Vitas Vasiliauskas. Speech at European Economics and Financial Centre
Good afternoon, dear Ladies and Gentlemen,
It is my great pleasure to be here with you today. Thank you for your invitation. And thank you for suggesting a topic that shows your interest in my country.
As far as I know after consulting your website, I am the second Lithuanian to speak at the European Economics and Financial Centre. The first one was the former Prime Minister of Lithuania, Mr Brazauskas, who in 2002 presented here Lithuania’s intentions to join the EU.
Today, after a little more than 10 years, I am representing the same but, in a way, completely different country — a member of the EU, NATO, euro area. A country on its way to joining the OECD.
Our dynamism makes it hard to know where we will be when the third Lithuanian speaks here.
But I am keen to share some thoughts on where we are today and where we are going to be in the foreseeable future.
I am also going to offer you an update on developments in the Baltic region. Lithuania’s entry into the euro area has completed the entry of the Baltic region as a whole. Therefore, today there is a new sense in seeing the three countries — Lithuania, Latvia and Estonia — as a single economic area.
And, finally, whether we are in the euro area or not, we all live in a globally interconnected world and depend on each other’s successes and failures. So I suggest that we also spend some time discussing the future of the Economic and Monetary Union and the financial sector developments in the global context.
Our latest big economic event is the euro.
“Why? And why now?” — I was asked these questions many times. I believe they might be particularly natural here, in London, and now, when the euro area is facing, let’s call it, some specific challenges.
Let me explain our reasoning.
First, in contrast to the UK, we were obligated to adopt the euro under the Treaty.
Even more important was our long-term objective to ensure monetary policy consistency.
Before the euro adoption, we had a currency board arrangement for more than 20 years. For more than a decade our currency — the litas — was pegged to the euro. And for more than a decade we participated in the Exchange Rate Mechanism II, which is like a “green room” before entering the euro area.
These two unilateral commitments had become an anchor of financial stability and discipline. They have also proven our adherence to rules and showed that it is possible to successfully function under the fixed exchange arrangement even during the most difficult periods.
The hard peg to the euro meant that Lithuania de facto was in the euro area.
The next de jure step allowed us to eliminate the speculative exchange rate risk component in our borrowing costs which — especially in difficult times — imposes a harmful burden on both the state and the private sector.
Before the final decision, the Bank of Lithuania carried out a quantitative assessment of the possible impact of euro adoption. Our experts also assessed how much we would have saved if we had adopted the euro in 2007. The findings were quite impressive: in total, the government and private non-financial sector could have saved up to 0.8 per cent of GDP in 2007–2012.
Additional economic rationale: more than 2/3 of our goods export goes to the EU. About 40% of it — to the euro area; 80 per cent of FDI inflows to the Baltics originate in the EU countries and about 45 per cent of it — in the euro countries.
We expect that in the longer run, the introduction of the euro will have a positive impact on our foreign trade. The experience of other countries shows that the euro introduction increased their trade by 5 to 10 per cent. We also expect that the common currency will be conducive to cross-border capital investment, even though empirical evidence is surrounded by more uncertainty in this area.
Of course, this does not complete the list of our motives. I will be frank: we did have some other motivation as well. If you are interested, I will be glad to discuss it with you later.
Now I would like to turn to our economic characteristics and I dare to say: the Baltic countries are an example of countries that are perfectly accommodated to work within a single currency area. Why do I say that? First — the flexibility of markets, especially the labour market.
We have surprised many counterparts, including international institutions, rating agencies and investors, by the high degree of responsiveness of our labour markets.
Before 2008, wages in the Baltic countries were growing at a particularly high rate. Wage growth was clearly outpacing productivity.
However, when the crisis struck, the labour market changed its course. The wage-productivity gap closed very swiftly, in slightly more than a year.
Most of the adjustment took the form of cuts in nominal wages.
In Lithuania, for example, wages were reduced by 10 per cent in just two years. It is also remarkable that these sizable wage cuts took place in both the private and the public sector.
Such a prompt adjustment helped us maintain competitiveness. And it clearly proved a high degree of flexibility, which is so necessary for countries operating within the single currency area.
Another key prerequisite for sustainable development, especially in the absence of monetary sovereignty, is prudent fiscal policy.
It is true that fiscal governance in the Baltic States did not always follow the highest standards. During the pre-crisis boom, very strong domestic-demand-led growth created a fiscal illusion that cyclical revenues could be turned into permanent current expenditures. The deep downturn that followed showed how wrong this assumption was.
However, every cloud has a silver lining. The economic crisis-related turmoil also gave us a lesson and we learned it. We undertook unprecedented fiscal consolidation that amounted to around 15 per cent of GDP.
The consolidation was largely expenditure-based. It included cuts in public sector wages and social benefits (pensions, maternity, unemployment and illness benefits). On the revenue side, the standard VAT rate and excise duties were raised, a number of VAT exemptions were abolished.
This was painful, but effective. The consolidation helped us restore market confidence and regain access to capital markets. All in all, we have managed to maintain our fiscal houses in order. The Baltic fiscal deficits and debt levels are well below the EU “benchmarks” of 3 and 60 per cent.
Looking ahead, it is clear that our fiscal policy will be affected and, hopefully, improved by the recently reformed, largely rules-based fiscal governance framework that has been agreed upon at the EU/euro area level. I am confident it is a step in the right direction. But it is crucial and our/Baltic experience supports this view — to have the political and institutional capacity to “own” the rules and adhere to them. The challenge is to ensure that this capacity is always in place, both in difficult and good times. In this regard, I believe we need to exploit the full potential of the existing framework first, before embarking on a more radical reform of the fiscal system as a whole. I will come back to this later.
You probably remember: when the turmoil in 2008 started, economists were busy debating what shape this crisis was to assume? Some said it had to be L-shaped — which meant a long-lasting recession. Some predicted a quite optimistic U scenario. Others warned against W. And all agreed that the most desirable would be V.
Regretfully, not many countries were able to recover in that V manner. The Baltics were among those that did.
We were back to growth already in 2010. Even in 2012–2013 — when the euro area was having a second recession — the Baltics managed to sustain relatively strong growth momentum. Recession in Lithuania lasted only 5 quarters. Since 2009 each of the Baltic countries grew by ~20 per cent.
How did we do that?
A flexible labour market, prudent fiscal policy and high competitiveness — these are our characteristics that definitely served the economy best and gave a strong foundation for future developments.
Up until now the Baltics are demonstrating strong resilience to external headwinds.
Following somewhat weaker growth in 2015, all three Baltic countries are expected to reach approximately 3 per cent annual growth in 2016.
Ladies and gentlemen,
That was a brief flashback at our — I dare to say — true success story.
Now let‘s turn to what is seen in the horizon, having to admit that the world around us poses a number of challenges. By saying “us” I mean all of us — the Baltics, the Euro area and the EU as a whole.
In 2016 economic growth in the Baltics is expected to pick up due to gradually improving outlook in our major trading partners — countries of euro area and other EU countries. Economic growth in these countries is expected to benefit from favourable financing conditions, low commodity prices and improving prospects in other developed economies [namely, US], resulting in greater domestic demand and demand for our exports.
The latest macroeconomic outlook was presented by ECB only a few days ago.
The good news is that despite challenging environment the euro area is showing moderate signs of improvement. GDP growth is positive in a number of core economies — Germany, Italy, Spain. Short-term economic activity indicators, like PMI (purchasing managers index), retail sales, show signs of returning confidence.
A number of factors are supporting the positive outlook. Low oil prices and substantial monetary policy easing are among the most important ones.
But this is not a reason to relax.
Estimations for all external regions have worsened.
The first region to mention is emerging Asia. Huge over-lending, that lasted for years, and the current rebalancing, that takes place in China, makes increasingly uncertain whether China’s growth will stay in line with the projections.
Another notable factor is that Russia’s economy is expected to shrink by around 4 per cent. Given low commodity prices, the economic growth in Russia and surrounding CIS economies will take time to re-emerge.
The US economy is also growing at a significantly slower rate than it was expected. The projections have been revised by around one percentage point.
No doubts these developments will influence Europe.
What can and needs and is being done to answer these supressing impacts and to enhance the positive ones?
Every policy-making institution has its objectives, responsibilities and a set of policy instruments at its disposal. As a member of the Governing Council I would like to start with the ECB.
First of all I will remind you of 2014 — a year when growth in the euro area was sluggish, inflation was at risk of becoming persistently low and the ECB, in response, started to substantially intensify its monetary policy easing.
Remember June 2014. The ECB further cut its policy rates and announced Targeted Long-Term Refinancing operations, designed to restore lending to the real economy.
In September 2014, the ECB once again lowered its main refinancing rate to 0.05 per cent and announced two additional programs — the Asset-Backed-Securities Purchase and Covered Bonds Purchase Program — both aimed at further credit-support.
Finally, in January 2015 the ECB announced that it would start implementing an Extended Asset Purchase Program (or Quantitative Easing) later in March.
Of course, it is still too early for doing final sums. The ultimate measure of success will have to be based on the assessment of inflation adjustment towards our medium term target. Clearly, more time and evidence are needed for such insights. But I feel quite comfortable stating that some positive results are already apparent.
Firstly, in addition to sovereign yields, bank lending rates have decreased, including, and more substantially so, in certain periphery countries.
Secondly, after years of decline, credit to the private sector has finally started to grow. In line with that, and for the first time since 2009, survey evidence shows that the number of SMEs reporting improvement in their access to credit is higher than the number reporting the opposite. All of these indications suggest that our policy has contributed to a general improvement in financial conditions. Eventually, these positive developments should help us achieve the main policy objective.
It is likely that accommodative ECB policy supported confidence in the private sector.
According to surveys conducted by the European Commission, the economic sentiment indicator in the euro area has already increased in 2015 and reached its highest level since 2011. In some periphery countries such as Italy or Spain the economic sentiment indicator has approached or even exceeded its pre-crisis levels.
Other optimistic news — after 3 years of contraction, credit growth in the euro area has resumed.
Historically low interest rates substantially reduced the loan repayment burden. This factor, along with rising confidence increased the private sector’s demand for credit. At the same time, better economic sentiments and better economic prospects have urged banks to soften their lending standards. According to the ECB’s surveys, since 2014, more banks have already been softening rather than tightening their lending standards.
In this environment in 2015 the growth of credit in the euro area has returned to positive territory. In July the growth of credit was already 4.5 percentage points higher than a year ago. And what is more, the trend of growth is expected to be maintained. Even in member states in which deleveraging is still ongoing, credit contraction is slowing down rather quickly.
Sustainable credit growth is a crucial ingredient to this growth. Therefore, recent trends in the credit market, indeed, fuel some optimism.
At the same time, the latest events in global financial markets have significantly raised uncertainty and heightened the risk of market contagion.
Just a month ago, we witnessed a strong worldwide sell off in equities that started with a crash in the Chinese stock market. The event was preceded by a relatively minor devaluation of the yuan and somewhat weaker economic data, but that was sufficient to hike investors’ concerns. And the financial contagion was very swift: in a single day major global financial markets suffered declines unseen since the recent financial crisis.
Worries over China have exerted downward pressure on global commodity prices. Oil prices reached a 6 year low. That, in turn, has worsened the prospects of commodity exporters, typically emerging markets, depreciating their currencies and prompting capital outflows into safe havens.
The resulting surge in volatility in the financial markets was the highest since 2011. It reminded us that markets have become very sensitive and ever more exposed to volatility.
By delivering very low interest rates and elevating financial asset prices, very accommodative monetary policy may have contributed to this sensitivity. That complicates the policy environment as higher volatility may feed into lower market confidence and lead to sudden corrections in asset prices. Hence, we should be mindful of the recent events and the challenges that may lie ahead, especially in the context of potentially diverging monetary policy directions by major central banks and worsening growth prospects in some emerging market economies.
In the context of increased market volatility, we should be more than ever mindful of systemic risks. In the Euro Area, they are mainly rooting from low growth and the prolonged period of low interest rates.
First — reversal of risk premia. Over the last years, the premia of holding riskier assets decreased substantially. An abrupt increase of the premia to their historically normal levels could result in significant losses for holders of relatively risky assets. That is especially relevant in the environment of rather low market liquidity.
Second — weak profitability. With interest rates at historically low levels, financial institutions [such as banks or insurance companies] are facing prospects of weak profitability. While the low interest rate environment persists, the pressure to “search for yield” and accumulate more risks is building up.
And finally — debt sustainability. The prospect of weak economic growth in the Euro area would pose debt sustainability concerns for countries where the debt-to-GDP levels are extremely high. As was already mentioned, the ECB’s monetary and credit easing is helping to restore confidence and growth in the more vulnerable and highly indebted countries, such as Spain, Portugal or Italy.
This is certainly a good news, but not a happy ending yet for this story. Even if we have found some short-term solutions that appear to be effective, it is important to admit: we still badly need long-term decisions and I would like to particularly underline action.
In dealing with the recent economic challenges the EU has proved its abilities to think strategically and take on ambitious commitments. But, at this stage, the most important thing is the ability to stick to what was agreed.
Just to illustrate: at the moment only 5 EU member states (the UK and Lithuania are not among them) fully comply with the provisions of the Stability and Growth Pact.
Another sad example: last year none of the EU states fully addressed any out of 157 country-specific recommendations. And that is despite all the assessments [presented by the Commission] showing, that EU GDP could be raised by 6 per cent after 10 years, if the EU member states reduced by half the observed “structural gaps” vis-a-vis the best performers in a number of areas.
Why is the EU track record in complying with the agreed rules so poor? And, most importantly: how to change that?
The so-called “5 Presidents Report”, published in June, aims at preparing the next steps towards completing the Economic and Monetary Union.
We have to acknowledge: the Report has already fuelled a hot debate that is more important today than ever before. At the same time, it reminds us that every suggestion, even if it comes from the EU presidents, requires both open-mindedness and critical thinking.
I have in mind, first of all, the proposals to create new institutions: a European fiscal board and national competitiveness authorities. In my understanding, the main problem today lies not in the lack of institutions, but in the complexity of the rules, which makes compliance weak and monitoring difficult.
My take-away point is: we should spend less time on creating new procedures and institutional bodies. What we really need is strong political will to enforce what we jointly agree on by strengthening and making more binding the existing rules.
I would like to turn now to the core idea of the EU — the single market.
Too often we tend to forget that the potential benefits of the single market are still not fully reaped.
The capital market is a proper example in this case. The degree of its development widely varies across the EU, although all, even the best performers, could gain from deeper financial integration.
First, there is no need to mention to this audience that well-developed capital markets reallocate capital more cost-efficiently across industries and countries.
Second, in Europe we are used to seeing banks as the main source of capital. However, they are often reluctant to take the risk of financing innovative projects, especially by start-up companies with high potential, but no credit history. The development of integrated EU-wide private equity, venture capital, and equity markets is essential to secure financing that might benefit long-term growth.
And finally, well-functioning capital markets could distribute risks more efficiently. This role is extremely important in the absence of fiscal redistribution capacity in the EU.
At the moment, the EU Capital Markets Union initiative lacks content, but we are looking forward to seeing the Commission’s concrete proposals on this priority promised by the end of the month.
A related initiative aimed at strengthening the single market in financial services is the banking union.
And it proved our abilities to offer a systemic response. While a typical legislative process in the EU lasts 1.5 years, the agreement on the Single Supervisory Mechanism was reached within 6 months and it became operational last autumn.
The second pillar of the new EU banking policy framework — the Single Resolution Mechanism — is expected to become fully operational next January.
However, the quick start faces the risk of a slowdown. The Single Resolution Fund has no credible backstop so far. The Bank Recovery and Resolution Directive is still not transposed into national law in a number of member states. Moreover, we still lack the third pillar a truly European Deposit Insurance Scheme.
It is noteworthy that the idea of integrating national deposit guarantee systems was suggested by one of the UK’s institutions back in 2009. In response to the Icelandic banking crisis, the UK’s former financial supervisor — the Financial Services Authority — urged to consider introducing pan-European arrangements for the deposit insurance of banks operating across-border in branch.
I strongly believe this was a good and timely idea. I am also convinced that without the third pillar the banking union will be incomplete and that we do not really need another lesson to show us that a “half-finished” project may fail to deliver.
Therefore, I am really happy to share with you the feeling that the European Commission has recently renewed its policy efforts and that there is a real possibility to have a fully-fledged banking union in the near future. The Commission has promised to present a legislative proposal on the common deposit guarantee system before the end of this year.