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Applause for 2006 should not abate policy efforts for 2007

Speech by Jürgen Stark, Member of the Executive Board of the ECBon the occasion of the New Year’s Receptionat Deutsches Aktieninstitut e.V., BrusselsBrussels, 25 January 2007

Economically, 2006 was a good year – globally and for the euro area. At the world level, we have seen in 2006 yet another year with growth rates above 5% with very dynamic growth in emerging Asia and high rates also in the new EU Member States. In addition, different from previous years, also the euro area regained more dynamism, thereby contributing to an urgently needed rebalancing in global economic growth. Euro area data for 2006 will show the highest real GDP growth rate since 2000. With a currently estimated growth rate of 2.7 % according to most forecasts it would be clearly above trend growth.

After we had seen dynamic growth of exports (and imports) and a solid growth of investment, in 2006 also private consumption strengthened. This is confirming the broadening of the basis for economic growth and pointing to the increasingly self-sustaining nature of the economic expansion in the euro area.

The latest information supports the assessment that robust economic growth has continued around the turn of the years. One very important feature over the recent period has been a remarkable dynamism in the euro area labour markets. This can be seen as a reflection of the adjustment efforts in the corporate sector, the implementation of major pieces of structural reforms and as a result of continued wage moderation in some countries of the euro area.

The unemployment rate has dropped since 2004 from 8.8% to 7.6% most recently. At the same time, euro area employment is estimated to have risen by 1.3% in 2006 (after 0.7% in 2004 and 0.8% in 2005). Notably, slightly more than 12 million new jobs were created in the euro area on a net basis in the eight year period since the start of Stage Three of EMU.

However, significant structural impediments continue to exist. These contribute to the still unacceptably high unemployment rates and still relatively low participation rates in labour markets, at levels below international standards.

At the same time, labour productivity growth after having increased for several quarters has slowed down again in the third quarter of 2006 and has remained close to historical averages. This seems to confirm the view that the pick up in labour productivity growth earlier in 2006 was mainly of a cyclical rather than a structural nature.

In an environment of an increasingly self-sustained economic growth, governments should keep the momentum for ongoing structural reforms and aim to even accelerate their implementation.

I have in mind 5 fields where further policy efforts are needed in order to achieve the overarching objectives of more market flexibility to weather out external shocks, to foster productivity growth and to create more and more job opportunities:

  • The functioning of product and labour markets should be further improved.

  • A more entrepreneurial-friendly economic environment should be created.

  • Innovation, technological change and human capital building should be further stimulated.

  • The current economic “good times” should be used to consolidate fiscal balances. The budget targets recently presented by euro area governments in many cases are not ambitious enough and do not consistently imply sufficient structural consolidation.

  • The European financial integration should be further promoted.

At this occasion, I would like to highlight in particular the significance of financial integration. It is common wisdom that well developed financial systems boost economic efficiency by channelling resources to the most profitable activities across time. They also lead to a better sharing and diversification of risks. The extent to which the financial system fosters growth crucially depends on its efficiency. Important progress has been made across the EU. The euro has acted as a catalyst for the integration of the euro area financial markets. Further efforts such as transposition and enforcement of the Financial Services Action Plan are needed to establish a single European market for financial services.

Looking ahead, the medium-term outlook for economic activity continues to be favourable and the conditions remain in place for the euro area economy to grow solidly, at rates around potential.

Global growth should remain robust notwithstanding some gradual but limited moderation in the growth momentum. The main factors supporting global growth in 2007 are:

  • Financing conditions are expected to remain favourable, notwithstanding past and possible future monetary policy adjustments in many countries and regions of the world;

  • The global economy should benefit from weaker headwinds stemming from oil markets.

Euro area exports should therefore continue to benefit from the supportive external environment.

Investment is expected to remain dynamic, benefiting from an extended period of very favourable financing conditions, balance sheet restructuring, accumulated and ongoing strong earnings, and gains in business efficiency.

Private consumption should also strengthen further, in line with developments in real disposable income, as employment conditions continue to improve.

The risks surrounding this broadly favourable outlook for economic growth over the medium term lie mainly on the downside:

  • The slowdown of the US economy and its impact on the world economy might be more pronounced. However, the baseline scenario is that of a soft landing of the US economy.

  • Protectionist tendencies or even pressures could increase due to … the uncertainty surrounding the conclusion of the Doha round of trade negotiations;… a potential change of sentiment in some countries against free trade and globalisation;… the re-emergence of national interests or “economic patriotism” in the EU which is not in line with the idea and the objectives of the single market;

  • Furthermore, oil prices could rise again,


The potential for a disorderly unwinding of global imbalances still remains a concern. It could impose heavy costs on the global economy.

With regard to price developments, annual HICP inflation came down to below 2% in the last months. All in all, the inflation rate for the year 2006 stood again at 2.2%. This year and the next, annual inflation rates are projected to hover around 2%, with a profile dependent on oil price developments and the impact of higher indirect taxes.

In the ECB’s-Governing Council’s view, the outlook for price developments remains subject to upside risks. These stem in particular from a stronger than anticipated pass-through of previous oil price increases, unforeseen increases in administered prices and indirect taxes, the possibility of renewed oil price increases and stronger than currently expected wage dynamics.

Let me remind you in this context that the wage developments over the last couple of years in the euro area were mainly influenced by ongoing wage moderation in a few countries. In these countries wage moderation has been key for job creation and has helped to improve price competitiveness. It is crucial that wage agreements in the coming wage negotiation rounds in the euro area economies are in line with price stability and take into account the still high level of unemployment, price competitiveness positions as well as productivity developments.

Inflation expectations are still well anchored at levels broadly in line with our definition of price stability. With inflation rates slightly above 2% since 2000 there is no room for complacency. In a forward looking manner we have to prevent a public perception that the Governing Council accepts inflation rates of above 2% on an ongoing basis.

The strong monetary and credit dynamics that we have seen over a prolonged period of time also point to upside risks to price stability at medium to longer term horizons. The strength of underlying monetary dynamics reflect the still low level of interest rates in the euro area and the strength of economic activity. On the counterpart side the impact of these factors is visible in the continued double-digit growth rates of loans to the private sector.

As already mentioned, the financing conditions in the euro area have been favourable for an extended period of time. Indeed:

  • real short term interest rates still remain below the levels observed in 1980’s and 1990’s;

  • real long term interest rates remain close to the lowest levels observed in almost a quarter of a century.

With the key ECB interest rates still low, money and credit growth strong, and liquidity ample in the euro area, the ECB’s monetary policy certainly continues to be accommodative.

We know that liquidity eventually finds its way through the financial system to consumer prices, although it might take some time. Against this backdrop we also have to carefully monitor asset prices. Liquidity feeds into asset prices: into stock prices, housing prices and bonds. And via the credit channel and increases in investment, asset prices can have an impact on the business cycle and thus ultimately end up in higher consumer price inflation.

These are some of the reasons for the Governing Council’s degree of alertness and for the very close monitoring of all related developments. Our mandate is to ensure price stability in the medium term. The euro area citizens can be assured of our strong commitment to our mandate. The ECB will always do what is necessary to maintain price stability.

Over an extended period of low interest rates, liquidity has also been accumulated in all the other major economic regions leading to abundant global liquidity. So far, due to lags in the transmission process, the recent withdrawal of monetary stimulus in the major economic areas did not change much.

The combination of abundant global liquidity, the low levels of interest rates and low financial market volatility appear to have encouraged excessive borrowing and risk taking among market participants.

There are various ways in which this has taken place in practice.

First, long-term institutional investors, such as insurance companies and pension funds – which are also facing mounting longevity problems – have struggled to generate sufficient returns to their policyholders in a low bond yield environment, encouraging them to take on greater risk in other asset markets. Lower financial market volatility allowed them to extend their exposures towards risky assets without breaching their risk limits.

Second, risk taking increased because of the rapid pace of financial innovation in the derivatives markets throughout the past decade. This has provided investors with unprecedented means to share and shed both credit risk and market risk, allowing them to issue and take positions in complex structured products. In this environment, stock prices have developed buoyantly and spreads on risky debt instruments have been compressed to record lows. One way of describing the situation in financial market developments is that valuations in some markets appear to be based on very favourable expectations regarding future economic outcomes and low risk premia.

However, there are reasons to believe that valuations in some markets could prove vulnerable to changing circumstances.

  • Rising debt servicing burdens due to higher interest rates are gradually putting pressure on those households and firms that may have acquired too much debt, thereby augmenting the burden on some borrowers.

  • On the financial market side, the risks are rather complex. A sudden spike in volatility could push multiple investors simultaneously beyond their risk limits. Exit from risky positions might cause liquidity problems that can spread rapidly in the financial system.

  • In addition, low borrowing costs and the seemingly endless search for high returns have created pockets of vulnerability in the financial system, which need to be monitored closely. One such area is the recent rapid growth of corporate sector borrowing to finance leveraged buy-out transactions. The vast amount of money raised by private equity funds and easy access to cheap debt have generated a boom in this market. As low credit-quality firms are increasingly in the centre of such transactions there are significant risks associated with a potential change in the current extremely benign credit conditions.

It is therefore of the utmost importance that central banks and regulators continue to keep a close eye on these developments.

Amid favourable global liquidity conditions and relatively high risk appetite among investors, it is not surprising that hedge funds and various other alternative investment vehicles have been gaining popularity among speculative and institutional investors searching for ways to improve their returns. Indeed, during 2006 investors poured more than USD 100 billion into hedge funds, and as a result capital under management globally is about USD 1.5 trillion.

Active hedge fund participation and sometimes even domination in various financial markets have raised many questions with respect to their role in the global financial system. Both positive and negative aspects can be identified.

On the positive side, hedge funds contribute significantly to market liquidity, they enhance the price discovery process, they can spur financial innovation and they provide more diversification opportunities for investors.

Nonetheless, there are concerns about possible negative influence of hedge fund activities on financial stability. Risks to financial stability may arise through the impact of hedge fund risk-taking activities on banks and financial markets. The still relatively high opacity surrounding the hedge funds contributes to the uneasiness.

Risks to financial markets mainly relate to collective and synchronous exits of hedge funds from so-called crowded trades, which may lead to adverse market dynamics and the drying up of liquidity in affected markets. As banks are key hedge fund trading counterparties and lenders, their exposures to hedge funds constitute a second channel through which hedge funds could affect financial stability.

The prevailing approach of indirect regulation of hedge fund activities places great emphasis on banks applying prudent risk management in their dealings with hedge fund clients.

In this context, initiatives are highly welcome that aim at fostering a dialogue between public and private sectors on the best ways to contain possible risks posed by hedge funds. Particular attention has to be given to counterparty risk management, risk monitoring and enhanced transparency and disclosure.

Other self-regulatory initiatives by the hedge fund industry are also worthy mentioning. I refer in particular to the voluntary codes of conduct for hedge fund managers. [1]

There are various ways to improve hedge fund transparency and filling in the remaining information gaps will be an important topic in various international fora this year. In the end it is essential for effective market discipline and financial stability that the banks are able to monitor the overall risk profile of a hedge fund on a continuous basis, and remain prudent in their dealings with hedge fund clients.

Let me conclude:

  1. After a good year 2006, conditions remain in place for the euro area economy to grow broadly-based and solidly at around potential.

  2. Inflation rates are projected to hover around 2% in 2007 and 2008 respectively, with risks to the upside, stemming from both economic and monetary dynamics.

  3. The ECB’s Governing Council is strongly committed to its mandate to ensure price stability in the medium-term. This is the best contribution monetary policy can make to support economic growth and job creation. As an institution independent from political influence, the ECB will always do what is necessary to maintain price stability.

  4. Abundant global liquidity, still low interest rates and low financial market volatility appear to have encouraged excessive borrowing and risk-taking among market participants. As a consequence, the risks to financial stability have increased. However, the financial systems have been quite resilient so far. Improved risk management, as well as enhanced transparency and disclosure are of the essence.

  5. To make economic growth and job creation in the euro area more sustainable, governments should not lose momentum to foster structural reforms. This is the major political task in 2007 and beyond. It is crucial to do everything to fully utilise the opportunities of the single market and the single currency for the citizens of Europe, particularly those in the euro area.

  1. [1] That has been prepared by two hedge fund trade associations, namely the Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA).


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