The Brussels Economic Forum
What kind of policies should the
new Member States apply to
optimise their speed of
convergence ?
Banco de
Portugal
VÍTOR CONSTÂNCIO
Brussels, 23d of April 2004
I. INTRODUCTION
SUMMARY
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
GDP per capita
(PPS in % of EU-15 average)
80.00%
75.00%
70.00%
65.00%
Portugal
60.00%
55.00%
50.00%
EMS entry
EU entry
Euro entry
45.00%
81
83
85
Source: Eurostat
87
89
91
93
95
97
99 2001 2003
Benefits and conditions of successful integration
Conditions of successful integration:
‰
High degree of trade integration
‰
Synchronization of economic cycles (similarity of economic
structures, institutions…)
‰
Good alternative mechanisms of adjustment:
•
flexible markets with flexible setting of wages and prices
•
anti-cyclical use of national fiscal policy
•
developed financial sector well integrated with the monetary
area
•
people mobility
•
fiscal federalism
8
MAASTRICHT CRITERIA
INFLATION: DIFFERENCES
TO THE REFERENCE
VALUES
6
4
2
0
-2
-4
-6
us ep. nia ary tvia nia lta nd kia nia
78 88 l 91 97
r
a
d
n
i
yp h R sto ung La hua M Pola ova love
an pa tuga eece
C
l
t
c E H
e
Sl S
Li
ze
Ir S Por Gr
C
MAASTRICHT CRITERIA
BUDGET DEFICITS:
DIFFERENCES TO THE
REFERENCE VALUES
6
5
4
3
2
1
0
-1
-2
-3
-4
us ep. nia ary tvia nia lta nd kia nia
78 88 l 91 97
r
a la a ve
d
n
n i a e
yp R to g a ua
C ech Es Hun L ith M Po Slov Slo
le a Spa tug eec
r r
L
z
Ir
C
Po G
PRICE LEVELS AND INFLATION
Price levels
( 2001)
Inflation differentials with EU15 if
price levels converge to Portugal’s
in (1)
5 years
10 years
EU-15 average
100.00
Portugal 1991
73.9
Czech Rep.
46.9
9.5
4.6
Estonia
51.2
7.6
3.7
Hungary
48.7
8.7
4.3
Latvia
47.9
9.1
4.4
Lithuania
52.1
7.2
3.6
Poland
60.9
3.9
1.9
Slovakia
42.1
11.9
5.8
Slovenia
66.6
2.1
1.1
(1) Source: OECD and De Nederlandsche Bank
Total revenue
50
Total revenue % GDP
Euro
Hungary
45
Italy
Greece
Portugal
Slovenia
Poland
40
Czech Rep
Spain
Lithuania
Slovakia
35
30
0
5
10
15
20
GDP per capita 1000 euros
Source: AMECO Autumn 2003, BP calculations
Regression line based on OLS estimate over the 15 EU countries
For euro area countries average 1995-2003, for CEC's 2003 estimates
25
Primary expenditure
50
Primary Expenditure % GDP
Czech Rep
Latvia
45
Malta
Poland
40
Euro
Hungary
Slovenia
Italy
Portugal
Greece
Spain
Lithuania
35
Slovakia
30
0
5
10
15
20
GDP per capita 1000 euros
Source: AMECO Autumn 2003
Regression line based on OLS estimate over the 15 EU countries
For euro area countries average 1995-2003, for CEC's 2003 estimates
25
Potential problems and risks
‰
Pressures for higher inflation. Strong Balassa-Samuelson effect. High
growth dynamics and catching-up of price levels. Real appreciation
above the equilibrium exchange rate.
‰
Possible real interest rate misalignment and consequent credit boom.
‰
Large capital inflows
Main risks:
o
Boom and bust cycle with recession and hysteresis
o
Overheating in asset markets (housing and stock exchange)
o
Loss of competitiveness and current account unbalance
o
Financial stability risks
These risks may occur before and after the euro adoption. To optimize
the speed of convergence countries must make proper use of ERM II
participation, avoid the worse consequences of overheating and
continue reforms to improve their growth potential and increase total
factor productivity.
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
INFLATION
20.0%
15.0%
Portugal
10.0%
EU
5.0%
EMS entry
0.0%
86
88
90
92
94
96
98
Escudo Exchange Rate v. the Deutsche Mark, Interventions and
the Overnight rate
140
140
120
120
100
100
80
60
80
40
60
20
0
40
Ja
n90
Ja
n91
Ja
n92
Ja
n93
Ja
n94
Ja
n95
Ja
n96
Ja
n97
Ja
n98
D
ez
-9
8
-20
-40
-60
Overnight rate
20
0
Intervention Index
PTE/DEM
Central rate
Band
Source: Adão A. and J. Pina (2003) Boletim Económico do BP, June
Band
Budget Deficits in % of GDP
6
4
Primary deficit
2
0
-2
-4
-6
Overall deficit
-8
EMS entry
-10
9
8
19
1
9
19
3
9
19
5
9
19
7
9
19
9
9
19
1
0
20
3
0
20
Successful and flexible use of ERM
ƒ Determined and simultaneous use of
interventions and interest rates with a
sense of the primacy of the exchange
Escudo Exchange Rate v. the Deutsche Mark, Interventions and
rate objective
the Overnight rate
During the period there were 2,4%
of days with active intervention with
140
140
91,5% of success.
120
120
Flexible use of realignments that
100
100
offset initial real appreciation and did
80
not affected the disinflation process.
60
80
Central rate was not seen as future
40
60
20
conversion rate.
0
The escudo stayed a long period in
40
-20
ERM gaining stability as policies
20
-40
gradually made the target of adopting
-60
0
the euro more credible. There was a
disciplinary effect.
Overnight rate
Intervention Index
PTE/DEM
Central rate
Band
Band
The initial success with disinflation
was helped by very high real interest
rates and by the the european recession
of the early 90’s. During the first years Source: Adão A. and J. Pina (2003) Boletim Económico
B.P, June.
of ERM participation there was no
demand or credit boom
ƒ
ƒ
Ja
n90
Ja
n91
Ja
n92
Ja
n93
Ja
n94
Ja
n95
Ja
n96
Ja
n97
Ja
n98
D
ez
-9
8
ƒ
ƒ
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
II. 1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
The change of regime with the adoption of the euro:
‰
Increased substitutability of financial assets
‰
Consolidated reduction of the cost of capital
‰
Increase in wealth and reduced liquidity constraints
‰
Different meaning of the current account and primacy of credit risk.
These features create the conditions for demand/credit booms and possible
overheating.
‰
The drop in interest rates increases wealth, reduces liquidity
constraints and favours consumption intertemporal smoothing.
‰
The reduction of the cost of capital and the prospects of higher
growth as a result of goods markets integration, lead to investment
growth
The counterbalancing policies are:
Anti-cyclical use of Fiscal Policy; Realistic wage policy; Good Prudential
Supervision; Flexible and competitive price setting mechanisms
6
Experience of overheating
in Euro Area countries.
5
4
3
Inflation (2001)
2
1
0
N
s
nd
a
l
er
h
et
l
ga
u
rt
Po
d
an
l
e
Ir
G
e
ec
e
r
n
ai
p
S
EU
12
6
5
4
Output gap (2001)
3
2
1
0
ds
nd
n
a
a
el
rl
Ir
e
h
et
N
r
Po
al
g
tu
n
ai
p
S
G
e
ec
e
r
EU
12
Experience of overheating
in Euro Area countries.
0
-1
-2
Real long term interest
rate - change from 1996
to 2001
-3
-4
-5
-6
l
s
d
e
ain tuga
eec rel an rland
r
Sp
r
G
I
Po
the
Ne
EU
12
25
Credit to residents
(excluding General
Government) – Average
rate of growth 1998-2001
20
15
10
5
0
d
al
ug
l an
t
e
r
r
I
Po
eec
Gr
e
d
ain
lan
Sp
r
e
th
Ne
s
EU
12
Experience of overheating
in Euro Area countries.
140
120
100
Housing prices –
percentage change
from 1995 to 2001
80
60
40
20
0
l an
Ire
d
th
Ne
ds
n
a
erl
P
gal
u
t
or
ain
Sp
EU
r
e
h
Ot
12
400
350
300
Stock Exchange índices
in Portugal
FT EU100
S&P 500
250
200
150
100
PTE PSI20
50
0
4
5
6
7
8
9
0
1
2
z-9 ez-9 ez-9 ez-9 ez-9 ez-9 ez-0 ez-0 ez-0
e
D
D
D
D
D
D
D
D
D
I. INTRODUCTION
SUMMARY
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
Inflation dispersion in the Euro Area and the USA
Source: ECB
Unit Labour Costs developments
and incomes policy
• Trends for higher inflation should
not be aggravated by wage
developments that could lead to a
loss of competitiveness. In a
monetary union the adjustment
variable would be unemployment.
• Necessary to apply adequate
guidelines for wage negotiations:
a) wage growth differentials with
the euro area should not deviate
much from the differential in real
productivity growth.
b) wage negotiations valid for two
years (stability of contracts)
Nominal Unit Labour Costs
(increase in % since 1995)
140
120
100
80
60
40
20
0
s
l
15 ga 10 ary and nia nia ep kia tvia ania alta ru
U
e
o
g
u
l
a
p
R
C
E ort A un Po lov st ch ov La thu M Cy
E e Sl
S
H
P
Li
Cz
Source: European Commission,
Economic Forecasts, Spring 2004
Real Effective exchange rate
(increase in % since 1995)
40
30
20
10
0
-10
-20
-30
ro
Eu
ar
ea
.
y
d
al
R
ar
an
g
ug
l
h
t
r
ec
un
Po
H
Po
Cz
Source: IMF, IFS
M
ta
al
o
Sl
a
ki
va
s
ru
p
Cy
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
Portugal:Short and Medium term real interest
rates
10
8
6
4
2
20
03
20
02
20
01
20
00
99
98
97
96
95
94
-2
93
0
92
A credit boom developed
after the drop in real
interest rates became
significant and was seen as
permanent as participation
in Monetary Union grew
more certain.
Portugal: Credit to the Private Sector
(Annual growth rates)
30%
25%
20%
15%
10%
5%
0%
92
93
94
95
96
97
98
99 2000 2001 2002 2003
120
100
Household debt,
interest charges and
total financial
charges in % of
Disposable Income
80
60
40
20
0
1995
1997
Debt
1999
Interest
2001
2003(e)
Total service
100
80
Debt of Firms and
interest charges (%
of GDP)
60
40
20
0
1995 1996 1997 1998 1999 2000 2001 2002 2003
Debt
Interest charges
Portugal: Investment and Savings Rate (% of GDP)
30
35
25
30
20
Investment
25
15
20
Savings
10
15
5
10
03
20
02
20
01
20
00
20
99
98
97
96
95
94
93
92
91
90
89
88
-5
87
86
0
5
External deficit
-10
0
Net lending (+) or Net Borrowing(-) by the Public, Private
and External sectors
10
External
8
6
Private sector
4
2
0
-2
Public Sector
-4
-6
External = - (Current Account +Capital Account)
03
20
02
20
01
20
00
20
99
98
97
96
95
94
93
92
91
90
-8
GREECE
26
24
22
20
Adjustment to a
new economic
regime.
18
16
90 91 92 93 94 95 96 97 98 99 00 01 02 03
19 19 19 19 19 19 1 9 1 9 1 9 1 9 2 0 2 0 2 0 2 0
SPAIN
Investment and
Savings
(% of GDP).
28
26
24
22
20
18
90 91 92 93 94 95 96 97 98 99 00 01 02 03
19 19 19 19 19 19 1 9 1 9 1 9 1 9 2 0 2 0 2 0 2 0
Source: AMECO
GDP and Domestic Demand growth.
Current Account in % of GDP
16
Domestic
demand
11
External
demand
6
GDP
1
-4
-9
External deficit
-14
89
91
93
95
97
99
01
0
2
03
0
2
05
0
2
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and market based adjustments
6. Financial stability risks
7. Structural reforms and potential growth
6
Primary deficit
3
0
Budget Deficits in %
of GDP
-3
-6
-9
Overall deficit
EMS entry
89
19
9
19
1
93
19
19
95
97
19
99
19
0
20
1
03
20
45.00%
Current Primary
Expenditures
(% of GDP and real growth
rates)
30.00%
15.00%
0.00%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Fiscal Revenue and Expenditure Multipliers
QUEST
Revenue
Expenditure
Austria
0.1
0.5
Belgium
0.1
0.5
Finland
0.3
0.4
France
0.1
0.5
Germany
0.2
0.4
Greece
0.1
0.5
Ireland
0.1
0.4
Spain
0.0
0.7
Portugal
0.1
0.5
Source: P. Hoeller et al (2002) “Overheating in small euro area economies:
should fiscal policy react ?” OCDE WP nº 323, Feb 2002
«Simulations suggest that market based adjustments is fairly
rapid in the small ecoconomies in returning demand shocks to
baseline. In this respect, deeper integration (stronger trade
linkages, greater migration and an anchoring of expectations in
area wide inflation) would help to smooth adjustment.
.... Concerning fiscal policy, the automatic stabilisers help to
smooth the impact of a demand shock, but only to a limited
extent and the fiscal multipliers are fairly small in open
economies. With low fiscal multipliers, big swings in expenditure
or revenues would be needed to damp the cycle. Such volatility
would undermine the effectiveness of fiscal policy and the
credibility of a rules-based fiscal policy.
(P. Hoeller et al. (2002) “Overheating in small euro area economies:
should fiscal policy react ?” OCDE WP nº 323, Feb 2002)
Simulation of a reduction of the Budget Deficit in 2 p. p. in
2001 by reducing expenditure from 1998 onwards
Difference from
base scenario
Annual Growth
rates
Primary expenditure
-2.8 p.p.
Real GDP
- 0.8 p.p.
Inflation
- 0.6 p.p.
Deficit value in
2001
Current Account
-2 % of GDP
(from 8 to 6 %)
DEMAND BOOMS AND THE ROLE OF FISCAL POLICY
2. Fiscal policy, in spite of its limitations, is essential to counter the more
negative effects of a demand/credit boom and partially smooth the cycle.
In particular, the Portuguese experience shows that the following points
are important:
a) Maintain at all times an anti-cyclical fiscal policy. A prudent approach
requires that real budget consolidation with a deficit well bellow 3%
should be achieved before adopting the euro.
b) The structural deficit should not exceed the level compatible with the
full play of the automatic stabilizers without breaching the 3% limit.
c) Introduce structural reforms early on to contain future budget
pressures. Adopt efficient institutional procedures for the preparation
and implementation of the budget. For instance, obtain multi-year
expenditure commitments from Government and Parliament; or in view
of the need to invest in infrastructure and the limitations of the Stability
Pact that does not allow the use of debt over the cycle to finance those
expenditures, prepare rules for PPP initiatives and project finance that
ensure real transfer of risk, transparent accounting of multi-year
commitments and limits to future expenditures.
DEMAND BOOMS, RISKS FOR INFLATION AND THE THE
CURRENT ACCOUNT
1. The problem is not the current account unbalance as such if it
is the result of one-time rational adjustment to a new intertemporal
equilibrium. Unbalances that stem from a rational adjustment by
private agents to a new steady state, have market driven selfcorrecting mechanisms that operate through change of
competitiveness and the consequences of budget constraints
monitored by the financial sector.
2. Serious problems may, nevertheless, arise if the
macroeconomic unbalances become sizable enough to create the
following effects: a boom/bust economic cycle with significant
recession and hysteresis; overheating in asset markets; loss of
competitiveness resulting from excessive inflation and ULC
misalignment; financial stability risks.
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and self-correcting mechanisms
6. Financial stability risks
7. Structural reforms and potential growth
Financial Account
15
10
(+) Net
inflows
Percentage of GDP
5
0
-5
(-) Net
outflows
Monetary Financial Institutions
Monetary Authorities
Public Administrations
-10
-15
Non-monetary Financial Institutions + households
Total
-20
1996
1997
1998
1999
2000
2001
2002
Portuguese consolidated Banking System
«Portuguese banks are
well managed, have
strong internal
management systems
and good credit risk
management, and
resemble their
European counterparts
in terms of product
range, innovation, and
sophistication.
... Portuguese banks
have maintained sound
and fairly consistent
profitability throughout
the economic cycle.»
(Standard & Poor’s,
April 2004, - Banking Risk
Analysis: Portugal))
2003
Total Assets in % of GDP
229 %
Transformation ratio (Credit /Deposits)
129 %
Cost/Income ratio
50.4 %
Non Performing Loans (% of total credit)
2.41%
Provisions in % of Non Performing Loans
107 %
Exposure to Emerging Countries (% of Assets)
1.7 %
Net Interest Income (% of Assets)
2.1%
Return on Assets (ROA)
0.81%
Return on Equity (ROE)
15.8%
Solvency Ratio
10.1 %
SUMMARY
I. INTRODUCTION
1. Benefits and conditions of successful integration
2. Situation of acceding countries. Problems and risks
II ERM participation
1. The role of ERM and the portuguese experience
2. Interventions, interest rates and realignments
3. Credibility and fiscal policy
III. Monetary Union: risks and policy responses
1. Experience of overheating in Euro Area countries. An unavoidable
adjustment to a new intertemporal equilibrium.
2. Inflation differentials in the Euro Area
3. Competitiveness and wage policy
4. Market driven demand booms and the external balance: the
Portuguese case.
5. The role of fiscal policy and self-correcting mechanisms
6. Financial stability risks
7. Structural reforms and potential growth
CONCLUSIONS
1. Adequate use of ERM II with a sense of the primacy of the
exchange rate objective. Monetary policy cannot be
conducted as a pure inflation targeting regime and that
should be clear to the markets. The initial central rate should
not be seen as the future conversion rate into the euro
2. Permanent anti-cyclical use of Fiscal Policy, building-up a very
solid and cautious position before joining the euro.
3. Realistic wage policy to avoid excessive real appreciation in
terms of relative Unit Labour Costs.
4. Strong prudential supervision of the banking sector, taking
seriously financial stability risks
5. Implement structural and institutional reforms to ensure
flexible and competitive markets.
6. Continue to improve Institutions necessary to increase the rate
of growth of potential GDP