Economic adjustment in the euro area and the experience of the

Baltics

Riga, 02 November 2012

Hans-Joachim Klöckers Deputy Director General Economics

European Central Bank The views expressed in this presentation are solely those of the presenter and do not necessarily

reflect those of the European Central Bank

2

Outline

1 Euro area sovereign debt crisis: where do we stand? 2 The experience of the Baltics: which lessons to draw?

3 Challenges for Latvia 4 Conclusions

3

1.1 Euro area sovereign debt crisis: causes Unit labour costs and current account

Source: Eurostat and European Central Bank. Note: Countries are ranked in ascending order according to the average unit labour costs growth in 1999-2007.

Rapid convergence in

terms of financial conditions and

overly optimistic income

expectations contributed to

macro-economic and financial imbalances gradually

accumulating.

-0.50.00.51.01.52.02.53.03.54.0

DE AT FI EA BE FR NL LU IT PT GR ES IE

Unit labour costs growth, annual averages1999-07

10.0

-5.0

0.0

5.0

10.0

15.0

DE AT FI EA BE FR NL LU IT PT GR ES IE

Current account balance as % of GDP, annual averages

4

1.1 Euro area sovereign debt crisis: causes Loans to private sector and house prices

Sources: Eurostat and European Central Bank. Note: Countries are ranked in ascending order according to the average loans growth in 1999-2007. *House prices data for Luxembourg not available.

Persistently low “real”

interest rates in some

countries supported

strong credit growth and

housing booms.

-5.0

0.0

5.0

10.0

15.0

20.0

DE AT BE EA FR IT NL LU FI PT ES GR IE

1999-07 Loans to the private sector (annual average growth rates)

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

DE AT BE EA FR IT NL LU* FI PT ES GR IE

Residential property prices, annual average growth rates

-15

-10

-5

0

5

ES IE GR CY FI SI LU BE EA NL FR PT SK IT AT DE MT

-5

0

5

10

15

20

25

30

ES IE GR CY FI SI LU BE EA NL FR PT SK IT AT DE MT

Cumulative change in fiscal balance (% of GDP)Cumulative real GDP growth (%)

5

1.1 Euro area sovereign debt crisis: causes Fiscal policy

2008-09

2005-07

Sources: European Commission and Eurostat. Note: Countries are ranked according to the change in the fiscal position over the period 2008-09.

During the boom period insufficient fiscal buffers were built up. When the crisis came, public finances deteriorated markedly.

6

Source: DataStream. Last observation: 26/10/2012.

High public debt

High private sector debt

Structural rigidities

Loss of competitiveness

Weak economic activity and rising unemployment

1.2 Euro area sovereign debt crisis: consequences Imbalances are now painfully exposed

10-year government bond spreads (vs. German bond; daily data; basis points)

Exacerbating factors: - cross-country spill-overs - bank-sovereign linkages

Greek spreads peaked above 4,000 basis points in March 2012

7

Five-year Bank and Sovereign CDS (daily data, basis points)

Sources: Thomson-Reuters and ECB calculations. 1) Average of DE, FR, IT, ES, NL, PT, BE, AT, FI, SK, IE, weighted by ECB capital key. 2) Simple average of 10 large banks in the euro area.

1.2 Euro area sovereign debt crisis: consequences Interconnection of fiscal sustainability and financial stability

Euro area United States

8

• Insufficient attention was paid to the build up of economic imbalances and vulnerabilities

• Fiscal policy surveillance was not effective

• Financial markets failed to induce discipline

1) Significant fiscal adjustments and structural reforms had to be implemented at the national level

2) New EU economic and fiscal governance framework is being put in place to ensure sound fiscal policies and to prevent the emergence of economic imbalances and financial vulnerabilities in the future

1.3 Euro area sovereign debt crisis: lessons

9

1.4 Euro area sovereign debt crisis: progress The gaps in economic governance are being filled (i) Stronger surveillance and enforcement rules

• The “six-pack”:

• Strengthened Stability and Growth Pact

• New Macroeconomic Imbalances Procedure

• Fiscal Compact

• “Two-pack” (in progress)

Improved coordination of economic policies

• European Semester

• Euro Plus Pact

European Stability Mechanism (ESM) • Stability support on the basis of strict conditionality • Initial maximum lending volume of the ESM is set at € 500 billion • Inaugural meeting of the ESM-Board of Governors on 8 October

2012 Single Supervisory Mechanism (SSM, in progress) • European Commission unveiled draft legislation

on 12 September • Proposal to confer ultimate responsibility for specific supervisory

tasks on the ECB 10

1.4 Euro area sovereign debt crisis: progress The gaps in economic governance are being filled (ii)

Fisc

al U

nion

Econ

omic

U

nion

Polit

ical

U

nion

Fina

ncia

l M

arke

t Uni

on

Monetary Union

EMU

Towards a genuine economic and monetary union .Interim Report by the Four Presidents to European Council 18-19 October 2012

11

1.4 Euro area sovereign debt crisis: progress The gaps in economic governance are being filled (iii)

12

Source: European Commission Spring 2012 forecast.

Budget balance path for EA and selected countries (as a percentage of GDP)

Budget Balance

Structural Primary Balance

Budget Balance

Structural Primary Balance

Ireland -14.0 -7.6 -8.3 -4.1Greece -15.6 -9.6 -7.3 3.4Spain -11.2 -6.9 -6.4 -1.6Italy -5.4 0.7 -2.0 4.7Portugal -10.2 -5.8 -4.7 1.8Euro area -6.4 -1.7 -3.2 1.1

2009 2012

1.4 Euro area sovereign debt crisis: progress Significant reduction in budget deficits in individual Member States

(I) Increase flexibility of labour market, e.g. • Increase firm level bargaining • Reduce employment protection • Scrutinise minimum wages; abolish wage indexation

(II) Strengthen competition in product markets, e.g. • Reduce protection of sheltered sectors • Facilitate entry of new firms • Reduce red tape

(III) Boosting total factor productivity, e.g. • Foster innovations • Improve skills of the labour force • Improve business environment

13

1.4 Euro area sovereign debt crisis: progress Structural reform priorities

14

Components of unit labour costs (cumulative pct. change 2008-2012) - relative to the euro area average -

Source: European Commission Spring 2012 forecast. Note: Countries are ranked in ascending order according to the ULC growth since 2008-2012.

1.4 Euro area sovereign debt crisis: progress Adjustment of imbalances is continuing

15

Source: European Commission Spring 2012 forecast. Note: Countries are ranked in ascending order according to the avg. balances in 2002-2008.

Current account balances (% of GDP)

1.4 Euro area sovereign debt crisis: progress Compression of domestic demand facilitated CA adjustment

1.5 Euro area sovereign debt crisis: conclusions

• Macroeconomic imbalances and un-sound fiscal policies were at the core of the crisis

• The lessons from these unsustainable developments have been learned

• The necessary economic adjustment is under way supported by national reform agendas and a stronger governance framework at the EU level

• However, the adjustment will take time and further measures both at the national level and through EU/EA institutional deepening have to be taken

16

17

Outline

1 Euro area sovereign debt crisis: where do we stand? 2 The experience of the Baltics: which lessons to draw?

3 Challenges for Latvia 4 Conclusions

18

Source: Eurostat. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries. Data for Greece is not seasonally adjusted.

(year-on-year growth rates; quarterly frequency)

2 The Baltics experience vs. EA program countries V-shaped recoveries in the Baltics Real GDP growth

-25

-20

-15

-10

-5

0

5

10

15

2006 2007 2008 2009 2010 2011 2012

IE GR PT

-25

-20

-15

-10

-5

0

5

10

15

2006 2007 2008 2009 2010 2011 2012

LV EE LT

19

Source: ECB. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries. Data for Greece is not seasonally adjusted, due to lack of data.

(Index 2007Q4 = 100, annual quarterly frequency)

2 The Baltics experience vs. EA program countries Significantly greater wage flexibility…

Compensation per employee

60

70

80

90

100

110

120

2006 2007 2008 2009 2010 2011 2012

IE GR PT

60

70

80

90

100

110

120

2006 2007 2008 2009 2010 2011 2012

LV EE LT

2 The Baltics experience vs. EA program countries …supported faster adjustments in competitiveness…

Unit labour cost (nominal)

Source: European Commission Spring 2012 forecast. Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).

(Index 2007 = 100, annual frequency)

70

80

90

100

110

120

130

2006 2007 2008 2009 2010 2011 2012 2013

IE GR PT

70

80

90

100

110

120

130

2006 2007 2008 2009 2010 2011 2012 2013

LV EE LT

20

21

Source: Eurostat. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.

(year-on-year growth rates; monthly frequency)

2 The Baltics experience vs. EA program countries …and was mirrored in price developments

HICP

-10

-5

0

5

10

15

20

2006 2007 2008 2009 2010 2011 2012

IE GR PT

-10

-5

0

5

10

15

20

2006 2007 2008 2009 2010 2011 2012

LV EE LT

22

Source: European Commission Spring 2012 forecast. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.

(as % of GDP; annual frequency)

2 The Baltics experience vs. EA program countries The Baltics followed more prudent fiscal policies…

General government structural primary balance

-10

-8

-6

-4

-2

0

2

4

2006 2007 2008 2009 2010 2011 2012 2013

IE GR PT

-10

-8

-6

-4

-2

0

2

4

2006 2007 2008 2009 2010 2011 2012 2013

LV EE LT

23

Source: European Commission Spring 2012 forecast. Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).

(as % of GDP; annual frequency)

2 The Baltics experience vs. EA program countries …which helped stabilising debt developments earlier…

General government gross debt

0

20

40

60

80

100

120

140

160

180

2006 2007 2008 2009 2010 2011 2012 2013

IE GR PT

0

20

40

60

80

100

120

140

160

180

2006 2007 2008 2009 2010 2011 2012 2013

LV EE LT

24

Source: NCBs and Eurostat. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.

(ratio of 4 quarter moving sums of quarterly observations)

2 The Baltics experience vs. EA program countries …and helped improving the current account balance rapidly.

Current account as % of GDP

-40

-30

-20

-10

0

10

20

2006 2007 2008 2009 2010 2011 2012

IE GR PT

-40

-30

-20

-10

0

10

20

2006 2007 2008 2009 2010 2011 2012

LV EE LT

25

Source: Eurostat. Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.

(% of labour force; monthly frequency)

2 The Baltics experience vs. EA program countries The negative trends in unemployment have been reversed…

Unemployment rate

0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012

IE GR PT

0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012

LV EE LT

26

Source: European Commission Spring 2012 forecast. Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).

(index =100 in 2007; annual frequency) Real GDP levels

2 The Baltics experience vs. EA program countries …but GDP still below pre-crisis levels.

70

75

80

85

90

95

100

105

2006 2007 2008 2009 2010 2011 2012 2013

IRL GRC PRT

70

75

80

85

90

95

100

105

2006 2007 2008 2009 2010 2011 2012 2013

LVA EST LTU

2 The Baltics experience vs. EA program countries Broader lessons for successful macroeconomic adjustment

• Flexible wages and prices facilitate adjustment • As do prudent fiscal policies • Critical mass of structural reforms is needed • Preserving financial stability is first order priority • Success ultimately rooted in strong national

ownership of reforms • The high cost of the adjustment calls for pre-emptive

policies to avoid build-up of future imbalances

27

28

Outline

1 Euro area sovereign debt crisis: where do we stand? 2 The experience of the Baltics: which lessons to draw?

3 Challenges for Latvia 4 Conclusions

3 Challenges for Latvia 2012 Convergence Report recommendations

• Continue fiscal consolidation to meet EDP commitments • Strengthen fiscal framework to avoid pro-cyclical policies • Contain unit labor costs increases going forward • Pursue structural reforms to support rebalancing of economy

towards the tradable sector and improve the functioning the labor market

• Guard financial sector soundness – Make further progress in restructuring state-owned banks – Prevent excessive credit growth in future – Implement ESRB recommendations on FX lending – Close cooperation between home and host supervisors

29

30

3 Challenges for Latvia Improvement in quality of institutions is also key.

Note: Countries are ranked from one (best performer in the EU) to 27 (worst performer in the EU) and ordered according to their average position in the rankings.

31

3 Challenges for Latvia Need for sustainable convergence

• Sustainable convergence is prerequisite for Euro adoption

• Euro area membership requires sound fiscal policies

• Flexible adjustment mechanisms need to be maintained

• Improvement in quality of institutions is important

32

Outline

1 Euro area sovereign debt crisis: where do we stand? 2 The experience of the Baltics: which lessons to draw?

3 Challenges for Latvia 4 Conclusions

33

4 Conclusions

• Substantial macroeconomic imbalances and unsustainable fiscal policies have been root causes of the sovereign debt crisis in the euro area

• The necessary economic adjustment is under way supported by national reform agendas and a stronger governance framework at the EU level

• However, the adjustment will take time and further measures both on the national level and through institutional deepening have to be taken

• Baltics experience shows importance of speedy fiscal adjustment, critical mass of structural reforms, and strong national ownership for successful adjustment

• Sustainable convergence is key for smooth participation in euro zone