MFI sector. In addition, thefrequency of the data on the sectoral breakdownof deposits, loans and holdings of securitieswas increased from quarterly to monthly.Revaluations of selected MFI balance sheet

4 NEW AND IMPROV ED S TAT I S T I C Sitems, e.g. write-offs/write-downs of loans,used in the calculation of the credit counterpartto the monetary aggregates are now availableseparately on a harmonised basis.

Following the adoption of GuidelineECB/2002/7 on the statistical reportingrequirements of the ECB in the field ofquarterly financial accounts in 2002,supplementary data on both the transactions andthe balance sheets of insurance corporationsand pension funds have been made available tothe ECB since February 2003.

In the field of statistics on non-MFIs other thaninsurance corporations and pension funds, dataon the balance sheets of investment funds,including a detailed breakdown by type, werepublished for the first time in January 2003.These quarterly statistics are compiled on thebasis of data currently available at the nationallevel and are not yet fully harmonised across theeuro area. In addition, since January 2003monthly data on quoted shares issued by euroarea residents, broken down by issuing sector,have been made available. An improved methodfor the calculation of growth rates for debtsecurities has also been used since January2003.

For euro area statistics compiled by Eurostat,the most important new statistics were the firstpublication of GDP flash estimates, based on asub-set of countries producing early estimates,and of industrial new order statistics.

As part of the further integration of statistics,the ECB published for the first time inJune 2003 the monetary presentation of thebalance of payments (b.o.p.). The monetarypresentation provides an important link betweenthe transactions in the external counterparts ofM3 and those by non-MFIs in the b.o.p. Aschanges in the net external assets of the MFIsector to a large extent reflect foreigntransactions of non-MFI euro area residents,this new presentation enhances the consistencybetween the monetary and the b.o.p. data. Inthis context, the collection of separate


information on loans and deposits within theother investment account will also make iteasier to monitor developments in the liquidassets held abroad by the non-MFI sector.

4.2 THE MEDIUM-TERM STRATEGY FORSTATISTICS

In 2003 the ECB statistical work followed amedium-term strategy to enhance statistics andimprove their integration and dissemination.Core elements of this strategy are:

– Preparing and incorporating the data onacceding countries, first as EU members andin the future as members of the euro area.

– Creating an integrated system of quarterlyfinancial and non-financial accounts for theeuro area and enhancing the conceptual andnumerical coherence of the data frameworkused for economic and monetary analysis.The quarterly system of accounts will becompiled both for the whole euro areaeconomy and for various institutionalsectors.

– Further expanding ECB statistics. Thisincludes a Centralised Securities Database(CSDB) and a Financial Markets Databasefor the euro area, which will support theproduction of consistent and accuratestatistics on securities markets and financialmarkets. The CSDB will also help to producemore accurate portfolio investment figures inthe b.o.p. and international investmentposition (i.i.p.) statistics.

– Extending the statistical framework for themonitoring and analysis of financialstability.

– Monitoring and responding to financialinnovations and other developments withpotentially important implications forstatistics, such as the new InternationalAccounting Standards and the Basel CapitalAccord.

– Improving the dissemination of statistics.

– Promoting timely and high-quality economicdata for the euro area, as compiled byEurostat on the basis of contributions byNSIs, e.g. by implementing the “first forEurope” principle, which encourages NSIsto give priority to their contribution to area-wide data, in particular the PrincipalEuropean Economic Indicators, and to abetter coordination of, for example, releasecalendars and revision policies.

– Actively participating in internationalstandard-setting fora, with the aim ofachieving greater consistency in basic data inthe different types of statistics collectedfrom companies.

As a way of improving the dissemination ofstatistics, since August 2003 the ECB haspublished a monthly Statistics Pocket Book,which provides the most important, up-to-datestatistics on the euro area in a handy format.

4.3 IMPROVEMENTS IN THE INSTITUTIONAL ANDLEGAL FRAMEWORK FOR STATISTICS

The ECB, together with the NCBs and incooperation with other European andinternational institutions, also works towardsthe strengthening of the legal and institutionalframework for the collection, compilation anddissemination of statistics.

The ECB has updated the Guidelineconcerning certain statistical reportingrequirements of the ECB and the procedures forreporting by the NCBs of statistical informationin the field of money and banking statistics(published as Guideline ECB/2003/2). The ECBhas also updated the Regulation concerningthe provision of MFI balance sheet statistics(published as Guideline ECB/2001/13) to covercertain positions vis-à-vis the accedingcountries and their currencies as from theiraccession on 1 May 2004. Furthermore, anupdate of the Guideline on b.o.p. and i.i.p.

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statistics was published as Guideline ECB/2003/7 in May 2003. This update will furtherimprove these statistics at the euro area level byproviding, among other things, a more detailedgeographical and sectoral breakdown of the b.o.p.flows and i.i.p. stocks.

Regarding the institutional framework, inMarch 2003 the ECB and the EuropeanCommission (Eurostat) signed an updatedMemorandum of Understanding on economicand financial statistics. It sets out theresponsibilities of, and cooperation between,the two institutions, without prejudice to thelegal provisions laid down in Article 285 of theTreaty and in Article 5 of the Statute of theESCB. The ECB continues to have primeresponsibility for money and banking statistics,including financial market statistics, whereasthe European Commission continues to haveprime responsibility for general economicstatistics. Responsibilities for b.o.p. statisticscontinue to be shared. The ECB also has primeresponsibility for statistics on internationalreserves, the nominal and real effectiveexchange rates of the euro, and the quarterlyfinancial accounts for the euro area. Annualaccounts by institutional sector for the MemberStates remain the prime responsibility of theEuropean Commission, while the developmentof quarterly non-financial accounts forinstitutional sectors and the statisticalinfrastructure, such as seasonal adjustment anddata transmission standards, is a sharedresponsibility.

Moreover, in 2003 a joint Task Force of theECB and the European Commission (Eurostat)identified elements that were most relevant forthe quality of b.o.p. statistics and developedquantitative indicators to monitor quality. Thesequantitative indicators for the euro area will beincorporated in an overall assessment of qualityand published in annual quality reports. Finally,the ECB and the European Commission(Eurostat) have closely cooperated in thepreparation of a list of monthly and quarterlyPrincipal European Economic Indicators thatshould become available for the euro area much

sooner than at present, based on more timelycontributions from Member States.


The goal of economic research at the ECB is toprovide a strong conceptual and empirical basisfor policy-making and to better communicatepolicy to the markets and the public. High-qualityresearch is essential to ensure that the ECB is wellequipped to cope with the unprecedentedchallenges associated with conducting a singlemonetary policy for a group of sovereigncountries. The most important task of economicresearch within the Eurosystem is to increaseknowledge of the functioning of the euro areaeconomy and, more specifically, to providemodels, tools and analyses relevant to the conductof monetary policy and the fulfilment of othertasks of the Eurosystem. An example of thispolicy orientation is its role in the evaluation ofthe ECB’s monetary policy strategy, where anumber of background studies served as input tothe Governing Council’s evaluation (see Box 1).

5.1 RESEARCH TOPICS

The research agenda for 2003 can be brokendown into six fields: monetary policy strategy,rules and indicators; the transmission ofmonetary policy; financial markets andinstitutions; international economics andfinance; the macroeconomic modelling of theeuro area; and general economic and structuralissues. Most of the research is first presented inthe ECB’s Working Paper series and – to a morelimited extent – the ECB’s Occasional Paperseries, as well as at conferences andworkshops, before being published in academicjournals or books.17

Chart 35 shows the growing volume of researchproduced since 1999 and the high number ofpapers already or soon to be published inacademic journals or books.18 Chart 36illustrates the focus on policy-relevantresearch at the ECB. It categorises ECBWorking Papers by topic, using the Journal ofEconomic Literature classification types.“Macroeconomics and monetary economics” isthe most common topic in the series, followedby “mathematical and quantitative methods”,“financial” and “international” economics.

5 ECONOM I C R E S E ARCH

5.2 RESEARCH NETWORKS

In many instances, ECB research is conductedwithin the framework of organised networks.These are groups of researchers jointly engagedin broad, multi-purpose projects. They mayinclude economists from the ECB, euro areaNCBs, other central banks and policy-makingorganisations, and academics. The ECBparticipates and provides coordination andorganisational support, alone or with otherinstitutions. In 2003 such research networkswere particularly active: for instance, the ECBconducted research on capital markets andfinancial integration in Europe together with theJohann Wolfgang Goethe University’s Centerfor Financial Studies in Frankfurt (see Box 10).

A major project completed in 2003 was theEurosystem Monetary Transmission Network.Launched in 1999 by the ECB and the euro area

17 For some descriptive statistics on the scope of the researchproduced at the ECB, see V. Gaspar and J. L. Vega, “Research ata policy making institution: launching research at theECB”, Swiss Journal of Economics and Statistics, vol. 138,issue 4, 2002, pp. 359-376.

18 The ECB Working Paper series comprises research work by ECBstaff and visitors. Papers by researchers not affiliated with theECB can also be released in the series to the extent that they havebeen produced in the context of ECB-led research initiativesand/or presented at research conferences/workshops organisedby the ECB.

Chart 35 Release of ECB Working Papers

Source: ECB.

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7080

90

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7080

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1999 2000 2001 2002 2003

not yet published in scientific journals or bookspublished/forthcoming in scientific journalspublished/forthcoming in books

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NCBs, it investigated how the single monetarypolicy affects the euro area economy. Theproject collected comprehensive evidence on thetransmission mechanism. Participantsconducted in-depth studies using bothmacroeconometric and microeconometric datawith a focus on firm investment behaviour andon the role of banks in the transmissionprocess. It also included a comparison of thetransmission mechanism in the euro area andthat in the United States. Several articles injournals and working papers resulted from theproject, and a book containing the completeresults was published in November 2003.19

While the network conducted most of itsresearch using data covering the period beforethe introduction of the euro, some of the follow-up evidence was extended in 2003 to cover theperiod since 1999.

In 2003, in order to gain a better understandingof the dynamics of inflation in the euro area andin the component countries, a EurosystemInflation Persistence Network was created,bringing together researchers from the ECB andall euro area NCBs. A wide range of data is

being used to study the phenomenon, includingindividual and sectoral data on consumer andproducer prices, macroeconomic inflation ratesand survey results. The results are expected in2004 and 2005.

The Euro Area Business-Cycle Network,organised in collaboration with the Centre forEconomic Policy Research, provides a forumfor the study of the euro area business cycle. Itbrings together researchers from academia,central banks and other policy institutions. TheNetwork held two workshops in 2003, and theECB hosted the Network’s first conference inDecember 2003, on the main sources ofexogenous shocks for the G7 economies and theeuro area.20

The International Wage Flexibility Project,sponsored by the ECB together with theInstitute for the Study of Labour (IZA) in Bonnand organised by the Federal Reserve Bank of

19 I. Angeloni, A. Kashyap and B. Mojon (eds.), Monetary policytransmission in the euro area, Cambridge University Press, 2003.

20 For more information on this network, see www.eabcn.org.

Source: ECB.

20031999-2003

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1 Mathematical and quantitative methods2 Microeconomics3 Macroeconomics and monetary economics4 International economics5 Financial economics

6 Public economics 7 Labour and demographic economics 8 Industrial organisation 9 Economic development, technological change and growth10 Others

1 2 3 4 5 6 7 8 9 10

Chart 36 ECB Working Paper series: Journal of Economic Literature classi f ication

(%)


New York and the Brookings Institution,provides a discussion forum for researchersfrom 13 countries studying the extent andnature of wage rigidities using individual data.Special emphasis is placed on the comparabilityof methodologies and results. A panel sessionat the meeting of the American EconomicAssociation was organised in 2003. The finalconference will be held at the ECB in June2004.

5.3 MACROECONOMETRIC MODELLING OF THEEURO AREA

Econometric models are used directly andindirectly in the monetary policy decision-making process, for example in preparing themacroeconomic projections, the main results ofwhich are published twice a year in the MonthlyBulletin.21 Furthermore, model-building hasbeen a catalyst for the development of newstatistical data. A major example is the Area-Wide Model macroeconomic database, availableon the ECB’s website and widely used byresearchers worldwide.

In 2003 both the ECB and the NCBs were veryactive in the area of econometric modelling. Themodelling framework for the euro areaencompasses, for example, traditionalmacroeconometric and time-series models aswell as state-of-the-art dynamic factor,structural vector auto-regressive and stochasticgeneral equilibrium models. This line of work,and the related cooperation, is now beingextended to cover the central banks of theacceding countries.

5.4 CONFERENCES AND VISITOR PROGRAMMES

As part of its broader commitment to acontinuous and active exchange with theacademic world, the ECB organises or co-organises a number of conferences andworkshops related to its core interests. Thereare at present two main recurring events. Thefirst is the ECB Central Banking Conference, an

event organised every two years on a topic ofparticular relevance to the ECB. This eventtargets high-level participants from centralbanks, international and European institutions,and academic institutions, as well as membersof the financial press. The proceedings of theconference are published. The second recurringevent is the series of conferences of theInternational Research Forum on MonetaryPolicy. Co-organised with the Board ofGovernors of the Federal Reserve System, theCenter for Financial Studies at the JohannWolfgang Goethe University (Frankfurt) andthe Center for German and European Studies atGeorgetown University (Washington D.C.,United States), this initiative focuses onresearch on monetary policy issues that arerelevant from a global perspective. The secondconference in the series took place in November2003 on the premises of the Board of Governorsof the Federal Reserve System.22

Interaction with visitors is an important channelof external communication and collaboration forECB researchers. To foster interaction betweenECB staff and the international researchcommunity, the ECB organises a ResearchVisitors Programme which enables recognisedresearchers working on topics of interest to theECB to spend a limited period of timeconducting research while hosted by theDirectorate General Research. Furthermore, in2003 a number of colleagues from the ACCBspresented their analytical and research work tothe ECB. On a junior level, the ECB continuedto offer outstanding students enrolled inpostgraduate courses at leading internationaluniversities the possibility to conduct part oftheir research at the ECB (see Section 2 ofChapter 8). Finally, external consultants adviseon selected issues and external speakerscontribute to the ECB’s extensive seminarprogramme.23

21 For more information on the projection exercise, see “A guideto Eurosystem staff macroeconomic projection exercises”,ECB, June 2001.

22 More information on ECB conferences and workshops can befound on the ECB’s website.

23 More information on visitor programmes can be found on theECB’s website.

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6.1 COMPLIANCE WITH THE PROHIBITIONS OFMONETARY FINANCING AND PRIVILEGEDACCESS

Pursuant to Article 237 (d) of the Treaty, theECB is entrusted with the task of monitoring thefulfilment by the 15 EU NCBs and the ECB oftheir obligations under Articles 101 and 102 ofthe Treaty and Council Regulations (EC) Nos3603/93 and 3604/93. This task is performed bythe General Council of the ECB. Article 101prohibits the ECB and the NCBs fromproviding overdraft facilities or any other typeof credit facility to governments andCommunity institutions or bodies, as well asfrom purchasing debt instruments directly fromthem. Article 102 prohibits any measure, notbased on prudential considerations, whichestablishes privileged access by governmentsand Community institutions or bodies tofinancial institutions. In parallel with theGeneral Council, the European Commissionmonitors Member States’ compliance with theabove provisions.

The General Council also monitors the EUcentral banks’ secondary market purchases ofdebt instruments issued by both the domesticpublic sector and the public sector of otherMember States. According to the recitals ofCouncil Regulation (EC) No 3603/93, theacquisition of public sector debt instruments inthe secondary market must not be used tocircumvent the objective of Article 101 of theTreaty. Such purchases should not become aform of indirect monetary financing of thepublic sector.

In 2003 the General Council found two cases ofnon-compliance with the above Treatyrequirements and the associated CouncilRegulations by NCBs of Member States. Inboth cases, the amount of coins held by theNCBs and credited to the public sector exceededthe limit of 10% of coins in circulation, as laiddown in Article 6 of Council Regulation (EC)No 3603/93. In the context of the stronginflows of coins to NCBs prior to theintroduction of euro coins on 1 January 2002,

6 OTHER TA S K S AND A C T I V I T I E SFinland exceeded the limit from October 2001and France from January 2002. In the case ofFrance, the limit continued to be exceeded untilApril 2003, while in the case of Finland, thesituation was only remedied in December 2003.Thus, at the end of 2003, the situation had beenfully corrected in both countries.

6.2 ADVISORY FUNCTIONS

Article 105 (4) of the Treaty and Article 4 of theStatute of the ESCB require that the ECB beconsulted by the relevant Community institutionand the responsible national authorities,24 asappropriate, on any proposed Community ornational legislation which falls within theECB’s fields of competence. The limits andconditions applicable to the consultation of theECB by national authorities in respect of draftlegislation are set out in Council Decision98/415/EC of 29 June 1998.25 All ECB opinionsare published on the ECB’s website.26

In total, 32 consultations were initiated in 2003,21 by a national authority and 11 by the EUCouncil. Of these 32, two concerned means ofpayment, four statistics and 11 rules whichcould influence the stability of financialinstitutions and markets. Three opinionsadopted in accordance with Article 105 (4) ofthe Treaty warrant specific mention: one on theproposal for an EU directive on investmentservices and regulated markets, which ispresented in more detail in Section 2 ofChapter 3, and the other two on the Finnish

24 In accordance with the Protocol on certain provisions relating tothe United Kingdom of Great Britain and Northern Ireland, asannexed to the Treaty, Article 105 (4) of the Treaty and Article4 of the Statute of the ESCB shall not apply to the UnitedKingdom. Hence, the obligation to consult the ECB does notextend to the national authorities of the United Kingdom.

25 Article 2 of this Decision elaborates the specific areas in whichthe ECB is to be consulted.

26 In 2002 the Governing Council endorsed a disclosure policyentailing that, as a general rule, all ECB opinions issued upon therequest of national authorities would be published on the ECB’swebsite in the languages of adoption (i.e. both English and thelanguage of the respective consulting authority) six months aftertheir adoption, unless they were of policy relevance, in whichcase they would be made publicly available immediately afteradoption.


Government’s draft proposals to amend theSuomen Pankki Act.

The proposal to amend the Suomen Pankki Act,on which the ECB delivered its first opinion,27

suggested limiting Suomen Pankki’s ability tomake financial provisions. It further suggestedtransferring the whole annual profit of SuomenPankki to the State unless the ParliamentarySupervisory Council decides otherwise, as wellas transferring around €740 million of thecapital to the State, which would have forcedSuomen Pankki to sell foreign reserve assets.The ECB objected to the proposal primarilybecause of the combined effect of the suggestedamendments on the financial situation ofSuomen Pankki and the lack of any statutorysafeguards ensuring the performance of ESCBtasks, which together would undermine thefinancial independence of Suomen Pankki. InDecember 2003 the ECB was consulted on arevised government proposal to amend theSuomen Pankki Act. In its second opinion, theECB welcomed the fact that the final legislativeproposal submitted to the ECB did not reducethe capital of Suomen Pankki. However, theECB noted that the requirements for financialindependence were not fully satisfied and thatthe proposal was therefore still incompatiblewith the Treaty and its intentions. Following thesecond opinion, the legislative proposal waswithdrawn.

In addition to the opinions adopted inaccordance with Article 105 (4) of the Treaty,the ECB also delivered an opinion pursuant toArticle 48 of the Treaty on European Unionconcerning the draft Treaty establishing aConstitution for Europe, which is presented inmore detail in Section 1.1 of Chapter 4.

The ECB also delivered two opinions pursuantto Article 112 (2) (b) of the Treaty andArticle 11.2 of the Statute of the ESCB. Theseopinions concerned recommendations from theEU Council on the appointment of the newPresident of the ECB and a new member of theExecutive Board of the ECB.

A list of the opinions adopted in 2003 and early2004 is included as an annex.

6.3 THE ADMINISTRATION OF THE BORROWINGAND LENDING OPERATIONS OF THEEUROPEAN COMMUNITY

In accordance with Article 123 (2) of the Treatyand Article 9 of Council Regulation (EC)No 332/2002 of 18 February 2002, the ECBcontinues to have responsibility for theadministration of the borrowing and lendingoperations of the European Community underthe Medium-Term Financial Assistancemechanism. During 2003, however, the ECBperformed no administration tasks of thisnature, as there was no outstanding balance atthe end of 2002 and as no new operations wereinitiated during 2003.

6.4 RESERVE MANAGEMENT SERVICES

In 2003 the Eurosystem started work on a newframework for the banking services that itsmembers offer to non-EU central banks,monetary authorities, third countries andinternational institutions for reservemanagement purposes. At the core of thisframework is a benchmark range of servicesthat will allow customers to manage their euro-denominated reserve assets through any of theeuro area central banks that have opted toprovide this range of services. The newframework will offer customers the possibilityof using the services concerned underharmonised conditions, irrespective of theEurosystem central bank they have selected asservice provider. Details of the new frameworkwill be finalised in the first half of 2004 andthen implemented in the second half of the year.

27 CON/2003/22, published on the ECB’s website.

ArtistGerhard BalderTitleRoter Nautilus, 1995MaterialOil on canvasFormat70 × 54 cm

CHAPTER 3

F INANCIAL STABILITYAND INTEGRATION


Throughout 2003 financial stability was animportant item on the agenda of internationaland European institutions and fora. At theinternational level, the Financial StabilityForum continued to provide an importantcontribution to identifying sources ofvulnerability for the financial system from aglobal perspective. At the EU level, following adecision taken by the ECOFIN Council inDecember 2002, the Economic and FinancialCommittee (EFC) started to hold regulardiscussions on financial stability issuesrelevant for the EU. Within the Eurosystem, theGoverning Council also began holding regulardiscussions on financial stability conditions inthe euro area/EU supported by work carried outby the ECB in collaboration with the ESCB’sBanking Supervision Committee (BSC). Theresults of this work are also intended tocontribute to international and Europeandiscussions on the matter.

1.1 FINANCIAL STABILITY MONITORING

The monitoring of financial stabilitydevelopments and conditions conducted by theECB in collaboration with the BSC is intendedto identify potential sources of vulnerability inthe financial system of the euro area/EU and toassess its resilience to potential shocks. Whilethe financial system as a whole (banks, non-bank financial institutions, financial marketsand the financial infrastructure) is monitored,the focus is on banks, given that they continueto represent the main component of the euroarea/EU financial system. In order to conduct aproper assessment, both cyclical and structuraldevelopments must be taken into account.

CYCLICAL DEVELOPMENTSThe unwinding of financial imbalances whichhad accumulated in the EU in the 1990scontinued to have an impact on the financialsystem in 2003. However, the system continuedto prove its resilience to these imbalances,also reflecting the improved macroeconomicand financial backdrop as 2003 progressed(discussed in greater detail in Chapter 1).

1 F I N ANC I A L S TA B I L I T YMost of the risks to the stability of theEuropean financial system were the legacy ofremaining domestic financial imbalances,notably in the corporate sector (see also Box 2).Corporations in Europe made efforts to adjusttheir balance sheets, particularly in thosesectors where relatively high indebtednesshad been an earlier concern. They embarkedupon cost-cutting programmes, scaled backinvestment and, in some sectors such astelecommunications, restructured their debt.While these efforts generally paid off inraising profitability, they were not sufficientto bring down debt ratios for the corporatesector as a whole. There were, however,sectoral differences, with financing conditionsimproving notably in the telecommunicationssector.

As for European households, debt/incomeratios rose further in the course of 2003, mostlyreflecting an accumulation of mortgage debt inan environment of historically low interest ratesand relatively stable labour market conditions.The relatively high demand of households formortgages proved to be important in sustainingthe interest income of banks in an otherwisechallenging environment. However, in somecountries it also led to relatively rapid increasesin residential property prices, which could posesome risk for credit institutions in thosecountries in the event of a sudden downwardmovement in house prices. Overall, however,these risks appeared to be rather remote.

The stability of financial markets improved in2003. After three years of almost continuousdecline and exceptional volatility, equitymarkets started to recover in mid-March 2003and volatility settled down as geopolitical risksreceded and confidence in prospects for aneconomic recovery began to broaden. Thisprovided scope for corporations to issue freshequity and/or debt, with bond spreadsdiminishing significantly and bond activityimproving. To some extent, these developmentscould also be explained by a “search for yield”by investors in an environment where long-terminterest rates had reached low levels by

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historical standards. Low interest rates in early2003, however, strained in particular somefinancial institutions, notably insurancecompanies and pension funds, through theirimpact on these institutions’ liabilities. Thesestrains were eased by an upturn in long-terminterest rates in the second half of the year.

In early 2003, following three years ofprofit erosion, EU insurance companies wereconfronted with significant pressures on theirsolvency positions that were the result of boththe tumble in stock prices since 2000 andthe more recent downward pressure on long-term interest rates. However, the subsequentrebound tended to ease balance sheet strains andsome signs of improvement became evidentby mid-2003. Nonetheless, some solvencyand income pressures remained, as well asuncertainties surrounding the extent to whichinsurance companies had accumulated creditrisk through the credit risk transfer market.

The EU banking sector remained resilient, albeitchallenged for a third consecutive year by sub-par economic growth in 2003. It absorbed theadverse effects of a less benign than expectedenvironment. Banks responded well to thechallenging environment by cutting costs,reorganising businesses and improving theirrisk management policies. Large bankssucceeded in maintaining, and even improving,profitability and solvency levels in the first halfof 2003. Relatively low provisioning for loanlosses, cost savings and an upturn in incomefrom financial market-related activities allserved to boost profitability in 2003. Thesedevelopments were also reflected in theregulatory solvency ratios of EU banks, whichremained favourable. However, the ratios ofsome banks benefited from asset sales and froma reduction in risk-weighted assets rather thanfrom either new equity issuance or profitreserving.

In February 2003 the ECB published for thefirst time a report entitled “EU banking sectorstability”, which was followed by a second

report in November of the same year. Thereports summarised the main findings by theBSC of the regular monitoring of the stability ofthe EU banking sector.

STRUCTURAL DEVELOPMENTSThe difficult economic and financial marketenvironment in recent years compelled banksto enhance efficiency, inter alia throughcost-cutting and the shedding of non-coreactivities. This implied a slowing-down in,or discontinuation of, some of the longer-term trends apparent in earlier years,notably internationalisation, consolidation anddisintermediation. Overall, these responses todifficult business conditions helped banks towithstand ongoing strains and also contributedto improving banking stability over the mediumand longer term.

Internationalisation strategies, particularly ininvestment banking and trading activities, werefrequently scaled back, although links to someregions, such as central and eastern Europe,continued to strengthen. A focus by banks ontheir “home markets” was apparent, particularlyfor retail operations. However, regional cross-border banking activities, regarded as a naturalextension of business in the home market, werefurther expanded. It seems that competitivepressures in the home market have, to a largeextent, driven recent internationalisationactivities. Thus recent expansion was mainlyaimed at improving profitability by enteringmarkets with higher margins and where therewas a clear comparative advantage.

Consolidation in the banking sector continued,albeit at a reduced speed, but competitivepressures in general remained high despite thisincreasing concentration. Banks continued toopt for a distribution strategy based on thesimultaneous use of branches and remotechannels, which could also be seen as part ofbanks’ efforts to improve the quality of serviceto customers. However, branch networksremained at the core of banks’ distributionstrategies. They increasingly moved away


from the pure processing of transactionstowards the provision of advice-intensive, moresophisticated and value-added services.

With regard to intermediation, i.e. the role ofbanks as intermediaries in channelling fundsfrom depositors to borrowers, banks were facedwith reduced corporate demand for funds andcapital market issuance. However, retailactivities proved to be a stable source ofincome. In particular, banks’ retail customerstended to shed equity from their portfolios amida volatile market environment, favouringrelatively safe and liquid deposits. At the sametime, household lending remained ratherbuoyant.

EU banks expanded their range of products andservices, particularly to retail customers. Banksoffered a greater number of new savinginstruments comprising products that linkreturns to an index in combination with optionfeatures, for example by including a floor onlosses. In some countries, high-risk investmentalternatives such as hedge funds have beenmade available to retail investors throughbanks. Hence, consumers are being faced withever-increasing product complexity. This hasinduced banks to increase their efforts toenhance investor confidence in securities-related products via organisational changes andimprovements in their governance structures.

Finally, banks improved their risk managementwith a view to better controlling increasedcredit risk and also in response to thechallenge posed by forthcoming changes incapital requirements (New Basel CapitalAccord, or Basel II; see Section 2 of thischapter). Increasing participation in the creditrisk transfer market was one avenue pursuedto better manage risks. Credit risk transferinstruments enable banks to unbundle risksmore easily and to shape their credit riskexposure more effectively. Banks mainly tendedto use these instruments to reduce credit risk,although in some cases they were able toachieve better portfolio diversification byassuming additional credit risks. Banks also

stepped up their efforts to increase resilience tooperational risks.

A more detailed analysis of the main structuraldevelopments in the EU banking sector can befound in the BSC’s report entitled “Structuralanalysis of the EU banking sector” published bythe ECB in November 2003.

1.2 COOPERATION IN CRISIS SITUATIONS

In early 2003 EU central banks and supervisoryauthorities agreed on a Memorandum ofUnderstanding (MoU) concerning cooperationin crisis situations. This MoU consists of a setof principles and procedures for cooperation incrisis situations involving individual creditinstitutions or banking groups, or relating todisturbances in financial markets and/or marketinfrastructures which could have potentialcommon implications for Member States. Theseprinciples and procedures deal specifically withthe identification of the national authoritiesresponsible for crisis management, the requiredflows of information between all authoritiesinvolved and the practical conditions forsharing cross-border information. In the courseof 2003, a crisis management simulationwas carried out with the aim of enhancingunderstanding of how the provisions of theMoU would assist the organisation ofcooperation and information-sharing betweenauthorities in practice. This exercise providedvery useful insights into the different aspects ofcross-border cooperation between bankingsupervisors and NCBs in the event of afinancial crisis.

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2.1 THE LAMFALUSSY FRAMEWORK

Following the results of the public consultationon the report by the EFC on “EU Arrangementsfor Financial Regulation, Supervision andStability”, the ECOFIN Council recommendedin December 2002 that the new Lamfalussyframework1, which was already in place in thesecurities sector, be extended to all otherfinancial sectors. The adoption of the newframework is expected to enhance the flexibilityand efficiency of the regulatory process, as itdistinguishes between primary legislation,adopted by the ECOFIN Council and theEuropean Parliament through the co-decisionprocedure (known as level 1 legislation), andsecondary legislation, which consists ofimplementing measures that can be adoptedmore quickly and in a more flexible way. Thiswill enable the regulatory process to respondmore quickly and effectively to technologicalchange and market developments. This newframework is also designed to meet the needfor effective supervisory cooperation andconvergence, and is thus expected to contributeto a more consistent implementation of EU rulesacross Member States.

The Lamfalussy framework relies in particularon the involvement of regulatory committeesin the different financial sectors. Thesecommittees, which are also known as level 2committees, are composed of representatives ofthe Member States nominated by the relevantministers. In addition, supervisory committees,also known as level 3 committees, have beenmandated to promote the convergence ofsupervisory practices, to enhance supervisorycooperation (including the exchange ofinformation on supervised institutions) and toprovide technical advice to the Commission ondraft implementing measures.

In November 2003 the Commission adopted aseries of measures to implement the Council’srecommendation. In the banking sector, theexisting Banking Advisory Committee (BAC)has been transformed into the regulatoryEuropean Banking Committee (EBC) and a new

Committee of European Banking Supervisors(CEBS) has been set up. Close cooperationbetween the ESCB’s Banking SupervisionCommittee (BSC) and the CEBS will besought to ensure that there is no overlap inactivities. In the insurance sector, the existingInsurance Committee has been convertedinto the regulatory European Insurance andOccupational Pensions Committee (EIOPC). Anew Committee of European Insurance andOccupational Pension Supervisors (CEIOPS)has also been established. In the areaof financial conglomerates, the regulatoryFinancial Conglomerates Committee (FCC) wasestablished in 2003 with no plans to set up asupervisory committee. The ECB participates asan observer or non-voting member in theregulatory and supervisory committees, withthe exception of those in the insurance sector.Thus the ECB is able to contribute to theshaping of EU financial regulation andsupervision in accordance with its institutionaltasks.

2.2 BANKING

In the area of banking regulation, the reviewof the framework for minimum capitalrequirements and the preparation of the NewBasel Capital Accord continued throughout2003. The ECB, which participates as anobserver in the relevant committees, continuedto contribute to the shaping of the newframework.

At the international level, the Basel Committeeon Banking Supervision (BCBS) madesubstantial progress in several areas. First, itfinalised and published in May 2003 the resultsof the third quantitative impact study (known asthe “QIS3”) aimed at gauging the overall impactof the new rules on banks’ minimum capitalrequirements. The study involved banks across43 countries and thus went well beyond thosecountries represented in the BCBS. Its main

1 “Final Report of the Committee of Wise Men on the Regulation ofEuropean Securities Markets”, 15 February 2001. This report isavailable on the European Commission’s website.

2 F I N ANC I A L R EGU L AT I ON AND S U P E RV I S I ON


findings were encouraging as they wereconsistent with the BCBS’s objectives toincrease the risk sensitivity of capitalrequirements while keeping the overall amountof current capital requirements broadlyunchanged. Second, the BCBS conducted twopublic consultations. The “third consultativepaper” was released in April 2003 andcomments were published in August. Thepublic consultation confirmed the broad supportfor the structure of the new Accord and the needto adopt a more risk-sensitive framework.Another public consultation was launched inOctober on proposed amendments that wouldchange the treatment of expected versusunexpected losses under the new Accord’sinternal ratings-based approach. In addition, theBCBS identified scope for further improvementin the areas of asset securitisation, credit cardcommitments and certain credit risk mitigationtechniques, on which work continues. The thirdarea in which the BCBS made substantialprogress was the analysis of issues concerningthe implementation of the new Accord, whichwill also be reflected in national legislation.These issues were increasingly taken intoconsideration by the BCBS through the work ofthe Accord Implementation Group. The BCBSalso released a paper specifying high-levelprinciples for the cross-border implementationof the new capital requirements.

In its response to the third consultative paperpublished on its website in September 2003, theECB reiterated its overall support for the Baselreform and acknowledged the progressachieved. In addition to its input on severaltechnical issues, the ECB focused on issueswarranting particular attention for bothfinalisation of the new Accord andimplementation of the new rules, as well as onfuture priorities. The ECB welcomed theproposals to tackle the potential pro-cyclicaleffects and pointed out that some improvementscould still be made by strengthening theincentives for banks to opt for more advancedrisk management policies. Special emphasiswas given to the importance of the timely

completion and implementation of thenew Accord. From a more forward-lookingperspective, the ECB underlined the need forclose monitoring of the new regime in order todevelop a full understanding of all its possibleimplications. The ECB also stressed the need toprioritise work on accounting and provisioning,as well as on the definition of own funds and onthe convergence of supervisory practices.

At the EU level, the reform of the regulatorycapital framework conducted within the remit ofthe Financial Services Action Plan (FSAP, seeSection 3 of this chapter) continued to followthe Basel reform process closely, while at thesame time taking European particularitiesinto account. In July 2003 the EuropeanCommission released a third working documentfor public consultation together with ananalysis of the EU results of the thirdquantitative impact study. Significant featuresof the EU context include the scope ofapplication of the new rules, the nature of theEU framework, the treatment of small andmedium-sized enterprises and the suitability ofthe framework for small and less complexbanks. Like the BCBS conclusions, the findingsof the European Commission on the quantitativeimpact study, released in parallel with the thirdconsultative proposals, were supportive of thereform’s main objectives. In addition, in April2003 the European Commission released twodocuments for consultation, one on real estatelending and one on the treatment of coveredbonds, and it subsequently published thecomments received on these two topics.

The ECB provided comments on the EuropeanCommission’s proposals for the revision of thecapital framework of banks and investmentfirms. The ECB supported the work beingundertaken at the EU level and highlighted theimportance of maintaining consistency betweenthe New Basel Capital Accord and the revisedEU framework and ensuring that they werecompleted and implemented at the same time.

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2.3 SECURITIES

In 2003 good progress was made on severalinitiatives to fill the gaps in the Europeansecurities markets legislation and to updateexisting rules. The ECB contributed tothe shaping of the relevant rules in the contextof both the preparatory discussions inthe appropriate EU committees and formalconsultations.

Within the context of the FSAP, two directiveswere adopted and a further two came closer tocompletion. In January 2003 the Market AbuseDirective was adopted, providing forharmonised rules on the prevention of insiderdealing and market manipulation, and in July2003 the Prospectus Directive was introduced,providing for a single passport for Europeansecurities issuers. In March 2003 the EuropeanCommission set out in its draft transparencydirective disclosure requirements for Europeanissuers listed on regulated markets. A commonposition was adopted in December by theECOFIN Council with regard to the proposalfor a new directive on markets in financialinstruments, which would replace the existingInvestment Service Directive dating back to1993.

In its opinion on this proposed new directive,the ECB welcomed the principles underlyingthe revised regulatory framework. An effectiveimplementation of the proposed directiveclearly has the potential to foster the integrationof European securities markets. Morespecifically, as regards the new regulatoryframework on trade execution, the ECBwelcomed the proposed strengthening oftransparency rules as a tool to avoid marketfragmentation and to allow investors to choosethe most efficient trading venues. However, theECB emphasised that the new transparencyrules should be applied to debt securities aswell as to shares, and that the means for a fullcomparison of all market prices should beprovided for.

2.4 OTHER ISSUES

The EU accounting framework has been at thecentre of debate owing to the legal requirementthat all listed European companies, includingbanks, prepare their consolidated financialstatements in accordance with InternationalAccounting Standards (IAS) by 2005. TheECB has a keen interest in this debate asthe accounting reforms will have a profoundimpact on the banking and financial industry.Furthermore, harmonised and high qualitystandards will provide a significantcontribution to the integration and efficiency offinancial markets in the euro area.

The ECB’s interest also stems from concernsthat the wider use of fair value for financialinstruments, mentioned in the IAS proposals,might have significant effects on financialstability. The Governing Council, particularlyin the light of analyses conducted in this areasince 2001, has reiterated in letters to the IASBoard and the European Commission itsconcerns about the potential implicationsfor financial stability of the introductionof fair value accounting for all financialinstruments, particularly in relation to thecompletion of IAS 39, which deals with therecognition and measurement of financialinstruments.

Finally, given the increasing number ofreforms being made to national supervisorystructures, the ECB published a report entitled“Developments in national supervisorystructures” in June 2003 in order to provide a“snapshot” of the main changes which hadrecently occurred in this area, together with theresulting institutional settings within the EUand the acceding countries.


The ESCB is committed to the integration ofEuropean financial markets and marketinfrastructures because of their key role in thetransmission of monetary policy and infinancial stability, and because their integrationshould help to create a level playing-field for allagents regardless of their location within theEU. In addition, Article 105 of the Treaty statesthat without prejudice to the objective of pricestability, the ESCB shall support the generaleconomic policies in the Community, amongwhich financial integration occupies aprominent position. This support takes the formof direct action, catalysis of collective actionand contributions towards raising the level ofawareness of the need for integration and themeans for achieving it.

In 2003 the ECB intensified its activities tohelp to achieve a broad-based integration ofEurope’s financial system, both by means of itsown activities and by contributing to the workof other European bodies within variouscommittees and fora.

THE ECB’S CONTRIBUTION TO THE EU STRATEGYFOR FINANCIAL SERVICESThe current framework for achieving a moreintegrated and efficient financial system in theEU is based on the 1999 Financial ServicesAction Plan (FSAP) and on a regulatoryprocess inspired by the 2001 LamfalussyReport. The first high-level assessment of thisframework is expected to take place in thesummer of 2004.

As agreed by the Heads of State or Governmentat the Brussels European Council in March2003, most legislative measures initiallyconsidered in the FSAP will have been adoptedby April 2004. The European Parliament willthen go into recess and further legislativework will be suspended. Work is still underway on several important initiatives. TheLamfalussy process is now being extendedto other financial sectors (see Section 2.1 of thischapter). Full and successful implementation ofthe Lamfalussy process should provide theEuropean financial system with a faster and

3 F I N ANC I A L I N T EGRAT I ONmore efficient regulatory structure than iscurrently the case.

While fundamental progress has been made inrecent years, there is still a considerable amountof work to be done to further integrate Europe’sfinancial system. New EU initiatives haverecently been launched to define the “post-FSAP” strategy, which will require the closecooperation of all those involved.

The ECB has been closely involved in this workand has provided its views in the form of ECBopinions, for example on the proposal forthe new directive on markets in financialinstruments (see also Section 2.3 of thischapter), and in the different fora where thevarious issues are discussed. In particular, theECB considers that the measures of the FSAPprovide the core legislative framework for thesingle market in financial services. Thepotential for further financial integration withinthis framework offers opportunities and poseschallenges to public authorities as well asmarket participants.

The ECB is of the opinion that it is importantfor public authorities to implement the FSAPmeasures in a coherent manner across MemberStates. The extension of the Lamfalussy processwill allow for more uniform technical rulesin this respect. This should contribute tothe establishment of a common regulatoryframework for market players which may alsobe quickly adjusted if needed. Furthermore, asintegration proceeds, the transmission channelsfor systemic risk are likely to change, whichjustifies increased cooperation and informationexchange between supervisors and centralbanks in order to promote a robust supervisoryand financial stability framework.

To complement public sector initiatives, marketparticipants also need to enhance theircontribution to EU financial integration throughcollective action in two main areas. First, theyneed to participate effectively in the policy-making process in the context of enhancedconsultation procedures at the EU level.

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Second, collective action by marketparticipants, possibly with the support ofpublic authorities, is equally warranted in thearea of market conventions and productstandardisation.

THE ECB’S ROLE IN FOSTERING COORDINATIONAMONG MARKET PARTICIPANTSBeyond its cooperation with other publicauthorities, the ECB also acts in collaborationwith the private sector in order to fostercollective action. The Short-Term EuropeanPaper (STEP) initiative and the activities of theEuropean Financial Markets Lawyers Group(EFMLG) are two examples of the ECB’sinvolvement in private sector initiatives.

The ECB welcomes and encourages the STEPinitiative, which is currently being carried outby a group of market participants under theauspices of the ACI, the Financial MarketsAssociation. This initiative aims to integrate thefragmented European markets for short-termdebt instruments and to promote theirdevelopment.

The ECB was requested to play the role offacilitator in this initiative, a role similar to thatplayed when it established the EONIA. Inparticular, the ECB has already hosted, at therequest and on behalf of private sectorparticipants, a public consultation on means offurther integrating this particular marketsegment.

STEP undertakes to create a de facto integratedwholesale market for short-term debtinstruments through the convergence ofexisting European markets. The aim is to helpmarket practices to converge under the existingEuropean and national legislative frameworksby means of market convention. This initiativewould rely on the voluntary participation ofissuers prepared to meet certain conditionsspecified in the market convention in order tohave their issuance programmes granted a STEPlabel. The above-mentioned conditions wouldnot substitute or change existing nationalregulations, but would be supplementary to

those already in existence. Credit institutions,other financial intermediaries (including issuersof asset-backed securities), corporations andpublic authorities would all be entitled to applyfor the STEP label for their issuanceprogrammes.

The EFMLG was established in 1999 and aimsto discuss and promote initiatives leading togreater harmonisation of European financialmarket activities (laws and market practices)following the introduction of the euro. TheEFMLG is composed of senior lawyers fromcredit institutions based in the EU and selectedon the basis of their personal expertise.Recently, the EFMLG provided support andassistance to the ACI with regard to the legalaspects of the STEP initiative. The group hasalso focused on the removal of legal barriers tothe cross-border use of collateral, the legalaspects of netting arrangements in the EU, theharmonisation of the legal framework for rightsin securities evidenced by book entries and thedematerialisation of securities, i.e. the processof issuing a security under an electronic schemerather than issuing physical certificates.2

SINGLE EURO PAYMENTS AREAIn 2002 the Eurosystem agreed on a cooperationmodel with the European Payments Council(EPC), i.e. the governance structure of theEuropean banking sector set up with the aim ofcreating a Single Euro Payments Area (SEPA)in which differences between the levels ofservice for national and cross-border retailpayments are to be eliminated by 2010.

The ECB participated as an observer in the EPCplenary, which is the decision-making body ofthe EPC, and the EPC working groups forcash, cards, straight-through processing (STP)and infrastructure. The Eurosystem formallyassessed the banking sector’s achievements interms of the SEPA in a progress report entitled“Towards a Single Euro Payments Area”published in June 2003. In this report, theEurosystem expressed strong support for the

2 For further details on the EFMLG see www.efmlg.org.


decisions taken and the general commitmentsmade by the EPC. One milestone was the launchof STEP 2 in April 2003 by the Euro BankingAssociation, a cooperative undertaking betweenEU-based commercial banks and EU branchesof non-EU banks. STEP 2 is a new retail cross-border system for the processing of bulkpayments (currently only credit transfers). It isthe first service provider for a pan-Europeanautomated clearing house (PE-ACH). STEP 2’sreceiver capability – which is a bank’scapability to receive a payment through thePE-ACH – was gradually extended to all EUbanks, thereby increasing its market share ofintra-EU credit transfers.

However, the progress report also made it clearthat should banks backtrack on their promiseddeliverables to achieve a SEPA, the Eurosystemwould consider regulatory measures in additionto its catalyst role. The Eurosystem specificallystressed the importance of implementing pan-European standards for STP as a prerequisitefor accomplishing a SEPA for all paymentinstruments.

In the progress report, the Eurosystem listedspecific indicators (known as “SEPAindicators”) for measuring progress madetowards a SEPA against the EPC’s ownobjectives and milestones. In the second half of2003, the EPC and the Eurosystem agreed on areporting framework for these SEPA indicators,including quarterly reports by the EPC tothe Eurosystem. The first report, deliveredat the end of 2003, showed progress indifferent areas, such as the implementation ofInternational Bank Account Numbers (IBAN)and the introduction of a basic credit transferservice (Credeuro) with a guaranteed speed ofexecution of three days.

In October 2003 the ECB, in cooperation withthe EPC, arranged a workshop on the SEPAtargeted specifically at involving accedingcountries in the SEPA process. Moreover,meetings were held in the course of the yearwith EU market participants in the ContactGroup for Euro Payments Strategy (COGEPS)

on the subject of large-value payments issues,as well as retail issues. Throughout 2003 theEurosystem also continued to cooperate closelywith the European Commission in view ofthe complementary roles played by the twoinstitutions in terms of facilitating the SEPA.In this respect, the ECB responded to thepublic consultation launched by the EuropeanCommission on a “New Legal Framework forPayments in the Internal Market”.

CONSOLIDATION OF THE EUROPEAN SECURITIESINFRASTRUCTUREThe Eurosystem has a keen interest in theintegration of the securities infrastructure at theEU level in order to ensure a level playing-fieldacross national boundaries. The process ofconsolidation of the EU securities clearing andsettlement industry continued in 2003 with themerger between two major central counterpartyclearing houses, Clearnet and the LondonClearing House. The merger in 2002 of thesecurities settlement systems Euroclear andCrestCo, which settle transactions for thestock exchanges served by Clearnet and theLondon Clearing House, marked anotherimportant step towards a more integratedsecurities infrastructure in the EU.

STATISTICAL DATA ON THE DEGREE OF FINANCIALINTEGRATION IN THE FINANCIAL SYSTEM OF THEEURO AREAIn 2003 further statistical data were provided toassess the level of financial integration in theeuro area’s financial system. Box 9 describessome of the measures used to assess the level ofintegration achieved in financial markets in theeuro area. Furthermore, the Eurosystem –together with academics – has promoted policy-relevant research on the level of integrationin the financial system of the euro area (seeBox 10).

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Box 9

MEASURES OF FINANCIAL MARKET INTEGRATION IN THE EURO AREA

Several quantitative measures can be used to measure the level of integration in euro areafinancial markets. This box briefly describes some of these measures and assesses the level ofintegration observed in different financial markets of the euro area.1

Measures of financial integration make it possible to assess the extent to which geographicalconsiderations affect the price of financial instruments and the behaviour of market participants.Some of these measures are based on the law of one price. They test whether assets which arecomparable and available in all euro area countries trade at the same price throughout the euroarea. Other measures estimate the relative importance of factors common to the euro area in thepricing of assets as opposed to idiosyncratic factors (notably country-related factors). Finally,some measures are used to quantify the effects of frictions on cross-border investment.

In general, most measures show that the degree of integration in the various financial markets isstill heterogeneous. While integration is quite advanced in many segments of the money market,it is less advanced in the bond and equity markets.

Yields on government bonds with similar, or in some cases identical, credit risk, maturity andissuing characteristics have not yet entirely converged. Differences in primary and secondarymarket liquidity or in the degree of development of derivatives markets connected to the variousindividual bond markets may partly account for this.

In the equity markets, the level of integration is not particularly high, although equity returnsappear to be increasingly determined by factors common to the euro area. At the same time, thehome bias in equity holdings (i.e. the fact that investors seem to allocate a disproportionatelylarge fraction of their equity holdings to domestic stocks) has decreased considerably over thepast few years. However, there are still a number of significant barriers to further integration inthe equity markets. Examples include cross-country regulatory differences and the considerablefragmentation of the euro area’s clearing and settlement systems.

In credit markets, there remains significant market fragmentation. For example, there arepersistent home biases in lending to and borrowing from non-financial corporations andhouseholds. Some of these home biases are “natural”, that is, explained by proximity advantageand information asymmetries; others are mainly due to regulatory obstacles, such as taxregulations, bankruptcy law, etc.

1 For further details of these measures, see the article entitled “The integration of Europe’s financial markets” in the October 2003 issueof the ECB’s Monthly Bulletin.


Box 10

RESEARCH NETWORK ON CAPITAL MARKETS AND FINANCIAL INTEGRATION IN EUROPE

In April 2002 the ECB and the Center for Financial Studies (CFS) launched a Research Networkto promote research on capital markets and financial integration in Europe. This Network aimsto stimulate and coordinate policy-relevant research by academic scholars and researchers frompolicy institutions, contributing significantly to the ECB’s understanding of the current andfuture structure and integration of the financial system in Europe and its links to the financialsystems of the United States and Japan. Further information can be found on the Network’swebsite (www.eu-financial-system.org). The Network’s first workshop was held at the ECB inApril 2002 and concentrated on agenda-setting, identifying five topics of priority for research:(i) bank competition and the geographical scope of banking activities, (ii) international portfoliochoices and asset market links between Europe, the United States and Japan, (iii) Europeanbond markets, (iv) European securities settlement systems (SSSs) and (v) the emergence anddevelopment of start-up financing and new markets in Europe. In March 2003 the secondworkshop, hosted by Suomen Pankki – Finlands Bank in Helsinki, addressed the first two ofthese topics. In November 2003 the third workshop, hosted by the Bank of Greece in Athens,focused on the third topic, as well as discussing the fourth and fifth topics.1 Within the contextof this Network, the ECB also established the “Lamfalussy Fellowship” programme, namedafter the first President of the EMI. This programme sponsors young researchers to conductvaluable research on the above-mentioned topics. Two years of work on the Network will beconcluded with a symposium at the ECB in Frankfurt in May 2004, presenting the mostimportant results found. Some of these results reveal first of all that some of the inherentcharacteristics of traditional loan and deposit business constrain the cross-border expansion ofcommercial banking, even in a common currency area. Second, some theoretical researchsuggests that supervisory structures may not be neutral towards further European bankingintegration. Third, there is increasing evidence that the introduction of the euro has contributedto a reduction in the cost of capital in the euro area. Fourth, too strong a vertical integrationbetween trading and securities settlement platforms can be an obstacle to the efficientconsolidation of SSSs. Finally, the growing globalisation of firms’ activities is one factorbehind the increasing correlation of equity returns observed around the world.

1 In October 2002 the ECB also held its Second Central Banking Conference. The proceedings are available on the ECB’s website, seeV. Gaspar, P. Hartmann, O. Sleijpen (eds), The transformation of the European financial system, June 2003.

With regard to the euro area banking system, theECB is developing a set of key indicators tomeasure the degree of integration in the system.These indicators are constructed on the basis ofquarterly stock data provided by MFIs. Theyprovide direct measures of cross-borderbanking business within the euro area. Inaddition to traditional measures of the share ofcross-border activity, these indicators alsofocus on the distribution of activity, the roleplayed by national banking systems as the huband the disparities between national banking

systems in terms of access. Indicators show thatthe share of cross-border activity is modest forthe retail segments of the banking business (seeBox 9), while it is more important and growingin the interbank market for deposits. It is worthnoting, however, that when conducting thesecross-border activities, banks are becomingincreasingly neutral as regards the geographicallocation of counterparties within the euro areafor retail and wholesale segments alike.

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New harmonised MFI interest rate statisticspublished for the first time in December 2003allow for a comparison of retail bank interestrates on deposits and loans across the euro areaon a harmonised basis (see Section 4 of Chapter2). These new monthly statistics contribute tothe assessment of the convergence towards asingle European financial market for depositsand loans and will increase the transparency ofbanking business in the euro area. Financialmarket statistics produced by the ECB alsoinclude price and volume indicators for themoney, bond and equity markets as well asvolatility and convergence measures across alleuro area market segments.


One of the statutory roles of the Eurosystem is toexercise oversight over payment and clearingsystems. This function aims to ensure that thegeneral organisation of the payment flows withinthe economy is efficient and safe. In particular,systemic risks arising either from themalfunctioning of payment and clearing systemsor from the contagion effects of a failure of aparticipant in the system should be minimised.

Furthermore, the Eurosystem takes a generalinterest in other infrastructures which areused for the transfer of securities, such assecurities clearing and settlement systems,because failures during the settlement ofcollateral could jeopardise the implementationof monetary policy and the smooth functioningof payment systems. Disruptions in securitiessettlement systems (SSSs) can spread topayment systems owing to the existence ofdelivery versus payment (DVP) mechanismsfor the transfer of securities and cash payments.Similarly, central counterparties’ inability toclear transactions can hinder the settlement ofsecurities transactions. In view of this generalinterest, the ECB met with the European CentralSecurities Depositories Association in 2003to discuss recent developments affectingsettlement service providers. Furthermore, theEurosystem discussed its collateral framework,which was subject to a public consultation in2003, as well as developments concerningshort-term securities, relayed links3 andsecurities transactions with market participantsat the Contact Group on Euro SecuritiesInfrastructures. Detailed information on themarket infrastructure is given in the ECB’spublication entitled “Payment and securitiessettlement systems in the European Union”,also known as the “Blue Book”.4

The Eurosystem’s oversight function extendsfrom systems for the exchange of very largepayments (“large-value payment systems”) andthe network providers on which those systemsrely to retail payment services as well as toother activities that could affect the smoothfunctioning of payments in the euro area.

4 OV ER S I GH T O F MARK E T I N F R A S T RUC TUR E4.1 OVERSIGHT OF LARGE-VALUE EURO

PAYMENT SYSTEMS AND INFRASTRUCTURE

THE TARGET SYSTEMThe oversight role of the Eurosystem comprisesall euro payment systems including thosemanaged by the Eurosystem itself, e.g. the Trans-European Automated Real-time Gross settlementExpress Transfer (TARGET) system. With regardto the latter, the minimum oversight standardsapplied are as strict as those applied to privatelyoperated payment systems.

According to the framework decided by theGoverning Council at the beginning of 2003,there are two major operational objectives forthe oversight of TARGET. First, overseersof TARGET (i.e. the NCBs for the domesticcomponents, the ECB for the EPM) are to reviewthe various aspects of the TARGET system andassess its compliance with the “Core Principlesfor Systemically Important Payment Systems”5

adopted by the Governing Council in 2001 as thebasis for its oversight policy on systemicallyimportant payment systems. Second, overseersare to inform those responsible at the NCBs andthe Governing Council of the results of thisassessment so that, if necessary, measures areconsidered and implemented to ensure fullcompliance with the Core Principles.

In 2003 TARGET overseers assessed allcomponents of TARGET against the CorePrinciples.6 The overall outcome of this

3 With a relayed link SSSs no longer have to establish a link with allother SSSs, but can limit themselves to one link with an intermediateSSS that is connected to many other SSSs.

4 In September 2003 the ECB published an addendum to the Blue Bookwith data on all 15 EU Member States from 1997 to 2001. Thispublication was prepared in cooperation with the NCBs.In addition, a two-day seminar for central bankers entitled “Paymentand securities settlement systems” was held at the ECB in the samemonth.

5 Report by the Committee on Payment and Settlement Systems entitled“Core Principles for Systemically Important Payment Systems”, BIS,January 2001. This report also includes an outline of theresponsibilities of the central banks in this respect. Responsibility Bstates that central banks should ensure that any systemically importantpayment system they operate complies with the Core Principles.

6 As part of the same assessment, overseers also evaluated the othereuro large-value payment systems, namely the French Paris NetSettlement (PNS), the Finnish Pankkien On-line Pikasiirrot jaSekit-järjestelmä (POPS) system, and the Spanish Servicio de PagosInterbancarios (SPI) against the Core Principles.

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assessment was positive, although issues forfurther improvement were identified. Theresults of this assessment will be made public.

EURO 1The Euro Banking Association (EBA) is acooperative undertaking between EU-basedcommercial banks and EU branches of non-EUbanks. The EBA created a multilateral large-value EU-wide payment system for euro credittransfers, called EURO 1. In April 2003 theEBA established a new retail cross-bordersystem, known as “STEP 2” (see also Section 3of this chapter). STEP 2 settles in EURO 1,making it necessary to implement sometechnical changes to the latter. In November2003 the EBA also introduced a new functioncalled the “Flexible Settlement Mechanism”allowing banks to settle their STEP 2 positionsin EURO 1 without becoming direct members/shareholders of EURO 1.

As overseer of EURO 1, the ECB evaluated thechanges to the system in respect of itscompliance with the Core Principles. The ECBfound only minor issues for concern, which didnot have any significant impact on the safetyand efficiency of EURO 1. The ECB willaddress these findings in cooperation with theEBA in due course.

CONTINUOUS LINKED SETTLEMENT SYSTEMThe Continuous Linked Settlement (CLS) is asystem designed to settle foreign exchangetransactions on a simultaneous, final andirrevocable basis. Prior to the introduction ofthe CLS, each side of a trade was paidseparately. The systemic risk in the event ofdefault was high considering the time intervalwhich typically elapsed between the settlementof the two sides of the trade. The CLS wasestablished as a market response to the pressureexercised by central banks to reduce foreignexchange settlement risk (known as “Herstattrisk”).7 The ECB performs a dual role withregard to the CLS. It is involved in theoversight of the system and it providessettlement services. Oversight of the CLS iscarried out by means of close collaboration

between the G10 central banks and the FederalReserve System as the lead overseer.

In September 2002 the CLS began settlingforeign exchange transactions in seven majorcurrencies on a payment versus payment (PVP)basis.8 In September 2003 four additionalcurrencies were added to the list of eligiblecurrencies.9 Following the start of liveoperations, banks quickly increased the valuesand volumes settled through the system. InDecember 2003 the CLS settled, on average,37,000 trades per day to the value of USD 550billion. After the US dollar, the euro is thesecond most important currency settled in thissystem, accounting for about one-quarter of allgross payments settled in the system.

Thanks to the PVP mechanism, the CLSstrongly reduces foreign exchange settlementrisk. The Eurosystem welcomes this risk-reducing factor. At the same time, however, theCLS introduces a certain degree of liquidityrisk, as banks are required to make substantialpayments into the CLS at a specific time of theday (between 7 a.m. and 12 noon C.E.T.) and, inthe event of a malfunctioning of the system,may not receive corresponding currencies asexpected. Banks have thus far handled theseliquidity requirements well. Their liquiditymanagement procedures seem to be welldeveloped, such that the liquidity demandnecessary to make CLS pay-ins has not had anegative impact on the overall market.10

7 The ECB cooperates with the other G10 central banks withregard to oversight and, more specif ically, systemicallyimportant settlement infrastructures, the smooth functioning ofwhich is of vital importance beyond the euro area.

8 These currencies are the US dollar, the euro, the Japanese yen,the pound sterling, the Swiss franc, the Canadian dollar and theAustralian dollar.

9 These currencies are the Danish krone, the Swedish krona, theNorwegian krone and the Singapore dollar.

10 Average funding requirements fall in the range of severalhundred millions of euro. The largest pay-ins account for, onaverage, around €1 billion, while the largest pay-in by anysingle bank thus far amounted to €5.9 billion. None of these pay-ins resulted in a negative impact on the euro money markets.


SWIFTThe Society for Worldwide Interbank FinancialTelecommunication (SWIFT) is a cooperativeorganisation created and owned by banks whichoperates a network to facilitate the exchange ofpayment and other financial messages betweenfinancial institutions throughout the entireworld. The ECB contributes to the oversight ofSWIFT, which is carried out by means ofcooperation between the G10 central banks andthe Nationale Bank van België/BanqueNationale de Belgique as the lead overseer.

In addition to SWIFT’s resilience to crises,much oversight attention was paid to thechangeover to a new network generation (theSWIFTNet migration), completion of which isscheduled by the end of 2004. SWIFT has keptthe overseers regularly informed of the status ofthe network roll-out, of any incidents or of anyenvisaged changes to the SWIFTNet migrationplan.

CORRESPONDENT BANKINGBanks often have arrangements to providepayments and related services to eachother primarily for payments across nationalborders. Such arrangements are referred toas correspondent banking. In the EU, eurocorrespondent banking is a highly concentratedactivity among a few players. A recent surveyconducted by the ECB among a sample of banksin the EU showed that the top 10% of reportingbanks accounted for almost 80% of thevalue (34% of the volume) of the reportedcorrespondent banking payments in euro.There are even some indications of furtherconcentration of the correspondent bankingbusiness.

At this stage, the Eurosystem does not see anyimmediate systemic risk in this high degree ofconcentration, as the share of correspondentbanking constitutes only a fraction of theoverall payment flows in euro. The largemajority of the payment flows are executedvia interbank funds transfer systems(e.g. TARGET). However, in view of theEurosystem’s interest in the stability of the

financial system as a whole, it will continue tomonitor developments in this particular area ofbusiness.

4.2 RETAIL PAYMENT SERVICES

OVERSIGHT OF RETAIL PAYMENT SYSTEMSIn order to carry out its statutory task ofpromoting the smooth operation of paymentsystems, the Eurosystem also refined its policystance on retail payment systems.

Following a public consultation initiatedin 2002, the Governing Council adopted“Oversight standards for euro retail paymentsystems” on 26 June 2003, which can be foundtogether with the accompanying press releaseon the ECB’s website. These retail standardsare based on the Core Principles forSystemically Important Payment Systems. Theadoption of standards in the field of retailpayment systems is aimed at fostering safetyand efficiency in this sector as well as atensuring the harmonised oversight of retailpayment systems in the euro area.

The retail standards provide indicators forcategorising retail payment systems assystemically important retail payment systems,retail systems of prominent importance andother retail payment systems. All CorePrinciples will be applied to systemicallyimportant retail payment systems, whereas onlya selection of six Core Principles will be appliedto systems of prominent importance. Otherretail payment systems will have to comply withother applicable standards (e.g. Eurosystemstandards for e-money schemes11 or standardsadopted at the national level).

E-MONEY SYSTEMSA common oversight approach by theEurosystem with regard to e-money wasdescribed in its report entitled “Electronicmoney system security objectives” in May

11 “Report on electronic money”, August 1998; “Electronic moneysystem security objectives”, May 2003.

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2003. These security objectives should ensurethe overall reliability and technical safety of theschemes and should also increase publicconfidence in these systems. These objectiveswere also designed with a view to achieving alevel playing-field for the different schemesfrom a regulatory point of view. All relevante-money schemes will be assessed against thesestandards by the NCBs in the course of 2004.

E-PAYMENTSIn recent years, the increasing use of newcommunications technologies and the need forspecific payment mechanisms for e-commercehave created opportunities for newintermediaries to facilitate the sending andprocessing of payment instructions. At the sametime, banks have also developed new means forcustomers to access their accounts and tooriginate payments.12 The ECB aims to providea forum for cooperation between stakeholdersand to offer analyses and statistics to supportthe work of the markets in further developingmore efficient and secure payment mechanisms.Its oversight activities vis-à-vis the provisionof payments via the internet and mobilenetworks will initially focus on the security ofthe corresponding instruments and systems. Inorder to achieve these objectives, in May 2003the ECB relaunched the electronic PaymentSystems Observatory (ePSO). The ePSOproject was initially launched in 2000 underthe auspices of the European Commission. Itconsists of a website used for sharinginformation on innovative electronic paymentsystems and instruments (www.e-pso.info) andcontains an electronic discussion forum, aninventory of e-payment schemes and articles ontopical subjects of interest.

4.3 SECURITIES CLEARING AND SETTLEMENTSYSTEMS

The Eurosystem has thus far played two roles inthe field of securities clearing and settlementsystems. First, the Governing Council assessesthe compliance of EU SSSs with specific userstandards.13 These standards were established

in January 1998 with a view to mitigatingthe risks to the Eurosystem when it conductsits monetary policy operations. Second, theEurosystem cooperates with other authoritiesresponsible for the regulation and oversight ofsecurities clearing and settlement systems at theEU level. Contributions to the GiovanniniGroup, a forum of financial experts whichadvises the European Commission on financialsector issues, were made and included inthe second Giovannini Report14. As regardsinternational cooperation, the ECB also tookpart in projects initiated by the Committeeon Payment and Settlement Systems (CPSS)and the International Organization ofSecurities Commissions (IOSCO) with a viewto developing recommendations for centralcounterparties. Finally, the ECB contributed tothe CPSS “Report on the role of central bankmoney in payment systems”15.

ASSESSMENT OF SECURITIES SETTLEMENTSYSTEMSThe Eurosystem assesses EU SSSs eligible forthe settlement of its credit operations on anannual basis. These assessments are aimed atlimiting the risks to which the Eurosystem isexposed during the settlement process. Thecriteria used for these assessments can be foundin the report entitled “Standards for the use ofEU securities settlement systems in ESCBcredit operations”, which was endorsed by theEMI in November 1997 and comprises ninestandards.

As part of the exercise carried out in 2003,22 SSSs were assessed (including four systemslocated in the three EU countries which have not

12 For further details see the article entitled “Electronification ofpayments in Europe” in the May 2003 issue of the ECB’s MonthlyBulletin.

13 In the absence of EU harmonised oversight standards, the userstandards have been regarded as de facto common standards forEU SSSs and, therefore, are dealt with in this chapter.Nevertheless, the user standards are not intended to be acomprehensive set of standards for the oversight or supervisionof SSSs.

14 “Second Report on EU Clearing and Settlement Arrangements”,the Giovannini Group, Brussels, April 2003, published on theEuropean Commission’s website at www.europa.eu.int.

15 BIS, August 2003.


yet joined the euro). By and large, thoseSSSs which were assessed complied withthe standards. However, in some casesimprovements are still necessary to achieve fullcompliance. The Eurosystem acknowledges andis monitoring the efforts being made by thesystem operators to enhance compliance withthe standards. For example, efforts have beenmade to increase operational reliability witha special focus on business continuity inthe event of a disaster. Some systems haveincreased the number of contingency sites andenhanced back-up facilities. Furthermore, insome countries amendments have been madeto the legal framework to enhance the legalsoundness of their systems. Finally, efforts toreduce the unwinding risk that can arise whentransactions are settled on a net basis have alsobeen made.

COOPERATION WITH THE COMMITTEE OFEUROPEAN SECURITIES REGULATORSIn 2001 the Governing Council approved aframework for cooperation on securitiesclearing and settlement systems between theESCB and the Committee of EuropeanSecurities Regulators (CESR). In particular, aworking group was set up, composed of arepresentative from each central bank of theESCB and from each securities regulator fromthe CESR.

The work of the group focused mainly ondeveloping European standards for clearingand settlement, based on the recommendationsof the CPSS and the IOSCO (referred toas “CPSS-IOSCO”). When developing thesestandards, the working group also took intoaccount the need to remove the barriers toefficient cross-border clearing and settlementprocesses in the EU, as identified in the above-mentioned Giovannini Group reports.

In 2003 the working group finalised aconsultative report consisting of a set of 19standards aimed at increasing the safety,soundness and efficiency of securities clearingand settlement systems in the EU. A public

consultation on these standards was conductedjointly by the ESCB and the CESR.

In its report, the working group sought toadopt a functional approach, i.e. to apply thestandards to all relevant functions related to thesecurities clearing and settlement business,without regard to the legal status of theinstitutions exercising these functions. Thus thefuture ESCB-CESR standards will apply tosecurities market infrastructures and, inparticular, to central counterparties and nationaland international central securities depositories.It is envisaged that some standards will alsoapply to major custodian banks (“systemicallyimportant custodians”) which are very activein the field of clearing and settlement. Sincepreventing distortion is important whenidentifying “systemically important” entities,the public consultation included a specificquestionnaire on the appropriateness ofincluding custodians and on how to identifymajor custodians. The results of the publicconsultation have been published on thewebsites of the ECB and the CESR. The reporton the ESCB-CESR standards is expected to befinalised by mid-2004.

ArtistJens FängeTitleJugend, 2003MaterialOil on canvasFormat132 × 122 cm

CHAPTER 4

EUROPEAN ANDINTERNATIONAL ISSUES


In 2003 the ECB continued to maintain itsregular contacts with Community institutionsand bodies. ECB representatives attendedmeetings of the ECOFIN Council when mattersrelating to the tasks and objectives of the ESCBwere discussed. The President of the ECOFINCouncil and the relevant Commissioner alsomade use of their right to participate in meetingsof the Governing Council when they deemed itappropriate. The President of the ECB and thegovernors of the NCBs participated in twoinformal meetings of the ECOFIN Council,which took place in Athens (Greece) and Stresa(Italy) in April and September respectively. ThePresident of the ECB also participated regularlyin meetings of the Eurogroup, which hascontinued to serve as a particularly importantforum for an open and informal policy dialoguebetween the ECB, the finance ministers of theeuro area countries and the Commission.Moreover, the ECB continued to attend thebiannual meetings of the MacroeconomicDialogue, which brings together representativesof the Member States, the Commission, theECB, the non-euro area central banks and theEU-level social partners.

In addition to these relations at the politicallevel, the ECB continued to participate inmeetings of various European bodies at seniorexpert and working levels, including, mostnotably, the Economic and Financial Committee(EFC), the Economic Policy Committee (EPC)and the newly created Financial ServicesCommittee (FSC). The ECB closely followedall discussions at the European level that wereof relevance for the pursuit of its tasks, takingpart, in particular, in discussions concerningthe draft Treaty establishing a Constitution forEurope (draft Constitution), the BroadEconomic Policy Guidelines and the Stabilityand Growth Pact.

1.1 POLICY ISSUES

CONSTITUTION FOR EUROPEIn July 2003 the European Convention on thefuture of Europe (Convention) finalised the

draft Constitution and transmitted it tothe European Council. In accordance withArticle 48 of the Treaty on European Union(TEU), the Italian Presidency of the Councilconvened an Intergovernmental Conference(IGC) to discuss and formally adopt changes tothe existing Treaties. The IGC started itsproceedings in October. At the EuropeanCouncil meeting on 12 and 13 December 2003,the Heads of State or Government could notreach an overall agreement on the draftConstitution. The European Council invited theIrish Presidency to make an assessment ofthe prospects for progress and report to theEuropean Council in March 2004.

The ECB followed the progress of both theConvention and the IGC very closely andcontributed to their deliberations on issues ofrelevance to the tasks and mandate of the ECBand the ESCB. These contributions includedtwo letters sent by the President of the ECB tothe Chairman of the Convention in May andJune 2003 to convey suggestions of theGoverning Council for improvements topreliminary drafts of the Constitution. Bothletters were made public on the ECB’s website.

In the summer of 2003 the Italian Presidency ofthe Council transmitted the Convention’s draftConstitution to the Council as a formal proposalfor the amendment of the Treaties and formallyinvited the ECB to deliver an opinion. Thecompetence of the ECB to deliver an opinion isbased on Article 48 of the TEU, which requiresthe consultation of the ECB in the event ofinstitutional changes in the monetary area. On19 September the ECB delivered its opinion tothe Presidency of the Council.1 In this opinion,the ECB welcomed the draft Constitution assimplifying, streamlining and clarifying thelegal and institutional framework of theEuropean Union. The ECB reaffirmed itsunderstanding that the necessary transfer of theprovisions on the ECB and the ESCB from thepresent Treaty to the Constitution would notentail any changes to the substance of their

1 CON/2003/20, OJ C 229, 25.9.2003, p. 7.

1 EUROP E AN I S S U E S

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tasks, mandate, status and legal regime. Whileattaching great value to institutional andoperational stability in the monetary domain,the ECB also signalled its awareness of the factthat a new Constitution had necessaryimplications for the institutional framework.However, it considered that the adjustments andupdates that the constitutional process wasenvisaging did not affect that stability.

Despite this generally positive assessment, theECB’s opinion identified some articles in thedraft Constitution which were of relevance forthe exercise of the ECB’s and ESCB’s functionsand tasks and would benefit from furtherclarification and adjustment.

The ECB’s principal suggestions were tointroduce a reference to “non-inflationarygrowth” or “price stability” in Article I-3 (3) onthe Union’s objectives, to clarify the ECB’sstatus in the institutional framework, to add areference to the ESCB and the Eurosystem inthe heading of Article I-29, which deals withthe ECB, the Eurosystem and the ESCB, torecognise the independence of NCBs inthis Article, to introduce a reference to thewidely recognised term “Eurosystem” in thedraft Constitution and to add an explicitreference to the responsibilities of the ESCB inArticle III-90 on the external representation ofthe euro.

The ECB intervened formally in thenegotiations of the IGC on one occasion. TheCouncil Presidency had proposed tosignificantly extend the current simplifiedamendment procedure for changes to Article10.2 of the Statute of the ESCB (for furtherdetails regarding the current procedure, seeChapter 8). The new procedure would havecovered any change to the basic provisionsgoverning the decision-making bodies of theECB and allowed for amendments to be madewithout ratification by the Member States. In aletter to the President of the EU Council dated26 November 2003, the ECB’s Presidentemphasised that the Governing Council hadserious concerns about this proposal, regarding

it as a far-reaching change to the currentconstitution of the ESCB. As a result, theCouncil Presidency decided to drop theproposal.

2003 BROAD ECONOMIC POLICY GUIDELINESThe Broad Economic Policy Guidelines adoptedin 2003 by the ECOFIN Council not only calledfor continued sound public finances but alsoplaced considerable emphasis on structuralreforms. In line with the Lisbon strategy,Member States were urged to pursue policiesaimed at integrating capital markets and toincrease competition in goods and servicesmarkets. In addition to recommendations toimprove the functioning of labour marketsthrough sound wage bargaining arrangementsand effective tax and benefit systems, the BroadEconomic Policy Guidelines also paid specialattention to the long-term sustainability of publicfinances in view of the ageing of the populationof the EU. From a procedural point of view,the 2003 Broad Economic Policy Guidelineswere for the first time adopted for a three-yearperiod, from 2003 to 2005 (as were theEmployment Guidelines). This new procedurereflects a desire to pay greater attention to theimplementation of policies, rather than to thefrequent adoption of new guidelines.

The ECB was involved in the discussions on theBroad Economic Policy Guidelines through itsparticipation in the EFC and the EPC. In thiscontext, the ECB welcomed the focus of theGuidelines on stability-oriented macroeconomicpolicies and structural reforms as well as theincreased emphasis on their implementation. Inits public statements and publications, the ECBcontinuously stressed that the implementationof structural reforms needed to be accelerated inorder to enhance the growth potential of theeuro area. In particular, the ECB sought to raiseawareness of the need to reform labour marketsand integrate financial markets (see also Box 5).

ECOFIN COUNCIL REPORT ON STRENGTHENINGTHE COORDINATION OF BUDGETARY POLICIESIn November 2002, in response to a request bythe European Council, the Commission


presented proposals to strengthen thecoordination of budgetary policies. TheECOFIN Council subsequently reviewed theCommission’s proposals and, in March 2003,adopted its own “Report on strengthening thecoordination of budgetary policies”. In itsreport, the ECOFIN Council agreed with theCommission that there was no need to changeeither the Treaty or the Stability and GrowthPact, or to introduce new budgetary objectivesor rules. At the same time, the ECOFIN Councilshared the Commission’s view that there wereareas where implementation could be improved.For example, the ECOFIN Council felt that,while the monitoring of nominal balancescontinued to be essential, compliance with theclose-to-balance-or-in-surplus requirement ofthe Stability and Growth Pact should beassessed in cyclically adjusted terms.Moreover, the ECOFIN Council consideredthat, when assessing Member States’ budgetarypolicies, attention should be paid to country-specific circumstances, such as the quality andlong-term sustainability of public finances andthe safety margin needed to prevent a breach ofthe deficit reference value of 3% of GDP. TheECOFIN Council also stressed that countrieswith deficits exceeding the close-to-balance-or-in-surplus requirement of the Stability andGrowth Pact must improve their cyclicallyadjusted budget position. In this context, theECOFIN Council recalled the Eurogroupagreement of 7 October 2002 that euro areacountries whose deficits exceed the close-to-balance-or-in-surplus requirement shouldreduce their underlying deficits by at least 0.5%of GDP per year.

Throughout the discussions on theCommission’s proposals, the ECB stressed thatthe rules and procedures of the Stability andGrowth Pact provide an appropriate frameworkfor fiscal policies in EMU. The ECB thereforefully supported the view of the ECOFINCouncil that changes to the Stability andGrowth Pact were not warranted.

IMPLEMENTATION OF THE STABILITY ANDGROWTH PACTIn 2003 the implementation of the Stability andGrowth Pact was at a critical juncture. In aneconomic environment that was less favourablethan previously expected, those Member Statesthat had failed to reach sound budgetarypositions during the previous upturn found itincreasingly difficult – and, in some cases, werealready seen to have failed – to respect thedeficit reference value of 3% of GDP. In 2002the ECOFIN Council had decided that anexcessive deficit existed in Portugal and issueda recommendation to Portugal with a view tobringing the situation of an excessive deficit toan end by 2003 at the latest. During 2003 theexcessive deficit procedure for Portugal washeld in abeyance pending this correction (seeBox 11 for an overview of the excessive deficitprocedure).

In January 2003 the ECOFIN Counciladopted a decision on the existence of anexcessive deficit in Germany and issued arecommendation to Germany with a view tobringing the situation of an excessive deficit toan end. The ECOFIN Council recommendedthat the German authorities adopt the correctivemeasures foreseen in their budgetary plansamounting to 1% of GDP in 2003 and that theexcessive deficit be corrected as rapidly aspossible and by 2004 at the latest.

The deficit and debt figures certified byEurostat in March 2003 subsequently showedthat France’s budget deficit also exceeded the3% of GDP reference value in 2002. As aconsequence, the ECOFIN Council adopted adecision in June 2003 on the existence of anexcessive deficit in France and issued arecommendation to France with a view tobringing the situation of an excessive deficit toan end. The ECOFIN Council recommendedthat the French authorities achieve asignificantly larger improvement than plannedat the time in the cyclically adjusted deficit in2003, and that the excessive deficit be correctedas rapidly as possible and by 2004 at the latest.

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In view of continued adverse fiscaldevelopments in France and Germany, theCommission decided in October and Novemberto initiate the next steps of the excessive deficitprocedures for these countries. To this end, theCommission issued recommendations forCouncil decisions on whether effective actionhad been taken or was proving adequate, andrecommendations for Council decisions givingnotice to France and Germany to take thenecessary measures to reduce their deficits. TheCommission expressed the view that France hadnot taken effective action, while the action takenby Germany was deemed inadequate. TheCommission recommended extending thedeadline for France and Germany to correcttheir excessive deficits from 2004 to 2005,citing worse than expected economic conditionsin these countries.

At its meeting on 25 November 2003, theECOFIN Council decided not to adopt thedecisions recommended by the Commission,explaining this action on the basis of both theworse than expected economic climate and thebudgetary commitments made by the French andGerman governments. Instead, it adoptedCouncil conclusions in which it decided to holdthe excessive deficit procedures in abeyanceand called on France and Germany to takemeasures that would ensure the correction oftheir excessive deficits by 2005.

In a statement issued immediately after theECOFIN Council meeting on 25 November, theGoverning Council expressed its deep regretregarding the decisions taken by the ECOFINCouncil. The Governing Council warned thatthe failure of the ECOFIN Council to follow therules and procedures foreseen in the Stabilityand Growth Pact risked undermining thecredibility of the institutional framework andconfidence in the soundness of the publicfinances of countries across the euro area.Noting the budgetary commitments by Franceand Germany, the Governing Council urgedthe governments concerned to live up totheir responsibilities, pointing out that it wasimperative that action be taken to limit negative

effects on confidence. The Governing Councilalso reassured the public that it remainedcommitted to maintaining price stability.

On 28 January 2004 the Commission broughtan action before the European Court of Justice,challenging the ECOFIN Council conclusionsof 25 November 2003 with a view to seekinglegal clarity regarding the application of therelevant provisions of the Stability and GrowthPact. The ECB shares the concerns of theCommission regarding the ECOFIN Councilconclusions and respects the Commission’sdecision to seek legal clarity in this matter.

On the same day the Commission announcedthat it would put forward proposals tostrengthen economic governance in the euroarea, including improvements to theimplementation of the Stability and GrowthPact. In this regard, the Governing Councildoes not see a need for changes to the Treaty,and the Stability and Growth Pact in its currentform is appropriate in its view. The ECB is inagreement with the Commission that theimplementation of the Stability and Growth Pactcould be further improved, in particular asregards the analysis of structural balances andstrengthening incentives for sound fiscalpolicies in good times. The clarity andenforceability of the fiscal rules should also beenhanced.

1.2 INSTITUTIONAL CHANGES RELATING TORELEVANT EUROPEAN BODIES

On 16 April 2003 the Accession Treaty wassigned, paving the way for the entry of ten newMember States into the EU as of 1 May 2004.As is customary following the signing of anaccession treaty, representatives of the accedingcountries have been granted observer status inthose Community institutions and bodies inwhich Member States are represented. They willbecome full members of these institutions andbodies on the date of accession.


Box 11

THE EXCESSIVE DEFICIT PROCEDURE

The excessive deficit procedure lays down the steps to be taken to assess and decide whether anexcessive deficit exists and to ensure its timely correction. It is based on Article 104 of theTreaty and on Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up andclarifying the implementation of the excessive deficit procedure. The latter is part of theStability and Growth Pact.

When the ratio of the planned or actual government deficit to GDP exceeds a reference value of3% and this excess is not small and temporary, or if the ratio of government debt to GDPexceeds a reference value of 60% and is not diminishing at a satisfactory pace, the Commissionprepares a report. The EFC prepares an opinion on this report and, if the Commission considersthat an excessive deficit exists, the Commission addresses an opinion to the ECOFIN Council.On the basis of a recommendation by the Commission, the ECOFIN Council adopts a decisionon whether or not an excessive deficit exists. If an excessive deficit is deemed to exist, theECOFIN Council recommends that the Member State concerned correct its excessive deficit andsets a deadline of no more than four months for the Member State to adopt corrective measures.The ECOFIN Council also sets a deadline for the correction of the excessive deficit, whichshould be completed in the year following its identification unless there are specialcircumstances. If the Member State adopts the recommended measures, the procedure is held inabeyance and the Commission and ECOFIN Council monitor their implementation. If themeasures are not adopted, the ECOFIN Council takes a decision to this effect and, within onemonth, gives notice to the Member State to take measures to reduce the deficit. The content ofthe notice may or may not differ from that of the earlier recommendation depending ondevelopments in the meantime. If these measures are adopted, the procedure is again held inabeyance and the Commission and the ECOFIN Council monitor their implementation. If,however, the necessary measures are not adopted within a period of no more than two months,as set by the ECOFIN Council, the ECOFIN Council takes a decision to impose sanctions.When the ECOFIN Council decides to impose sanctions, as a rule, a non-interest-bearingdeposit is required. If the excessive deficit is not corrected after two years, the deposit is, as arule, converted into a fine.

In summary, the excessive deficit procedure consists of three main steps. First, the decision thatan excessive deficit exists and the issuing of recommendations by the ECOFIN Council to theMember State concerned. Second, a notice by the ECOFIN Council to the Member State to takemeasures to reduce the deficit. And, third, the imposition of sanctions. If it emerges at any pointin time that the measures adopted by the Member State are not being implemented or are noteffective, the ECOFIN Council proceeds to the next step of the procedure. The potentialimposition of sanctions provides the ultimate incentive for the Member State to correct itsexcessive deficit in a timely manner.

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In order to ensure that they will continue tofunction effectively after enlargement, both theEFC and the EPC reviewed their compositionand working methods in the first half of 2003.Following these reviews, on 18 June 2003 theECOFIN Council amended the statutes of thesetwo committees. In the case of the EPC, it wasdecided to reduce the number of members thateach delegation appoints to the committee.Whereas previously the Member States, theCommission and the ECB could each appoint upto four members, the number of members perdelegation has been reduced to two under thenew statutes. In the case of the EFC, bycontrast, it was decided to leave the membershipof the committee unchanged. The MemberStates, the Commission and the ECB willcontinue to appoint two members each.Moreover, the two members appointed by eachof the Member States will continue to beselected from among senior officials from,respectively, the administration and the NCB.However, it was decided to vary participation inmeetings of the committee depending on theissues discussed. Whenever the committeediscusses issues related to the tasks andexpertise of NCBs, the committee will meet inits “full composition”, with all memberspresent. Otherwise, the committee may meet inits “restricted composition”, with only themembers from administrations, the Commissionand the ECB attending. The committee deems itimportant to retain the expertise and analyticalinsight of the NCBs, and to keep them involvedin issues for which they bear responsibility.

The review of the EFC’s working methods tookplace not only in view of enlargement, but alsoagainst the background of the new EUarrangements for financial stability, regulationand supervision (see Section 2 of Chapter 3). Inthis regard, at its meeting on 3 December 2002the ECOFIN Council asked the EFC to report toit on financial stability issues. In response tothis mandate, the EFC now undertakes regularreviews of financial stability. Relevant non-members, including the Chairman of theESCB’s Banking Supervision Committee,attend the meetings dedicated to this review.

In February 2003 the ECOFIN Councilestablished the FSC, which replaced the formerFinancial Services Policy Group. It reports tothe EFC and has the task of providing advice tothe ECOFIN Council and the Commission on awide range of policy issues affecting financialmarkets. The ECB has been granted observerstatus in the FSC.


The ECB and NCBs continued to participate inthe process of monetary, financial and economiccooperation at the international level.The arrangements for the internationalrepresentation of the ECB remained unchanged.Within the EU, the coordination of internationalmacroeconomic and financial issues continuedin the context of the EFC, as well as among theIMF Executive Directors representing the EUMember States, including the ECB Observer.

On 29 May 2003 the President of the UnitedStates issued an executive order extending tothe ECB the privileges, exemptions andimmunities provided to public internationalorganisations under the “InternationalOrganizations Immunities Act” of 1945. Thisfollowed the passage by the US Congress inNovember 2002 of legislation providing for theapplicability of this Act to the ECB. The newlegal framework should not only ensure betterprotection of the ECB’s assets held in theUnited States, but also facilitate a furtherstrengthening of bilateral relations withrelevant US institutions.

2.1 INTERNATIONAL MONETARY AND FINANCIALSYSTEM

MULTILATERAL AND BILATERAL SURVEILLANCEOF MACROECONOMIC POLICIESThe ECB regularly exchanged information andviews on economic developments and policieswith policy-makers outside the euro area andwith international institutions. The Presidentof the ECB, together with the EurogroupPresidency, participated in the globalsurveillance and exchange rate sessions of themeetings of G7 finance ministers and centralbank governors. The President of the ECB alsoparticipated in the discussions on the state ofthe world economy in other fora, such as themeetings of the G10 governors, which hecurrently chairs, and those of the ministers andgovernors of the G10 and the G20. At the IMF,the ECB Observer took part in the IMFExecutive Board’s discussions on the worldeconomic outlook and its regular reviews of

2 I N T E RNAT I ONA L I S S U E Sworld economic and market developments.Finally, at the OECD, the ECB participated inthe activities of the Economic PolicyCommittee, which focused on global economicdevelopments, prospects and policyrequirements.

The IMF and the OECD conducted their regularreviews of the monetary, financial andeconomic policies of the euro area. The IMFdecided to streamline, from 2003 onwards, itssurveillance of euro area policies by reducingthe number of fully-fledged Article IVconsultations on those policies from two to oneper year. The IMF also decided that IMF staffwould continue to carry out two missions peryear to the euro area authorities, including theECB, but that the IMF Executive Board woulddiscuss the outcome of the second mission onlyinformally. The fully-fledged Article IV reporton euro area policies, prepared by IMF staff,was published in September 2003.

In July 2003 the OECD published its EconomicSurvey of the Euro Area, which reviewed recentdevelopments and short-term prospects, as wellas fiscal, monetary and structural policies, andincluded a study on product market competitionpolicies. The survey, prepared by an OECDteam on the basis of, inter alia, a visit to theECB, was finalised by the Economic andDevelopment Review Committee of the OECDin which the Eurogroup Presidency, theEuropean Commission and the ECB jointlyrepresented the EU.

MONITORING OF DEVELOPMENTS IN GLOBALFINANCIAL MARKETSA number of international organisations andfora monitor global financial marketdevelopments. In 2003 the ECB and NCBsparticipated in these monitoring activities,providing their own analysis and views,particularly in the Financial Stability Forum(FSF), the BIS-based Committee on the GlobalFinancial System (CGFS) and the OECD’sCommittee on Financial Markets.

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The ECB Observer participated in the IMFExecutive Board discussions on the IMF’sGlobal Financial Stability Reports. The ECBalso participated as a member or observer in thework of a number of international institutionsand fora on specific aspects of the functioningof international financial markets. The FSFreviewed issues related to the reinsuranceindustry, credit risk transfers, audit practices,accounting standards, corporate governance andoffshore financial centres. The Basel Committeeon Banking Supervision continued its work onthe new Capital Accord (see Section 2 ofChapter 3). The CGFS published reports on“Credit risk transfer” and “Incentive structuresin institutional asset management and theirimplications for financial markets” andlaunched work on studying the role of ratingagencies in the area of structured finance andforeign direct investment in the financialsectors of emerging market economies. TheECB also took part in the activities of theCommittee on Payment and Settlement Systems(CPSS), which is chaired by a member of theECB’s Executive Board (see Section 4 ofChapter 3).

INTERNATIONAL FINANCIAL ARCHITECTUREThe ESCB contributed with its own assessmentand analysis to the ongoing discussions on thearchitecture of the international financialsystem in the IMF and related fora, boththrough direct participation and through itsinvolvement in EU coordination.

This included work on the promotion ofeconomic and financial stability, inter aliathrough improved debt sustainabilityassessments and greater attention to potentialbalance sheet weaknesses in emerging marketeconomies.

The international community also studied thecontribution of institution-building to economicperformance. In that context, the G20 held adiscussion on the role of institution-building inthe financial sector on the basis of case studiesprepared by a number of G20 members,

including an ECB contribution on experiencewith financial integration in the EU.2

With regard to the orderly resolution offinancial crises in emerging market economies,the IMF completed its review of access policy,i.e. the rules for determining the volume offinancial assistance to be given to a membercountry that is experiencing balance of paymentdifficulties. The IMF Executive Board agreedon a number of procedural requirements andsubstantive criteria governing access to itsresources beyond the normal limits, which areproportional to the quota assigned to each IMFmember country.

The debate continued on procedures to facilitateorderly sovereign debt restructuring. The ESCBtook the view that further progress wasdesirable with respect to the three broad groupsof instruments that had been proposed.3 Oneproposal involved modifying the contractualframework by including collective actionclauses (CACs) aimed at facilitating coordinationamong creditors. This proposal is already beingimplemented. In the course of 2003 there wassignificant progress towards a more widespreadinclusion of CACs in sovereign bonds issuedunder foreign jurisdictions. In an effort to leadby example, the EU Member States committedthemselves to including such CACs intheir relevant issues. A second proposal wasthe establishment of a Sovereign DebtRestructuring Mechanism (SDRM), a type ofinternational bankruptcy procedure whichwould have been embedded in international law.At the spring meeting of the IMFC in April2003, however, it became clear that there wasinsufficient political support for the creation ofeven a soft version of such a mechanism.Nevertheless, it remains to be explored to whatextent specific features of the SDRM – such asthe enhancement of transparency and disclosure,

2 “Globalisation: The role of institution building in the financialsector – The EU experience”, ECB, November 2003.

3 For more details see the article entitled “Crisis resolution inemerging market economies – challenges for the internationalcommunity” in the November 2003 issue of the ECB’s MonthlyBulletin.


aggregation across debt issues and the creationof a dispute resolution forum – could bereplicated outside an international legalframework. A third proposal was to develop acode of conduct to be implemented on avoluntary basis, which would set out bestpractices and guidelines for borrowers, lendersand the international official community. Workis currently ongoing on the drafting of such acode.

THE INTERNATIONAL ROLE OF THE EUROIn 2003 the ECB continued its analysis of theinternational role of the euro.4 It undertookwork to improve its statistical framework andits analytical understanding of the use of theeuro by non-euro area residents. New data weremade available, in particular on the currencybreakdown of the external trade of selected euroarea countries, on daily foreign exchangetransactions settled through Continuous LinkedSettlement (CLS) and on the euro’s role in theinternational loan market.

The ECB also launched work in 2003 onanalysing at the microeconomic level themarkets where the euro is mostly used by non-euro area residents. Particular attention waspaid to the City of London’s contribution to therole of the euro in financial markets outside theeuro area. Overall, the results of this reviewconfirmed that the international role of the eurocontinues to grow gradually, that it ischaracterised by a strong regional focus andthat it is, to a certain extent, driven by the euroarea itself.

The results also provided a clearer picture of boththe geographical distribution of the users ofthe euro and the extent of its global role. Incountries that are geographically remote fromEurope, agents have thus far used the europrimarily to borrow funds (issuance ofdebt securities) and in foreign exchangetransactions. Large US corporations have beenvery active issuers of euro-denominated bondssince the start of Stage Three of EMU, inparticular to diversify their investor base.Financial centres in the United States and Asia

together accounted for a not insignificantproportion of foreign exchange activity in euro.There are indications that financial marketparticipants from some of these countries tendto use the City of London as an entry point fortheir euro-denominated financial activities. Inaddition, according to market sources, demandfrom Asian investors for euro-denominatedbonds issued by non-euro area residentsincreased in 2003, which points to a broaderrole of the euro as an international investmentcurrency. However, the use of the euro as aninternational currency remains most prominentin countries neighbouring the euro area. Infinancial markets outside the euro area, a majorrole is played by the City of London. The shareof the City of London in financial activity ineuro by non-euro area residents typically rangesfrom one-third to two-thirds. Finally, additionalevidence gained in 2003 suggests that the euroarea is itself an important determinant of theinternational role of its currency, as it is a largeand financially open economy. Since the startof Stage Three of EMU, euro-denominatedbonds issued by non-euro area residents haveto a significant extent been targeted at andpurchased by euro area investors. Moreover,work conducted in 2003 highlighted that euroarea-owned banks are among the largest playersin euro-denominated markets in the City ofLondon, thereby contributing substantially tothe euro’s role in financial markets outside theeuro area.

2.2 COOPERATION WITH COUNTRIES OUTSIDETHE EU

As part of its international activities, the ECBcontinued in 2003 to develop a broad range ofbilateral relations as well as contacts inmultilateral frameworks with countries invarious other regions of the world. In the EU’sbroad geographical neighbourhood, the ECBextended cooperation with Russia, Turkey, theMediterranean region, the Middle East and

4 See “Review of the international role of the euro”, ECB,December 2003.

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Africa. Furthermore, relations with keyemerging market economies in Asia and thePacific and in Latin America were deepened.

In November 2003 the Eurosystem startedimplementing a two-year project to providetechnical assistance to the Central Bank ofRussia (CBR), funded by the European Unionwithin the framework of its programme ofTechnical Assistance for the Commonwealth ofIndependent States (TACIS programme). Theproject covers banking supervision andregulation, inspection and licensing, as well asbank rehabilitation. It draws on the vastexperience which NCBs and supervisoryauthorities in the EU have in the field ofbanking supervision. Nine NCBs5 and three EUnon-central bank supervisors6 will assignexperts to provide training to around 400members of the staff and management of theCBR over 24 months. The training will consistof courses and seminars, most of which willtake place in Moscow at the CBR premises, aswell as study visits by CBR experts to EUcountries. The ECB is coordinating the project.With this project, the Eurosystem intends tocontribute to further strengthening the CBR’sbanking supervision function as a key measureto foster a more stable financial environment.

The ECB continued its high-level policydialogue with the Central Bank of the Republicof Turkey (CBRT). Turkey currently has thestatus of a candidate country for EU accession.7

The discussions with the CBRT focused onTurkey’s macroeconomic stabilisation process,the planned introduction of a formal inflation-targeting framework by the CBRT and theeconomic situation in the euro area. In additionto the policy dialogue, technical cooperationbetween various business areas of the ECB andthe CBRT continued throughout 2003.

Over the past few years, the ECB hasestablished bilateral relations with centralbanks in the Mediterranean region. In October2003 the ECB, in cooperation with the Bancad’Italia, organised a technical workshop forrepresentatives of the central banks of the

5 The Deutsche Bundesbank, the Banco de España, the Banque deFrance, the Central Bank & Financial Services Authorityof Ireland, the Banca d’Italia, De Nederlandsche Bank, theOesterreichische Nationalbank, the Banco de Portugal andSuomen Pankki – Finlands Bank.

6 Rahoitustarkastus from Finland, the Finansinspektionen fromSweden and the Financial Services Authority from the UnitedKingdom.

7 The European Council in Helsinki in 1999 granted Turkey thestatus of a candidate for EU membership. The European Councilin Copenhagen in 2002 indicated that if the European Council inDecember 2004 decided that Turkey fulf illed the Copenhagenpolitical criteria, the EU would open accession negotiations withTurkey without delay.

8 Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon, Malta,Morocco, the Palestinian Authority, Syria, Tunisia and Turkey.

9 Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UnitedArab Emirates.

10 Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger,Senegal and Togo.

Barcelona partner countries.8 The workshopwas in preparation for a high-level Eurosystemseminar involving governors of Mediterraneancentral banks, which took place in January 2004in Naples. This seminar focused on economicand financial relations between the euro areaand the Mediterranean countries, on exchangerate arrangements and on financial sectorreforms highlighted by the workshopparticipants.

In the Middle East, the ECB further developedits relations with the Gulf Cooperation Council(GCC) in view of the intention of the six GCCmember states9 to launch a single currency by2010. In June the ECB participated in a meetingin Qatar of the GCC technical committee taskedwith preparing for monetary union.

In 2003 bilateral relations with central banks inAfrica continued to focus on issues related tomonetary unions. Several events provided theECB with the opportunity to contribute to thediscussions in the region on the basis of theexperience of EMU. The ECB was invited toparticipate in meetings of the Committee for theInstitutional Reform of the West AfricanMonetary Union,10 which were held at theBanque Centrale des Etats de l’Afrique del’Ouest (BCEAO) in Dakar, Senegal. TheCommittee, which includes experts from theBCEAO, other central banks, governments andacademia, is mandated to examine the BCEAO


statutes and the institutional set-up of themonetary area without prejudice to the existingexchange rate arrangement. Moreover, the ECBparticipated in the forum for finance ministersof the West African Monetary Zone11 that washeld in Accra, Ghana, to follow progresstowards monetary integration between English-speaking countries in the region. The ECBadditionally attended the annual governors’forum of the Macroeconomic and FinancialManagement Institute of Eastern and SouthernAfrica, which brought together, in Basel,central bank governors from 12 Africancountries. The forum discussed existingregional monetary union projects in Africa, aswell as the lessons on monetary integration tobe drawn from EMU.

In the course of the year, bilateral relations withEast Asia were further strengthened, not leastby a visit by a member of the Executive Board toKorea, Japan and Indonesia. The ECB alsoparticipated in the fifth Asia-Europe (ASEM)Finance Ministers’ Meeting in Bali, Indonesia,in July 2003. The contribution of the ECBfocused on economic integration in the EastAsian region, the role of central banks in crisismanagement and European experience withregulation and cooperation in pursuing financialstability.

In 2003 the ECB became a “collaboratingmember” of the Centre for Latin AmericanMonetary Studies (CEMLA), after havingparticipated in an increasing number of CEMLAconferences and meetings since 1999. One ofthe main objectives of CEMLA is to promote abetter understanding of monetary and bankingmatters in Latin America and the Caribbean, aswell as to inform on developments in regionaland international monetary and financialpolicies. CEMLA also initiated a project topromote convergence at a sub-regionalgrouping level.

11 Gambia, Ghana, Guinea, Nigeria and Sierra Leone.

ArtistKyriakos MortarakosTitleUntitledMaterialMixed media on canvasFormat220 × 320 cm

CHAPTER 5

ACCOUNTABILITY


Over the past decades, central bankindependence has emerged as a key institutionalfeature of the economic policy frameworks ofindustrialised countries. The decision to grantcentral banks independence from politicalinfluence is firmly grounded in historicalexperience, economic theory and empiricalevidence, which shows that central bankindependence is conducive to maintaining pricestability and thus contributes to overalleconomic welfare.

At the same time, it is a fundamental principleof democratic societies that public authoritiesneed to be accountable to the general public,from which their mandate and independenceultimately derive. Accountability can beunderstood as the legal and institutionalobligation of an independent central bank toexplain its decisions clearly and thoroughly tocitizens and their elected representatives,thereby holding the central bank responsible forachieving its objectives.

The Treaty establishing the European Community,which lays down the tasks and objectives of theESCB, has been ratified by all EU MemberStates in line with their national constitutionalrequirements. Thus, the European citizens haveendowed the ESCB with the mandate to maintainprice stability and, without prejudice to thisprimary objective, to support the general economicpolicies of the Community. At the same time, theTreaty contains precise reporting requirements,which allow the European public and their electedrepresentatives to hold the ECB responsible forattaining these objectives. This institutional set-uphas been reconfirmed by the Convention onthe future of Europe and included in the draftTreaty establishing a Constitution for Europe (seeSection 1 of Chapter 4).

From its inception, the ECB has acknowledgedthe fundamental importance of its accountabilityobligations and therefore maintains a regulardialogue with European citizens and theirelected representatives. This commitment isreflected, inter alia, in the numerous publicspeeches held by members of the Governing

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Council throughout the euro area in 2003. Suchcontacts with European citizens allow theEurosystem to explain the Governing Council’spolicy decisions and to directly address anyissues or concerns.

Beyond such direct contacts with Europeancitizens, the Treaty lays down a number ofreporting obligations for the ECB, of which theAnnual Report – addressed to the EuropeanParliament, the EU Council, the Commission andthe European Council – is one example. Otherreporting requirements include the publication ofa quarterly report and a weekly financialstatement. The ECB exceeds these requirementsby publishing comprehensive bulletins on amonthly basis. At the institutional level, theTreaty assigns a prominent role to the EuropeanParliament with regard to the accountability ofthe ECB (see Section 2 of this chapter).

In several respects, accountability is closelyrelated to transparency. Transparency meansnot only releasing information, but alsostructuring that information in such a way thatthe public can understand it. Transparencyfacilitates the process of holding central banksaccountable for their actions. The ECB regardstransparency as a crucial component of itsmonetary policy framework. Transparencyrequires central banks to clearly explain howthey interpret and implement their mandates.This helps the public to monitor and evaluate acentral bank’s performance. It also requires anexplanation both of the analytical frameworkused for its internal decision-making andassessment of the state of the economy andof the economic rationale underlying its policydecisions. Transparency is strongly enhancedby means of a publicly announced monetarypolicy strategy. In line with theseconsiderations, the ECB announced its monetarypolicy strategy in 1998. This strategy wasconfirmed and clarified in May 2003, followinga thorough evaluation by the Governing Council(see Section 1 of Chapter 1). The ECBthereby provided the general public with aclear benchmark against which the ECB’sperformance can be assessed.

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Transparency can render monetary policy moreeffective for several reasons. First, a centralbank can foster credibility by being clear aboutthe interpretation of its mandate and how it goesabout achieving it. When a central bank isperceived as being determined and capable ofachieving its policy mandate, it helps to anchorexpectations about future price developments.If, in turn, expectations are well anchored atlevels compatible with price stability, there isless reason for economic agents to deviate fromthe assumption of price stability when settingwages or prices and there is also a lower risk ofan inflationary or deflationary wage-price spiraldeveloping.

Second, a strong commitment to transparencyimposes self-discipline on policy-makers,which, in turn, helps to ensure that their policydecisions and explanations are consistent overtime. Facilitating public scrutiny of monetarypolicy decisions enhances the incentives fordecision-making bodies to fulfil their mandatesin an appropriate and consistent manner.

Third, by publicly announcing its monetarypolicy strategy and communicating its regularassessment of economic developments, thecentral bank provides guidance to the marketsso that expectations can be formed moreefficiently and accurately. This helps financialmarkets to better understand the responsepattern of monetary policy to economicdevelopments and thus to anticipate the broaddirection of monetary policy over the mediumterm. This, in turn, should contribute tosmoothing financial market developments.

In order to ensure that it is both accountable andtransparent, the ECB uses a variety ofcommunication tools, which go far beyond thereporting requirements laid down in the Treatyand which are explained in more detail inChapter 6.1

1 For a more detailed discussion of accountability andtransparency, see the November 2002 issue of the MonthlyBulletin.


2.1 OVERVIEW OF RELATIONS WITH THEEUROPEAN PARLIAMENT IN 2003

In line with the provisions of Article 113 of theTreaty, the ECB continued to report regularly tothe European Parliament on the decisions takenin the field of monetary policy and its othertasks. As in past years, the main forum for theexchange of views between the ECB and theEuropean Parliament were the quarterlytestimonies by the President of the ECB beforethe Committee on Economic and MonetaryAffairs. The President was also invited topresent the ECB’s Annual Report 2002 at theplenary session of the European Parliament.

Moreover, in line with common practice, othermembers of the Executive Board were alsoinvited to appear before the EuropeanParliament for an exchange of views on avariety of topics. In April 2003 the Vice-President presented the ECB’s Annual Report2002 to the Committee on Economic andMonetary Affairs. In March the Committeeon Economic and Monetary Affairs heardMr Issing’s views on the economicenvironment and on the draft Broad EconomicPolicy Guidelines for 2003-2005.

Beyond the scope of its Treaty obligations, theECB continued its voluntary practice ofreplying to written questions submitted bymembers of the European Parliament on issuesregarding the fulfilment of the ECB’s mandate.

Finally, the role of the European Parliament inthe appointment of a new President and othermembers of the Executive Board should also bementioned. Article 112 of the Treaty stipulatesthat the European Parliament shall give itsopinion on candidates prior to their appointmentby common accord of the governments of theMember States at the level of Heads of State orGovernment. In order to prepare its opinions,the European Parliament invited Mr Trichet andMrs Tumpel-Gugerell to appear before theCommittee on Economic and Monetary Affairsto present their views and answer questionsfrom Committee members. Following these

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hearings, the plenary of the EuropeanParliament endorsed both appointments.

2.2 VIEWS OF THE ECB ON SELECTED TOPICSRAISED AT MEETINGS WITH THE EUROPEANPARLIAMENT

While the testimonies before the Committee onEconomic and Monetary Affairs covered a widerange of policy areas, the main focus was on theECB’s monetary policy decisions and itsassessment of the economic and monetarydevelopments underlying these decisions. Thefollowing sub-sections deal with otherimportant issues raised by the EuropeanParliament and recall the views presented by theECB. Many of these issues are also addressedin the European Parliament resolution of 3 July2003 on the Annual Report presented by theECB last year.

REFORM OF THE VOTING MODALITIES OF THEGOVERNING COUNCILIn accordance with Article 10.6 of the Statute ofthe ESCB, on 3 February 2003 the ECBsubmitted a recommendation to the EU Councilfor a reform of the voting modalities of theGoverning Council (see Section 1 of Chapter 8for further details). The above-mentionedArticle also stipulates that the EuropeanCommission and the European Parliament shallbe consulted prior to any decision by the EUCouncil. In February 2003 the President of theECB presented the recommendation to theCommittee on Economic and Monetary Affairs.During the debate, the recommendation metwith criticism.

In its opinion of 13 March 2003, the EuropeanParliament rejected the ECB’s recommendationand suggested maintaining the existing rules,whereby all NCB governors of the Eurosystemhave the right to vote in the Governing Council.

In March 2003 the EU Council meeting in thecomposition of the Heads of State orGovernment unanimously adopted the newvoting modalities of the Governing Council,

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endorsing the ECB’s recommendation. Thereform of the voting modalities will enter intoforce following ratification by all MemberStates in accordance with their respectiveconstitutional requirements. The new votingmodalities will apply once the number ofNCB governors in the Governing Councilexceeds 15.

EVALUATION OF THE ECB’S MONETARY POLICYSTRATEGYThe President reported to the EuropeanParliament on the outcome of the GoverningCouncil’s evaluation of the ECB’s monetarypolicy strategy (for further details, seeSection 1 of Chapter 1). A number of membersof the Committee on Economic and MonetaryAffairs welcomed the confirmation andclarification of the strategy, in particular asregards the definition of price stability, and saidit ensured the continuity of the ECB’s policy.Other Committee members raised the issue ofwhether the ECB’s monetary policy strategywas symmetric in terms of avoiding bothinflation and deflation, and whether the ECB’sdefinition of price stability would takesufficient account of a potential measurementbias in the HICP.

The President explained that the ECB wouldcontinue to remain vigilant in terms of avoidingboth inflation and deflation. In this respect, therecent clarification that, in the pursuit of pricestability, the Governing Council would aim tomaintain inflation rates below, but close to, 2%of an annual increase in the HICP over themedium term, ensured a significant andadequate safety margin to guard against the riskof deflation. He added that, although the size ofthe measurement bias in the euro area was stilluncertain, available studies indicated that it waslikely to be limited. By making it clear that pricestability should be maintained over the mediumterm, the ECB took account of the fact that itwas impossible for a central bank to fine-tuneshort-term price developments and that thesecould therefore temporarily exceed the level ofprice increases regarded as compatible withprice stability.

In its resolution on the ECB’s Annual Report2002, the European Parliament welcomed theevaluation of the ECB’s monetary policystrategy and expressed its belief “thatthe clarifications will strengthen theappropriateness of the policy strategy for theyears to come”.

ACCOUNTABILITY AND TRANSPARENCYAccountability and transparency once againfigured prominently in the exchanges betweenthe ECB and the European Parliament. Theviews of both institutions remained, insubstance, unchanged. In its resolution on theECB’s Annual Report 2002, the EuropeanParliament reiterated its call for both thepublication of summary minutes and the balanceof votes in Governing Council meetings.

The President recalled that the ECB’s policy onthese issues reflected the specific institutionalenvironment in which the ECB operated, withmonetary policy decisions being taken at theeuro area level and economic policies remaininglargely the responsibility of the individualMember States. Given that this arrangement ranthe risk of making Governing Council membersseem like national representatives, the ECB haddecided not to provide any indications thatcould reveal – or lead to speculations about –individual voting behaviour. This would help toensure that Governing Council decisionscontinued to be taken exclusively from a euroarea perspective. The ECB’s approach alsohelped to focus public attention on the outcomeof policy deliberations rather than on individualvoting behaviour. Thus it ensured that itsmessages were clear, thereby enhancing theeffectiveness and predictability of its monetarypolicy decisions. Finally, the President recalledthat the communication channels chosen by theECB, in particular the monthly pressconferences held immediately after theGoverning Council meetings, were moreeffective in terms of timeliness than thepublication of minutes.

On a more general level, the Presidentemphasised the fact that the exchanges of views


with the European Parliament were carefullyassessed and taken into account in thedeliberations of the ECB’s decision-makingbodies. For example, the President mentionedthe publication of the staff economicprojections, which had come about as a result ofa request from the European Parliament. Indeed,the ECB would continue to seek ways ofenhancing its accountability and transparencywherever the accomplishment of its policyobjectives allowed.

INTERNATIONAL ROLE OF THE EURO ANDEXTERNAL REPRESENTATION OF THE EURO AREAAnother policy area considered in much detailby the European Parliament in 2003 was theinternational role of the euro and the externalrepresentation of the euro area. Severalmembers of the Committee on Economic andMonetary Affairs called for more active policiesin order to contribute to a greater use of thesingle currency at the international level, forinstance as an invoicing currency for the importof commodities and energy supplies to the euroarea. Moreover, in its resolution on theinternational role of the euro area and its firstassessment of the introduction of banknotes andcoins, adopted on 3 July 2003, the EuropeanParliament suggested the appointment of asingle representative for the euro area, whowould be given “broad powers to speak and acton behalf of euro zone countries in all importantmultilateral financial and economic fora”. In theEuropean Parliament’s view, this role could beperformed by a Vice-President of the EuropeanCommission responsible for Economic andMonetary Affairs.

The President recalled that, in the view of theECB, the international role of the euro wasessentially market-driven. Against thisbackground, the ECB would neither encouragenor discourage non-euro area residents to usethe euro. At the same time, the President alsosaid that the international role of the singlecurrency had gradually increased over the pastfew years. He shared the European Parliament’sview that there was a need to improve thestatistical framework for monitoring the use of

the euro at the international level, an objectiveto which the ECB was actively contributing andwhich was also addressed in its legal opinions.

As regards the external representation of theeuro area, the President emphasised that as faras the euro was concerned, the ECB wouldcontinue to act as the institution expressing theeuro area’s positions internationally, in linewith its responsibilities, as set out in the Treaty.According to its mandate, the ECB, asrepresented by members of its decision-makingbodies, was the single external voice of the euroarea for all matters related to the singlemonetary policy, a role that had also beenendorsed by the Convention on the future ofEurope.

ArtistGérard GarousteTitleLa duègne et le pénitent, 1998MaterialOil on canvasFormat195 × 160 cm

CHAPTER 6

EXTERNALCOMMUNICATION


Communication is an integral part of the ECB’smonetary policy and the performance of itsother tasks. In its communication with thepublic, the media and specialised audiences –such as financial market participants – the ECBseeks to contribute to the effectiveness,efficiency and credibility of its monetarypolicy. A further objective is to give fullaccount of its actions, as explained in moredetail in Chapter 5. In order to achieve theseobjectives, the ECB must be open andtransparent. It must enhance the public’sknowledge and understanding of its tasks andpolicies as well as its close collaboration withthe NCBs in the Eurosystem.

The ESCB’s communication efforts are targetedat audiences in the EU with particular focus onthe euro area. It is therefore important for theESCB to be able to address a variety of regionaland national audiences in their own languagesand environments. In this context, thedecentralised framework of the ESCB isinstrumental in ensuring the properdissemination of information to the generalpublic and to interested parties. Communicationexperts from the ECB and the NCBs regularlyexchange views in order to coordinate theirefforts.

In view of the forthcoming enlargement of theEU, the ESCB’s communication efforts havealso been increasingly directed towardsaudiences in the acceding countries. The ECBclosely cooperates with the acceding countrycentral banks, thus broadening the geographicalscope of its external communication.

1 COMMUN I C AT I ON PO L I C Y

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The ECB uses a number of communication toolsin order to meet the above-mentionedobjectives. The most important channels ofcommunication are the monthly pressconferences held by the President and the Vice-President, which are an essential tool for real-time communication, the Monthly Bulletin andthe Annual Report. The press conferences andthe Monthly Bulletin are used to present theECB’s assessment of economic developmentsand explain monetary policy decisions in atransparent and timely manner. The ECBremains one of the most transparent centralbanks in the world. The concept of a regular,real-time and detailed explanation of the ECB’spolicy, assessments and decisions, introducedin 1999, represents a uniquely open andtransparent approach to central bankcommunication.

The Annual Report is also particularlyimportant, as it is one of the statutorypublications of the ECB and is addressed to theEuropean Parliament, the EU Council, theEuropean Commission and the EuropeanCouncil. It presents the activities of the ESCBand the monetary policy of both the previousand the current year, and thus helps to hold theECB accountable for its actions.

The Monthly Bulletin also contains articlesproviding information on longer-termdevelopments, general central banking topicsand the analytical tools used by the Eurosystemfor the monetary policy strategy. A list ofarticles published in 2003 can be found in theannex on documents published by the ECB. InJanuary 2004 the Monthly Bulletin waspublished for the first time in its new format.This new format provided the basis for a reviewof the format of other publications and willeventually lead to the adoption of a newcorporate design for all ECB publications.

The President of the ECB makes quarterlyappearances in the form of testimonies beforethe European Parliament’s Committee onEconomic and Monetary Affairs and once a yearbefore the European Parliament at its plenary

2 COMMUN I C AT I ON TOOL Ssession. Other members of the Executive Boardof the ECB are also invited to appear before theCommittee (see Section 2 of Chapter 5).

Speeches and interviews given by membersof the ECB’s decision-making bodies alsoconstitute an important means ofcommunication.

Furthermore, as part of its regular reporting tothe financial sector and the general public, theECB publishes press releases on relevantGoverning Council decisions, on specialstudies conducted by the ECB and on othertopics of interest.

Dialogue with financial market participants andwith other interested parties is sometimesformalised through public consultationprocedures. In 2003 this instrument was used toreceive their views on issues related to paymentand securities settlement systems, as well as tothe collateral framework of the Eurosystem (seeChapter 2).

In addition, the ECB contributes to thedissemination of research findings on thewhole range of central bank activities bypublishing Working Papers and OccasionalPapers and organising academic conferences,seminars and workshops. In 2003 the mainevents of this kind included the “Seminar onBanknote Substrates”, the conference on“Private and public sector challenges in thepayment system”, organised by the ECB and theG10 Committee on Payment and SettlementSystems, the “Insolvency Symposium”, jointlysponsored with the BIS, the conference on“Prices, Productivity and Growth” organised incollaboration with the Banco de España, theconference on the “Euro Area Business CycleNetwork”, the “International Research Forumon Monetary Policy” in Washington D.C.,and a number of other workshops organisedin collaboration with various academicassociations and euro area NCBs.

All documents published by the ECB areavailable on the ECB’s website (www.ecb.int),


which also serves as a contact point for queriesfrom the public and as a platform for the launchof public consultations. The use of the websitehas grown rapidly over recent years. Inparticular, the “Statistics”, “Press releases” and“Job opportunities” sections are frequentlyvisited. In 2003 the ECB began redesigning itswebsite to facilitate searches for specificdocuments and to aid navigation between thevarious sections. Another important objectivewas to enhance the accessibility of the websitenot only for experts, but also for the general

public and disabled users. The launch of thisnew website is scheduled for the second quarterof 2004.

The ECB also practises openness in a literalsense, by welcoming visitor groups to itspremises in Frankfurt. In 2003 more than 7,000visitors received first-hand information in theform of lectures and presentations given byECB staff. Students of economics and othersocial sciences make up the majority of visitors.

3 COMMUN I C AT I ON I S S U E S I N 2 0 0 3Among the most important communicationissues in 2003 were:

– The evaluation of the monetary policystrategy. The Governing Council confirmedthe monetary policy strategy and clarifiedsome of its elements (see Section 1 ofChapter 1).

– The monetary policy stance (see Section 2 ofChapter 1).

– The Governing Council’s view on fiscaldevelopments in the euro area (seeSection 2 of Chapter 1).

– Monetary policy operations. Following apublic consultation procedure, a number ofchanges to the operational framework wereadopted to take effect in the first quarter of2004 (see Section 1 of Chapter 2).

– Counterfeiting of euro banknotes. The ECBcontinued to regularly inform the public ofdevelopments in the area of euro counterfeits(see Section 3 of Chapter 2).

– The ECB’s view on the draft Treatyestablishing a Constitution for Europe (seeSection 1 of Chapter 4).

– Supervisory issues and financial stability, inparticular the ECB’s participation in thepreparations for the introduction of the NewBasel Capital Accord (“Basel II”) (seeChapter 3).

– The Governing Council’s policy position onexchange rate issues relating to the accedingcountries (see Section 1 of Chapter 7).

– Cooperation with the central banks of theacceding countries and development ofworking relationships with the media inthose countries (see Chapter 7).

– Development of new and improved moneyand banking statistics (see Chapter 2).

– Organisational matters of the ECB, inparticular the preparations for the ECB’sfuture premises as well as the efforts tostrengthen the functioning of its internalorganisation (see Box 12 and Section 2 ofChapter 8).

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Box 12

THE ECB’S MISSION STATEMENT

In August 2003 the Executive Board adopted the ECB’s mission statement. It is regardedas fundamental in both the internal and external communication of the ECB. Its adoption shouldbe seen as part of the efforts to strengthen the functioning of the ECB’s internal organisation(see Section 2 of Chapter 8). The mission statement reads as follows:

“The European Central Bank and the national central banks together constitute theEurosystem, the central banking system of the euro area. The main objective of the Eurosystemis to maintain price stability: safeguarding the value of the euro.

We at the European Central Bank are committed to performing all central bank tasks entrustedto us effectively. In so doing, we strive for the highest level of integrity, competence, efficiencyand transparency.”

In four short sentences the mission statement captures the “what, why and how” of the ECB.The first sentence recognises the ECB’s vital relationship with the NCBs of the euro area. Thesecond sentence emphasises the primary objective assigned to the Eurosystem by the Treaty. Inaddition to this primary objective, the ECB also carries out a wide range of other tasks andactivities in the pursuit of its mandate, as reflected in the third sentence. The fourth and finalsentence illustrates the values which the staff and management of the ECB regard as importantfor the performance of their duties. In a survey, the staff of the ECB were given the opportunityto influence the choice of values which should be given particular prominence. All staffmembers were asked to rank a number of values according to their importance for the work ofthe ECB. The results of this survey served as direct input for the formulation of the missionstatement.

ArtistÁrpád SzabadosTitleUntitled, 1995MaterialMixed media on canvasFormat120 × 90 cm

CHAPTER 7

ENLARGEMENT OF THEEUROPEAN UNION


The ten acceding countries – the CzechRepublic, Estonia, Cyprus, Latvia, Lithuania,Hungary, Malta, Poland, Slovenia andSlovakia – and the 15 current EU Member Statessigned the Accession Treaty at the informalEuropean Council meeting in Athens on 16 April2003. Two additional countries – Bulgaria andRomania – have not yet concluded accessionnegotiations but were given the prospect ofjoining the EU in 2007.1 The Accession Treatysets out the framework and conditions forenlarging the EU to 25 Member States. All thecurrent and new Member States have ratified theTreaty. As part of the ratification process, all ofthe acceding countries except Cyprus heldpublic referendums: these nine countries votedin favour of joining the EU, eight of them by alarge majority.

Upon accession, the ten countries will joinEMU with the status of “Member States witha derogation” (countries which have not yetadopted the euro) and their central banks willbecome part of the ESCB. Once these countriesare deemed to have achieved sustainableconvergence in compliance with the Maastrichtconvergence criteria2, they will adopt the euroand their central banks will become part of theEurosystem.

In 2003 the Eurosystem continued to beinvolved in the accession process in all its areasof competence. It conducted policy andtechnical dialogues to help prepare the centralbanks of the acceding countries for integrationinto the ESCB and, subsequently, theEurosystem. As regards the policy dialogue, anumber of bilateral contacts were made with theacceding country central banks to discussmonetary and exchange rate policies and othercentral banking issues. The main aim was to tryto enhance mutual understanding of thechallenges ahead. In addition, the ECBcontinued to be involved in the “EconomicDialogue” between the EU and the candidatecountries3 and, in November 2003, it presenteda report on macroeconomic and financialstability challenges in acceding countries to theEconomic and Financial Committee. Finally, in

March 2004 a high-level seminar on theaccession process was held in Paris with allESCB and accession country central banks.Among other topics, this seminar coveredmonetary and exchange rate policies and thepractical functioning of the Exchange RateMechanism II (ERM II).

As far as technical cooperation in 2003 wasconcerned, the Eurosystem intensified itssupport for the acceding country central banksto help them prepare for membership of theESCB and the Eurosystem. These activitiesfocused primarily on statistics, legal issues,payment systems, monetary policy andoperational issues, but also involved other areasof central banking, such as financial stabilityand supervision, banknotes, internal audit andinformation technology.

This chapter gives an overview of recenteconomic, financial and legal developments inthe acceding countries and describes in moredetail some of the accession-related preparatoryactivities carried out by the Eurosystem.

1 The term “accession countries” is used to refer to the ten accedingcountries and Bulgaria and Romania.

2 See Article 121 (1) of the Treaty establishing the EuropeanCommunity.

3 The term “candidate countries” is used to refer to the 12 accessioncountries and Turkey.

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In 2003 the Eurosystem continued to monitoreconomic and financial developments inthe acceding countries. The most relevanteconomic issues for the Eurosystem wereinflation developments, monetary and exchangerate policies, economic growth andreal convergence, balance of paymentsdevelopments and fiscal policy. The monitoringof financial markets included recentdevelopments in both the banking sector andbond and stock markets.

1.1 ECONOMIC DEVELOPMENTS

INFLATIONInflation rates in the acceding countries havefallen remarkably quickly in recent years.Average inflation has now fallen from double-digit rates at the end of the 1990s to a level closeto that of the euro area. In early 2003 averageinflation was even below the euro area level.Towards the end of 2003 a pick-up in inflationrates to slightly above euro area levels wasrecorded. However, progress with disinflationcontinued to vary across individual countries.While some countries recorded very lowinflation and, in a few cases, even temporarydecreases in general price levels, thedisinflation process is not yet complete inothers.

The strong general decline in inflation rates waslargely the result of policy frameworks with aclear focus on fighting inflation. However,temporary factors also played an important role,in particular cyclical developments, the laggedeffects of strong exchange rate appreciationagainst the euro, some easing of energy pricesand a decline in food prices. Alongsidediminishing inflationary pressures, policyinterest rates continued to decline in mostacceding countries in 2003.

It will, however, be a real challenge to keepinflation at such low levels. Several factorscould lead to higher inflationary pressures,which in turn would make the economiesvulnerable to rising inflation expectations and

1 K E Y E CONOM I C AND F I N ANC I A LD E V E LOPMENT S AND PO L I C Y I S S U E S

wage-price spirals. First, cyclical conditionsare beginning to improve in some countries.Second, temporary factors such as decliningfood prices are fading out. Third, temporaryinflationary pressures may also arise fromaccession-related factors, such as pricederegulation, an adjustment of food prices asthe acceding countries adopt the CommonAgricultural Policy, and indirect taxadjustments required by EU law. Finally, thecatching-up process is likely to affect to someextent the inflation performance in the comingyears as a result of the “Balassa-Samuelsoneffect” (see Box 4) and wage pressures, theimpact of which is likely to depend on thebehaviour of nominal exchange rates.

MONETARY AND EXCHANGE RATE POLICIESThe acceding countries maintain a variety ofmonetary policy strategies, reflecting theheterogeneity among them in nominal, real andstructural terms. Some countries with fixedexchange rate regimes have an exchange ratetarget in place, while other countries operateinflation-targeting frameworks or mixedstrategies. Two countries peg their currencyunilaterally to the euro within a ±15%fluctuation band. During 2003 exchange rateregimes in the acceding countries remainedunchanged, although some refinements weremade to the monetary policy frameworks ofseveral acceding countries, mostly with a viewto gearing monetary policy more towards futuremonetary integration.

Monetary and exchange rate strategies inplace made a significant contribution tomacroeconomic stabilisation in the accedingcountries by providing a credible anchor forinflation expectations, taking into account thehigh degree of openness that most of thesecountries display. More recently, however,some countries with more flexible exchange ratearrangements have experienced an increase innominal exchange rate volatility. Thesedevelopments reflected a number of factors,including changes in investor sentimentfollowing new macroeconomic and fiscaldevelopments and, in some cases, possibly


external shocks. High exchange rate volatilitymay complicate monetary policy, have adverseeffects on trade and make it more difficult toassess equilibrium exchange rates.

When the new Member States join the EU, theywill be required to treat their exchange ratepolicies as a matter of common interest and topursue price stability as the primary objectiveof monetary policy. Moreover, they will beexpected to join ERM II at some point in time.Although ERM II can accommodate differentexchange rate regimes, it is not compatible withfree floating (or managed floats without amutually agreed central rate), crawling pegs orpegs against anchors other than the euro. Thismeans that, in some cases, exchange rate policyframeworks must be brought into line with thefeatures of the mechanism. Several accedingcountries are currently reviewing theirmonetary and exchange rate strategies in thelight of future participation in ERM II.

On 18 December 2003 the ECB published apolicy position of the Governing Council onexchange rate issues relating to the accedingcountries. This position aims to help to guidethe process of monetary integration in theprospective Member States.

ECONOMIC GROWTH AND REAL CONVERGENCEIn an environment of slow global growth,economic growth showed significant resiliencein most acceding countries in 2003, with realGDP growth projected to be around 3.5% onaverage. Output developments were particularlystrong in the Baltic States, and Poland, thelargest acceding country, experienced a solideconomic recovery after two years of lowgrowth. The key engine of growth in mostacceding countries was strong domesticdemand, fuelled in some countries by fiscalloosening and strong increases in wages. Inmost acceding countries real export growthmoderated but still displayed robust momentumconsidering the weak global environment andthe countries’ strong trade integration with theeuro area. In some countries the contribution of

net exports to real GDP growth actuallyincreased considerably.

At present, the GDP-per-capita gap with thecurrent EU Member States is still large for mostacceding countries. Expressed in purchasingpower parity terms, the acceding countries’estimated per capita GDP stood on average ataround 49% of the EU average in 2002. Interms of nominal exchange rates, however, itreached only 26% on average. Moreover, realconvergence in income levels with the EU is agradual process, with growth differentialsbetween the acceding countries and the currentEU Member States usually having been in therange of around 2 percentage points in the pastfew years.

In the years to come, a key challenge foracceding countries will be to advance realconvergence without putting currentachievements in terms of macroeconomicstability at risk. For most acceding countries, anaverage medium-term growth rate of between4% and 6% seems within reach, provided thatstructural reforms proceed and stability-oriented policies are kept in place. Real GDPgrowth is expected to rise as a number ofgrowth-enhancing factors increasingly comeinto play, in particular EU accession. Althoughstructural changes and high investment will beconducive to growth, they might also implyincreased output volatility, especially asinvestment tends to be more cyclical thanconsumption. This factor will thereforecontinue to pose challenges for policy-makers.

BALANCE OF PAYMENTS DEVELOPMENTSReal convergence was accompanied by sizeablecurrent account deficits in most accedingcountries. The average current account deficitfor the ten countries is estimated to have beenaround 3.9% of GDP in 2003, with deficitsbeing particularly high in some of the smallercountries. To the extent that the widening of thecurrent account deficit reflects savings andinvestment decisions based on incorrectperceptions of economic conditions – for

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example, an overestimation of potential outputgrowth or an underestimation of the probabilityof adverse shocks – the sustainability of theexternal position may come under pressure inthe medium to longer term and externalvulnerabilities may increase. Up to now,empirical findings have suggested that most ofthe acceding countries do not face majorcompetitiveness problems. Despite the globaleconomic slowdown, most countries havewitnessed sustained rates of export growth overthe past few years and, in many cases, haveenlarged their market shares in the EU.

Looking ahead, risks to external competitivenesscould arise if countries were to be confrontedwith strong pressure to align their wage andprice levels too quickly with those of the EU.Moreover, an inappropriate mix of loose fiscalpolicy and tight monetary policy could trigger astrong, albeit temporary, appreciation of thecurrency. Potential risks to current accountsustainability relate also to possible futurechanges in the financing pattern. Althoughcapital inflows are generally expected tocontribute to real convergence – for example,through imported technology and managementskills – they might imply some destabilisingeffects. This would be the case if the scale andnature of capital flows were to changesubstantially from the current pattern where netforeign direct investment (FDI) inflowsessentially cover the current account deficits inmany countries. Following the end of theprivatisation process in most of the accedingcountries, a potential slowdown in FDI inflowsmight pose a challenge within this context,although EU accession may boost greenfieldFDI inflows, i.e. investments in new projects,which may well compensate for diminishingprivatisation-related FDI. Managing highlyvolatile capital flows might become even morechallenging as macroeconomic policies focusincreasingly on preparing the ground forERM II and, subsequently, the adoption of theeuro. Furthermore, capital flows largely inexcess of the countries’ absorption capacitycould lead to overheating and more accentuatedoutput volatility.

FISCAL DEVELOPMENTSDespite the recent pick-up in economic activity,fiscal deficits in the acceding countriesremained on average at high levels in 2003: inthe order of 5% of GDP for the ten countries asa whole. At the same time, fiscal performancecontinued to vary across countries. In mostacceding countries fiscal deficits are largely of astructural nature, while the strength ofautomatic stabilisers (the automatic reactions ofthe budget to economic fluctuations) seems tobe limited. To consolidate the fiscal situation,the acceding countries will need to furtherreform their public expenditure and revenuestructures in a sustainable and forward-lookingmanner. Although the average debt level iscomparatively low in the acceding countries,running continuously high deficits at a timewhen privatisation receipts are coming to an endcould trigger unfavourable public debtdynamics, with possible repercussions forcapital flows and exchange rate developments.Moreover, implicit fiscal liabilities related tothe ageing of societies might pose an additionalchallenge, at least for some of the accedingcountries.

Fiscal consolidation is all the more challengingas the acceding countries will be confrontedwith expenditure pressures in the coming years.These will arise as a result of the completion ofthe transition process, contributions to the EUbudget, the continuing implementation of theacquis communautaire and budgetaryrequirements related to NATO membership.Moreover, forthcoming reforms of health andpension systems, as well as public investmentsduring the catching-up process, may have animportant bearing on fiscal accounts in theacceding countries. At the same time, theimplementation of the EU competition laws maylead to cuts in selected subsidies, which mayalleviate some of the fiscal strain.

Upon EU accession, the new Member Stateswill be subject to the provisions of the Stabilityand Growth Pact that apply to all EU MemberStates, including the requirements to avoidexcessive fiscal deficits and to aim for


budgetary positions that are close to balance orin surplus over the medium term. A crediblefiscal consolidation path is also needed in viewof the prospective future monetary integrationof acceding countries. While entry into ERM IIis not subject to a set of pre-established criteria,to ensure smooth participation in themechanism, major policy adjustments should bemade before countries join and a credible fiscalconsolidation path followed.

1.2 FINANCIAL MARKET DEVELOPMENTS IN THEACCEDING COUNTRIES

BANKING SECTORMost financial markets in the accedingcountries are shallow, reflecting the size ofthese economies and the low stock of credit anddeposits. While financial markets in theacceding countries are largely dominated by thebanking sector, the degree of financialintermediation (the role of banks asintermediaries in channelling funds fromdepositors to borrowers) is still rather low.This is not, however, the case in Cyprus andMalta as these countries did not have to undergoa transition from a centrally planned economy toa market economy. In the acceding countries ofcentral and eastern Europe, the level of financialintermediation amounts to only one-third of theeuro area average and is lower than in emergingmarket economies with comparable incomelevels. This is largely because of i) the initialconditions of the transition process,ii) the disruptive effects brought about bybanking crises in the early 1990s in thesecountries, iii) the relatively short track record ofdomestic enterprises, which translates intoheavy reliance on financing coming from ownsources, and iv) large FDI inflows into somecountries.

Nevertheless, despite their limited size, bankingsectors in the acceding countries appear to berelatively consolidated and sound, with anoverall satisfactory level of capitalisation,profitability and asset quality. Moreover, thebulk of the banking sector in the acceding

countries is foreign-owned: at the end of 2002,foreign ownership of the banking sector in theacceding countries (excluding Cyprus andMalta) amounted to around 70% of registeredcapital and 80% of total assets.4 Restructuringand consolidation in the banking sector throughprivatisation and opening up to foreignownership have contributed to the soundness ofthe sector by increasing capital and funding andenhancing technology, governance and riskmanagement expertise. Nevertheless, someacceding countries still have sizeable non-performing loans, even if these are on adeclining trend and provisions against relatedrisks appear to be relatively good. Moreover,the foreign-currency exposure of the enterprisesector is comparatively high in some countries.If the domestic currency were to weakensubstantially in any of these countries, creditrisks for the banking sector could emerge,which could in turn have implications for theconduct of monetary and exchange rate policies.

As the catching-up process to higher incomelevels proceeds, the main challenge for policy-makers will be to manage the deepening offinancial intermediation and a dynamicexpansion of financial institutions’ activitieswithout risking the stability of the sector or theeconomy as a whole. For example, it is likelythat domestic enterprises will rely increasinglyon external sources of finance, rather than oninternal funds. Likewise, as their incomeprospects and creditworthiness improve,households may increasingly engage inintertemporal consumption smoothing. In mostacceding countries financial intermediation hasgrown substantially in recent years, albeitstarting from a very low base. In 2002 and 2003credit growth to private firms and householdswas particularly strong in Cyprus, Hungary,Slovakia and the three Baltic States. Loans tohouseholds grew particularly quickly, outpacingthe overall credit growth rate. Regarding thedistribution of loans among economic activities,

4 Latvia and Slovenia stand out in this respect, as foreign ownershipof the banking sectors in these countries is considerably below theaverage.

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mortgage loans are one of the fastest growingcredit segments, having taken off fromnegligible levels. In 2002 and early 2003mortgage lending growth was particularlystrong in Hungary, Latvia and Poland.

Although the stock of credit remains low inmost acceding countries, and much of it issecured by mortgages, the rapid deepening offinancial intermediation and the expansion offinancial sector balance sheets may entail highervolatility in financial performance both inindividual financial institutions and the sectoras a whole. This highlights the need to maintaina credible and well-run prudential supervisionand regulatory framework in acceding countriesand calls, with regard to the financial sectorstructure, for greater cooperation between homesupervisors and those responsible forsupervising foreign parent banks.

BOND AND STOCK MARKETSThe size of bond markets differs acrossacceding countries, while government is themain issuer of debt securities in most of thecountries. The stock markets of most accedingcountries are relatively small, particularly ininternational terms, and the information andresearch coverage of these markets is selective.

Compared with key emerging markets, such asBrazil, Russia or Turkey, external debt marketsare small in all the acceding countries exceptPoland. Foreign debt levels differ acrosscountries and in some countries – such asEstonia and Latvia – there is a substantialdifference between net and gross debt levels.An acceleration of debt dynamics was alsoobserved in some countries.

In this context, the bond markets are thesegment that has developed most over the pastfew years, especially in the Czech Republic,Hungary and Poland. Macroeconomicstabilisation – in particular, disinflation andlower interest rates – and the prospect of EUmembership have helped to reduce country riskand attract investors, resulting in a significantfall in long-term yields on domestic bonds in

most of the acceding countries. However, in thesecond half of 2003, increasing concerns aboutthe course of fiscal policies and overall policyconsistency in some countries led to a reversalof some of the compression in yield spreadsvis-à-vis the euro area witnessed in previousperiods.

Yields of acceding countries’ sovereign bondsdenominated in key currencies remained at lowlevels. Yield compression vis-à-vis the euroarea was partly due to the global emergingmarket bond rally, although the prospect of EUmembership, together with the improvement ofsovereign ratings, also appears to have loweredspreads. More generally, the acceding countriesseem to have disconnected themselves fromdevelopments in other emerging markets. Thebenevolent effects of EU membership shouldcontinue to play a key role in macroeconomicand structural developments in this respect.However, conclusions about yielddevelopments should be drawn with cautionsince many acceding countries have ratherilliquid bond markets.

Stock markets in the acceding countriesperformed, on average, favourably in 2003 andbroadly in line with stock markets in otheremerging market regions, while outperformingeuro area stock markets. The stock markets inLatvia and Lithuania performed particularlystrongly, with share prices roughly doublingduring 2003. In Estonia and many centralEuropean acceding countries, stock marketsalso recorded solid gains. However, in a fewcountries, stock exchanges recorded a lessfavourable performance in 2003: in Cyprusstock prices fell, and in Malta the gains wereonly relatively moderate.


The Eurosystem has a crucial interest inensuring that acceding countries adopt andimplement in time the parts of the acquiscommunautaire (the body of EU law) that relateto its fields of competence. This refers to theTreaty and ESCB Statute provisions on centralbanks, and in particular central bankindependence, as well as EU legislation in thefinancial field. In 2003 the Eurosystem workedclosely with the acceding country central banks(ACCBs) to analyse the level of compliancewith these requirements.

As regards central bank independence, thestatutes of the ACCBs were analysed on thebasis of the criteria – institutional, personal,functional and financial independence – definedin the legal convergence reports prepared by theEMI and the ECB. The analysis was alsoconducted in the light of EMI and ECB opinionson draft national legislation in their field ofcompetence and, in particular, on the draftstatutes of the NCBs of the EU Member States.These opinions have helped the accedingcountries to revise their central bank acts tocomply with the Treaty requirements, thuslaying the foundations for independentinstitutions.

Central banks and financial institutions mustoperate within a sound legal environment. Theacquis communautaire includes important rulesfor the financial sector and central bankingactivities. It is crucial for the new MemberStates to comply with these rules as soon asthey join the EU (except where the AccessionTreaty provides for transitional arrangements).This is why the Eurosystem’s analysis alsofocused on legislation in the financial field,especially in the areas of freedom of movementof capital, prohibition on monetary financingand privileged access, regulation of thefinancial markets, collateral, payment systems,insolvency and banknotes.

The analysis gave an overview of the lawsenacted and legislative drafts that had beenpresented for adoption to the respective nationalparliaments by 1 October 2003. Movement

2 L EGA L D E V E LOPMENT Stowards central bank independence has startedin all of the acceding countries and in most ofthem it has been completed or is well advanced.In some cases, where the wording of thenational act was not yet fully in line with that ofthe Statute, the analysis suggested furtheradaptation of the national act. Theimplementation of the acquis in theEurosystem-relevant areas will take place, at thelatest, when these countries join the EU, subjectto any agreed transitional arrangements.

The results of this analysis were presented tothe ACCBs and to the EU Council and theEuropean Commission. This analysis was notpart of an assessment leading to the adoption ofthe convergence reports for the new MemberStates, which the ECB will have to prepareunder Article 122 (2) of the Treaty. Its purposewas to provide background information onthe preparations for implementing theEurosystem’s legal regime in the accedingcountries, which are to join EMU as MemberStates with a derogation. In addition, it helpedthe ACCBs to better define their role in theaccession process at the national level. It hasalso helped the Commission in furtherstrengthening the in-depth analysis of issuesrelating to central bank independence.

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In 2003 the Eurosystem intensified itsmultilateral and bilateral cooperation with theacceding countries. Since May 2003 thegovernors of the ACCBs have been attendingthe meetings of the General Council asobservers and ACCB experts have alsoparticipated as observers in meetings of ESCBcommittees and working groups (see Section 1of Chapter 8). This has made it much easier forall parties to carry out detailed work on a widerange of enlargement-related issues. Inaddition, technical consultations were heldregularly and a comprehensive programme ofvisits was implemented for senior experts fromACCBs.

In general, preparations for EU enlargement areon track, which should enable the ACCBs tointegrate smoothly into the ESCB as planned.

In 2003 the ECB set out an Accession MasterPlan with a view to guiding the planning,implementation and monitoring of all ECBactivities for ESCB and Eurosystemenlargement. The Master Plan was inspired bythe EMI Master Plan, which had laid down theorganisational and logistical frameworknecessary for the ESCB to perform its tasks inStage Three of EMU. Regular monitoringensures that all relevant issues are dealt with ina timely manner. This will enable the ACCBs tointegrate smoothly into the ESCB frameworkwithout affecting the overall operationalintegrity of the ESCB’s systems. Regularupdates of the Master Plan are communicatedthroughout the ESCB and to the ACCBs. Allactivities are being implemented according tothe Plan.

3.1 CENTRAL BANK OPERATIONS

In the area of central bank operations, thepreparations for accession were directed mainlytowards those central bank tasks that will beaffected by the enlarged ESCB membershipas of May 2004, in particular those concerningeligible assets and ERM II.

3 PR E PARAT I ON S F OR A C C E S S I ONAs regards eligible assets for the Eurosystem’scredit operations, certain assets listed only inacceding countries will be included in the list ofeligible assets from the day the ACCBs join theESCB. Therefore, from May 2004, the ACCBswill start performing the collateral managementfunctions of identification, assessment andreporting of eligible assets. In preparation, theECB organised a workshop for accedingcountries on these functions in November 2003.

The ESCB studied in detail the operationalfunctioning of an enlarged ERM II. In February2004 it held a workshop for acceding countrieson related aspects. This preparatory work,together with testing to be conducted in spring2004, should guarantee the smooth operationalfunctioning of ERM II.

In addition to the areas affected by ESCBenlargement, significant steps were also takenin operational areas related to Eurosystemenlargement. For example, studies werelaunched on the implications of enlargement formonetary policy implementation and themanagement of the ECB’s foreign reserves.

3.2 PAYMENT AND SETTLEMENT SYSTEMS

In 2003 the ECB defined the modalities forintegrating the acceding countries intoTARGET, essentially offering them thepossibility of connecting to TARGET whenthey join the EU. However, most accedingcountries only plan to join the system when theyadopt the euro. Work has also been carried outon developing a fall-back solution to be used ifthe shared platform of TARGET2 (see Section2.2 of Chapter 2) is not available when the firstacceding countries join the euro area.

As a follow-up to the 2002 assessment of thesafety and efficiency of market infrastructuresand the related oversight functions, ACCBsreported on the progress they had made in 2003in implementing the ECB’s general and country-specific recommendations. Substantial progresshas been made and the ACCBs are continuing


their efforts to complete outstanding issues,where necessary, in close cooperation withother national parties concerned.

The ECB also organised a series of workshopsfor the ACCBs aimed at providing assistance inthe preparations for accession to the EU and,subsequently, the euro area. One workshop inWarsaw focused on the preliminary results ofwork carried out jointly by the ESCB and theCommittee of European Securities Regulatorson standards for EU securities clearing andsettlement systems. Another workshop inPrague addressed the collateral framework ofthe Eurosystem with a view to enabling theACCBs to adjust to the key features of thisframework as soon as possible. And a thirdworkshop in Ljubljana examined cost, benefitand risk issues relating to central counterpartyclearing. Furthermore, the “Repo conference forcentral banks – the landscape of the Europeanmarket” held in Rome focused on recentdevelopments as well as requirements for theestablishment of an efficient and integrated repomarket, particularly in the light of EUenlargement. All these events were organisedby the ECB in cooperation with the local centralbank.

Moreover, during 2003 the Eurosystem helpedthe ACCBs to carry out self-assessments oftheir securities clearing and settlement systemsagainst the “Standards for the use of EUsecurities settlement systems in ESCB creditoperations”. These standards have provided thenecessary framework for the efficient and safeexecution of central bank credit operations (seeSection 4.3 of Chapter 3). The objective of theassessment was to identify, at an early stage,issues that needed to be addressed to ensure thesmooth functioning of the Eurosystem creditoperations. A total of 20 securities settlementsystems and one arrangement operated by anACCB were assessed and a list ofrecommendations was produced for eachsystem. These recommendations will have to beimplemented to make the system fully eligiblefor use in Eurosystem credit operations.

The ECB met for the fifth time with the Centraland Eastern European Central SecuritiesDepositories and Clearing Houses Associationin October 2003. At this meeting the ECBprovided information on a wide range ofaccession-related issues to representatives ofACCBs, securities regulators, central securitiesdepositories and clearing houses.

The ECB and the European Payments Council,which was established by the European CreditSector Associations and the major banks,organised a special workshop for selectedACCB representatives and their respectivebanking communities. The purpose of thisworkshop, which was also attended by theEuropean Commission, was to share importantinformation on how to successfully integratethe acceding countries into the Single EuroPayments Area.

3.3 BANKNOTES

In 2003 the ECB supported the ACCBs inestablishing the infrastructure for handling eurocounterfeits. The infrastructure must be in placewhen the acceding countries join the EU.Moreover, in view of the long lead time forpreparing the cash changeover in thesecountries after adoption of the euro, the ECBorganised workshops for the ACCBsaddressing, in particular, the arrangements forthe issuance and handling of euro banknotesand the procurement of banknote launchrequirements in the acceding countries.

3.4 STATISTICS

At a high-level meeting in Copenhagen in October2002, the ministers for economics and financefrom the EU Member States and the candidatecountries invited the European Commission(Eurostat) and the ECB to provide an Action Planfor economic, monetary and financial statistics forcandidate countries. This Action Plan wasprepared and subsequently endorsed at a high-

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level meeting with the candidate countries in May2003. The participants noted that the completenessand timeliness of statistical information had beensteadily improving. However, the Action Plan alsorevealed that, unless major efforts were made inthe run-up to accession, the acceding countrieswould not be in a position to meet all requirements,i.e. data timeliness, level of detail and other qualityaspects.

The Action Plan puts emphasis on the supply ofstatistics required for the purpose of assessingconvergence and on structural statistics. It ismade up of two main parts: the first part refersto statistics which fall under the responsibilityof the European Commission (Eurostat),namely annual national accounts, governmentdeficit and debt, the HICP, structural indicatorsand short-term statistics. Most action pointsaim at improving i) the availability of statisticsand conceptual compliance by May 2004 andii) compliance with EU statistical regulations ingeneral. The second part of the Action Plancovers issues under the responsibility of theECB in the fields of balance of payments(b.o.p.) and international investment position(i.i.p.) statistics, money, banking and financialmarket statistics and quarterly financialaccounts. These statistics are mainly collectedvia the ACCBs. The action points in this partaim at ensuring compliance with therequirements of the ESCB.

Both parts of the Action Plan are subject toregular review. A high-level progress reportdrafted by the European Commission (Eurostat)and the ECB is to be published in mid-2004. Inaddition, the Executive Board of the ECB hasset up a biannual progress review for theindicators for which the ECB has primary orshared responsibility.

3.5 IT INFRASTRUCTURE AND APPLICATIONS

Significant progress was made in 2003 inpreparing the IT infrastructure and applicationsfor ESCB enlargement. Three major elements

are being enhanced to provide the necessarynetwork and communications infrastructure.

The core network is the physical connectionbetween the ESCB central banks for data andvoice communication. A new core network isbeing set up to connect all members of theenlarged ESCB. The detailed technical designwork for this network began in July 2003.

In October 2003 the ECB started to implement aproject to extend the ESCB-wide datacommunications infrastructure (the “ESCB-Net”) to the ACCBs. The ESCB-Net is a datacommunications platform which hosts themajority of ESCB-wide applications. Theseinclude the applications required for supportingmonetary policy, carrying out ECB foreignreserve operations, exchanging statistical andnon-statistical data, and monitoring currencyinformation.

The “ESCB Teleconference System” is alsobeing extended to the ACCBs. Newteleconference equipment is being installed toallow all current and new ESCB members toparticipate in teleconferences via the samesecure infrastructure.

Preparations were also made for the significantenhancements to IT applications that arenecessary for the enlargement of the ESCB and,subsequently, the Eurosystem. IT applicationsfor the exchange of statistical data wereupdated. The necessary changes to theapplication for combating euro counterfeitingare ongoing and will be completed before theACCBs join the operational framework of theESCB.

ArtistKoen VermeuleTitleUntitled (detail), 2002MaterialOil on canvasFormat210 × 210 cm

INSTITUTIONALFRAMEWORK,

ORGANISATION ANDANNUAL ACCOUNTS

CHAPTER 8


1.1 THE EUROSYSTEM AND THE EUROPEAN SYSTEM OF CENTRAL BANKS

1 D E C I S I ON -MAK I NG BOD I E S AND CORPORAT EGOVERNANCE O F THE E CB

The European System of Central Banks (ESCB)is composed of the European Central Bank(ECB) and the national central banks (NCBs) ofall EU Member States (currently 15, 25 as of1 May 2004), i.e. it includes the NCBs of theMember States which have not yet adopted theeuro. In order to enhance transparency andfacilitate understanding of the structure ofcentral banking in the euro area, the GoverningCouncil has adopted the term “Eurosystem”,which comprises the ECB and the NCBs of theMember States which have adopted the euro. Aslong as there are Member States which have notyet adopted the euro, it will be necessary tomake a distinction between the Eurosystem andthe ESCB.

The ECB has legal personality under publicinternational law. It was established as the coreof the Eurosystem and the ESCB and ensures

that their respective tasks are carried out eitherthrough its own activities or via the NCBs.

Each of the NCBs has legal personalityaccording to the national law of its respectivecountry. The euro area NCBs, which form anintegral part of the Eurosystem, carry out thetasks conferred upon the Eurosystem inaccordance with the rules established by theECB’s decision-making bodies. The NCBs alsocontribute to the work of the ESCB throughtheir participation in the various ESCBcommittees (see Section 1.5 of this chapter).They may perform non-Eurosystem functionson their own responsibility, unless theGoverning Council finds that such functionsinterfere with the objectives and tasks of theEurosystem.

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Bank of Greece

Banco de España

Banque de France

Central Bank & FinancialServices Authority of Ireland

DanmarksNationalbank

Banca d’Italia

Banque centrale duLuxembourg

De Nederlandsche Bank

Oesterreichische Nationalbank

Banco de Portugal

Suomen Pankki – Finlands Bank

Sveriges Riksbank

Bank of England

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Governing ExecutiveCouncil Board

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The Eurosystem and the ESCB are governed bythe decision-making bodies of the ECB: theGoverning Council and the Executive Board.Decision-making within the Eurosystem and theESCB is centralised. However, in taking itsdecisions on the way in which the above tasksshould be carried out, the ECB is committed tothe principle of decentralisation in accordancewith the Statute of the ESCB. The GeneralCouncil is constituted as a third decision-making body of the ECB, if and for as long asthere are Member States which have not yetadopted the euro. The functioning of thedecision-making bodies is governed by theTreaty, the Statute of the ESCB and the relevantRules of Procedure.1

1.2 THE GOVERNING COUNCIL

The Governing Council comprises all themembers of the Executive Board and thegovernors of the NCBs of the Member Stateswhich have adopted the euro. According to theTreaty, its main responsibilities are:

– to adopt the guidelines and take the decisionsnecessary to ensure the performance of thetasks entrusted to the Eurosystem; and

– to formulate the monetary policy of theeuro area, including, as appropriate,decisions relating to intermediate monetaryobjectives, key interest rates and the supplyof reserves in the Eurosystem, and toestablish the necessary guidelines for theirimplementation.

The Governing Council meets, as a rule, twice amonth at the ECB’s premises in Frankfurt amMain, Germany. Specifically at its first meetingin the month it, inter alia, conducts an in-depthassessment of monetary and economicdevelopments and takes related decisions, whilethe second meeting usually focuses on issuesrelated to other tasks and responsibilities of theECB and the Eurosystem. In 2003 two meetingswere held outside Frankfurt: one was hosted by

the Banca d’Italia in Rome and the other by theBanco de Portugal in Lisbon.

When taking decisions on monetary policy andon other tasks of the ECB and the Eurosystem,the members of the Governing Council do notact as national representatives, but in a fullyindependent personal capacity. This is reflectedby the principle of “one member, one vote”applied within the Governing Council.

In December 2002 the Governing Councildecided unanimously on the contents of itsproposal on the future adjustment of its votingmodalities, which will become necessary in thewake of future expansions of the euro area in anenlarged EU. The proposal was made inaccordance with the ECB “enabling clause”contained in the Treaty of Nice. Followingthe entry into force of the Treaty of Nice on1 February 2003, the ECB formally adopted arecommendation on the adjustment of the votingmodalities in the Governing Council.

The ECB recommendation was submitted tothe EU Council in February 2003. On the basisof the recommendation, and after takinginto account the opinions of the EuropeanCommission and the European Parliament, theEU Council, meeting in the composition ofHeads of State or Government, unanimouslyadopted a Decision to amend Article 10.2 of theStatute of the ESCB (voting modalities in theGoverning Council) on 21 March 2003. Inorder to enter into force, this Decision needs tohave been ratified by all Member States, whichis not yet the case.

1 See Decision ECB/2004/2 of 19 February 2004 adopting theRules of Procedure of the European Central Bank, OJ L 80,18.3.2004, p. 33; Rules of Procedure of the General Council ofthe ECB, OJ L 75, 20.3.1999, p. 36 and L 156, 23.6.1999, p. 52;Decision ECB/1999/7 of 12 October 1999 concerning the Rulesof Procedure of the Executive Board of the European CentralBank, OJ L 314, 8.12.1999, p. 34. These rules are also availableon the ECB’s website.


According to this Decision, all members of theGoverning Council will continue to attendmeetings and participate in the deliberations.However, the number of NCB governorsholding a voting right at any one time will notexceed 15. The 15 voting rights will rotateamong the governors according to pre-established rules. The six members of theExecutive Board will each maintain a permanentvoting right. In order to ensure that at anyparticular time the governors with a voting rightare from countries which, taken together, arerepresentative of the euro area economy asa whole, governors will hold a voting rightwith different frequencies. However, thisdifferentiation between governors will applyexclusively to the prior determination of thefrequency with which each governor has avoting right. For all governors having a votingright at any point in time, the “one member, onevote” principle will apply.

Governors will be allocated to different groups,according to a ranking of the weight of theeconomies of their countries within the euroarea, derived from an indicator which inaddition to gross domestic product also reflectsthe size of their financial markets. When thenumber of euro area countries exceeds 15, therewill be two such groups. When there are 22 euroarea countries, the system will be based on threegroups. The governors within each group willhave a voting right for equal periods of time.The new voting system is designed to becapable of accommodating any sequencingof euro area enlargement up to 27 countries,i.e. the current EU Member States and the12 accession countries listed in the Declarationon the enlargement of the European Unionannexed to the Treaty of Nice. The rotationsystem will allow the Governing Council tomaintain its capacity for timely and efficientdecision-making while at the same timeretaining the principle of ad personamparticipation of the members of the GoverningCouncil and the “one member, one vote”principle.

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THE GOVERNING COUNCIL

Back row (left to right):Guy Quaden, Matti Vanhala,Nicholas C. Garganas,Ernst Welteke, Jaime Caruana,Nout Wellink, Klaus Liebscher,Eugenio Domingo Solans,Tommaso Padoa-Schioppa

Front row (left to right):Vítor Constâncio,Yves Mersch, Otmar Issing,Lucas D. Papademos,Jean-Claude Trichet,Gertrude Tumpel-Gugerell,Antonio Fazio, John Hurley,Christian Noyer

Willem F. Duisenberg(until 31 October 2003)President of the ECBJean-Claude Trichet (as from 1 November 2003)President of the ECBLucas D. PapademosVice-President of the ECBJaime CaruanaGovernor of the Banco de EspañaVítor ConstâncioGovernor of the Banco de PortugalEugenio Domingo SolansMember of the Executive Board of the ECBAntonio FazioGovernor of the Banca d’ItaliaNicholas C. GarganasGovernor of the Bank of GreeceSirkka Hämäläinen (until 31 May 2003)Member of the Executive Board of the ECBJohn HurleyGovernor of the Central Bank & FinancialServices Authority of IrelandOtmar IssingMember of the Executive Board of the ECB

Klaus LiebscherGovernor of the Oesterreichische NationalbankYves MerschGovernor of the Banque centrale duLuxembourgChristian Noyer (as from 1 November 2003)Governor of the Banque de FranceTommaso Padoa-SchioppaMember of the Executive Board of the ECBGuy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueJean-Claude Trichet (until 31 October 2003)Governor of the Banque de FranceGertrude Tumpel-Gugerell(as from 1 June 2003)Member of the Executive Board of the ECBMatti VanhalaGovernor of Suomen Pankki – Finlands BankNout WellinkPresident of De Nederlandsche BankErnst WeltekePresident of the Deutsche Bundesbank


1.3 THE EXECUTIVE BOARD

Back row (left to right):Eugenio Domingo Solans,

Tommaso Padoa-Schioppa,Otmar Issing

Front row (left to right):Lucas D. Papademos,Jean-Claude Trichet,

Gertrude Tumpel-Gugerell

The Executive Board comprises the President,the Vice-President and four other members,appointed by common accord, at the level of theHeads of State or Government, of thegovernments of the Member States which haveadopted the euro. The main responsibilities ofthe Executive Board, which as a rule meets oncea week, are:

– to prepare the meetings of the GoverningCouncil;

– to implement the monetary policy of the euroarea in accordance with the guidelines anddecisions laid down by the GoverningCouncil and, in doing so, to give thenecessary instructions to the euro areaNCBs;

– to manage the current business of the ECB;and

– to exercise certain powers delegated to it bythe Governing Council, including some of aregulatory nature.

A Management Committee, which is chaired bya member of the Executive Board and reports tothe Executive Board, has been established witheffect as of 1 October 2003 (see Section 2.2 ofthis chapter). The new Committee is expected toease the workload of the Executive Board andallow it to focus on strategic issues.

Willem F. Duisenberg(until 31 October 2003)President of the ECBJean-Claude Trichet(as from 1 November 2003)President of the ECBLucas D. PapademosVice-President of the ECBEugenio Domingo SolansMember of the Executive Board of the ECB

Sirkka Hämäläinen(until 31 May 2003)Member of the Executive Board of the ECBOtmar IssingMember of the Executive Board of the ECBTommaso Padoa-SchioppaMember of the Executive Board of the ECBGertrude Tumpel-Gugerell(as from 1 June 2003)Member of the Executive Board of the ECB

DirectorateInternal Audit

Michèle Caparello

DirectoratePlanning and Controlling

Klaus Gressenbauer

Directorate GeneralEconomics

Gert Jan HogewegDeputies: Philippe Moutot,

Wolfgang Schill

DirectorateCommunications

Elisabeth Ardaillon-Poirier

Directorate GeneralInternational and

European Relations Pierre van der Haegen

Deputy: Georges Pineau

Directorate GeneralPayment Systems

Jean-Michel GodeffroyDeputy: Koenraad de Geest

Directorate GeneralResearch

Vítor GasparDeputy: Ignazio Angeloni

Directorate GeneralStatistics

Steven KeuningDeputy: Werner Bier

Directorate GeneralAdministrationGerald Grisse

DirectorateBanknotes

Antti Heinonen

Directorate GeneralSecretariat and

Language Services Frank Moss

Deputy: Julio Durán

Directorate General Operations

Francesco PapadiaDeputies: Paul Mercier,

Werner Studener

Directorate GeneralLegal Services

Antonio Sáinz de VicuñaDirectorate

Financial Stabilityand Supervision

Mauro Grande

Counselto the Executive Board

Gilles Noblet

ECB Permanent Representation in Washington, D.C.

Johannes Onno de Beaufort Wijnholds

Directorate GeneralInformation Systems

Jim EtheringtonDeputy: Hans-Gert Penzel

1 Effective as of 1 May 2004.2 Reports on specific issues directly to the Executive Board.

Divisions: � Juristes-Linguistes � Linguistic Services � Secretariat � Translation

Divisions: � Euro Area Accounts and Economic Statistics � External Statistics � Monetary, Financial Institutions and Markets Statistics � Statistical Information Management and User Services � Statistics Development and Coordination

Divisions: � Banknote Issue � Banknote Printing

Divisions: � Official Publications and Library � Press and Information � Protocol and Conferences

Divisions 1: � Econometric Modelling � Monetary Policy Research � Financial Research

Divisions: � Budget and Projects � Organisational Planning

Divisions: � Payment Systems Policy � Securities Settlement Systems Policy � TARGET

Divisions: � Financial Law � Institutional Law

Divisions: � EU Institutions and Fora � EU Neighbouring Regions � Multilateral, Asia/Pacific and Western Hemisphere

Divisions: � Back Office � Front Office � Investment � Operations Analysis � Portfolio Management Systems � Risk Management 2

Divisions: � ECB Audit � ESCB Audit

Divisions: � Financial Stability � Financial Supervision

Divisions: � Office Services � Premises � Security and TransportationDirectorate Internal Finance: Ian IngramDivisions: � Accounting � Financial Reporting and PolicyDirectorate Human Resources: Berend van BaakDivisions: � Compensation and Staff Relations � Recruitment and Staff Development

Directorate IT Projects: N.N.Divisions: � IT Management Functions � IT Operations and Support

Directorate Economic DevelopmentsWolfgang SchillDivisions: � Euro Area Macroeconomic Developments � EU Countries � External Developments

Directorate Monetary PolicyHans-Joachim KlöckersDivisions: � Capital Markets and Financial Structure � Monetary Policy Stance � Monetary Policy Strategy

Executive BoardBack row (left to right): Eugenio Domingo Solans, Tommaso Padoa-Schioppa, Otmar Issing

Front row (left to right): Lucas D. Papademos (Vice-President), Jean-Claude Trichet (President), Gertrude Tumpel-Gugerell

Fiscal Policies Division

Executive Board


1.4 THE GENERAL COUNCIL

Back row (left to right):John Hurley, Nout Wellink,

Ernst Welteke, Klaus Liebscher,Nicholas C. Garganas,Bodil Nyboe Andersen

Middle row (left to right):Antonio Fazio, Matti Louekoski,

Guy Quaden, Lars Heikensten,Christian Noyer, Jaime Caruana

Front row (left to right):Yves Mersch,

Vítor Constâncio,Jean-Claude Trichet,

Lucas D. Papademos,Mervyn King

The General Council is composed of thePresident and the Vice-President of the ECBand the governors of the NCBs of all EUMember States. It carries out those tasks takenover from the European Monetary Institutewhich still have to be performed by the ECB onaccount of the fact that not all the MemberStates have adopted the euro. In 2003 theGeneral Council met four times, in line with its

regular schedule. With a view to enhancingcooperation with the acceding country centralbanks (ACCBs) in preparation for enlargementof the ESCB, the General Council decided inSeptember 2002 to invite the governors of theACCBs to attend, as from the date of thesigning of the Accession Treaty, the meetingsof the General Council in an observer capacity.On 26 June 2003 the governors of the tenACCBs participated for the first time asobservers in a meeting of the General Council.

Willem F. Duisenberg (until 31 October 2003)President of the ECBJean-Claude Trichet (as from 1 November 2003)President of the ECBLucas D. PapademosVice-President of the ECBBodil Nyboe AndersenGovernor of Danmarks NationalbankJaime CaruanaGovernor of the Banco de EspañaVítor ConstâncioGovernor of the Banco de PortugalAntonio FazioGovernor of the Banca d’ItaliaNicholas C. GarganasGovernor of the Bank of GreeceEdward A. J. George (until 30 June 2003)Governor of the Bank of EnglandLars HeikenstenGovernor of Sveriges RiksbankJohn HurleyGovernor of the Central Bank & FinancialServices Authority of Ireland

Mervyn King (as from 1 July 2003)Governor of the Bank of EnglandKlaus LiebscherGovernor of the Oesterreichische NationalbankYves MerschGovernor of the Banque centrale duLuxembourgChristian Noyer (as from 1 November 2003)Governor of the Banque de FranceGuy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueJean-Claude Trichet (until 31 October 2003)Governor of the Banque de FranceMatti Vanhala2

Governor of Suomen Pankki – Finlands BankNout WellinkPresident of De Nederlandsche BankErnst WeltekePresident of the Deutsche Bundesbank

2 Replaced in the photo by Matti Louekoski, Deputy Governor ofSuomen Pankki – Finlands Bank.

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1.5 ESCB COMMITTEES AND THE BUDGET COMMITTEE

Payment and Settlement Systems Committee (PSSC)Jean-Michel Godeffroy

Statistics Committee (STC)Steven Keuning

E SCB COMMITTEE S , THE BUDGET COMMITTEE AND THE I R CHA I RPERSONS

Accounting and Monetary Income Committee (AMICO)Ian Ingram

International Relations Committee (IRC)Hervé Hannoun

Banking Supervision Committee (BSC)Edgar Meister

Legal Committee (LEGCO)Antonio Sáinz de Vicuña

Banknote Committee (BANCO)Antti Heinonen

Market Operations Committee (MOC)Francesco Papadia

External Communications Committee (ECCO)Elisabeth Ardaillon-Poirier

Monetary Policy Committee (MPC)Gert Jan Hogeweg

Information Technology Committee (ITC)Jim Etherington

Internal Auditors Committee (IAC)Michèle Caparello

Budget Committee (BUCOM)Liam Barron

The ESCB committees have continued to playan important role in the performance of thetasks of the Eurosystem/ESCB. At the requestof both the Governing Council and theExecutive Board, the ESCB committees haveprovided expertise in their fields of competenceand have facilitated the decision-makingprocess. Membership of the ESCB committeesis usually restricted to staff of the Eurosystemcentral banks. However, the NCBs of theMember States which have not yet adopted theeuro take part in the meetings of an ESCBcommittee whenever it deals with matters thatfall within the field of competence of theGeneral Council. Where appropriate, othercompetent bodies may also be invited, such asnational supervisory authorities in the case ofthe Banking Supervision Committee. Since thesigning of the Accession Treaty in April 2003,and in line with the decision to invite ACCBgovernors to participate in the meetings of the

General Council, experts from the ACCBs areinvited to attend the meetings of ESCBcommittees in an observer capacity wheneverthey deal with matters that fall within the fieldof competence of the General Council. Atpresent there are 12 ESCB committees, all ofwhich were established under Article 9 of theRules of Procedure of the ECB.

The Budget Committee, which was establishedunder Article 15 of the Rules of Procedure ofthe ECB, assists the Governing Council inmatters related to the ECB’s budget.


1.6 CORPORATE GOVERNANCE

In addition to the decision-making bodies, thecorporate governance of the ECB alsoencompasses a number of external and internalcontrol layers.

EXTERNAL CONTROL LAYERSThe Statute of the ESCB provides for twolayers, namely the external auditor, whichaudits the annual accounts of the ECB (Article27.1 of the Statute of the ESCB), and theEuropean Court of Auditors, which examinesthe operational efficiency of the management ofthe ECB (Article 27.2).

In August 2002 the Governing Council decidedthat, in order to give the fullest public assuranceas to the independence of the ECB’s externalauditor, the principle of audit firm rotationshould be applied. This decision wasimplemented as part of the procedure for theappointment of the ECB’s external auditor(under Article 27.1 of the Statute of the ESCB).The new external auditor commenced its dutiesin September 2003.2

The annual report of the European Court ofAuditors, together with the ECB’s reply, ispublished on the ECB’s website and in theOfficial Journal of the European Union.

INTERNAL CONTROL LAYERSIn 2003 the ECB’s internal audit continued toperform audit missions under the responsibilityof the Executive Board. Its mandate is definedin the ECB Audit Charter.3 The internal auditassesses and evaluates, on an ad hoc basis, theadequacy and effectiveness of the ECB’ssystem of internal control and the quality of theECB’s performance in carrying out assignedresponsibilities. As endorsed by the ExecutiveBoard, the internal audit adheres to theInternational Standards for the ProfessionalPractice of Internal Auditing established by theInstitute of Internal Auditors.

The Internal Auditors Committee, an ESCBcommittee established under a mandate from the

Governing Council, is composed of the heads ofinternal audit at the ECB and the NCBs. It isresponsible for ensuring the coordination ofaudit coverage for joint projects and jointoperational systems at the ESCB level.

The internal control structure of the ECB isbased on a functional approach, whereby eachorganisational unit (division, directorate ordirectorate general) is responsible for its owninternal control and efficiency. In performingthis task, organisational units implement a setof operational control procedures within theirarea of responsibility. For example a set ofrules and procedures – known as a Chinese wall– are in place to prevent inside information, forinstance originating from the areas responsiblefor monetary policy implementation, fromreaching the areas responsible for themanagement of the ECB’s foreign reserves andown funds portfolio. In addition to thesecontrols, the Directorate Planning andControlling, the Risk Management Division andthe Directorate Internal Audit advise and makeproposals to the business areas and to theExecutive Board on specific control issuesaffecting the organisation as a whole.

The members of the Governing Council adhereto a Code of Conduct, which reflects theirresponsibility to safeguard the integrity andreputation of the Eurosystem and to maintainthe effectiveness of its operations.4 TheGoverning Council has also appointed anadviser to provide guidance to its members onsome aspects of professional conduct. The Codeof Conduct for the members of the GoverningCouncil is comparable with the Code ofConduct of the European Central Bank, whichgives guidance to, and sets benchmarks for, thestaff of the ECB and the members of the

2 Following a tender procedure, KPMG Deutsche Treuhand-Gesellschaft AG Wirtschaftsprüfungsgesellschaft wasappointed as the ECB’s new external auditor with a f ive-yearmandate.

3 The ECB Audit Charter is published on the ECB’s website tofoster the transparency of audit arrangements in place at theECB.

4 See the Code of Conduct for the members of the GoverningCouncil, OJ C 123, 24.5.2002, p. 9 and the ECB’s website.

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Executive Board, all of whom are expected tomaintain high standards of professional ethicsin the performance of their duties.5

The ECB has detailed rules preventing the abuseof sensitive financial market information(“insider trading rules”). The staff of the ECBand the members of the Executive Board arethereby prohibited from taking advantage,whether directly or indirectly, of insideinformation to which they have access whenconducting private financial activities at theirown risk and for their own account, or at therisk and for the account of a third party.6 AnEthics Adviser appointed by the ExecutiveBoard ensures a consistent interpretation ofthese rules.

ANTI-FRAUD MEASURESIn 1999 the European Parliament and the EUCouncil adopted Regulation (EC) No 1073/1999 concerning investigations carried out bythe European Anti-Fraud Office7 (“OLAFRegulation”) in order to step up the fightagainst fraud, corruption and any other illegalactivity detrimental to the Communities’financial interests. It provides inter alia for theinternal investigation of suspected fraud byOLAF within the Community institutions,bodies, offices and agencies.

While fully recognising and accepting the needfor strong measures to prevent fraud, theGoverning Council was of the view that theECB’s independent position and statutory tasksprecluded the application of the OLAFRegulation to the ECB. Instead, it adopted theseparate Decision ECB/1999/5 of 7 October1999 on fraud prevention, which provided forthe establishment of a comprehensive anti-fraudscheme under the ultimate control of anindependent Anti-Fraud Committee. Thecreation of this independent committeeenhanced the original layers of control withinthe ECB. In 2003 the Anti-Fraud Committeeheld one meeting and was regularly informed bythe Directorate Internal Audit of all issuesrelated to the performance of its tasks.

The European Commission, supported by theKingdom of the Netherlands, the EuropeanParliament and the EU Council, subsequentlychallenged this stance (Case C-11/00). On10 July 2003 the European Court of Justiceruled on the submissions of these parties andannulled Decision ECB/1999/5.

The Court ruling unambiguously placed theECB “within the framework of theCommunity”. At the same time it stated that thelegislator had wanted to ensure that the ECBcould independently carry out the tasksconferred on it. However, the Court ruled thatthis independence does not have theconsequence of separating the ECB entirelyfrom the Community and exempting it fromevery rule of Community law. This is in linewith the approach taken by the ECB. Theapplication of the OLAF Regulation should notimpair the independent performance of theECB’s tasks.

The ECB is now in the process of finalising anew Decision that will take full account of thejudgement delivered by the Court.

5 See the Code of Conduct of the European Central Bank inaccordance with Article 11.3 of the Rules of Procedure of theEuropean Central Bank, OJ C 76, 8.3.2001, p. 12 and the ECB’swebsite.

6 See Part 1.2 of the ECB Staff Rules containing the rules onprofessional conduct and professional secrecy, OJ C 236,22.8.2001, p. 13 and the ECB’s website.

7 Regulation (EC) No 1073/1999 of the European Parliament andof the Council of 25 May 1999 concerning investigationsconducted by the European Anti-Fraud Office (OLAF),OJ L 136, 31.05.1999, p. 1. See also the identical Regulation(Euratom) No 1074/1999 of 25 May 1999 concerninginvestigations conducted by the European Anti-Fraud Office(OLAF), OJ L 136, 31.05.1999, p. 8.


2.1 HUMAN RESOURCES

STAFFINGThe total number of budgeted staff positions for2003 was 1,271.5 full-time equivalent (FTE)positions. At the end of 2003 the number ofstaff employed by the ECB was 1,217(1,213.5 FTE positions), compared with 1,109(1,105.5 FTE positions) at the end of 2002. Theaverage number of staff employed by the ECBin 2003 was 1,160, compared with 1,080 in2002. In 2003 151 new staff were recruited and41 members of staff left the service of the ECB.The number of FTE positions for 2004 has beenset at 1,362.5, representing a 7.1% increaseover 2003.

From 1 January 2003 all vacant positions wereopened up to acceding country nationals. TheECB successfully launched recruitmentcampaigns aimed specifically at recruiting suchnationals as translators, lawyer-linguists andlegal counsels. 39 staff members from accedingcountries are currently employed on contractsfor more than one year.

In 2003 90 experts from NCBs came to the ECBfor short periods of approximately four monthson average. Of these experts, 48 came fromACCBs. These short-term assignments provedparticularly useful for both the ECB and theACCBs in the preparations for the enlargementof the EU.

In 2003 the ECB offered 113 short-termcontracts (including extensions) to replace staffon maternity, parental and unpaid leave,compared with 60 in 2002.

The ECB provided traineeships to 166 studentsand graduates, mainly with an economicsbackground, for an average duration of threeto four months. 135 such traineeships wereoffered in 2002. In 2003 48 of the trainees werenationals of an acceding country.

Under the Research Visitors Programme, whichfocuses on specific high-level research projectsin the field of monetary policy, 24 research

2 ORGAN I S AT I ONA L D E V E LOPMENT Svisitors were welcomed in 2003 compared with20 in 2002 (see Section 5 of Chapter 2).

The Graduate Research Programme, which isaimed at highly talented research students at anadvanced stage of their doctoral studies,attracted 12 participants in 2003, the samenumber as participated in 2002.

INTERNAL MOBILITYIn 2003 93 staff members changed jobspermanently after successfully applying forinternal vacancies for permanent positions. Inaddition, the ECB encouraged temporaryinternal mobility. 12 staff members took onanother job for a limited period in order to gainwork experience or to address an urgent buttemporary business need, before returning totheir previous position.

EXTERNAL MOBILITYAt the beginning of the year the External WorkExperience Scheme was introduced to supportstaff development. In the framework of thisscheme, staff may be seconded to NCBs andother relevant international and Europeaninstitutions. Three staff members participated inthis scheme during 2003 for a period of two tofive months.

CHILDCARE FACILITIES AND THE EUROPEANSCHOOLThe ECB childcare facilities have been enlargedby a third permanent facility offeringapproximately 90 additional places for thechildren of ECB staff. This brings to 221 thetotal number of places available for childrenaged three months and above.

The secondary school of the European SchoolFrankfurt opened in September 2003 with fivegrades. Like the primary and pre-primarylevels, the secondary school has four languagesections: English, French, German and Italian.

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2.2 MEASURES TO STRENGTHEN THEFUNCTIONING OF THE INTERNALORGANISATION

Since 1998 the ECB’s priorities have been theestablishment of its functions, the formulationand implementation of the single monetarypolicy and the introduction of the euro. At thesame time, however, the ECB has steadilygrown, and the number of staff memberssubstantially increased, creating a need toreinforce the functioning of its internalorganisation. Following the successfulcompletion of the euro cash changeover, theExecutive Board therefore decided to improvethe organisational set-up, further develop themanagement structure and processes andreinforce human resources policies, inparticular with regard to recruitment and careerdevelopment.

ECB IN MOTIONIn the context of the increased focus onstrengthening the internal organisation of theECB, the Executive Board also decided, in early2003, to launch staff surveys on the issues ofcorporate principles, internal communicationand organisational performance. On the basis ofthe survey results, the Executive Board decidedto embark on a process aimed at improvingthe functioning of the ECB called “ECB inMotion”. The process, which involved staffto the largest extent possible, addressed theissues raised in the surveys. Four projectteams were established, under the guidanceof a project office and the Executive Board.The teams developed proposals regardingmanagement, professional development,internal communication and measures aimed atreducing bureaucracy. In October 2003 theExecutive Board endorsed the bulk of theproposals made by the four project teams andset up a programme office that will oversee thefurther development and implementation of themeasures endorsed. Most of the approved ECBin Motion measures should be ready forimplementation by July 2004.

ESTABLISHMENT OF A MANAGEMENT COMMITTEEThe Executive Board also reviewed its ownfunctioning and its role in the management ofthe ECB. It decided to establish a ManagementCommittee which will advise and assist theExecutive Board with regard to the managementof the ECB, its strategic planning and the annualbudget process. This will enable the ExecutiveBoard to increase the attention it devotes to thepreparation and discussion of strategic issues,with regard to both the tasks and policies andthe internal structure and functions of the ECB.The Management Committee, which reports tothe Executive Board, is chaired by a member ofthe Executive Board and composed of membersof senior management. The committee began itswork in October 2003.

RESTRUCTURING OF THE DIRECTORATE GENERALINFORMATION SYSTEMSSince 1994 significant work has been devotedto establishing the core infrastructures andapplications required for the start of StageThree of EMU and the introduction of the euro.During this time, the IT departments of both theEMI and the ECB have successfully met thedeadlines set, and the information systems ofthe ECB and the ESCB have proven to be soundand robust.

At the beginning of 2002 the ECB decided toreview the way in which information systemsservices are delivered at the ECB. The aim wasto assess the existing organisation, structureand effectiveness of the ECB’s informationsystems delivery and to give guidance on itsfuture direction.

In July 2003 the Executive Board approved fourmain recommendations which had been made incooperation with an external consultant chosento assist in the review. These recommendationswill result in the strategic redirection ofinformation systems delivery and include thefollowing measures:

– The project portfolio management, focusingon prioritisation and the allocation of IT andfinancial resources, will be strengthened.


– The Directorate General InformationSystems (DG-IS) has been reorganised inorder to focus on enhancing projectmanagement and delivery capabilities.Accordingly, the staff in DG-IS willconcentrate more on in-house projectmanagement and delivery skills to cope withthe growing IT project demand from thebusiness areas of the ECB and from theESCB.

– The ECB will focus more on theestablishment and enforcement of commonIT architecture standards in order to reducethe complexity and maintenance costs of theIT landscape.

– Finally, the ECB will reassess the sourcingoptions for the IT operational, support andinfrastructure activities.

The new organisational structure is beingestablished around three areas: an IT ProjectsDirectorate, an IT Operations and SupportDivision and an IT Management FunctionsDivision. The implementation of the otherrecommendations has started and should becompleted by the end of 2004.

RESTRUCTURING OF THE DIRECTORATE GENERALSTATISTICSDuring 2003 a restructuring of the DirectorateGeneral Statistics (DG-S) took place. Since theestablishment of the ECB, the output and staffof DG-S had more than doubled, but theorganisational structure had remainedessentially the same. The medium-term strategyfor statistics, as adopted by the ECB in early2003 (see Section 4 of Chapter 2), could onlybe implemented following an organisationalreview of the Directorate General. This reviewstarted in February 2003 and was carried out bya team including an NCB expert. Based onthe team’s proposals, the Executive Boardapproved a new organisational structure,effective as of 1 February 2004.

One of the main features of the reorganisation isthe strengthening of the user-orientation of

DG-S, e.g. through a centralised userinformation service. Furthermore, the newset-up serves to increase efficiency andeffectiveness in the development of newstatistics and statistical standards by combiningpreviously scattered positions allocated to thesetasks in a separate new division.

2.3 NEW ECB PREMISES

Being currently located in several differentrented buildings, the ECB decided to have newpremises built. For this purpose it acquired asite, the Grossmarkthalle area, from the City ofFrankfurt. Within the framework of the “NewECB Premises” project, a worldwide call wasissued for candidates to participate in thearchitectural design competition, with adeadline for applications of 20 January 2003.The ECB received applications from more than300 architects from 31 nations and fivecontinents. In April a Pre-Selection Committee,consisting of five ECB experts supportedby five architects, chose 80 candidates, 70“established” and 10 “emerging young”architects. All 80 candidates were invited to aquestion and answer session in Frankfurt amMain, which included a site visit to theGrossmarkthalle area. Many of the questionsraised by the architects related to the technicalspecifications of the old Grossmarkthallebuilding, which dates from 1928, and to therequirements stemming from its status as alisted building. The architects were then askedto anonymously submit a design proposal forthe first phase by 7 July.

The competition was judged by an internationaljury chaired by the ECB’s Vice-President andconsisting of 12 members: three members fromthe ECB, three members from NCBs, the fiveexternal, internationally renowned architectswho had participated in the Pre-SelectionCommittee and one representative of the Cityof Frankfurt am Main. On 28 and 29 Augustthe jury shortlisted 12 candidates to be admittedto the second phase of the competition. TheECB asked the 12 candidates to present a more

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detailed architectural design concept by12 December. The jury chose the three prize-winning designs on 13 February 2004.8 Alldesign proposals submitted in both phases ofthe competition were subsequently displayed tothe public in a three-week exhibition at theDeutsches Architektur Museum in Frankfurt amMain.

The ECB may ask the prize-winning candidatesto revise their design concepts in line with therecommendations of the jury and adjustedfunctional and technical requirements set bythe ECB. After examining and evaluating thefinal design concepts, the ECB will award thecontract for the ECB’s new premises to thecandidate who in the opinion of the ECB bestmeets the selection criteria. The planningprocess will start thereafter and construction isscheduled to begin in 2006.

8 A press release and pictures are available on the ECB’s website.


In 2003 two meetings of the ESCB SocialDialogue were held, in which employeerepresentatives from all the central banks of theESCB and European trade union federationsmet with the ECB to discuss developments inthe ESCB which have an impact on the situationof NCB employees. Employee representativesof the ten ACCBs were invited to attend asobservers.

As in previous years, the main items discussedwere developments in banknotes, paymentsystems, and financial stability andsupervision.

In the field of banknotes, the focus was on thearrangements for banknote printing in the longterm (see Section 3 of Chapter 2). Employeerepresentatives argued that banknotes were apublic good and highlighted that the quality andsecurity of the banknotes were crucial forpublic confidence. They also felt that the jobsecurity of printing works’ staff should besafeguarded for various reasons, in particular inacknowledgement of the major efforts involvedin having the euro banknotes printed in time forthe cash changeover. Therefore, central banksshould continue to be involved in all processesrelated to banknotes, in particular their printing.

Regarding payment systems, the focus was onthe progress in the preparations for TARGET2(see Section 2 of Chapter 2). The ECB informedthe participants in the ESCB Social Dialogue onan ongoing basis of the progress made. Theemployee representatives commented on thepossible solutions and expressed a preferencefor a decentralised solution along the lines ofthe current system.

As regards financial stability and supervision,the ECB provided the participants withinformation on the reform of EU arrangementsfor financial regulation, supervision andstability, the process of implementation of theLamfalussy framework in the banking sector,the process of revision by the Basel Committeeon Banking Supervision of the capital adequacyrequirements for banks (the New Basel Capital

3 E S C B S O C I A L D I A LOGUEAccord), and reforms of national supervisorystructures (see Section 2 of Chapter 3).Employee representatives reiterated theirpreference for tasks relating to financialstability and supervision to be allocated to thecentral banks.

The ESCB Social Dialogue meetings alsoprovided opportunities to discuss other moregeneral issues such as the development ofcommon training programmes and a corporateculture for the ESCB, the preparations of theECB for the enlargement of the ESCB in 2004and the restructuring in some NCBs followingthe establishment of the Eurosystem. Withregard to the latter issue, the factors underlyingsuch reorganisations were discussed and theemployee representatives expressed theirconcern about maintaining employment levels inthe NCBs.

The views and concerns expressed by the tradeunion representatives were conveyed to theGoverning Council and the General Council.

At the meetings of the ESCB Social Dialoguethe ECB emphasised that the GoverningCouncil, in taking its decisions, applies theprinciples of efficiency, effectiveness, security,high quality and high standards of service.Furthermore, the impact of its decisions onemployment and social conditions is taken intoaccount.

In October 2003 the ECB launched an ESCBSocial Dialogue Newsletter in order toenhance both the flow of information to theparticipants between meetings and the commonunderstanding of the topics covered. Finally,participants stressed the need to strengthenthe corporate culture within the ESCB. To thisend common training programmes are beingorganised.

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4 ANNUA L A C COUNT S O F T H E E C B


BA L ANC E S H E E T A S AT 3 1 D E C EMBER 2 0 0 3ASSETS NOTE 2003 2002

NUMBER € €

Gold and gold receivables 1 8,145,320,117 8,058,187,254

Claims on non-euro area residentsdenominated in foreign currency 2

Receivables from the IMF 211,651,948 164,788,323Balances with banks and security investments,external loans and other external assets 28,593,384,857 37,151,511,287

28,805,036,805 37,316,299,610

Claims on euro area residentsdenominated in foreign currency 2 2,799,472,504 3,047,976,497

Claims on non-euro area residentsdenominated in euro 3

Balances with banks, securityinvestments and loans 474,743,402 183,237,923

Other claims on euro area creditinstitutions denominated in euro 4 25,000 0

Intra-Eurosystem claims 5Claims related to the allocation ofeuro banknotes within the Eurosystem 34,899,471,205 28,681,074,010Other claims within the Eurosystem (net) 4,599,894,403 5,468,478,796

39,499,365,608 34,149,552,806

Other assets 6Tangible fixed assets 128,911,950 112,624,758Other financial assets 5,573,756,258 5,529,030,465Accruals and prepaid expenses 590,646,023 1,260,718,561Sundry 37,791,421 609,968,394

6,331,105,652 7,512,342,178

Loss for the year 476,688,785 0

Total assets 86,531,757,873 90,267,596,268

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Banknotes in circulation 7 34,899,471,205 28,681,074,010

Liabilities to other euro area residentsdenominated in euro 8 1,065,000,000 1,036,000,000

Liabilities to non-euro area residentsdenominated in euro 9 146,867,501 227,805,777

Liabilities to non-euro area residentsdenominated in foreign currency 10

Deposits, balances and other liabilities 1,452,432,822 5,192,380,656

Intra-Eurosystem liabilities 11Liabilities equivalent to the transfer offoreign reserves 40,497,150,000 40,497,150,000

Other liabilities 12Accruals and income collected in advance 1,162,299,071 1,417,939,194Sundry 174,890,973 75,191,137

1,337,190,044 1,493,130,331

Provisions 13 87,195,777 2,644,780,685

Revaluation accounts 14 2,176,464,065 4,404,834,096

Capital and reserves 15Capital 4,097,229,250 4,097,229,250Reserves 772,757,209 772,757,209

4,869,986,459 4,869,986,459

Profit for the year 0 1,220,454,254

Total liabilities 86,531,757,873 90,267,596,268

LIABILITIES NOTE 2003 2002NUMBER € €


PRO F I T AND LO S S A C COUNT F OR TH E Y E A REND ING 3 1 D EC EMBER 2 0 03

Frankfurt am Main, 9 March 2004

EUROPEAN CENTRAL BANK

Jean-Claude TrichetPresident

Interest income on foreign reserve assets 541,294,375 990,618,897Interest income arising from the allocationof euro banknotes within the Eurosystem 698,245,187 726,917,226Other interest income 1,449,963,923 1,965,003,344Interest income 2,689,503,485 3,682,539,467Remuneration of NCBs’ claims in respectof foreign reserves transferred (807,683,148) (1,140,963,789)Other interest expense (1,166,693,660) (1,547,042,623)Interest expense (1,974,376,808) (2,688,006,412)

Net interest income 20 715,126,677 994,533,055

Realised gains/losses arising fromfinancial operations 21 525,260,622 735,425,388Write-downs on financial assets and positions 22 (3,972,689,560) (276,955,036)Transfer to/from provisions for foreignexchange rate and price risks 2,568,708,838 154,000,000

Net result of financial operations, write-downsand risk provisions (878,720,100) 612,470,352

Net (expense)/income from fees and commissions 23 (63,466) (227,158)

Other income 24 2,911,280 3,744,153

Total net income (160,745,609) 1,610,520,402

Staff costs 25 & 26 (129,886,988) (120,003,344)

Administrative expenses 27 (153,549,282) (133,966,576)

Depreciation of tangible fixed assets 28 (30,410,140) (17,738,206)

Banknote production services 29 (2,096,766) (118,358,022)

(Loss)/Profit for the year (476,688,785) 1,220,454,254

NOTE 2003 2002NUMBER € €

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FORM AND PRESENTATION OF THE FINANCIALSTATEMENTSThe financial statements of the EuropeanCentral Bank (ECB) have been designed topresent fairly the financial position of the ECBand the results of its operations. They have beendrawn up in accordance with the followingaccounting policies2, which the GoverningCouncil of the ECB considers to be appropriateto the nature of central bank activity.

ACCOUNTING PRINCIPLESThe following accounting principles have beenapplied: economic reality and transparency,prudence, recognition of post-balance-sheetevents, materiality, the accruals principle, goingconcern and consistency and comparability.

BASIS OF ACCOUNTINGThe accounts have been prepared on a historicalcost basis, modified to include market valuationof marketable securities, gold and all other on-balance-sheet and off-balance-sheet assets andliabilities denominated in foreign currency.Transactions in financial assets and liabilitiesare reflected in the accounts on the basis of thedate on which they are settled.

GOLD AND FOREIGN CURRENCY ASSETS ANDLIABILITIESAssets and liabilities denominated in foreigncurrency are converted into euro at the exchangerate prevailing on the balance sheet date. Incomeand expenses are converted at the exchange rateprevailing at the time of the transaction. Therevaluation of foreign exchange assets andliabilities is performed on a currency-by-currency basis, including on-balance-sheet andoff-balance-sheet instruments.

Revaluation to the market price for assets andliabilities denominated in foreign currency istreated separately from the exchange raterevaluation.

Gold is valued at the market price prevailing atthe year-end. No distinction is made betweenthe price and currency revaluation differencesfor gold. Instead, a single gold valuation is

accounted for on the basis of the price in europer fine ounce of gold, which is derived fromthe exchange rate of the euro against the USdollar on 31 December 2003.

SECURITIESAll marketable debt securities and similar assetsare valued at the mid-market prices prevailing atthe balance sheet date on a security-by-securitybasis. For the year ending 31 December 2003,mid-market prices on 30 December 2003 wereused. Non-marketable securities are valued atcost.

INCOME RECOGNITIONIncome and expenses are recognised in theperiod in which they are earned or incurred.Realised gains and losses arising from the saleof foreign exchange, gold and securities aretaken to the profit and loss account. Suchrealised gains and losses are calculated byreference to the average cost of the respectiveasset.

Unrealised gains are not recognised as income,but are transferred directly to a revaluationaccount.

Unrealised losses are taken to the profit and lossaccount if they exceed previous revaluationgains registered in the correspondingrevaluation account. Unrealised losses in anyone security, currency or in gold are not nettedagainst unrealised gains in other securities,currencies or gold. In the event of an unrealisedloss on any item at the year-end, the averagecost of that item is reduced to the year-endexchange rate and/or market price.

1 The detailed accounting policies of the ECB are laid down in aDecision of the Governing Council of the ECB of 5 December2002 (ECB/2002/11), OJ L 58, 3.3.2003, pp. 38-59.

2 These policies are consistent with the provisions of Article 26.4 ofthe Statute of the ESCB, which require a harmonised approach tothe rules governing the accounting and financial reporting ofEurosystem operations.

A C COUNT I NG PO L I C I E S 1


Premiums or discounts arising on purchasedsecurities are calculated and presented as part ofinterest income and are amortised over theremaining life of the assets.

REVERSE TRANSACTIONSUnder a repurchase agreement, securities aresold for cash with a simultaneous agreement torepurchase them at an agreed price on a setfuture date. These agreements to repurchase arereflected on the liability side of the balancesheet and also lead to an interest expense in theprofit and loss account. Securities sold undersuch an agreement remain on the balance sheetof the ECB.

Under a reverse repurchase agreement securitiesare bought for cash with a simultaneousagreement to sell them back to the counterpartyat an agreed price on a set future date. Theseagreements to sell are recorded on the asset sideof the balance sheet, but are not included in theECB’s security holding and give rise to interestincome in the profit and loss account.

Reverse transactions (including securitylending transactions) conducted under anautomated security lending programme arerecorded on the balance sheet only wherecollateral is provided to the ECB in the form ofcash over the maturity of the transaction. In2003 the ECB did not receive any collateral inthe form of cash over the maturity of suchtransactions.

OFF-BALANCE-SHEET INSTRUMENTSCurrency instruments, namely foreign exchangeforward transactions, forward legs of foreignexchange swaps and other currency instrumentsinvolving an exchange of one currency foranother at a future date, are included in the netforeign currency position for the purpose ofcalculating foreign exchange gains and losses.Interest rate instruments are revalued on anitem-by-item basis. Outstanding interest ratefutures positions are recorded in off-balance-sheet accounts. Since 2003 daily changes in thevariation margin have been recorded in theprofit and loss account.

POST-BALANCE-SHEET EVENTSAssets and liabilities are adjusted for events thatoccur between the annual balance sheet date andthe date on which the Governing Council of theECB approves the financial statements if suchevents materially affect the condition of assetsand liabilities at the balance sheet date.

INTRA-ESCB BALANCES/INTRA-EUROSYSTEMBALANCESIntra-ESCB transactions are cross-bordertransactions that occur between two EU centralbanks. These transactions are processed primarilyvia TARGET – the Trans-European AutomatedReal-time Gross settlement Express Transfersystem (see Chapter 2) – and give rise to bilateralbalances in accounts held between those EUcentral banks connected to TARGET. Thesebilateral balances are then assigned to the ECB ona daily basis, leaving each NCB with a single netbilateral position vis-à-vis the ECB only. Thisposition in the books of the ECB represents the netclaim or liability of each NCB against the rest ofthe ESCB.

Intra-ESCB balances of the euro area NCBswith the ECB (except for the capital of the ECBand positions resulting from the transfer offoreign reserve assets to the ECB) are describedas intra-Eurosystem claims or liabilities and arepresented in the balance sheet of the ECB as asingle net asset or liability position.

Intra-Eurosystem balances arising from theallocation of euro banknotes within theEurosystem are included as a single net asset under“Claims related to the allocation of euro banknoteswithin the Eurosystem” (see “Banknotes incirculation” in the notes on accounting policies).

Intra-ESCB balances of the non-euro areaNCBs (Danmarks Nationalbank, SverigesRiksbank and the Bank of England) with theECB are disclosed under “Liabilities to non-euro area residents denominated in euro”.

TREATMENT OF FIXED ASSETSFixed assets, with the exception of land, arevalued at cost less depreciation. Land is valued

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at cost. Depreciation is calculated on a straight-line basis, beginning in the quarter afteracquisition and continuing over the expectedeconomic lifetime of the asset, namely:

The depreciation period for capitalised buildingand refurbishment expenditure relating to theECB’s existing premises has been reduced inorder to ensure that these assets are completelywritten off by the end of 2008, by which time theECB is expected to have moved to its finallocation.

THE ECB’S RETIREMENT PLANThe ECB operates a defined contributionpension scheme. The assets of the plan, whichexist solely for the purpose of providingbenefits for members of the plan and theirdependants, are included in the other assets ofthe ECB and are identified separately in thenotes on the balance sheet. Valuation gains andlosses arising on the assets of the pension fundare recognised as income and expenditure of theretirement plan in the year in which they arise.The benefits payable from the core benefitaccount, resulting from the contributions of theECB, have minimum guarantees underpinningthe defined contribution benefits.

BANKNOTES IN CIRCULATIONThe ECB and the 12 euro area NCBs, whichtogether comprise the Eurosystem, issue eurobanknotes.3 The total value of euro banknotes incirculation is allocated to the Eurosystem centralbanks on the last working day of each month inaccordance with the banknote allocation key.4 TheECB has been allocated a share of 8% of the totalvalue of euro banknotes in circulation, which isdisclosed under the balance sheet liability item

“Banknotes in circulation”. The ECB’s share ofthe total euro banknote issue is backed by claimson the NCBs. These claims, which bear interest5,are disclosed under the sub-item “Intra-Eurosystem claims: claims related to the allocationof euro banknotes within the Eurosystem”(see “Intra-ESCB balances/intra-Eurosystembalances” in the notes on accounting policies).Interest income on these claims is included withinthe item “Net interest income”. The GoverningCouncil has decided that this income shall bedistributed separately to the NCBs in the form ofan interim distribution after the end of eachquarter6. It will be distributed in full unless theECB’s net profit for the year is less than itsincome earned on euro banknotes in circulation,and subject to any decision by the GoverningCouncil to reduce this income in respect of costsincurred by the ECB in connection with the issueand handling of euro banknotes.

OTHER ISSUESTaking account of the ECB’s role as a centralbank, the Executive Board of the ECB considersthat the publication of a cash flow statementwould not provide the readers of the financialstatements with any additional relevantinformation.

In accordance with Article 27 of the Statute ofthe ESCB, and on the basis of a recommendationof the Governing Council of the ECB, theCouncil of the European Union has approvedthe appointment of KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschafts-prüfungsgesellschaft as the external auditors ofthe ECB for a five-year period starting from thefinancial year 2003.

3 ECB Decision of 6 December 2001 on the issue of euro banknotes(ECB/2001/15), OJ L 337, 20.12.2001, pp. 52-54.

4 “Banknote allocation key” means the percentages that result fromtaking into account the ECB’s share in the total euro banknoteissue and applying the subscribed capital key to the NCBs’ sharein that total.

5 ECB Decision of 6 December 2001 on the allocation of monetaryincome of the national central banks of participating MemberStates from the financial year 2002 (ECB/2001/16), OJ L 337,20.12.2001, pp. 55-61.

6 ECB Decision of 21 November 2002 on the distribution of theincome of the European Central Bank on euro banknotes incirculation to the national central banks of the participatingMember States (ECB/2002/9), OJ L 323, 28.11.2002, pp. 49-50.

Computers, related hardware andsoftware, and motor vehicles 4 years

Equipment, furniture and plantin building 10 years

Capitalised building and refurbishmentexpenditure 25 years

Fixed assets costing less than €10,000 Writtenoff in the

year ofacquisition


1 GOLD AND GOLD RECEIVABLES

The ECB holds 24.7 million ounces of fine gold(2002: 24.7 million ounces). No transactions ingold took place in 2003. The balance sheetmovement compared with 2002 is due to theyear-end revaluation of these holdings (see“Gold and foreign currency assets andliabilities” in the notes on accounting policies).

2 CLAIMS ON NON-EURO AREA AND EURO AREARESIDENTS DENOMINATED IN FOREIGNCURRENCY

Receivables from the IMFThis asset represents the ECB’s holdings ofSpecial Drawing Rights (SDRs) as at31 December 2003. It arises as the result of atwo-way SDR buying and selling arrangementwith the International Monetary Fund (IMF)whereby the IMF is authorised to arrange salesor purchases of SDRs against euro, on behalf ofthe ECB, within minimum and maximumholding levels. The SDR is defined in terms of abasket of currencies. Its value is determined asthe weighted sum of exchange rates of the fourmajor currencies (euro, Japanese yen, poundsterling and US dollar). For accountingpurposes, SDRs are treated as a foreigncurrency (see “Gold and foreign currency assetsand liabilities” in the notes on accountingpolicies).

Balances with banks and security investments,external loans and other external assetsClaims on euro area residents denominated inforeign currencyThese claims consist of balances with banks,loans denominated in foreign currency andinvestments in securities, denominated in USdollar and Japanese yen. They can be brokendown as follows:

NOTE S ON TH E B A L ANC E S H E E T

The reduction in these positions in 2003 isprimarily due to the year-end revaluation of theECB’s US dollar denominated assets. Thedepreciation of the US dollar vis-à-vis the eurohas resulted in a significant decline in their euroequivalent value (see “Gold and foreigncurrency assets and liabilities” and “Incomerecognition” in the notes on accountingpolicies).

3 CLAIMS ON NON-EURO AREA RESIDENTSDENOMINATED IN EURO

As at 31 December 2003, this claim consisted ofbank deposits with non-euro area residents.

4 OTHER CLAIMS ON EURO AREA CREDITINSTITUTIONS DENOMINATED IN EURO

As at 31 December 2003, this claim consisted ofa bank deposit with a euro area resident.

Claims onnon-euro area 2003 2002 Changeresidents € € €

Currentaccounts 1,365,187,080 1,249,268,747 115,918,333

Money marketdeposits 1,197,220,582 1,665,333,388 (468,112,806)

Reverserepurchaseagreements 3,834,025,154 8,252,807,861 (4,418,782,707)

Securityinvestments 22,196,952,041 25,984,101,291 (3,787,149,250)

Total 28,593,384,857 37,151,511,287 (8,558,126,430)

Claims oneuro area 2003 2002 Changeresidents € € €

Currentaccounts 26,740 78,898 (52,158)

Money marketdeposits 2,799,445,764 3,047,897,599 (248,451,835)

Total 2,799,472,504 3,047,976,497 (248,503,993)

191ECB

Annua l Repor t2003

5 INTRA-EUROSYSTEM CLAIMS

Claims related to the allocation of eurobanknotes within the EurosystemThis item consists of the claims of the ECB vis-à-vis the euro area NCBs relating to theallocation of euro banknotes within theEurosystem (see “Banknotes in circulation” inthe notes on accounting policies).

Other claims within the Eurosystem (net)This item consists of the TARGET balances ofthe euro area NCBs vis-à-vis the ECB andamounts due in respect of the interimdistributions of the ECB’s income derived frombanknotes. As at 31 December 2003, an amountof €533 million was due from the euro areaNCBs in respect of interim distributions of theECB’s income derived from banknotes. Thisrepresents the interim distributions of suchincome to the euro area NCBs for the first threequarters of the year, which were subsequentlyrecalled (see “Banknotes in circulation” in thenotes on accounting policies and note 20 in the“Notes on the Profit and Loss Account”).

6 OTHER ASSETS

Tangible fixed assetsThese assets comprised the following mainitems on 31 December 2003:

Net book Net bookvalue as at value as at

31 Dec. 2003 31 Dec. 2002 Change€ € €

Land andbuildings 54,929,962 51,496,140 3,433,822

Computers 45,407,622 33,522,388 11,885,234

Equipment,furniture, plantin building andmotor vehicles 2,149,813 2,575,083 (425,270)

Assets underconstruction 23,259,861 9,092,185 14,167,676

Other fixed assets 3,164,692 15,938,962 (12,774,270)

Total 128,911,950 112,624,758 16,287,192

The main increase in this item relates tocapitalised costs of the ECB’s installations atthe ECB’s third site and the purchase ofadditional information systems equipment.

Other financial assetsThe main components of this item are asfollows:

2003 2002 Change€ € €

Securitiesdenominatedin euro 5,276,052,927 5,428,324,673 (152,271,746)

Reverserepurchaseagreementsin euro 167,100,400 0 167,100,400

Claims relatingto the ECBpension fund 91,727,194 61,852,580 29,874,614

Other financialassets 38,875,737 38,853,212 22,525

Total 5,573,756,258 5,529,030,465 44,725,793

2003 2002€ €

Due from euro areaNCBs in respect ofTARGET 49,646,309,854 56,546,091,330

Due to euro area NCBsin respect of TARGET (45,579,175,620) (50,471,612,534)

Net TARGET position 4,067,134,234 6,074,478,796

Due from/(to) euro areaNCBs in respect of theinterim distribution ofthe ECB’s income derivedfrom banknotes 532,760,169 (606,000,000)

Other claims within theEurosystem (net) 4,599,894,403 5,468,478,796


(a) Securities denominated in euro and reverserepurchase agreements in euro constitute theinvestment of the ECB’s own funds (seealso note 12).

(b) The investment portfolios relating to theECB pension fund are valued at €91.7million (2002: €61.9 million). The assetsheld represent the investments ofaccumulated pension contributions by theECB and the staff of the ECB as at31 December 2003, and are managed byan external fund manager. The regularcontributions of the ECB and members ofthe plan have been invested on a monthlybasis. The assets of the plan are not fungiblewith other financial assets of the ECB, andnet income thereon does not constituteincome of the ECB, but is reinvested in thefunds concerned, pending payment ofbenefits. The external fund manager valuesthe assets of the pension fund using year-end market prices.

(c) The ECB holds 3,000 shares in the Bank forInternational Settlements (BIS) which areincluded at the acquisition cost of €38.5million.

Accruals and prepaid expensesIn 2002 this position included accrued interestreceivable of €727 million on the ECB’s claimsrelated to the allocation of euro banknoteswithin the Eurosystem for the whole year. Asfrom 2003, this interest is received after the endof each quarter. Consequently this position nowincludes only the final quarterly accruedinterest due to the ECB of €165 million (see“Banknotes in circulation” in the notes onaccounting policies).

The remainder of this balance consistsprincipally of accrued interest on securities andother financial assets.

SundryIn 2002 this position included the accruedinterim distribution of the ECB’s incomederived from banknotes of €606 million. In

2003, all such income was retained by the ECB(see note 20 in the “Notes on the Profit andLoss Account”).

7 BANKNOTES IN CIRCULATION

This item consists of the ECB’s share of thetotal euro banknotes in circulation (see“Banknotes in circulation” in the notes onaccounting policies).

8 LIABILITIES TO OTHER EURO AREARESIDENTS DENOMINATED IN EURO

This item comprises deposits by members of theEuro Banking Association (EBA) which areused in order to provide the ECB with collateralin respect of the EBA’s payments settledthrough the TARGET system.

9 LIABILITIES TO NON-EURO AREA RESIDENTSDENOMINATED IN EURO

These liabilities principally represent balancesheld at the ECB by non-euro area NCBs arisingfrom transactions processed via the TARGETsystem (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies).

10 LIABILITIES TO NON-EURO AREA RESIDENTSDENOMINATED IN FOREIGN CURRENCY

The liabilities arising from repurchaseagreements conducted with non-euro arearesidents in connection with the management ofthe foreign currency reserves of the ECB are asfollows:

2003 2002 Change€ € €

Repurchaseagreements 1,452,432,822 5,192,380,656 (3,739,947,834)

193ECB

Annua l Repor t2003

11 INTRA-EUROSYSTEM LIABILITIES

These represent the liabilities to euro areaNCBs that arose from the transfer of foreignreserve assets to the ECB. The liabilities aredenominated in euro at a value fixed at the timeof their transfer. They are remunerated atthe latest available marginal rate for theEurosystem’s main refinancing operations,adjusted to reflect a zero return on the goldcomponent (see note 20 in the “Notes on theProfit and Loss Account”).

% €

Nationale Bank van België/Banque Nationale de Belgique 2.8658 1,432,900,000

Deutsche Bundesbank 24.4935 12,246,750,000

Bank of Greece 2.0564 1,028,200,000

Banco de España 8.8935 4,446,750,000

Banque de France 16.8337 8,416,850,000

Central Bank &Financial Services Authorityof Ireland 0.8496 424,800,000

Banca d’Italia 14.8950 7,447,500,000

Banque centrale du Luxembourg 0.1492 74,600,000

De Nederlandsche Bank 4.2780 2,139,000,000

Oesterreichische Nationalbank 2.3594 1,179,700,000

Banco de Portugal 1.9232 961,600,000

Suomen Pankki – Finlands Bank 1.3970 698,500,000

Total 80.9943 40,497,150,000

12 OTHER LIABILITIES

This item consists mainly of interest due to theNCBs in respect of their claims relating to theforeign reserves transferred (see note 11). TheECB’s obligations in respect of the pensionfund, including a provision based on theactuary’s report, amount to €100.6 million(2002: €72.4 million). Also included withinthis balance are other accruals and outstandingrepurchase transactions of €64 million,conducted in connection with the managementof the ECB’s own funds (see note 6).

13 PROVISIONS

In 2000, a general provision against the ECB’slarge exposure to exchange rate and interest raterisk was made. The size and continuingrequirement for this provision was reviewedannually, based on the ECB’s assessment of itsfuture exposure to exchange rate and interestrate risk. Given the significant depreciation ofthe US dollar vis-à-vis the euro in 2003, thisprovision was used in full to cover unrealisedlosses expensed at year-end arising principallyfrom the revaluation of the ECB’s holding ofUS dollar denominated assets (see “Incomerecognition” in the notes on accounting policiesand note 22 in the “Notes on the Profit and LossAccount”)7.

This position also includes provisions relatingto pensions and expenditure on goods andservices, together with an appropriate provisionagainst the contractual obligation of the ECB torestore its current premises to their originalcondition when they are vacated and the ECBmoves to its final site.

14 REVALUATION ACCOUNTS

These accounts represent revaluation reservesarising from unrealised gains on assets andliabilities.

2003 2002 Change€ € €

Gold 2,070,968,381 1,983,835,491 87,132,890

Foreigncurrency 1,901 1,682,723,875 (1,682,721,974)

Securities 105,493,783 738,274,730 (632,780,947)

Total 2,176,464,065 4,404,834,096 (2,228,370,031)

7 ECB Decision of 21 November 2002 on the distribution of theincome of the European Central Bank on euro banknotes incirculation to the national central banks of the participatingMember States (ECB/2002/9), OJ L 323, 28.11.2002, pp. 49-50.


% Subscribed Paid-upcapital capital

€ €

Nationale Bank vanBelgië/BanqueNationale de Belgique 2.8658 143,290,000 143,290,000

Deutsche Bundesbank 24.4935 1,224,675,000 1,224,675,000

Bank of Greece 2.0564 102,820,000 102,820,000

Banco de España 8.8935 444,675,000 444,675,000

Banque de France 16.8337 841,685,000 841,685,000

Central Bank &Financial ServicesAuthority of Ireland 0.8496 42,480,000 42,480,000

Banca d’Italia 14.8950 744,750,000 744,750,000

Banque centraledu Luxembourg 0.1492 7,460,000 7,460,000

De NederlandscheBank 4.2780 213,900,000 213,900,000

OesterreichischeNationalbank 2.3594 117,970,000 117,970,000

Banco de Portugal 1.9232 96,160,000 96,160,000

Suomen Pankki –Finlands Bank 1.3970 69,850,000 69,850,000

Total euro areaNCBs 80.9943 4,049,715,000 4,049,715,000

DanmarksNationalbank 1.6709 83,545,000 4,177,250

Sveriges Riksbank 2.6537 132,685,000 6,634,250

Bank of England 14.6811 734,055,000 36,702,750

Total non-euroarea NCBs 19.0057 950,285,000 47,514,250

Total euro areaand non-euroarea NCBs 100.0000 5,000,000,000 4,097,229,250

15 CAPITAL AND RESERVES

CapitalThe fully paid-up subscriptions of the euro areaNCBs to the ECB’s capital of €5 billion amountto a total of €4,049,715,000 as shown below:

The non-euro area NCBs’ contributions represent5% of their share in the ECB’s subscribed capitaland amount to a total of €47,514,250. Theamounts paid up by these NCBs are contributionsto the operational costs of the ECB. Unlike theeuro area NCBs, the non-euro area NCBs are notentitled to receive any share of the distributable

profits of the ECB, including income arising fromthe allocation of euro banknotes within theEurosystem, nor are they liable to fund any loss ofthe ECB.

ReservesThis position represents the general reservefund of the ECB, established under Article 33of the Statute of the ESCB.

16 POST-BALANCE-SHEET EVENTS

CHANGES TO THE ECB’S CAPITAL KEY

BackgroundUnder Article 29.3 of the Statute of the ESCB,the key of NCBs for subscription of the ECB’scapital must be adjusted every five years. Thefirst such adjustment following the establishmentof the ECB was made on 1 January 2004. On1 May 2004 a second change of the ECB’s capitalkey will follow as a result of the accession of tennew Member States. Based on the CouncilDecision of 15 July 2003 on the statistical data tobe used for the determination of the key forsubscription of the capital of the EuropeanCentral Bank, the capital keys of NCBs wereadjusted on 1 January 2004 as follows:

From 1 January From 1 January1999 to 31 2004 to 1

December 2003 May 2004% %

Nationale Bank van België/Banque Nationale de Belgique 2.8658 2.8297

Deutsche Bundesbank 24.4935 23.4040

Bank of Greece 2.0564 2.1614

Banco de España 8.8935 8.7801

Banque de France 16.8337 16.5175

Central Bank & FinancialServices Authority of Ireland 0.8496 1.0254

Banca d’Italia 14.8950 14.5726

Banque centrale du Luxembourg 0.1492 0.1708

De Nederlandsche Bank 4.2780 4.4323

Oesterreichische Nationalbank 2.3594 2.3019

Banco de Portugal 1.9232 2.0129

Suomen Pankki – Finlands Bank 1.3970 1.4298

Subtotal for euro area NCBs 80.9943 79.6384

195ECB

Annua l Repor t2003

Danmarks Nationalbank 1.6709 1.7216

Sveriges Riksbank 2.6537 2.6636

Bank of England 14.6811 15.9764

Subtotal for non-euro area NCBs 19.0057 20.3616

Total 100.0000 100.0000

IMPACT OF CHANGES

Capital of the ECBDue to the overall reduction of 1.3559% in theweighting of the euro area NCBs (with fullypaid-up subscriptions) in the ECB’s capital, andthe increase in that of the non-euro area NCBs(who only paid up 5% of their subscription), theECB’s capital decreased by a total of €64million on 1 January 2004.

NCBs’ claims equivalent to the foreign reserveassets transferred to the ECBGiven the decrease in the weighting in the ECBcapital key of the euro area NCBs (whichtransferred foreign reserve assets to the ECBaccording to their prevailing subscribed sharesin the ECB’s capital), the initial claim of€40,497 million equivalent to this transfer wasalso adjusted accordingly. This resulted in areduction of €678 million, which was repaid tothe euro area NCBs.

Changes as at 1 May 2004When the new countries join the EuropeanUnion and their respective NCBs become partof the ESCB, the subscribed capital of the ECBand the limit on the amount of foreign reserveassets that may be transferred to the ECB willbe increased automatically.

OFF-BALANCE-SHEET INSTRUMENTS

17 AUTOMATIC SECURITY LENDING PROGRAMME

As part of the management of the ECB’s ownfunds, the ECB has concluded an automaticsecurity lending programme agreement wherebyan appointed agent enters into security lendingtransactions on behalf of the ECB with a

number of counterparties, designated by theECB as eligible counterparties. Under thisagreement, reverse transactions conductedunder repurchase and reverse repurchaseagreements, each with a value of €0.4 billion(2002: €1.4 billion), were outstanding as at31 December 2003 (see “Reverse transactions”in the notes on accounting policies).

18 INTEREST RATE FUTURES

In 2003 foreign currency interest rate futureswere used within the management of the ECB’sforeign reserves. As at 31 December 2003, thefollowing transactions were outstanding, statedat nominal value:

Foreign currency interest Contract valuerate futures €

Purchases 1,928,169,982

Sales 610,966,084

19 CAPITAL COMMITMENTS

On 5 March 2002 the ECB and the City ofFrankfurt am Main signed a purchase agreementfor the site of the ECB’s final premises. Basedon a predefined area of construction floorspace, the minimum purchase price had been setat €61.4 million, payable in instalments by31 December 2004 at the latest, when legal titleto the site will pass to the ECB. A firstinstalment was paid to the City of Frankfurt in2003.


20 NET INTEREST INCOME

Interest income on foreign reserve assetsThis item includes interest income, net ofinterest expense, in respect of the assets andliabilities denominated in foreign currency, asfollows:

NOT E S ON TH E P RO F I T AND LO S S A C COUNT

2003 2002 Change€ € €

Interest on currentaccounts 3,679,287 6,076,316 (2,397,029)

Money marketdeposit income 45,699,455 76,811,025 (31,111,570)

Reverserepurchaseagreements 66,206,740 120,729,765 (54,523,025)

Net income onsecurities 445,357,205 857,373,212 (412,016,007)

Total interestincome on foreignreserve assets 560,942,687 1,060,990,318 (500,047,631)

Interest expenseon currentaccounts (73,292) (263,018) 189,726

Repurchaseagreements (19,575,020) (70,108,403) 50,533,383

Interest incomeon foreign reserveassets (net) 541,294,375 990,618,897 (449,324,522)

Interest income arising from the allocation ofeuro banknotes within the EurosystemThis item consists of the interest income of theECB relating to its 8% share in the total eurobanknote issue. Interest on the claims of theECB in respect of its share of banknotes isearned at the latest available marginal rate forthe Eurosystem’s main refinancing operations.This income is distributed to the NCBs asoutlined in “Banknotes in circulation” in thenotes on accounting policies.

Based on the ECB’s estimated financial resultfor the year ending 31 December 2003, theGoverning Council decided in December 2003:

(a) to recall the three interim quarterlydistributions already paid to the NCBsduring the year amounting to €533 million intotal;

(b) to withhold the final quarterly interimdistribution of €165 million.

Remuneration of NCBs’ claims in respect offoreign reserves transferredRemuneration paid to euro area NCBs on theirclaims on the ECB in respect of the foreignreserve assets transferred under Article 30.1 ofthe Statute of the ESCB is disclosed under thisitem.

Other interest income and Other interestexpensesThese positions include interest income andexpenses on balances arising from TARGETand in respect of other assets and liabilitiesdenominated in euro.

Net interest income has decreased comparedwith 2002, primarily due to the further declinein both US dollar and euro interest rates duringthe year.

21 REALISED GAINS/LOSSES ARISING FROMFINANCIAL OPERATIONS

2003 2002 Change€ € €

Net realisedprice gains onsecurities 528,606,147 734,191,562 (205,585,415)

Net realisedexchange rate(losses)/gains (3,345,525) 1,233,826 (4,579,351)

Realised gainsarising fromfinancialoperations 525,260,622 735,425,388 (210,164,766)

Net realised gains arose on sales of securities asa result of normal portfolio managementtransactions. In 2003 there were no materialoutflows of foreign currencies.

197ECB

Annua l Repor t2003

22 WRITE-DOWNS ON FINANCIAL ASSETS ANDPOSITIONS

This expense is primarily due to the write-downof the average acquisition cost of the ECB’s USdollar holding to its end-of-year exchange rateas at 31 December 2003, following thedepreciation of this currency against the euroover the year. It was partially covered by therelease of the remaining general provisionagainst foreign exchange and interest rate risks(see “Income recognition” in the notes onaccounting policies and note 2 in the “Notes onthe Balance Sheet” respectively).

23 NET (EXPENSE)/INCOME FROM FEES ANDCOMMISSIONS

24 OTHER INCOME

Other miscellaneous income during the yeararose principally from the transfer of unusedadministrative provisions to the profit and lossaccount.

25 STAFF COSTS

Salaries and allowances of €108.2 million(2002: €92.6 million) and employer’scontributions to the ECB’s pension fund and tohealth and accident insurance are includedunder this heading. The emoluments of theExecutive Board of the ECB amounted to a totalof €2.0 million (2002: €2.0 million). Nopensions were paid to former members of theExecutive Board or their dependants during theyear. Transitional payments were made todeparting members of the Executive Board.Salaries and allowances, including theemoluments of holders of senior managementpositions, are modelled in essence on, and arecomparable with, the remuneration scheme ofthe European Communities.

At the end of 2003 the ECB employed 1,213staff, of whom 84 held managerial positions.The movement of staff during 2003 was asfollows:

2003 2002 Change€ € €

Income from feesand commissions 700,271 634,241 66,030

Expenses relatingto fees andcommissions (763,737) (861,399) 97,662

Net (expense)/income from feesand commissions (63,466) (227,158) 163,692

Income under this heading arose primarily frompenalties imposed on credit institutions fornon-compliance with the minimum reserverequirements. Expenses primarily relate to feespayable on current accounts and in connectionwith the execution of foreign currency interestrate futures (see note 18 in the “Notes on theBalance Sheet”).

2003 2002

As at 1 January 1,105 1,043

New staff 149 113

Resignations 41 51

As at 31 December 1,213 1,105

Average number employed 1,160 1,080

26 THE ECB’S RETIREMENT PLAN

In accordance with the rules of the ECB’sretirement plan, a triennial full actuarialvaluation is required. The latest full actuarialvaluation was carried out as at 31 December2002, assuming all members left service, andpensionable service ceased, on that date.

2003 2002 Change€ € €

Unrealisedprice losses onsecurities (10,349,709) 0 (10,349,709)

Unrealisedexchange ratelosses (3,962,339,851) (276,955,036) (3,685,384,815)

Total (3,972,689,560) (276,955,036) (3,695,734,524)


The pension cost relating to the plan is assessedin accordance with the advice of a qualifiedactuary. The total pension cost to the ECBincluding a provision for disability and post-retirement benefits was €21.7 million (2002:€27.4 million). This cost includes a provisionfor pensions to members of the Executive Boardof €1.9 million (2002: €2.1 million) and anysupplementary contributions. The required rateof future service contributions by the ECB is16.5% of pensionable earnings of all staff.

27 ADMINISTRATIVE EXPENSES

These cover all other current expenses relatingto rental and maintenance of premises, goodsand equipment of a non-capital nature,professional fees and other services andsupplies, together with staff-related expensesincluding recruitment, relocation, installation,training and resettlement.

28 DEPRECIATION OF TANGIBLE FIXED ASSETS

The rise in the level of the depreciation chargesin 2003 reflects for the first time the effect ofreducing the depreciation period for capitalexpenditure on buildings and refurbishment(see “Treatment of fixed assets” in the notes onaccounting policies).

29 BANKNOTE PRODUCTION SERVICES

In 2003 this expense related to cross-bordertransportation costs of euro banknotes betweenNCBs to meet unexpected fluctuations indemand. These costs are borne centrally by theECB. The figure for 2002 related to theexpensing of a contingency stock of eurobanknotes acquired for the Eurosystem in 2001.

199ECB

Annua l Repor t2003

This note is not part of the financial statements ofthe ECB for the year 2003. It is published in theAnnual Report for information purposes only.

INCOME RELATED TO THE ECB’S BANKNOTE ISSUE

Following a decision by the Governing Councilof the ECB, the amount of €698 million wasretained by the ECB to ensure that the totalprofit distribution for the year did not exceedthe ECB’s net profit for the year. This amount isall of the income relating to the ECB’s share oftotal euro banknotes in circulation for 2003.

COVERAGE OF ECB LOSSES

Under Article 33.2 of the Statute of the ESCB,in the event of a loss incurred by the ECB, theshortfall may be offset against the generalreserve fund of the ECB and, if necessary,following a decision by the Governing Council,against the monetary income of the relevantfinancial year in proportion and up to theamounts allocated to the national central banksin accordance with Article 32.5 of the Statute.8

At its meeting on 18 March 2004, theGoverning Council of the ECB decided to coverthe loss for the year ending 31 December 2003as follows:

NOT E ON TH E A L LO C AT I ON O F L O S S E S

2003 2002€ €

(Loss)/Profit for the year (476,688,785) 1,220,454,254

Income on the ECB’sbanknote issue distributedto NCBs 0 (606,000,000)

(Loss)/Profit for theyear after distributionof income on the ECB’sbanknote issue (476,688,785) 614,454,254

(Transfers to)/withdrawals fromgeneral reserve fund 476,688,785 0

Distributable profits 0 614,454,254

Distribution to NCBs 0 (614,454,254)

Total 0 0

8 Under Article 32.5 of the Statute of the ESCB, the sum of thenational central banks’ monetary income is to be allocated to thenational central banks in proportion to their paid-up shares in thecapital of the ECB.

Auditor’s report

President and Governing Councilof the European Central Bank

Frankfurt am Main

We have audited the accompanying balance sheet of the European Central Bank as of31 December 2003 and the related profit and loss account for the year then ended as well as thenotes. These annual accounts are the responsibility of the European Central Bank’s ExecutiveBoard. Our responsibility is to express an opinion on these annual accounts based on our audit.

We conducted our audit in accordance with International Standards on Auditing. ThoseStandards require that we plan and perform the audit to obtain reasonable assurance aboutwhether the annual accounts are free of material misstatement. An audit includes examining, ona test basis, evidence supporting the amounts and disclosures in the annual accounts. An auditalso includes assessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall presentation of the annual accounts. We believethat our audit provides a reasonable basis for our opinion.

In our opinion, the annual accounts give a true and fair view of the financial position of theEuropean Central Bank as of 31 December 2003 and of the results of its operations for the yearthen ended in accordance with the accounting policies as described in the first part of the notes.

Frankfurt am Main, 9 March 2004

KPMG Deutsche Treuhand-GesellschaftAktiengesellschaftWirtschaftsprüfungsgesellschaft

(Wohlmannstetter) (Dr. Lemnitzer)Wirtschaftsprüfer Wirtschaftsprüfer

Marie-Curie-Straße 30 Postfach 50 05 20 Telefon (0 69) 95 87-0D-60439 Frankfurt am Main D-60394 Frankfurt am Main Telefax (0 69) 95 87-10 50

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Aufsichtsratsvorsitzender:WP StB Dipl.-Kfm.Gerhard Brackert

Vorstand:WP StB Dipl.-Kfm.Axel BergerWP RA StBDr. Bernd ErleWP StB Dipl.-Kfm.Prof. Dr. Gerd GeibWP Dr. Martin Hoyos

RA StBDr. Hartwich LüßmannWP Dipl.-Kfm. Ulrich MaasWP StBProf. Dr. Rolf NonnenmacherWP StB Dipl.-Kfm.Rüdiger ReinkeCPA Kenneth D. RussellWP Dipl.-Oec.Bernd Ulrich SchmidWP Dipl.-Kfm.Prof. Dr. Wienand SchruffWP StB Dr. Peter Wesner

WP RA StBProf. Dr. Harald WiedmannSprecherWP StB CPA Dipl.-Kfm. MScGottfried WohlmannstetterWP StB Dipl.-Kfm.Hans ZehnderWP StB Dipl.-Kfm.Wolfgang Zielkestellv. Sprecher

Zertifiziert nachDIN EN ISO 9001

Sitz: Berlin undFrankfurt am Main

Handelsregister:Charlottenburg (HRB 1077)und Frankfurt am Main(HRB 14345)

Bankverbindung:Deutsche Bank AG,Frankfurt a. M., 096 386 800BLZ 500 700 10

USt.-IdNr.: DE 136 751 547


5 CONSOL IDATED BALANCE SHEET OF THE EUROSYSTEMAS AT 31 DECEMBER 2003

(EUR MILLIONS)

ASSETS 31 DECEMBER 31 DECEMBER2003 2002

1 Gold and gold receivables 130,344 130,739

2 Claims on non-euro area residents denominatedin foreign currency 175,579 234,4862.1 Receivables from the IMF 29,130 31,3052.2 Balances with banks and security investments,

external loans and other external assets 146,449 203,181

3 Claims on euro area residents denominated inforeign currency 17,415 19,823

4 Claims on non-euro area residents denominated in euro 6,049 4,1904.1 Balances with banks, security investments and loans 6,049 4,1904.2 Claims arising from the credit facility under ERM II 0 0

5 Lending to euro area credit institutions related tomonetary policy operations denominated in euro 298,163 227,6545.1 Main refinancing operations 253,001 180,0005.2 Longer-term refinancing operations 45,000 45,0005.3 Fine-tuning reverse operations 0 05.4 Structural reverse operations 0 05.5 Marginal lending facility 134 2,6215.6 Credits related to margin calls 28 33

6 Other claims on euro area credit institutionsdenominated in euro 729 147

7 Securities of euro area residents denominated in euro 54,466 27,828

8 General government debt denominated in euro 42,686 44,486

9 Other assets 109,365 105,808

Total assets 834,796 795,161

Totals/subtotals may not add up due to rounding.

203ECB

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LIABILITIES 31 DECEMBER 31 DECEMBER2003 2002

1 Banknotes in circulation 436,128 371,866*

2 Liabilities to euro area credit institutions related to monetarypolicy operations denominated in euro 147,328 133,5652.1 Current accounts (covering the minimum reserve system) 147,247 133,4952.2 Deposit facility 80 702.3 Fixed-term deposits 0 02.4 Fine-tuning reverse operations 0 02.5 Deposits related to margin calls 1 0

3 Other liabilities to euro area credit institutions denominatedin euro 257 15

4 Debt certificates issued 1,054 2,029

5 Liabilities to other euro area residents denominated in euro 39,865 46,1975.1 General government 34,106 41,1235.2 Other liabilities 5,759 5,074

6 Liabilities to non-euro area residents denominated in euro 10,279 8,813

7 Liabilities to euro area residents denominated inforeign currency 499 1,125

8 Liabilities to non-euro area residents denominated inforeign currency 11,205 18,5888.1 Deposits, balances and other liabilities 11,205 18,5888.2 Liabilities arising from the credit facility under ERM II 0 0

9 Counterpart of special drawing rights allocated by the IMF 5,761 6,340

10 Other liabilities 54,757 62,470

11 Revaluation accounts 67,819 82,615

12 Capital and reserves 59,844 61,538

Total liabilities 834,796 795,161

* The “Banknotes in circulation” figure for 31 December 2002 includes €13,338 million of euro area national banknotes incirculation. On 1 January 2003 these national banknotes were transferred to the position “Other liabilities” and amountedto €11,338 million as at 31 December 2003.

ANNEXES


ECB/2003/1 Recommendation, under Article 10.6 of the Statute of theEuropean System of Central Banks and of the European CentralBank, for a Council Decision on an amendment to Article 10.2of the Statute of the European System of Central Banks and ofthe European Central Bank

ECB/2003/2 Guideline of the European Central Bank of 6 February 2003concerning certain statistical reporting requirements of theEuropean Central Bank and the procedures for reporting by thenational central banks of statistical information in the field ofmoney and banking statistics

ECB/2003/3 Recommendation of the European Central Bank of 6 March2003 to the Council of the European Union on the externalauditors of the Deutsche Bundesbank

ECB/2003/4 Decision of the European Central Bank of 20 March 2003 onthe denominations, specifications, reproduction, exchange andwithdrawal of euro banknotes

ECB/2003/5 Guideline of the European Central Bank of 20 March 2003 onthe enforcement of measures to counter non-compliantreproductions of euro banknotes and on the exchange andwithdrawal of euro banknotes

ECB/2003/6 Guideline of the European Central Bank of 4 April 2003amending Guideline ECB/2001/3 on a Trans-EuropeanAutomated Real-time Gross settlement Express Transfersystem (TARGET), as amended on 27 February 2002

ECB/2003/7 Guideline of the European Central Bank of 2 May 2003 on thestatistical reporting requirements of the European Central Bankin the field of balance of payments and international investmentposition statistics, and the international reserves template

ECB/2003/8 Recommendation of the European Central Bank of 2 May 2003on the statistical reporting requirements of the EuropeanCentral Bank in the field of balance of payments andinternational investment position statistics, and theinternational reserves template

ANNEXE S

L EGA L I N S T RUMENT S A DOP T ED B Y TH EEUROP E AN C EN TR A L B ANKThe following table lists the legal instrumentsthat were adopted by the ECB in 2003 and early2004 and published in the Official Journal ofthe European Union. Copies of the OfficialJournal can be obtained from the Office for

Official Publications of the EuropeanCommunities. For a list of all the legalinstruments adopted by the ECB sinceits establishment, see the ECB’s website(www.ecb.int).

Number Title OJ reference

OJ C 29,7.2.2003,p. 6

OJ L 241,26.9.2003,p. 1

OJ C 75,27.3.2003,p. 11

OJ L 78,25.3.2003,p. 16

OJ L 78,25.3.2003,p. 20

OJ L 113,7.5.2003,p. 10

OJ L 131,28.5.2003,p. 20

OJ C 126,28.5.2003,p. 7

207ECB

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ECB/2003/9 Regulation of the European Central Bank of 12 September 2003on the application of minimum reserves

ECB/2003/10 Regulation of the European Central Bank of 18 September 2003amending Regulation ECB/2001/13 concerning theconsolidated balance sheet of the monetary financialinstitutions sector

ECB/2003/11 Recommendation of the European Central Bank of 3 October2003 to the Council of the European Union on the externalauditors of the Banque centrale du Luxembourg

ECB/2003/12 Guideline of the European Central Bank of 23 October 2003 forparticipating Member States’ transactions with their foreignexchange working balances pursuant to Article 31.3 of theStatute of the European System of Central Banks and of theEuropean Central Bank

ECB/2003/13 Decision of the European Central Bank of 23 October 2003amending Decision ECB/2002/12 of 19 December 2002 on theapproval of the volume of coin issuance in 2003

ECB/2003/14 Decision of the European Central Bank of 7 November 2003concerning the administration of the borrowing and lendingoperations concluded by the European Community under themedium-term financial assistance facility

ECB/2003/15 Decision of the European Central Bank of 28 November 2003on the approval of the volume of coin issuance in 2004

ECB/2003/16 Guideline of the European Central Bank of 1 December 2003amending Guideline ECB/2000/7 on monetary policyinstruments and procedures of the Eurosystem

ECB/2003/17 Decision of the European Central Bank of 18 December 2003on the national central banks’ percentage shares in the key forsubscription to the European Central Bank’s capital

ECB/2003/18 Decision of the European Central Bank of 18 December 2003laying down the measures necessary for the paying-up of theEuropean Central Bank’s capital by the participating nationalcentral banks

ECB/2003/19 Decision of the European Central Bank of 18 December 2003laying down the measures necessary for the paying-up of theEuropean Central Bank’s capital by the non-participatingnational central banks


OJ L 250,2.10.2003,p. 10

OJ L 250,2.10.2003,p. 17

OJ C 247,15.10.2003,p. 16

OJ L 283,31.10.2003,p. 81

OJ L 283,31.10.2003,p. 87

OJ L 297,15.11.2003,p. 35

OJ L 324,11.12.2003,p. 57

OJ L 69,8.3.2004,p. 1

OJ L 9,15.1.2004,p. 27

OJ L 9,15.1.2004,p. 29

OJ L 9,15.1.2004,p. 31



ECB/2003/20 Decision of the European Central Bank of 18 December 2003laying down the terms and conditions for transfers of theEuropean Central Bank’s capital shares between the nationalcentral banks and adjustment of the paid-up capital

ECB/2003/21 Decision of the European Central Bank of 18 December 2003laying down the measures necessary for the contribution to theEuropean Central Bank’s reserves and provisions and foradjusting the national central banks’ claims equivalent to thetransferred foreign reserve assets

ECB/2003/22 Decision of the European Central Bank of 18 December 2003amending Article 1(f) of Decision ECB/2001/16 of 6 December2001 on the allocation of monetary income of the nationalcentral banks of participating Member States from the financialyear 2002

ECB/2003/23 Decision of the European Central Bank of 18 December 2003amending Decision ECB/2001/15 of 6 December 2001 on theissue of euro banknotes

ECB/2004/1 Guideline of the European Central Bank of 13 February 2004amending Guideline ECB/2003/2 concerning certain statisticalreporting requirements of the European Central Bank and theprocedures for reporting by the national central banks ofstatistical information in the field of money and bankingstatistics

ECB/2004/2 Decision of the European Central Bank of 19 February 2004adopting the Rules of Procedure of the European Central Bank

OJ L 9,15.1.2004,p. 32

OJ L 9,15.1.2004,p. 36

OJ L 9,15.1.2004,p. 39

OJ L 9,15.1.2004,p. 40

OJ L 83,20.3.2004

OJ L 80,18.3.2004,p. 33

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Annua l Repor t2003

The following table lists the opinions adoptedby the ECB in 2003 and early 2004 underArticle 105 (4) of the Treaty and Article 4 of theStatute of the ESCB, Article 112 (2) (b) of theTreaty and Article 11.2 of the Statute of the

OP I N I ON S ADOP T ED B Y TH E E UROP E ANC EN TRA L B ANK

CON/2003/1 Netherlands Amendment to the rules on the reporting of balance ofpayments data

CON/2003/2 Denmark Replacement of the Financial Business Act and the MortgageLoans and Mortgage Bonds Act

CON/2003/3 Sweden Amendments to the Sveriges Riksbank Act and the Riksdag Act

CON/2003/4 Greece Amendment to the Statute of the Bank of Greece

CON/2003/7 Belgium Royal Decree on off-exchange market for linear bonds, stripsand treasury certificates

CON/2003/8 Austria Foreign Exchange Act 2003 and amendment to the Cross-border Transfers Act

CON/2003/10 Sweden Legislative reform of banking and finance law

CON/2003/11 Austria Financial collateral arrangements in financial markets,implementing Directive 2002/47/EC

CON/2003/14 Italy Payment systems, payment infrastructures and paymentinstruments

CON/2003/15 Sweden Amendment to the Sveriges Riksbank Act

CON/2003/17 Austria Mortgage bond division of regional public banks, andamending other acts

CON/2003/19 Belgium Prudential supervision of the financial sector and financialservices

CON/2003/22 Finland Amendments to the Suomen Pankki Act and related acts

CON/2003/23 Netherlands Merger of De Nederlandsche Bank and the NetherlandsPension and Insurance Supervisory Authority Foundation

CON/2003/24 Ireland Central Bank and Financial Services Authority of Ireland Bill(No 2) 2003

ESCB as well as Article 48 of the Treaty onEuropean Union. For a list of all the opinionsadopted by the ECB since its establishment, seethe ECB’s website.

(a) ECB opinions following a consultation by a Member State1

Number2 Originator Subject

1 ECB opinions issued upon the request of national authorities are usually published on the ECB’s website six months after they areadopted; policy-important opinions are published immediately.

2 Consultations are numbered in the order in which the Governing Council adopted them.


CON/2003/25 Belgium Amendments to the Law on the prevention of the use of thefinancial system for the purpose of money laundering and otherlaws

CON/2003/27 Austria The National Foundation for Research, Technology andDevelopment

CON/2003/28 Spain Amendments to the Law on the autonomy of the Banco deEspaña

CON/2003/29 Portugal Amendments to the Organic Law of the Banco de Portugal

CON/2004/1 Finland Amendments to the Suomen Pankki Act and related acts

CON/2004/2 Sweden Replacement of Sveriges Riksbank’s regulations and generaladvice on the reporting by MFIs of money and bankingstatistics

CON/2004/3 Luxembourg Establishment of a specific legal framework for securitisationtransactions

CON/2004/5 Austria Financial Conglomerates Law implementing Directive2002/87/EC

CON/2004/6 France Authorisation of an existing State guarantee to the Banque deFrance

Number2 Originator Subject

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Annua l Repor t2003

3 Published on the ECB’s website.4 Consultations are numbered in the order in which the Governing Council adopted them.

CON/2003/5 EU Council Statistical data to be used for the adjustment ofthe key for subscription to the capital of theECB

CON/2003/6 EU Council Recommendation on the appointment of a newmember of the Executive Board of the ECB

CON/2003/9 EU Council Investment services and regulated markets

CON/2003/12 EU Council Quarterly financial accounts for generalgovernment

CON/2003/13 EU Council Recommendation on the appointment of thenew President of the ECB

CON/2003/16 EU Council Analysis and cooperation with regard tocounterfeit euro coins

CON/2003/18 EU Council Recommendation on amendments to theMonetary Agreement between the ItalianRepublic, on behalf of the EuropeanCommunity, and the Holy See, on behalf ofthe Vatican City State

CON/2003/20 EU Council The draft Treaty establishing a Constitutionfor Europe

CON/2003/21 EU Council Transparency requirements on informationabout issuers whose securities are admitted totrading on a regulated market

CON/2003/26 EU Council Community statistics on balance of payments,international trade in services and foreigndirect investment

CON/2004/4 EU Council Compilation of quarterly non-financialaccounts by institutional sector

CON/2004/7 EU Council Establishment of a new financial servicescommittee organisational structure

(b) ECB opinions following a consultation by a European institution3

Number4 Originator Subject OJ reference

OJ C 102,29.4.2003,p. 11

OJ C 105,1.5.2003,p. 37

OJ C 144,20.6.2003,p. 6

OJ C 165,16.7.2003,p. 6

OJ C 187,7.8.2003,p. 16

OJ C 202,27.8.2003,p. 31

OJ C 212,6.9.2003,p. 10

OJ C 229,25.9.2003,p. 7

OJ C 242,9.10.2003,p. 6

OJ C 296,6.12.2003,p. 5

OJ C 42,18.2.2004,p. 23OJ C 58,6.3.2004,p. 23

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This list is designed to inform readers about selected documents published by the European CentralBank since January 2003. For Working Papers, the list only refers to publications releasedbetween December 2003 and February 2004. The publications are available to interested partiesfree of charge from the Press and Information Division. Please submit orders in writing to thepostal address given on the back of the title page.

For a complete list of documents published by the European Central Bank and by the EuropeanMonetary Institute, please visit the ECB’s website.

ANNUAL REPORT“Annual Report 2002”, April 2003.

MONTHLY BULLETIN ARTICLES“The demand for currency in the euro area and the impact of the euro cash changeover”,January 2003.“CLS – purpose, concept and implications”, January 2003.“The relationship between monetary policy and fiscal policies in the euro area”,February 2003.

“Exchange rate regimes for emerging market economies”, February 2003.“The need for comprehensive reforms to cope with population ageing”, April 2003.“Developments in general economic statistics for the euro area”, April 2003.“A bank lending survey for the euro area”, April 2003.“Recent trends in residential property prices in the euro area”, May 2003.“Electronification of payments in Europe”, May 2003.“The adjustment of voting modalities in the Governing Council”, May 2003.“The outcome of the ECB’s evaluation of its monetary policy strategy”, June 2003.“Trends in euro area gross fixed capital formation”, July 2003.“Early experience of the management of euro banknote printing and issuance”, July 2003.“Changes to the Eurosystem’s operational framework for monetary policy”, August 2003.“Recent developments in the euro area banking sector”, August 2003.“Developments in the euro area’s international cost and price competitiveness”, August 2003.“Recent developments in financial structures of the euro area”, October 2003.“The integration of Europe’s financial markets”, October 2003.“Developments in the debt financing of the euro area private sector”, November 2003.“Crisis resolution in emerging market economies – challenges for the international community”,November 2003.“The international role of the euro: main developments since the inception of Stage Three ofEconomic and Monetary Union”, November 2003.“EMU and the conduct of fiscal policies”, January 2004.“Opinion survey on activity, prices and labour market developments in the euro area: features anduses”, January 2004.“Measuring and analysing profit developments in the euro area”, January 2004.“The acceding countries’ economies on the threshold of the European Union”,February 2004.“Developments in private sector balance sheets in the euro area and the United States”, February2004.“The impact of fair value accounting on the European banking sector – a financial stabilityperspective”, February 2004.

DOCUMENT S PUB L I S H ED B Y TH EEUROPE AN C EN TR A L B ANK S I N C E J A NUARY 2 0 0 3


OCCASIONAL PAPER SERIES8 “An introduction to the ECB’s survey of professional forecasters” by J. A. Garcia,

September 2003.9 “Fiscal adjustment in 1991-2002: stylised facts and policy implications” by M. G. Briotti,

February 2004.10 “The acceding countries’ strategies towards ERM II and the adoption of the euro:

an analytical review” by a staff team led by P. Backé and C. Thimann and includingO. Arratibel, O. Calvo-Gonzalez, A. Mehl and C. Nerlich, February 2004.

11 “Official dollarisation/euroisation: motives, features and policy implications of currentcases” by A. Winkler, F. Mazzaferro, C. Nerlich and C. Thimann, February 2004.

WORKING PAPER SERIES294 “Does the yield spread predict recessions in the euro area?” by F. Moneta,

December 2003.295 “Optimal allotment policy in the Eurosystem’s main refinancing operations”

by C. Ewerhart, N. Cassola, S. Ejerskov and N. Valla, December 2003.296 “Monetary policy analysis in a small open economy using Bayesian cointegrated structural

VARs” by M. Villani and A. Warne, December 2003.297 “Measurement of contagion in banks’ equity prices” by R. Gropp and G. Moerman,

December 2003.298 “The lender of last resort: a 21st century approach” by X. Freixas, B. M. Parigi and

J.-C. Rochet, December 2003.299 “Import prices and pricing-to-market effects in the euro area” by T. Warmedinger, January

2004.300 “Developing statistical indicators of the integration of the euro area banking system” by

M. Manna, January 2004.301 “Inflation and relative price asymmetry” by A. Rátfai, January 2004.302 “Deposit insurance, moral hazard and market monitoring” by R. Gropp and

J. Vesala, February 2004.303 “Fiscal policy events and interest rate swap spreads: evidence from the EU”

by A. Afonso and R. Strauch, February 2004.304 “Equilibrium unemployment, job flows and inflation dynamics” by A. Trigari, February

2004.305 “A structural common factor approach to core inflation estimation and forecasting” by

C. Morana, February 2004.306 “A markup model of inflation for the euro area” by C. Bowdler and E. S. Jansen, February

2004.307 “Budgetary forecasts in Europe – the track record of stability and convergence

programmes” by R. Strauch, M. Hallerberg and J. von Hagen, February 2004.308 “International risk-sharing and the transmission of productivity shocks”

by G. Corsetti, L. Dedola and S. Leduc, February 2004.309 “Monetary policy shocks in the euro area and global liquidity spillovers”

by J. Sousa and A. Zaghini, February 2004.310 “International equity flows and returns: A quantitative equilibrium approach”

by R. Albuquerque, G. H. Bauer and M. Schneider, February 2004.311 “Current accounts dynamics in OECD and EU acceding countries – an intertemporal

approach” by M. Bussière, M. Fratzscher and G. J. Müller, February 2004.

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312 “Similarities and convergence in G-7 cycles” by F. Canova, M. Ciccarelli andE. Ortega, February 2004.

313 “The high-yield segment of the corporate bond market: a diffusion modelling approach forthe United States, the United Kingdom and the euro area” by G. de Bondt and D. Marqués,February 2004.

OTHER PUBLICATIONS“EU banking sector stability”, February 2003.“List of Monetary Financial Institutions and institutions subject to minimum reserves”,February 2003.“Review of the foreign exchange market structure”, March 2003.“Structural factors in the EU housing markets”, March 2003.“List of Monetary Financial Institutions in the accession countries”, March 2003.“Memorandum of Understanding on the exchange of information among credit registers for thebenefit of reporting institutions”, March 2003.“Memorandum of Understanding on Economic and Financial Statistics between the DirectorateGeneral Statistics of the European Central Bank and the Statistical Office of the EuropeanCommunities (Eurostat).Annex 1: Share of responsibilities in the field of balance of payments and internationalinvestment position statistics”, March 2003.“TARGET Annual Report 2002”, April 2003.“Supplementary guidance notes concerning statistics on the holders of money market fundshares/units”, April 2003.“Money, banking and financial market statistics in the accession countries.Methodological Manual. Vol. 1: The current definition and structure of money and bankingstatistics in the accession countries”, May 2003.“Money, banking and financial market statistics in the accession countries.Methodological Manual. Vol. 2: Statistics on other financial intermediaries, financial marketsand interest rates in the accession countries”, May 2003.“Accession countries: balance of payments/international investment position statisticalmethods”, May 2003.“Electronic money system security objectives according to the common criteria methodology”,May 2003.“The transformation of the European financial system, Second ECB Central BankingConference, October 2002, Frankfurt am Main”, June 2003.“Letter from the ECB President to the President of the Convention regarding the draftConstitutional Treaty”, June 2003.“Developments in national supervisory structures”, June 2003.“Oversight standards for euro retail payment systems”, June 2003.“Towards a Single Euro Payments Area – progress report”, June 2003.“Amendments to the risk control framework for tier one and tier two eligible assets”,July 2003.“ECB statistics: A brief overview”, August 2003.“Portfolio investment income: Task force report”, August 2003.“The New Basel Capital Accord”, August 2003.“Payment and securities settlement systems in the European Union: Addendum incorporating2001 figures”, September 2003.


“Letter from the ECB President to the President of the Council of the European Union regardingthe Opinion of the ECB of 19 September 2003 at the request of the Councilof the European Union on the draft Treaty establishing a Constitution for Europe(CON/2003/20)”, 22 September 2003.“Inflation differentials in the euro area: potential causes and policy implications”,September 2003.“Correspondent central banking model (CCBM): procedures for Eurosystem counterparties”,September 2003.“Bond markets and long-term interest rates in European Union accession countries”,October 2003.“Manual on MFI interest rate statistics – Regulation ECB/2001/18”, October 2003.“European Union balance of payments/international investment position statistical methods”,November 2003.“Money market study 2002”, November 2003.“Background studies for the ECB’s evaluation of its monetary policy strategy”,November 2003.“Structural analysis of the EU banking sector, Year 2002”, November 2003.“TARGET: the Trans-European Automated Real-time Gross settlement Express Transfer system– update 2003”, November 2003.“TARGET2: the payment system of the €urosystem”, November 2003.“Seasonal adjustment”, November 2003.“Comments of the ECB on the third consultative document of the European Commission onregulatory capital review”, November 2003.“EU banking sector stability”, November 2003.“Review of the international role of the euro”, December 2003.“Policy position of the Governing Council of the European Central Bank on exchange rateissues relating to the acceding countries”, December 2003.“Assessment of accession countries’ securities settlement systems against the standards for theuse of EU securities settlement systems in Eurosystem credit operations”,January 2004.“The monetary policy of the ECB”, January 2004.“The implementation of monetary policy in the euro area: General documentation on Eurosystemmonetary policy instruments and procedures”, February 2004.“Guidance notes on the MFI balance sheet statistics relating to EU enlargement as laid down inRegulation ECB/2003/10”, February 2004.“Comments on the communication from the Commission to the Council and the EuropeanParliament concerning a new legal framework for payments in the internal market (consultativedocument)”, February 2004.

INFORMATION BROCHURES“Information guide for credit institutions using TARGET”, July 2003.

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CHRONOLOGY O F MONE TARY PO L I C YMEA SUR E S O F T H E E URO S Y S T EM 1

1 The chronology of monetary policy measures of the Eurosystemtaken in 1999 to 2001 can be found on pages 176 to 180 of theECB’s Annual Report 1999, on pages 205 to 208 of the ECB’sAnnual Report 2000 and on pages 219 to 220 of the ECB’s AnnualReport 2001 respectively.

9 JANUARY 2003

The Governing Council of the ECB decides thatthe minimum bid rate on the main refinancingoperations and the interest rates on the marginallending facility and the deposit facility willremain unchanged at 2.75%, 3.75% and 1.75%respectively.

23 JANUARY 2003

The Governing Council of the ECB decides toimplement the following two measures toimprove the operational framework formonetary policy:

First, the timing of the reserve maintenanceperiod will be changed so that it will alwaysstart on the settlement day of the mainrefinancing operation (MRO) following theGoverning Council meeting at which themonthly assessment of the monetary policystance is pre-scheduled. Furthermore, as a rule,the implementation of changes to the standingfacility rates will be aligned with the start of thenew reserve maintenance period.

Second, the maturity of the MROs will beshortened from two weeks to one week.

These measures are scheduled to come intoeffect during the first quarter of 2004.

Further to the press release of 10 July 2002, theGoverning Council also decides to maintain at€15 billion the allotment amount for each of thelonger-term refinancing operations to beconducted in the year 2003. This amount takesinto consideration the expected liquidity needsof the euro area banking system in 2003 andreflects the desire of the Eurosystem to continueto provide the bulk of liquidity through its mainrefinancing operations.

6 FEBRUARY 2003


6 MARCH 2003

The Governing Council of the ECB decides tolower the minimum bid rate on the mainrefinancing operations by 0.25 percentage pointto 2.50%, starting from the operation to besettled on 12 March 2003. It also decides tolower the interest rates on both the marginallending facility and the deposit facility by 0.25percentage point, to 3.50% and 1.50%respectively, both with effect from 7 March2003.

3 APRIL 2003


8 MAY 2003



It also announces the results of itsevaluation of the ECB’s monetary policystrategy. This strategy, which wasannounced on 13 October 1998, consists ofthree main elements: a quantitativedefinition of price stability, a prominentrole for money in the assessment of risks toprice stability, and a broadly basedassessment of the outlook for pricedevelopments.

The Governing Council confirms the definitionof price stability formulated in October 1998,namely that “price stability is defined as a year-on-year increase in the Harmonised Index ofConsumer Prices (HICP) for the euro area ofbelow 2%. Price stability is to be maintainedover the medium term”. At the same time, theGoverning Council agrees that in the pursuit ofprice stability it will aim to maintain inflationrates close to 2% over the medium term.

The Governing Council confirms that itsmonetary policy decisions will continue to bebased on a comprehensive analysis of the risksto price stability. At the same time, theGoverning Council decides to clarify in itscommunication the respective roles played byeconomic and monetary analysis in the processof coming to the Council’s overall assessmentof risks to price stability.

To underscore the longer-term nature of thereference value for monetary growth as abenchmark for the assessment of monetarydevelopments, the Governing Council alsodecides that it will no longer conduct a reviewof the reference value on an annual basis.However, it will continue to assess theunderlying conditions and assumptions.

5 JUNE 2003

The Governing Council of the ECB decides tolower the minimum bid rate on the mainrefinancing operations by 0.50 percentage pointto 2.0%, starting from the operation to besettled on 9 June 2003. It also decides to lower

the interest rates on both the marginal lendingfacility and the deposit facility by 0.50percentage point, to 3.0% and 1.0%respectively, both with effect from 6 June 2003.

10 JULY, 31 JULY, 4 SEPTEMBER,2 OCTOBER, 6 NOVEMBER, 4 DECEMBER 2003AND 8 JANUARY 2004


12 JANUARY 2004

The Governing Council of the ECB decides toincrease the allotment amount for each of thelonger-term refinancing operations to beconducted in the year 2004 from €15 billion to€25 billion. This increased amount takes intoconsideration the higher liquidity needs of theeuro area banking system anticipated for theyear 2004. The Eurosystem will, however,continue to provide the bulk of liquiditythrough its main refinancing operations. TheGoverning Council may decide to adjust theallotment amount again at the beginning of2005.

5 FEBRUARY, 4 MARCH 2004


219ECB

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Asset allocation: the process of distributing investment funds over different asset classes to achieve goalssuch as optimising portfolio risk/return characteristics.

Acceding countries: see Accession countries

Accession countries: there are currently 13 countries in central and eastern Europe and in the Mediterraneanwhich have been recognised by the European Council as candidates for accession to the European Union(EU). Ten countries will join the EU on 1 May 2004: the Czech Republic, Estonia, Cyprus, Latvia, Lithuania,Hungary, Malta, Poland, Slovenia and Slovakia. These ten countries are termed the acceding countries. Twoother countries, Bulgaria and Romania, have already entered into accession negotiations and have been giventhe prospect of entry into the EU in 2007. Turkey is also an official candidate for accession and is included inthe Economic Dialogue with the EU, but accession negotiations have not yet begun. The term accessioncountries refers to the 12 countries with which negotiations for EU membership have been completed or are stillongoing.

Acquis communautaire: the body of Community legislation by which all EU Member States are bound.Countries joining the EU must have implemented the existing acquis communautaire by the time of accession.

Balance of payments (b.o.p.): a statistical statement that summarises, for a specific time period, theeconomic transactions of an economy with the rest of the world. The transactions considered are those involvinggoods, services and income; those involving financial claims on, and liabilities to, the rest of the world; andthose (such as debt forgiveness) that are classified as transfers. The concepts and definitions used in the euroarea balance of payments generally conform to the 5th edition of the IMF Balance of Payments Manual, to therelated Guideline ECB/2003/7 of 2 May 2003 and to Eurostat’s documentation.

Basel Capital Accord: a regulatory framework setting out minimum capital requirements to ensure thatbanks are able to cover their risks. This framework was adopted in 1988 by the Basel Committee on BankingSupervision on which the central banks and other banking supervisory authorities from the G10 countries, Spainand Luxembourg are represented. The Accord has evolved into a global standard and is now under review in orderto adapt it to developments that have occurred in the financial sector since it was initially introduced (“NewBasel Capital Accord” or “Basel II”).

Benchmark portfolio: in relation to investments, a reference portfolio or index constructed on the basis ofthe objectives for the liquidity and risk of, as well as the return on, the investments. The benchmark portfolioserves as a basis for comparison of the performance of the actual portfolio.

Bond market: the market on which medium and long-term debt securities, i.e. debt securities with anoriginal maturity of more than one year, are issued and traded.

Broad Economic Policy Guidelines (BEPGs): the Treaty obliges the Member States to regard theireconomic policies as a matter of common concern and to coordinate them within the EU Council. The BEPGsconstitute the main instrument of this coordination. They contain recommendations to policy-makers onmacroeconomic and structural policies and provide a yardstick for ex post assessment in the context ofmultilateral surveillance within the EU Council. The EU Council, acting on a recommendation from theEuropean Commission, formulates a draft of the BEPGs and reports its findings to the EuropeanCouncil. The EU Council then adopts a recommendation on the BEPGs based on the European Council’sconclusions.

G L O S S A RY


Central counterparty: an entity which interposes itself as the buyer to every seller and as the seller to everybuyer of a specified set of contracts.

Central securities depository (CSD): an entity which holds and administers securities and enablessecurities transactions to be processed by book entry. Securities can be held in a physical but immobilised formor in a dematerialised (book-entry only) form. In addition to the safekeeping and administration of securities, aCSD may incorporate clearing and settlement functions.

Central government: the government as defined in the European System of Accounts 1995(ESA 95) but excluding state and local governments (see also general government). It includes alladministrative departments of the (central) state and other central agencies whose competence normally extendsover the entire economic domain except for the administration of social security funds.

Collateral: assets pledged (e.g. by credit institutions with central banks) as a guarantee for the repaymentof loans, as well as assets sold (e.g. to central banks by credit institutions) under repurchase agreements.

Committee of European Securities Regulators (CESR): this committee, which was established bythe European Commission in June 2001 in the light of the recommendation of the Report of the Committeeof Wise Men on the Regulation of European Securities Markets, is composed of representatives from the nationalauthorities regulating the securities markets. As the Level 3 body of the revised European regulatory approach,it advises the European Commission on securities policy issues and contributes to ensuring a more consistentimplementation of Community legislation in the Member States. It also improves coordination among Europeansecurities regulators.

Consolidated balance sheet of the MFI sector: obtained by netting out inter-MFI positions (mainlyloans granted by one MFI to another) on the aggregated MFI balance sheet.

Corporate governance: procedures and processes according to which an organisation is directed andcontrolled. The corporate governance structure specifies the distribution of rights and responsibilities among thedifferent participants in the organisation – such as the board, managers, shareholders and other stakeholders –and lays down the rules and procedures for decision-making. In so doing, it also provides the structure withinwhich the organisation’s operational targets are set, and specifies the means of attaining those targets and ofmonitoring performance.

Counterparty: the opposite party in a financial transaction (e.g. any party transacting with a central bank).

Credit institution: an institution covered by the definition in Article 1 (1) of Directive 2000/12/EC of theEuropean Parliament and of the Council of 20 March 2000 relating to the taking up and pursuit of the businessof credit institutions, as amended by Directive 2000/28/EC of the European Parliament and of the Council of18 September 2000. Thus, a credit institution is: (i) an undertaking whose business is to receive deposits orother repayable funds from the public and to grant credit for its own account; or (ii) an undertaking or any otherlegal person, other than those under (i), which issues means of payment in the form of electronic money.

Credit risk: the risk that a counterparty will not settle an obligation in full, either when due or at any timethereafter.

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Debt (financial accounts): includes loans, debt securities issued, and pension fund reserves of non-financial corporations, valued at market value at the end of the period. In the quarterly financial accounts, debtdoes not include loans granted by the non-financial sector (e.g. inter-company loans) or by banks outside theeuro area, whereas these components are included in the annual financial accounts.

Debt ratio (general government): general government debt is defined as total gross debt at nominal valueoutstanding at the end of the year and consolidated between and within the sectors of general government. Thegovernment debt-to-GDP ratio is defined as the ratio of general government debt to gross domestic product atcurrent market prices. It is the subject of one of the fiscal criteria laid down in Article 104 (2) of the Treaty todefine the existence of an excessive deficit.

Debt securities: represent a promise on the part of the issuer (i.e. the borrower) to make one or morepayment(s) to the holder (the lender) on a specified future date or dates. They usually carry a specific rate ofinterest (the coupon) and/or are sold at a discount to the amount that will be repaid at maturity. Debt securitiesissued with an original maturity of more than one year are classified as long-term.

Deficit ratio (general government): the general government deficit is defined as net borrowing andcorresponds to the difference between government revenue and government expenditure. The deficit ratio isdefined as the ratio of the general government deficit to gross domestic product at current market prices. It is thesubject of one of the fiscal criteria laid down in Article 104 (2) of the Treaty establishing the EuropeanCommunity to define the existence of an excessive deficit. It is also referred to as the budget deficit ratio or thefiscal deficit ratio.

Deposit facility: a standing facility of the Eurosystem which counterparties may use to make overnightdeposits, remunerated at a pre-specified interest rate, at an NCB (see also key ECB interest rates).

Direct investment: cross-border investment that reflects the objective of obtaining a lasting interest in anenterprise resident in another economy (in practice assumed for ownership equivalent to at least 10% of thevoting rights). The direct investment account records net acquisitions of assets abroad by euro area residents(as “direct investment abroad”) and net acquisitions of euro area assets by non-residents (as “direct investmentin the euro area”). Direct investment includes equity capital, reinvested earnings and other capital associatedwith inter-company operations.

ECOFIN Council: see EU Council.

Economic analysis: one pillar of the ECB’s framework for conducting a comprehensive analysis of the risksto price stability, which forms the basis for the Governing Council’s monetary policy decisions. Theeconomic analysis focuses mainly on the assessment of current economic and financial developments and theimplied short to medium-term risks to price stability from the perspective of the interplay between supply anddemand in goods, services and factor markets at those horizons. In this respect, due attention is paid to the needto identify the nature of shocks affecting the economy, their effects on cost and pricing behaviour and the shortto medium-term prospects for their propagation in the economy (see also monetary analysis).

Economic and Financial Committee (EFC): a consultative Community body which contributes to thepreparation of the work of the EU Council. It was set up at the start of Stage Three of Economic andMonetary Union (EMU). The Member States, the European Commission and the ECB each appointno more than two members of the Committee. Article 114 (2) of the Treaty contains a list of the tasks of theEFC, which include reviewing the economic and financial situation of the Member States and of the Community,and budgetary surveillance.


Economic and Monetary Union (EMU): the Treaty describes the process of achieving EMU in theEuropean Union (EU) in three stages. Stage One of EMU started in July 1990 and ended on 31 December 1993;it was mainly characterised by the dismantling of all internal barriers to the free movement of capital within theEU. Stage Two of EMU began on 1 January 1994. It provided for, inter alia, the establishment of theEuropean Monetary Institute (EMI), the prohibition of financing of the public sector by the centralbanks, the prohibition of privileged access to financial institutions by the public sector and the avoidance ofexcessive government deficits. Stage Three started on 1 January 1999 with the transfer of monetary competenceto the ECB and the introduction of the euro. The cash changeover on 1 January 2002 completed the processsetting up EMU.

Economic Policy Committee (EPC): a consultative Community body which contributes to the preparationof the work of the EU Council. It works in close cooperation with the Economic and FinancialCommittee (EFC) and focuses mainly on structural policies aimed at improving the growth potential andemployment in the Community. The Committee, which is provided for in Article 272 of the Treaty, was setup by a Council Decision in 1974. Each Member State appoints two members of the Committee, as does theEuropean Commission and the ECB .

Effective exchange rates (EERs, nominal/real): nominal euro EERs are weighted averages of bilateraleuro exchange rates against the currencies of the euro area’s main trading partners. The ECB publishesnominal EER indices for the euro against the currencies of a narrow and a broad group of trading partners. Theweights used reflect the share of each partner country in euro area trade. Real EERs are nominal EERs deflatedby a weighted average of foreign, relative to domestic, prices or costs. They are, thus, measures of price and costcompetitiveness.

Electronic money (e-money): an electronic store of monetary value on a technical device that may bewidely used as a prepaid bearer instrument for making payments to undertakings other than the issuer, withoutnecessarily involving bank accounts in the transactions.

EONIA (euro overnight index average): a measure of the interest rate prevailing in the eurointerbank overnight market, based on transactions.

Equity market: the market in which claims to a share in the ownership of a business are issued and traded.A major difference between equity and debt is that the former does not have to be repaid by the issuer.

Equity securities: represent ownership of a stake in a corporation. They comprise shares traded on stockexchanges (quoted shares), unquoted shares and other forms of equity. Equities usually produce income in theform of dividends.

ERM II (exchange rate mechanism II): the exchange rate arrangement which provides the framework forexchange rate policy cooperation between the euro area countries and the EU Member States not participatingin Stage Three of EMU.

EU Council (Council of Ministers): an institution of the European Community made up ofrepresentatives of the governments of the Member States, normally the ministers responsible for the mattersunder consideration (therefore often referred to as the Council of Ministers). The EU Council meeting in thecomposition of the ministers of economy and finance is often referred to as the ECOFIN Council. Inaddition, for decisions of particular importance, the EU Council meets in the composition of the Heads of Stateor Government. This should not be confused with the European Council, which also brings together the Heads

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of State or Government but which provides the Union with the necessary impetus for its development and definesthe general political guidelines.

EURIBOR (euro interbank offered rate): the rate at which a prime bank is willing to lend funds ineuro to another prime bank, computed daily for interbank deposits with different maturities of up to 12 months.

Euro: the name of the European single currency adopted by the European Council at its meeting in Madridon 15 and 16 December 1995.

Euro area: the area encompassing those Member States in which the euro has been adopted as the singlecurrency in accordance with the Treaty and in which a single monetary policy is conducted under theresponsibility of the Governing Council of the ECB. The euro area currently comprises Belgium, Germany,Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland.

Eurogroup: informal grouping bringing together those members of the ECOFIN Council who representthe euro area countries. It meets on a regular basis (usually prior to meetings of the ECOFIN Council) todiscuss issues connected with the euro area countries’ shared responsibilities for the single currency. TheEuropean Commission and, when appropriate, the ECB are invited to take part in these meetings.

European Central Bank (ECB): the ECB lies at the centre of the European System of CentralBanks (ESCB) and the Eurosystem and has legal personality under Community law. It ensures that thetasks conferred upon the Eurosystem and the ESCB are implemented either through its own activities or throughthose of the NCBs, pursuant to the Statute of the European System of Central Banks and of the European CentralBank. The ECB is governed by the Governing Council and the Executive Board, and, as a third decision-making body, by the General Council.

European Commission: the institution of the European Community which ensures the application of theprovisions of the Treaty. The Commission develops Community policies, proposes Community legislationand exercises powers in specific areas. In the area of economic policy, the Commission recommends BroadEconomic Policy Guidelines (BEPGs) and reports to the EU Council on economic developments andpolicies. It monitors public finances within the framework of multilateral surveillance and submits reports to theEU Council. It consists of 20 members (until 1 May 2004) and includes two nationals each from Germany,Spain, France, Italy and the United Kingdom, and one from each of the other Member States. Following atransition period after EU enlargement, the Commission will consist of 25 members, one national from each ofthe 25 Member States.

European Council: provides the European Union with the necessary impetus for its development and definesthe general political guidelines thereof. It brings together the Heads of State or Government of the MemberStates and the President of the European Commission (see also EU Council).

European Monetary Institute (EMI): a temporary institution established at the start of Stage Two ofEconomic and Monetary Union (EMU) on 1 January 1994. The two main tasks of the EMI were tostrengthen central bank cooperation and monetary policy coordination and to make the preparations requiredfor the establishment of the European System of Central Banks (ESCB), for the conduct of the singlemonetary policy and for the creation of a single currency in Stage Three. It went into liquidation upon theestablishment of the ECB on 1 June 1998.

European Parliament: consists of 626 representatives of the citizens of the Member States. In addition, 162observers have been appointed by the national parliaments of the acceding countries. The Accession Treaty


provides that, following its ratification by the current and future Member States, the European Parliament shallcomprise 732 members as of the forthcoming parliamentary term (2004-2009). The Parliament contributes to thelegislative process, although with different prerogatives according to the procedures through which EU law is tobe enacted. In the framework of Economic and Monetary Union (EMU), the Parliament has mainlyconsultative powers. However, the Treaty establishes certain procedures for the democratic accountability ofthe ECB to the Parliament (presentation of the Annual Report, general debate on monetary policy, testimoniesbefore the competent parliamentary committees).

European Payments Council (EPC): governance body consisting of 52 representatives of institutions,including commercial banks, cooperative banks and savings banks, entrusted with bringing about the single europayment area and with representing the European banking industry on issues related to payment systems.

European System of Accounts 1995 (ESA 95): a system of uniform statistical definitions andclassifications aimed at achieving a harmonised quantitative description of the economies of the Member States.The ESA 95 is the Community’s version of the world System of National Accounts 1993 (SNA 93).

European System of Central Banks (ESCB): composed of the ECB and the NCBs of all 15 MemberStates, i.e. it includes, in addition to the members of the Eurosystem, the NCBs of those Member States thathave not yet adopted the euro. The ESCB is governed by the Governing Council and the ExecutiveBoard of the ECB, and, as a third decision-making body of the ECB, by the General Council.

Eurostat: the Statistical Office of the European Communities. Eurostat is part of the EuropeanCommission and is responsible for the production of Community statistics.

Eurosystem: comprises the ECB and the NCBs of those Member States that have adopted the euro in StageThree of Economic and Monetary Union (EMU) (see also euro area). There are currently 12 NCBs inthe Eurosystem. The Eurosystem is governed by the Governing Council and the Executive Board of theECB.

Eurosystem’s international reserves: these comprise the reserve assets of the ECB and the reserveassets held by the NCBs of the euro area countries. According to the IMF definition, reserve assets must beunder the effective control of the relevant monetary authority, whether the ECB or the NCB of one of the euroarea countries, and comprise highly liquid, marketable and creditworthy foreign (i.e. non-euro) currency-denominated claims on non-euro area residents, plus gold, special drawing rights and the reserve positions in theInternational Monetary Fund of the euro area NCBs.

Excessive deficit procedure: the provision defined in Article 104 of the Treaty and specified in theProtocol on the excessive deficit procedure requires EU Member States to maintain budgetary discipline, definescriteria for a budgetary position to be considered an excessive deficit and sets out the steps to be taken followingthe observation that the criteria for the budget balance or government debt have not been fulfilled. This issupplemented by the Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying theimplementation of the excessive deficit procedure, which is an element of the Stability and Growth Pact.

Executive Board: one of the decision-making bodies of the ECB. It comprises the President and the Vice-President of the ECB and four other members appointed by common accord by the Heads of State or Governmentof the countries that have adopted the euro.

External trade in goods: intra- and extra-euro area exports and imports of goods, measured in terms ofvalue and as volume and unit value indices. Intra-euro area trade records the arrival and dispatch of goods

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flowing between the euro area countries, while extra-euro area trade records the external trade of the euro area.External trade statistics are not directly comparable with exports and imports recorded in the national accounts,as the latter include both intra- and extra-euro area transactions and also combine goods and services.

Fair value accounting (FVA): a valuation principle that stipulates the use of either a market price, whereit exists, or an estimation of a market price as the present value of expected cash flows, to establish the balancesheet value of financial instruments.

Fine-tuning operation: a non-regular open market operation executed by the Eurosystem mainly inorder to deal with unexpected liquidity fluctuations in the market.

Foreign exchange swap: simultaneous spot and forward transactions exchanging one currency againstanother. The Eurosystem can execute open market operations in the form of foreign exchange swaps,where the NCBs (or the ECB) buy or sell euro spot against a foreign currency and, at the same time, sell or buythem back in a forward transaction.

General Council: one of the decision-making bodies of the ECB. It comprises the President and the Vice-President of the ECB and the governors of all EU NCBs.

General government: as defined in the European System of Accounts 1995 (ESA 95), comprisescentral, state and local government and social security funds. Publicly owned units carrying out commercialoperations, such as public enterprises, are in principle excluded from general government.

Governing Council: the supreme decision-making body of the ECB. It comprises all the members of theExecutive Board of the ECB and the governors of the NCBs of the countries that have adopted the euro.

Harmonised Index of Consumer Prices (HICP): a measure of consumer prices which is compiled byEurostat and harmonised for all EU countries.

Implied volatility: a measure of expected volatility (standard deviation in terms of annualised percentagechanges) in the prices of, for example, bonds and stocks (or of corresponding futures contracts), which can beextracted from option prices.

Interest rate: the amount that a debtor has to pay to the creditor over a given period of time in relation to theamount of the principal of the loan, deposit or debt security, usually expressed as an annual percentage.

Interlinking mechanism: one of the components of the TARGET system. The term is used to designatethe infrastructures and procedures which link domestic RTGS systems in order to enable the processing ofcross-border payments within TARGET.

International Accounting Standards (IAS): generally recognised accounting principles issued by theInternational Accounting Standards Board (IASB), an independent, privately funded setter of accountingstandards. These are enforceable global standards relating to the provision of transparent and comparableinformation in general-purpose financial statements. In April 2001 the IASB announced that its accountingstandards would in future be designated International Financial Reporting Standards (IFRS).

International investment position (i.i.p.): the value and composition of an economy’s outstanding netfinancial claims on (or financial liabilities to) the rest of the world. Also referred to as the net external assetposition.


Key ECB interest rates: the interest rates, set by the Governing Council, which reflect the monetarypolicy stance of the ECB. They are the minimum bid rate on the main refinancing operations, theinterest rate on the marginal lending facility and the interest rate on the deposit facility.

Liquidity risk: the risk that a counterparty or a participant in a payment or settlement system will notsettle an obligation at its full value when due. Liquidity risk does not imply that the counterparty is insolvent,since it may be able to settle the required debt obligations at some unspecified time thereafter.

Longer-term refinancing operation: a monthly open market operation, conducted by theEurosystem, with a usual maturity of three months. The operations are conducted as variable rate tenders withpre-announced allotment volumes.

M1: narrow monetary aggregate. Comprises currency in circulation plus overnight deposits held with MFIs andcentral government (e.g. at the Post Office or Treasury).

M2: intermediate monetary aggregate. Comprises M1 and deposits redeemable at a period of notice of up to andincluding three months (i.e. short-term savings deposits) and deposits with an agreed maturity of up to andincluding two years (i.e. short-term time deposits) held with MFIs and central government.

M3: broad monetary aggregate. Comprises M2 and marketable instruments, i.e. repurchase agreements,money market fund shares and units and debt securities with a maturity of up to and including two yearsissued by MFIs.

Main refinancing operation: a weekly open market operation conducted by the Eurosystem. In2003 the Governing Council decided that as of 9 March 2004 the maturity of these operations would bereduced from two weeks to one. The operations are conducted as variable rate tenders with a pre-announcedminimum bid rate .

Maintenance period: the period over which credit institutions’ compliance with reserverequirements is calculated. It was decided that as of 10 March 2004 the maintenance period would begin onthe settlement day of the first main refinancing operation following the meeting of the GoverningCouncil at which the monthly assessment of the monetary policy stance is pre-scheduled. The ECB publishesa calendar of the reserve maintenance periods at least three months before the start of the year.

Marginal lending facility: a standing facility of the Eurosystem which counterparties may use toreceive credit from an NCB at a pre-specified interest rate against eligible assets (see also key ECBinterest rates).

MFIs (monetary financial institutions): financial institutions forming the money-issuing sector of theeuro area. They include the ECB, the NCBs of the euro area countries, and credit institutions and moneymarket funds located in the euro area.

MFI credit to euro area residents: comprises MFI loans to euro area residents and MFI holdings ofsecurities issued by euro area residents. Securities comprise shares, other equity and debt securities.

MFI interest rates: those interest rates that are applied by resident credit institutions and otherinstitutions to euro-denominated deposits and loans vis-à-vis households and non-financial corporationsresident in euro area countries. The requirements for the MFI interest rate statistics are laid down inRegulation ECB/2001/18 of 20 December 2001.

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MFI longer-term financial liabilities: comprise deposits with an agreed maturity of over two years,deposits redeemable at a period of notice of over three months, debt securities issued with an originalmaturity of more than two years and the capital and reserves of the euro area MFI sector.

MFI net external assets: comprise external assets of euro area MFIs (such as gold, non-euro banknotes,securities issued by non-euro area residents and loans granted to non-euro area residents) minus externalliabilities of the euro area MFI sector (such as non-euro area residents’ holdings of deposits, repurchaseagreements, money market fund shares and units and debt securities with a maturity of up to andincluding two years issued by MFIs).

Minimum bid rate: lower limit to the interest rates at which counterparties may submit bids in thevariable rate tenders of the main refinancing operations. This is one of the key ECB interest ratesreflecting the stance of monetary policy.

Monetary analysis: one pillar of the ECB’s framework for conducting its comprehensive analysis ofthe risks to price stability, which forms the basis for the Governing Council’s monetary policydecisions. Monetary analysis helps to assess medium to long-term trends in inflation, in view of the closerelationship between money and prices over extended horizons. The monetary analysis takes into accountdevelopments in a wide range of monetary indicators including M3, its components and counterparts,notably credit, and various measures of excess liquidity (see also economic analysis).

Monetary income: income accruing to the NCBs in the performance of the Eurosystem’s monetary policyfunction, derived from assets earmarked in accordance with guidelines established by the Governing Counciland held against banknotes in circulation and deposit liabilities to credit institutions.

Money market: the market in which short-term funds are raised, invested and traded using instruments whichgenerally have an original maturity of up to and including one year.

Open market operation: an operation executed on the initiative of the central bank in the financial marketsinvolving one of the following transactions: (i) buying or selling assets outright (spot or forward); (ii) buyingor selling assets under a repurchase agreement; (iii) lending or borrowing against underlying assets ascollateral; (iv) issuing central bank debt certificates; (v) accepting fixed-term deposits; or (vi) conductingforeign exchange swaps between domestic and foreign currencies.

Option: an option is a financial instrument which gives the owner the right, but not the obligation, to buy orsell a specific underlying asset (e.g. a bond or a stock) at a predetermined price (the strike or exercise price) onor up to a certain future date (the exercise or maturity date). A call option gives the holder the right to purchasethe underlying asset at an agreed exercise price, whereas a put option gives the holder the right to sell it at anagreed exercise price.

Portfolio investment: a record of net acquisitions by euro area residents of securities issued by non-residents of the euro area (“assets”) and net acquisitions by non-residents of the euro area of securities issued byeuro area residents (“liabilities”). Includes equity securities, debt securities in the form of bonds andnotes, and money market instruments. Transactions are recorded at the effective price paid or received, lesscommissions and expenses. To be regarded as a portfolio asset, ownership in an enterprise must be equivalent toless than 10% of the voting rights.


Price stability: the maintenance of price stability is the primary objective of the Eurosystem. TheGoverning Council defines price stability as a year-on-year increase of below 2% in the HarmonisedIndex of Consumer Prices (HICP) for the euro area. The Governing Council has also made it clear that,in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the mediumterm.

Primary balance: government net borrowing or net lending excluding interest payments on consolidatedgovernment liabilities.

Projections: the results of exercises conducted by Eurosystem staff to project possible futuremacroeconomic developments in the euro area. Eurosystem staff macroeconomic projections are obtained in away consistent with individual country projections. The projections, which are published twice a year, form partof the monetary policy strategy of the ECB and are one of several inputs into the Governing Council’sassessment of the risks to price stability.

Real-time gross settlement (RTGS) system: a settlement system in which processing and settlementtake place on an order-by-order basis (without netting) in real time (continuously) (see also TARGET).

Reference value for M3 growth: the annual growth rate of M3 over the medium term consistent with themaintenance of price stability. At present, the reference value for annual M3 growth is 4½%.

Repo market: see repurchase agreement.

Repurchase agreement: an agreement to sell an asset and to repurchase it at a specified price on apredetermined future date or on demand. Such an agreement is similar to collateralised borrowing, although itdiffers in that the seller does not retain ownership of the assets. Sale and repurchase agreements are also termedrepo transactions and are traded on the repo market.

Reserve base: the sum of the balance sheet items (in particular liabilities) which constitute the basis forcalculating the reserve requirement of a credit institution.

Reserve ratio: a ratio defined by the central bank for each category of balance sheet items included in thereserve base. The ratios are used to calculate the reserve requirement.

Reserve requirement: the minimum amount of reserves a credit institution is required to hold with theEurosystem. Compliance is determined on the basis of the average of the daily balances over a maintenanceperiod of around one month.

Retail bank interest rates: see MFI interest rates.

Reverse transaction: an operation whereby the central bank buys or sells assets under a repurchaseagreement or conducts credit operations against collateral.

Securities settlement system (SSS): a system which permits the holding and transfer of securities or otherfinancial assets, either free of payment or against payment (delivery versus payment).

Settlement risk: a general term used to designate the risk that settlement in a transfer system will not takeplace as expected. This risk may comprise both credit and liquidity risk.

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Stability and Growth Pact: consists of two Council Regulations, namely (i) Regulation (EC) No 1466/97of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance andcoordination of economic policies and (ii) Regulation (EC) No 1467/97 of 7 July 1997 on speeding upand clarifying the implementation of the excessive deficit procedure, and of a European CouncilResolution on the Stability and Growth Pact adopted at the Amsterdam summit on 17 June 1997. It is intendedto serve as a means of safeguarding sound government finances in Stage Three of Economic and MonetaryUnion (EMU) in order to strengthen the conditions for price stability and for strong, sustainable growthconducive to employment creation. More specifically, budgetary positions close to balance or in surplus arerequired as the medium-term objective for Member States.

Stability programmes: medium-term government plans and assumptions provided by euro area countriesregarding the development of key economic variables. They set out the medium-term objective of a budgetaryposition that is close to balance or in surplus, or the adjustment path towards this objective as referred to in theStability and Growth Pact. Stability programmes must be updated annually. They are examined by theEuropean Commission and the Economic and Financial Committee (EFC), whose assessmentsserve as the basis for the examination by the ECOFIN Council.

Standing facility: a central bank facility available to counterparties on their own initiative. TheEurosystem offers two overnight standing facilities: the marginal lending facility and the depositfacility.

Straight-through processing (STP): the automated end-to-end processing of trades/paymenttransfers including the automated completion of generation, confirmation, clearing and settlement ofinstructions.

Systemic risk: the risk that the failure of one participant in a funds transfer system or exchange-for-value system, or in financial markets generally, to meet its required obligations will cause otherparticipants or financial institutions to be unable to meet their obligations (including settlementobligations in a transfer system) when due. Such a failure may cause significant liquidity or creditproblems and, as a result, might threaten the stability of financial markets.

TARGET (Trans-European Automated Real-time Gross settlement Express Transfersystem): the RTGS system for the euro. It is a decentralised system consisting of 15 national RTGSsystems, the ECB payment mechanism (EPM) and the interlinking mechanism.

Treaty: refers to the Treaty establishing the European Community. The Treaty was signed in Rome on25 March 1957 and entered into force on 1 January 1958. It established the European EconomicCommunity (EEC), which is now the European Community (EC), and is often referred to as the “Treaty ofRome”. The Treaty on European Union (which is often referred to as the “Maastricht Treaty”) was signedon 7 February 1992 and entered into force on 1 November 1993. The Treaty on European Union amendedthe Treaty establishing the European Community and established the European Union. The “Treaty ofAmsterdam”, which was signed in Amsterdam on 2 October 1997 and entered into force on 1 May 1999,and most recently the “Treaty of Nice”, which was signed on 26 February 2001 and entered into force on1 February 2003, amended both the Treaty establishing the European Community and the Treaty onEuropean Union.


Valuation haircut: a risk control measure applied to underlying assets used in reverse transactions, inwhich the central bank calculates the value of underlying assets as their market value reduced by a certainpercentage (haircut). The Eurosystem applies valuation haircuts reflecting features of the specific assets, suchas their residual maturity.

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