The European Central Bank, Italy and the integration of Eastern Europe
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB
“Eastern Europe, the EU and Italy”
Conference by the Accademia Nazionale dei Lincei and Fondazione Edison
Rome, 31 March 2006
Ladies and gentlemen,
It is a great pleasure to be here and to have the opportunity to contribute to the discussion on economic integration in Europe.
Yesterday was the 30 March, which in ancient times was the day of the festival for Salus Publica Populi Romani –goddess of the public welfare of the Roman people. In the past, we would have prayed for prosperity, leaving matters in the hands of Salus. Today, treasuring our welfare, we prefer to take things into our own hands and think about practical ways of how to improve welfare.
In this context, I would like to share some thoughts with you on European economic integration and its impact on the welfare of the citizens of Italy and the European Union (EU), as well as countries in Eastern Europe that are outside the EU. I would like to present a central banker’s perspective on these issues.
In my speech today, first I will discuss how the European Central Bank (ECB) contributes to the welfare of euro area citizens, using the example of Italy. I shall argue that the best strategy in this respect is to maintain price stability and to help ensure efficient financial markets. I will also mention that in order to maximise the welfare gains from a stability-oriented monetary policy, sound fiscal policies and flexible labour and product markets are needed, a message that was also reiterated at the spring European Council just one week ago. Then, I will provide a few facts on the current state of economic integration in Europe, focusing in particular on trade and foreign direct investment flows between Italy and Eastern Europe. I will demonstrate that European economic integration brings many opportunities for increased welfare, but also poses some challenges.
The contribution of the ECB to welfare in an integrated Europe
Economic and political integration in Europe started a long time ago and has gone through various stages: from the creation of the European Coal and Steel Community in the early 1950s, the signing of the Treaty of Rome, the introduction of the euro to enlargement. The underlying rationale for integration was – and still is – political and economic stability, leading to the improved welfare of European citizens.
European integration is a complex process affecting many aspects of social, political and economic life. What is the role of the European Central Bank in this process and how can it contribute to welfare gains? Without hesitation, I can answer that the best way in which monetary policy can improve welfare in euro area countries is to maintain price stability and to help ensure efficient financial markets. Let me now discuss these two aspects in more detail.
Price stability is key
Prices are the main source of economic information in a market economy. With low and stable inflation, consumers and producers are able to receive price signals stemming from the difference between demand and supply for various goods and services in an efficient way, leading to the smooth functioning of the whole economy. Price stability also preserves the purchasing power of the euro and thus facilitates long-term planning – especially in terms of consumption and investment decisions, as well as borrowing and lending. With stable prices, lenders are likely to require less compensation. Consequently, lower interest rates are more likely to prevail, contributing to higher long-term economic growth, employment and consequently welfare. By safeguarding price stability, a credible monetary policy anchors inflation expectations at low levels. In such an environment, shocks to the economy require less reaction from monetary policy than would have been otherwise necessary, resulting in lower short-term volatility in employment and output. In this way, ensuring price stability – the European Central Bank’s main task – supports the general economic policies in the Community and thus contributes to a high level of employment and sustainable non-inflationary growth both in the long and short term.
In recent years, low and stable inflation has been a fundamental achievement for the euro area as a whole, and in particular for Italy. In 1996, inflation in Italy stood at 4%, while the average figures for those countries that are now members of the euro area was 2.3%. In 2005, the inflation gap versus the euro area has almost disappeared. Moreover, thanks to the stability-oriented policy framework of the European Central Bank, inflation expectations have stabilised at low levels and long-term interest rates have declined considerably. Today, the euro area economy benefits from the benchmark long-term market interest rates of below 4%, a level which most issuers have not experienced in the last 50 years. In Italy, in particular, the 10-year interest rate spread versus the euro area average fell from 2.9 percentage points at the beginning of 1996 to 0.2 percentage point at the beginning of 1998 and has since then remained roughly at this level. It should be noted that in most euro area countries the decline in long-term government bond interest rates has considerably reduced financing costs. For instance, in Italy, the cost of public debt servicing declined very significantly from 11.5% of GDP in 1996 to 4.9% of GDP in 2005. This implies that due to the disappearance of the spread the reduction in the interest expenditure burden represents a gain of 0.8% of GDP per year.
The success of the European Central Bank in delivering these objectives can be attributed to its institutional framework and the principles it follows. First, the European Central Bank is independent and has a clearly defined mandate under the Treaty to pursue price stability and safeguard financial stability. Second, the ECB has provided and made public a clear definition of price stability corresponding to inflation rates below but close to 2%. Third, the medium-term orientation and the very nature of our concept of monetary policy has contributed to a solid anchoring of medium and long-term inflation expectations, in line with our definition of price stability.
Given the topic of today’s conference, let me also say a few words on euro area enlargement. All ten new Member States that joined the European Union in May 2004 are expected to adopt the euro as soon as they achieve sustainable economic and legal convergence. Seven of these countries, including Italy’s neighbouring country, Slovenia, have already entered the Exchange Rate Mechanism II (ERM II), which is a necessary pre-condition for adopting the euro. The enlargement of the euro area is a process which follows clearly defined procedures and rules. Countries adopting the euro must demonstrate that they have sufficiently converged towards the euro area for this convergence to be sustainable. The necessary conditions for this are set out clearly in the Treaty and include price stability, sound public finances, a stable exchange rate, the convergence of long-term interest rates towards the best performing EU countries and legal convergence. The need to meet these criteria will result in a further improvement of the macro-economic situation in the new EU Member States, which in turn will also benefit the euro area, as it further enhances trade and investment opportunities in these countries.
Financial markets matter
Turning to the second area where the European Central Bank is strongly involved, let me stress that stable, open and mature financial markets are essential for the proper functioning of market economies and an effective conduct of the single monetary policy in the euro area. This also positively affects the optimality conditions of the currency union, as a better diversification and sharing of risks among members of the union is possible. Financial markets are also important from the growth and welfare perspectives. The role of financial systems is to facilitate a smooth and efficient reallocation of financial resources from savers to investors, to assess and price accurately financial risk, and manage it efficiently. The high degree of integration and competition in the financial markets has a positive effect on the depth, liquidity, economies of scale, intermediation costs and more efficient allocation of capital.
Since the introduction of the euro, there have been a lot of changes in the financial markets in Europe. The elimination of exchange rate risk has increased the depth and breadth of financial markets and boosted financial innovation. Government bond yields in the euro area have become nearly perfectly correlated. There is also evidence of close integration of stock markets. The euro had a particularly significant impact on the European market for corporate bonds, with a considerable increase in the number of medium-sized firms placing issues outside their home country. Integration has facilitated the harmonisation and consolidation of financial structures, thereby increasing cross-border corporate linkages. In recent years, large flows of foreign direct investment among euro area countries have exemplified this intensification of corporate linkages.
More structural reforms are needed
While price stability and stable financial markets provide a favourable environment for economic growth, higher employment and the welfare of euro area citizens, this may not be enough. In order to maximise the positive effects of the stability-oriented monetary policy, sound fiscal policies and flexible labour and product markets must also be in place.
Sound fiscal policies, as required by the European Stability and Growth Pact, have many virtues. A government that maintains a budgetary position that is close to balance or in surplus over the medium term and reduces its debt to a low and sustainable level has room to let automatic stabilisers operate and can pursue its desired tax and spending policies without putting fiscal sustainability at risk. Moreover, fiscal discipline adds to macroeconomic stability by creating a predictable economic environment. Unfortunately, the Stability and Growth Pact has not prevented the experience of excessive deficits in several euro area countries, including Italy. During the past three years, the budgetary situation of Italy has gradually worsened. As a result, an excessive deficit procedure was opened in July 2005, requiring Italy to reach the 3% limit by 2007. A few weeks ago, the Council of the European Union approved the corrective measures set by the Italian government for this year and also indicated that the implementation of substantial additional measures would be necessary in the course of next year to ensure adequate improvement in the budgetary position. In my view, this is a good illustration of the fact that, in those countries which currently have excessive deficits, budgetary positions would have been even worse without the Pact. For instance, in Italy, the fiscal deficit averaged 10.2% of GDP between 1990 and 1995, whereas between 1999 and 2005 it stood on average at 2.8% of GDP.
The effectiveness of monetary policy is also dependent on structural policies in labour and product markets. Rigidities in these markets determine how changes in policy interest rates propagate into the economy and how resilient the economies are to various shocks. With significant rigidities, the adjustments to negative shocks may be more prolonged and costly in terms of output and employment. By contrast, flexible markets result in a more efficient and prompt reallocation of resources and contribute to higher long-term growth. This is especially important in the context of the Lisbon strategy and the ambitions of increasing welfare in the European Union.
It is important to keep in mind that flexible markets and growth-conducive structural policies are first and foremost in the self-interest of any country and its citizens. They should not be seen as an obligation that stems from euro area or European Union membership. What is true, however, is that European integration and – even more so – the process of globalisation have greatly increased the opportunities for countries to enhance the welfare of their citizens. At the same time strengthened economic integration at the European and global level requires fostering the ability of countries to adjust to a changing environment.
The case of Italy and Eastern Europe
Since 1992 – when the trade-liberalising “Europe Agreements” were signed between the 15 countries belonging to the Union or preparing for membership and the countries which joined the European Union later in 2004 – trade flows across the whole Europe have surged. Over the past 14 years, the euro area countries have re-established and reinforced their economic links with central and eastern European countries via stronger trade, increased foreign direct investments and sizeable financial integration.
The process of financial integration is, of course, far from complete and the European Central Bank is very active in providing a helping hand to overcome the barriers that still exist. Yet, I am optimistic that initiatives, such as the “Single Euro Payment Area” project of the European banking industry, will contribute to transforming Europe’s financial sector and thus generate significant benefits to customers and the economy as a whole.
Italy, like other euro area countries, has benefited from the integration process. The key example of UNICREDIT shows that Italy has been able to reach a high degree of financial integration with central and eastern European countries. As far as “fixed” capital integration is concerned, outward foreign direct investment flows towards central and Eastern Europe have enhanced opportunities for Italian firms. Indeed, during the past five years, central and eastern European countries have witnessed the largest increase in the number of affiliates of Italian transnational companies. Foreign direct investment is beneficial both for the recipient and the investor country. The former gains in a number of ways, including transfer of technologies and sources of financing. These factors played and will continue to play a very important role in Eastern Europe’s catching-up process. Regarding the country of origin, foreign direct investments allow for the expansion of business activity and gaining of shares in the markets of the recipient countries.
The high levels of foreign direct investment by euro area countries, including Italy, in Eastern Europe have been accompanied by the loss of export market shares in this region. Besides some substitution of exports with foreign direct investment, the loss of export market shares of most euro area countries in the new Member States reflects the fact that the number of players able to enter the enlarged European market has increased markedly in recent years, and this should be seen as a natural outcome of increased globalisation. Furthermore, the loss in market shares should be also related to some normalisation of export flows towards the new Member States after they peaked in the late 1990s.
Let me mention that, in contrast to the group of new Member States, Italy has shown an excellent export performance towards Romania and Bulgaria. Moreover, Italy has been able to maintain market shares in the Balkan countries and Russia. Among central and eastern European countries, Romania is also a major recipient of Italian foreign direct investment, not only due to its geographical proximity, but also due to greater language and cultural similarities.
Notwithstanding some clear benefits to Italy resulting from European integration, a number of challenges need to be addressed. Besides the loss of market shares in the new Member States, Italy has suffered greatly from losses of market shares in the intra-euro area market. This poor performance may be related to increased competition from low production-cost countries that have a pattern of specialisation similar to Italy, comprising a relatively large share of low-tech products. This increased competition stems from the new Member States, other Eastern European countries and, more recently and from certain Asian countries, particularly China. Thus, it seems that many euro area countries have been substituting their imports of Italian goods with imports of similar goods from the new Member States, southern and eastern Asia, as well as China. For instance, Germany appears to have been gradually substituting imports of Italian goods with imports from the new Member States, both in the basic manufacturing industry and in machinery and transport equipment.
What are the reasons behind the somewhat disappointing performance of Italy, especially with regard to intra-euro area trade? The loss of competitiveness is a key explanation. Over the last seven years, unit labour costs in Italy have grown at an average pace of 2.8% per year, both in the total economy and in the manufacturing sector. In the whole euro area, the figures are 1.5% for the total economy and 0.1% for the manufacturing sector. Why have unit labour costs increased so much in Italy compared with the European partners? The key reason is that labour productivity has been virtually stagnating. Growth in compensation per employee has thus considerably outpaced the subdued productivity advancements. If we take a closer look at labour productivity growth, we see that some of the weak labour productivity performance can be explained by higher employment growth rates in Italy than those in the rest of the euro area, which is of course a positive signal. But most of the low labour productivity growth is associated with a decreasing “ability” of Italian firms to create value added, which is well captured by the decline in total factor productivity. A great number of studies have investigated the poor productivity growth in Italy in recent years and found that rigidities in product and labour markets, inability to attract inwards foreign direct investment, low spending on research and development, judicial inefficiencies, an unfavourable business environment, unfavourable specialisation pattern and persisting regional disparities were among the main impediments to productivity advancement. These inefficiencies call for completing the process of reforms in the product and labour market, which were enthusiastically initiated in the early 1990s. On the labour market side, recent reforms appear to have been in the right direction and should be continued.
Let me now summarise the main points of my speech. Economic integration in Europe has a great potential for welfare improvements in all participating economies. The best way for the European Central Bank to contribute to this process is by ensuring price stability and the smooth functioning of financial markets. The benefits of such policies are clearly visible in Italy, with the cost of financing public debt being a particularly striking example. However, in order to reap the maximum benefits from the stability-oriented monetary policy, sound fiscal policy and flexible labour and product markets must be in place. Such policies must be focused on economic stability and the removal of structural impediments and adapt to a changing environment determined by European and – possibly even more – global economic integration.
In conclusion, let me stress that our welfare is not in the hands of Salus, but is determined by responsible economic polices capable of identifying and facing the challenges of a competitive global economy. Some European countries that are ahead in the process of adopting such changes show that these reforms are able to deliver higher output and employment growth. Thank you very much for your attention.