DG ECFIN Session III: Panel discussion Euro and macroeconomic stability Servaas Deroose Director DG ECFIN, European Commission Conference hosted by Mr. Miroslav Kalousek, Minister of Finance of the Czech Republic, November 25, 2008 Ten Years of the Euro Inspirations for the Czech Republic

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 2 Outline Assessing macroeconomic stability Assessing macroeconomic stability o Domestic: from overheating to hard-landing? o Financial: Are financial systems resilient? o External: Are external positions sustainable? Lessons from for future € members Lessons from for future € members o Challenges o Policy requirements Conclusion Conclusion

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 3 Real convergence is advancing but remains a long-term challenge GDP per capita in 2007 (in PPS, EU=100) and average change,

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 4 Growth is slowing considerably due to global and domestic factors (in %, y-o-y)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 5 Price level convergence but also demand pressures 12-month average inflation (in %, y-o-y)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 6 Financially-driven convergence – large capital inflows and extension of external balance sheets

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 7 Very rapid financial deepening from a low base (less pronounced amongst ‘floaters’) Domestic credit growth (in % of GDP)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 8 Large external imbalances (especially in ‘fixers’) Balance on current account (in % of GDP)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 9 Fiscal positions External constraints seem to matter for fiscal performance General government balance and government debt (in % of GDP; 2007)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 10 Exchange rate developments vs. euro, monthly averages (index numbers, Jan 2007 = 100)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 11  Price stability: equilibrium real appreciation complicates inflation control ; shorter history of anti-inflation policy and lower credibility ; conflict between fiscal and monetary authorities ; wage catching up  Effective adjustment capacity (incl. stabilisation):  To deal with shocks without exchange rate instrument (but nominal exchange rate flexibility acts also as shock propagator, hence less ‘cost’ of giving up the XR instrument);  Relatively more frequent and persistent common shocks with asymmetric impact (exchange rates, terms of trade, shifting comparative advantages…); asymmetric shocks still possible (see Spain, Ireland, …)  Correction of large current account imbalances may require long and painful disinflation processes if coupled with stagnating productivity  EMU and financial integration help efficient resource allocation and allow for longer adjustment periods, but managing credit booms can be a challenge (already well before euro adoption)  Do not lose sight of long-term challenges: sustain high potential growth, in a context of ageing, globalisation (with more rapid shifts in comparative advantages) Lessons from for future euro area members (1 - challenges)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 12  Improved budgetary control to reduce the risk of fiscal policy pro-cyclicality; budgetary frameworks in NMS are less developed and assessing cyclical component even more challenging  Sustainability of public finances  Quality of public finances ; bias towards current expenditure in NMS  Flexible and integrated goods and factor markets  More efficient use of labour resources (participation rates, structural unemployment, skill mismatches)  Business environment and investment climate (innovation, FDI, education, favour entry /exit of firms)  Growth-enhancing use of capital inflows ; NMS are receiving huge inflows, included EU funds; utilisation has differed a lot across NMS  Effective supervision and regulation of financial markets ; NMS experience accelerated financial development Lessons from for future euro area members (2 – policy needs)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 13 Fiscal policy Fiscal policy has to balance multiple challenges Fiscal policy has to balance multiple challenges  need for well-targeted public spending (infrastructure, education and R&D) vs  fiscal policy key to rein in demand pressures and overheating risks, especially in fixed XR regimes Preventing imbalances may require substantial surpluses of longer periods Preventing imbalances may require substantial surpluses of longer periods Quality of public finances (pro-growth priorities) Quality of public finances (pro-growth priorities)

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 14 Coping with financial deepening and credit growth Vigilance to prevent the build-up of imbalances and vulnerabilities Vigilance to prevent the build-up of imbalances and vulnerabilities Prudential and administrative measures Prudential and administrative measures o Raise minimum capital adequacy ratio o Strengthen loan-loss provisioning o Mandatory loan-to-income or loan-to-value limits Strengthen supervisory framework Strengthen supervisory framework o Improvements in credit registers o Strengthening risk management, expand stress testing o Harness cross-border supervision

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 15 Structural policy implications  Boost external competitiveness  Ensure favourable business environment and investment climate  Encourage innovation and entrepreneurship to maintain competitiveness and move up the value-added chain  Move toward high value-added and fast-growing sectors  Sectoral composition of exports  Productivity growth in the tradables sector  Enhance internal economic adjustment  NMS will have to manage underlying structural divergences for some time  Ensure functioning of goods, services and labour markets  labour mobility, skill development & wage flexibility  wage setting in line with productivity gains  Entrepreneurship, etc.

DG ECFIN S. Deroose, Director, Macroeconomy of the euro area European Commission, Economic and Financial Affairs 16 Conclusion Catching-up is proceeding but accompanied by varying imbalances Catching-up is proceeding but accompanied by varying imbalances Euro adoption – readiness more important than timing Euro adoption – readiness more important than timing Ability to cope with country-specific adjustment needs Ability to cope with country-specific adjustment needs Adequate preparation in fiscal, structural and prudential domains Adequate preparation in fiscal, structural and prudential domains Short-term challenges: deal with fall-out from the financial crisis; manage orderly unwinding of imbalances among the ‘fixers’, keep progress towards convergence on track for the ‘floaters Short-term challenges: deal with fall-out from the financial crisis; manage orderly unwinding of imbalances among the ‘fixers’, keep progress towards convergence on track for the ‘floaters