The Agenda for the Competitiveness of Europe’s Economy and Financial System

Speech by Jürgen Stark, Member of the Executive Board of the ECBSpeech delivered at Ambrosetti Finance WorkshopCernobbio, 5 April 2008

Ladies and gentlemen,

I wish to thank the organisers of this event [ Ambrosetti] for their invitation, which allows me to speak about the competitiveness of the euro area – a topic which has even become more of a prime concern in many advanced countries in view of the increasing challenges resulting from globalisation. Given the varied facets of “competitiveness” – that I broadly define as “the ability of an economy to compete in international markets” – I would like to start by reviewing some specific aspects of economic and financial performance of the euro area. I would continue thereafter with some aspects regarding the performance of the euro area banking sector, including the link between financial development and the transmission of monetary policy. Finally, with a view to reforms which aim at improving further the performance of the euro area economy and financial system, I will draw some lessons from the recent financial turmoil.

Starting by an assessment of the competitiveness of euro area firms and thus their capacity to play a leading role in world markets, losses in world export market shares over the last decade point to increasing challenges for the euro area. While being partly an adjustment to the emergence of new competitors, and most notably China and India, with lower labour costs, this may in principle also reflect losses in price competitiveness against other advanced competitors or a more unfavourable export specialisation. Nevertheless, it is important to note that most other advanced competitors have also experienced export market share losses over the same period. On a more positive note, recent analyses of highly disaggregated data, at the product and variety level, further show that instead European firms have gained market shares in the high-price and high-quality segment of mature sectors. ^[1]

However, important differences remain with regard to the export performance across individual euro area countries. Unfavourable price and cost developments thereby often seem to have been a major cause of a weaker export performance. Contrarily, the relatively stronger export performance of Germany appears, to a large extent, be due to very moderate increases in labour costs. Other factors such as differences in the export specialisation - the product range and product quality - and the geographical orientation certainly have also played a role. For example, due to its higher share of capital goods exports, Germany might have also benefited, to a greater extent, than both Italy and France, from the sustained world demand. Italy and France, by contrast, have a significantly higher export specialisation in consumer goods.

In the medium-term, however, it is in particular the lower productivity growth, which weighs on the competitiveness of European firms. Since the mid-1990s, productivity has slowed down substantially in the euro area, leading to a productivity gap with the US. While this gap is closing more recently, improvements in euro area productivity seem to be cyclical and not of a structural nature. At the same time, labour markets in euro area countries have witnessed an increase in participation rate and a decline in the unemployment rate. However, the employment rate still falls behind the objective of 70% set by the Lisbon strategy, and unemployment rates remain unacceptably high in a number of euro area countries. These weaknesses in economic performance point to continued rigidities and imperfections in the euro area economy.

To ensure that the advantage of European exporters in specific high value added varieties is not eroded over time, to regain price competitiveness across all euro area countries, and to improve labour market performance and potential output growth, the euro area needs to implement structural reforms directed to boost productivity growth and enhance the functioning of both labour and product markets.

This is even more crucial in a monetary union. Since euro area countries can no longer rely on monetary policy and nominal intra-euro area exchange rate adjustment to adjust to adverse shocks and the challenges posed by globalisation, other adjustment mechanisms become even more important. In this context, wage and price flexibility plays a pivotal role. The smooth functioning of the price mechanism is a prerequisite for the efficient allocation of resources across different sectors and over time. In the same vein, the mobility of capital and labour across countries and regions and between different sectors is of particular importance in a monetary union. It is therefore essential that governments establish an institutional framework which allows the economic adjustment processes to function efficiently and effectively. In particular, setting appropriate incentives for economic agents and thus enhanceing the overall growth performance of the economy require further progress in following 5 main policy areas:

Over the past decade, progress in these areas has been uneven across euro area countries. Some significant efforts have been made and countries see the benefits from these reforms coming in. However, the reform process needs to continue and the past years of good economic performance are no reason for complacency or even a reversal of past reforms. There is still a long way to go if we want to attain the objective of the Lisbon Strategy to make the European Union “the most competitive and dynamic knowledge-based economy in the world”.

Let me now turn to the competitiveness of the euro area financial sector. Financial efficiency has made large progress since the introduction of the euro and has contributed to the competitiveness of the euro area, by accelerating the speed of capital reallocation. Generally, in an efficient financial system, information is accessible and widely distributed. An efficient financial system usually enhances economic growth, whereas, by contrast, information asymmetries or insufficiently developed markets may lead to financing constraints, often especially for SMEs. Therefore, a well-functioning financial system is an EU policy priority as it allows the economy to fully exploit its growth potential, fosters the accumulation of capital and the diversification of risk.

Compared with securities markets, the process of financial integration has advanced more slowly in the banking sector. Against this background, let me discuss the strengths and weaknesses of the euro area banking sector.

Let me start the discussion of strengths and weaknesses from a structural point of view, with respect to the integration and efficiency of the banking markets.

First, on the positive side, the internationalisation of EU banking groups has increased during recent years. This has resulted, to a large extent, from the overall rise in terms of value in cross-border mergers and acquisitions in the euro area banking sector since 2004. In 2005, the value of cross-border bank M&A deals was particularly high, mainly owing to the acquisition of the Bayerische Hypo- und Vereinsbank by UniCredito Italiano. Generally, cross-border M&A activity is one way to increase competition in the banking sector, which tends to contribute positively to economic growth.

While cross-border M&A activity tends to increase competition, extensive public ownership of banks constitutes a possible distortion of competition in the banking sector, which also works against the development of capital markets.

In addition, while the integration in the wholesale and capital-market related banking market has advanced well during recent years, the still fragmented retail banking market can be regarded as a further weakness of the euro area banking sector. This can be seen, for instance, in the dispersion of interest rates on loans and deposits from banks to non-financial corporations and households. ^[12]

In addition, in contrast to large-value payment systems (TARGET, TARGET 2), retail payment systems in the euro area are still fragmented. However, the SEPA (Single Euro Payments Area) initiative aims at achieving a fully integrated market for retail payment services in the euro area with no distinction between cross-border and national payments, meaning that in the end all euro payments will be “domestic”. In fact, since the end of January 2008, the first step has become reality with the launch of “SEPA Credit Transfer”, which allows sending euro payments quickly, and in the same way, to any beneficiary in Europe. Overall, the launch of SEPA is a major step in the integration of the euro area retail banking sector.

In addition to a structural discussion of the strengths and weaknesses of the euro area banking sector in the light of the performance of the financial system, one may also look at the banking sector in the context of the financial turmoil.

Starting from the US sub-prime market, several reasons may lie behind the spill-over of the turmoil to other market segments. A global macroeconomic environment characterised by sustained growth, low inflation, muted long-term interest rates, a long period of very favourable credit conditions, abundant market and funding liquidity, and relatively low official rates may have strengthened investors’ appetite for risk and increased the “hunt for yield”. This, in turn, may have brought about an under-pricing of risk. In addition, the “originate and distribute” banking model, compounded with the proliferation of new and complex financial instruments, notably structured finance products has contributed to a dispersion of credit risk in the financial system and an increased indebtedness of non-financial sectors.

In this context, the loosening of credit standards and a probably riskier lending attitude may be identified ex post as a weakness of the banking sector. As banks were able to transfer part of their credit risk, they were able to extend further loans.

In addition, there was a widespread underestimation of risks and a lack of transparency in the context of the extensive use of derivative products, partly related to their evaluation by rating agencies, leading to mistrust between market participants, an increase in the cost of funding and liquidity shortages in the course of the turbulences. This underestimation of risks may be seen as another key weakness of the banking sector.

Against this background, let me finally discuss the need for potential reforms with respect to preventing and handling financial crises. It seems clear that some very important lessons can be drawn from the turmoil for market players as well as for public authorities.

Let me just mention few key areas where reforms are needed. First, with respect to banks, the turmoil has highlighted that some risk categories have been underestimated, especially liquidity risks relating to banks’ commitments to structured investment vehicles and conduits. Second, market players seem to have relied excessively on ratings of complex assets. This has been the case in part due to the wide distribution of risks through the financial sector which made the assessment of the value of the underlying asset difficult for the investor. While, on the positive side, credit risk transfer has facilitated a widespread sharing of risk in the financial system over recent years, the recent financial turmoil made clear that more transparency and monitoring is needed on the credit risks and where they ultimately reside in the financial system. Finally, with respect to public authorities, it seems of high importance that there is a smooth and effective cooperation and exchange of information between supervisory authorities as well as between them and central banks in the detection of threats to the financial system. Particularly, with respect to central banks, it is their own interest to contribute to an orderly functioning of money markets and to solidly anchor inflation expectations in order to avoid additional volatility in already highly volatile financial markets.

Let me briefly conclude by summing up what all of this means for the outlook of the euro area.

First, from the real economic side, there are encouraging signs indicating the good potential of the euro area to successfully adapt and to remain competitive going forward. Nevertheless, there are important challenges ahead and to implement the necessary structural reforms will be decisive to raise productivity growth and, hence, to foster the competitiveness of euro area firms.

Second, with respect to the financial side, the financial development of the euro area has increased markedly since the introduction of the euro. This is particularly important as a well developed financial system allows economies to better allocate resources to industries with good growth opportunities and thus experience faster overall economic growth. In addition, the financial integration of the euro area has made large progress during recent years. This has increased the competitiveness of the euro area. Notwithstanding some reforms, which appear necessary especially following the experience of the recent financial turmoil and further steps which are needed on the way to a fully integrated euro area financial system, the progress already achieved is highly beneficial for the efficiency and competitiveness of the euro area financial system and will ultimately foster the performance of the euro area economy.