Strengthening the European Financial Architecture IV Astana Economic Forum & The International Monetary System: New configuration of the economic and monetary.

Strengthening the European Financial Architecture

IV Astana Economic Forum &

The International Monetary System: New configuration of the economic and monetary power

Astana May 3-4, 2011

Franz Nauschnigg

Head, European Affairs and International Financial Organisations Division, Central Bank of Austria.

The views expressed are only those of the author

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Financial Crises - The Problem of market failure and Contagion

• Neoliberal paradigm after breakdown of Bretton Woods System - Trend of deregulation and privatization

• Market elements were incorporated even into financial regulation (Basel II) and accounting rules (mark-to-market), providing for strong pro cyclical effects.

• Large parts of the financial system without proper supervision. • The number of financial crises increased dramatically – IMF 1970 – 2007, 124

banking, 208 currency, and 63 sovereign debt crises.

• Strong pro cyclical tendency of the financial sector leads to overshooting and boom/bust cycles.

• Contagion: Iceland – Hungary – CESEE region Greece – Ireland - Portugal – Spain• Market failure in the Euro area - first under pricing and later overpricing of

sovereign bond spreads.

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Financial Crisis - The Problem of Overshooting Capital Flows

• Capital flows volatile even FDI - findings of UNCTAD working group after Asian crisis

• Iceland and CESEE region - massive overshooting of capital flows, first flooding of the countries with capital, later reversal.– Made possible by extensive liberalisation, financial deregulation and

privatisation processes in Iceland and the Central European and South Eastern European (CESEE) Region.

– The Nordic crisis (Finland, Norway and Sweden) in the early 1990s also result of rapid financial deregulation and liberalisation. Austria on the contrary followed a very gradual path and had no crisis.

– Monetary policy during the boom – although restrictive - was undermined by carry trades and foreign currency loans increasing the vulnerability.

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Capital Mobility and Banking Crises

Quelle: Reinhart , Rogoff, This time is different 2009

•EU, Euro area financially integrated, liberalised markets therefore vulnerable

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Crises in CESEE region

Contagion of markets following the collapse of Lehman Brothers and Iceland:

– Iceland financial crisis in Q3 2008.

– Hungary financial crisis in Q3 2008.

– CESEE currencies under pressure Q1 2009 (even of countries with strong fundamentals)

– Euro Area banks and countries with large CESEE exposures under pressure in Q1 2009.

– Financial markets did not differentiate enough between countries

– Strong speculative attacks against exchange rate in Latvia

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Financial Crisis CESEE – Policy Actions

EU/European Council March 2009:1. EU Balance of payments (BOP) assistance increased to 50 bn € (after

intense Austrian lobbying)2. 75 bn € EU contribution to IMF funding puts pressure on US to follow, later

increased to up to 125 bn €. 3. Coordination Banking and Fiscal packages; New order in EU financial

markets – regulation and supervision

G 20 April 2009 strong increase IMF funding to 750 bn $, 250 bn $ SDR distribution

Vienna Initiative – close cooperation on banking sector – home/host countries, IFIs to maintain private sector exposure

EU and IMF support CESEE countries – when not in agreement usually EU prevailed – defence of FX rate in Latvia avoided contagion

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EU crisis support for EU Countries outside Euro Area

• 50 bn.€ EU Medium-term financial assistance (balance of payment difficulties).

• ECB liquidity support for Western banks active in CESEE.• Guarantees and recapitalisation by home countries of banks active

in CESEE.• Joint IFI Action plan: EBRD, EIB and World Bank Group 24,5 bn. €

(2009-10) lending to business.• European Economic Recovery Plan: Advance payments from EU

structural funds.• “Vienna Initiative”: Meetings international financial organisations

(IMF, EBRD; EC, NCB, Supervisors home-host), international banks active in the country concerned

• Macro financial assistance for non EU countries

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Crises in CESEE region – EU policy response sucessful

0

100

200

300

400

500

600

700

800

1.3.

2009

6.3.

2009

11.3

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9

16.3

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21.3

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26.3

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31.3

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5.4.

2009

10.4

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15.4

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20.4

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25.4

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30.4

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5.5.

2009

Czech Republic Hungary Poland

Slovakia Romania Russia

Turkey Croatia Bulgaria

in basis points

Sovereign 5-year credit default swap spreads

Quelle: Datastream. OeNB.

0

100

200

300

400

500

600

700

800

1.3.

2009

6.3.

2009

11.3

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16.3

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2009

10.4

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5.5.

2009

Austria Germany UK

Greece Spain

Cut-off date: 07/05/2009

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

5Y CDSS

0

50

100

150

200

250

300

350

400

450

juil-08 oct-08 janv-09 avr-09 juil-09 oct-09 janv-10

Greece

Portugal

Ireland

Spain

Italy

Austria

Belgium

France

Source: Bloomberg

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Assistance for Euro Area Members

1. May 2010 - Euro area financial support for Greece - 110 bn. € - 80 bn Euro area bilateral loans, 30 bn IMF

2. May 2010 European Stabilisation Mechanism – 500 bn. €• European Financial Stabilisation Mechanism (EFSM) - 60 bn €• European Financial Stability Facility (EFSF) 440 bn € - temporary 3

years SPV in Luxemburg – Financing on capital markets with guaranties of Euro area countries

• Additional IMF financing up to 250 bn €

3. Eurosystem buys government bonds of affected Euro area countries on secondary market – Securities Market Programme to stabilise bond markets 83 bn €

4. EU/IMF rescue Ireland 85 bn. €, Portugal

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EU financial regulation and assistance for Euro Area Members

• September 2010 new architecture for European financial supervision and better regulation of financial sector

• European System Risk Board (ESRB)

• March 2011 European Semester for fiscal consolidation and structural reform, Euro Plus pact for stronger economic policy cooperation for competiveness and convergence, EU 2020 strategy for jobs and growth

• Permanent European Stability Mechanism (ESM) with an effective lending capacity of € 500 bn

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Conclusion

Overall EU/Euro area crises management successful• Stabilisation of CESEE, Greece, Ireland• Good EU cooperation with the IMF - eases financing pressure on IMF

resources, sets an example for other regions, taps IMF expertise, allows EU to influence IMF Programmes .

Problems remainNon Euro area EU, CESEE countries• Pro cyclical fiscal policies - room for countercyclical monetary policies

limited• Exchange rate volatility in countries with flexible exchange rates• Pressures on some CESEE countries with fixed exchange rates could returnEuro area countries• High spreads for some Euro area countries government bonds – Greece,

Portugal, Ireland, Spain. • Imbalances in Euro Area, Germany – southern members

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Proposed further Policy Actions

1. Introduction of a credit growth stabilisation tax (CGST) on all new private sector credit, to limit credit growth. Higher tax on foreign currency credits. Tax-receipts to flow into a cyclical stabilisation fund (CSF), used to finance countercyclical measure in recession. Allows restrictive fiscal policy in boom, as monetary policy given fully liberalized and integrated financial markets is undermined by capital inflows.

2. creation of an EUR 50 bn € EU facility for BOP and macro financial assistance for European Economic Area, EU candidates, EFTA and EU neighbouring countries.

3. Creation of an EU wide € bond market with - EFSM, EFSF, EU-BoP - bonds emitted and backed by the EU – up to 550 bn €.

4. Establishment of bilateral swap or repo facilities between the Eurosystem and the EU (and possibly other European central banks)

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Conclusion

• Measures would strengthen European financial architecture, help stabilize financial markets, stimulate the economies and correct market failure throughout the EU.

• End Boom/Bust cycles and enable countercyclical policies in the recession

• Deepen European Integration with no cost for EU taxpayers

• Help countries in the early stages of a crisis and avoid that they

develop into serious currency, solvency, or even sovereign debt crises with possible contagion effects on stronger EU economies