SPEECH/08/66
Joaquín Almunia
European Commissioner for Economic and Monetary Policy Japan and the EU: global partners in a challenging environment
Keizai Doyukai Brussels, 8 February 2008
Ladies and Gentlemen,
I would like to begin by thanking Kunio Kojima for his kind introduction and for inviting me to speak to you today. It is a great pleasure to meet such distinguished representatives of Japanese business and commerce.
Europe and Japan may be continents apart, but we are equally concerned by the latest developments in financial markets and by the ominous clouds hanging over the global economy.
Uncertain global economic prospects
World economic conditions are particularly challenging this year. Oil and food prices have reached record highs and the US economy is undergoing a pronounced slowdown. The turmoil in international financial markets is also expected to continue for longer than initially thought.
(i) Developments in financial markets
What started as a US subprime loan crisis has spread to other market segments and signs of deteriorating loan quality are appearing in several lending segments in the US, including commercial real estate loans, leveraged loans, credit card loans and car loans. Financial turbulence has happened in the past. This is nothing new. What is important to note this time is the speed with which problems in the US sub-prime mortgage market rapidly spread across the global financial system.
Exposure to losses in the sub prime market were spread around the world via the markets for complex derivative products known as collateralised debt obligations (CDOs). As credit ratings for many CDOs were abruptly downgraded, uncertainty about the ultimate scale and location of financial losses knocked investor confidence and caused liquidity in markets to dry up.
Losses of around 100 billion dollars have been reported so far by about 20 major banks, although we expect more to be announced in the early part of this year. The liquidity dry up coupled with the financial losses incurred by banks have had serious repercussions on their capital base and profitability.
While some of the larger banks have managed to recapitalise, often by attracting investments from sovereign wealth funds, their balance sheets remain vulnerable. A full disclosure of losses suffered by banks would encourage the normalisation of securities markets and speed up the process of recapitalisation in Europe following what has taken place in the US.
Until recently, the most visible evidence of distress has been in the market for interbank lending. However, interventions by the major central banks to provide liquidity to the system has managed to stabilise the situation and since December, interbank liquidity conditions have eased.
Meanwhile, problems in other credit markets have intensified. Stock markets throughout the world sold off abruptly towards the end of January, and although most have recovered since, volatility remains higher than would be desirable. Corporate spreads too have widened to levels not seen in five years. Attention is also now focused on the solvency of so-called monoline insurance companies, which provide insurance for debt issued by lower-rated entities.
Clearly conditions in financial markets are set to remain fragile for some time. And the consequences of the turmoil - a tightening in bank lending standards, re-pricing of risk and a general reduction in investor risk appetite - will inevitably impact on the real economy.
(ii) The impact on the real economy
World economic growth has been robust in recent years, which should stand us in good stead to weather the turbulent times we are living in. Nevertheless, the turmoil is affecting performance via three main channels:
First, as investors become significantly more risk averse, we are seeing a tightening in credit conditions both in Europe and in the US and banks the world over have become more cautious about their lending practices. This means credit will be harder to come by and more expensive than in the past. But just exactly how tight credit conditions will be and how long they will last is difficult to predict.
Second, private consumption, particularly in the US, is vulnerable at the moment. Even though the importance of US consumption has declined over the past year thanks to a rebalancing of world demand, a sharp downturn in US private demand could have serious implications for economic growth prospects elsewhere in the world.
Third, the turmoil is impacting on economic confidence. Confidence effects are always difficult to predict. But certainly the longer this current period of financial turbulence continues, the greater the risk of negative spillovers to both consumer and business confidence.
Additionally, inflationary pressures pose a major challenge going forward. Oil prices have again increased above 90 US-dollars a barrel. Food prices have also surged since 2006, especially for cereals and dairy products, and we expect them to remain at elevated levels over the next twelve months. High food and energy prices may also bring second-round effects on inflation through higher wage claims. Some countries in Europe are already experiencing this, despite the fact that the strong euro has sheltered them from some of these price increases.
Taking all these factors into account, it is clear that world economic activity will moderate in the period ahead. The IMF recently revised down world growth to 4.1% of GDP for 2008 after five exceptional years of an annual growth rate of around 5%. However, the IMF's new forecast would still be a robust rate of growth.
In the US, the fallout from the housing downturn and from financial market tensions will be stronger with the IMF forecasting growth of 1.5% this year down from an estimated 2.2% in 2007. Some indicators are now pointing to a clear increase in the risk of recession.
The question is how Europe, but also Japan and other economies, will be affected.
A major slowdown will no doubt impact on Europe and the rest of the world. But the EU has become more resilient to shocks stemming from the US and its economic fundamentals are solid. Both the private and public sector in Europe are in a healthier financial position than in the US, and the EU's external accounts are broadly balanced. We currently have the lowest unemployment rate in 25 years, thanks to which private consumption became one of the main drivers of growth in 2007. This should gradually help Europe to be less dependent on growth abroad.
In addition, soaring oil prices are expected to take a smaller toll on the EU economy than expected. This is thanks to better energy-efficiency and to the fact that the appreciation of the euro has helped cushion the rise of dollar denominated oil prices.
On the 21st February the European Commission will release its Interim Forecasts which will give a more precise indication of the European outlook for 2008. Most indicators in January point to an easing of growth and clearly Europe will not be immune to the impact of record high oil prices, the strong euro and a marked slowdown in the US. As such we expect growth this year to be lower than the 2.4% and 2.2% we forecast last autumn for the EU and the euro area respectively.
In Japan, weaker investment, and lower household spending is also likely to slow economic activity this year although external demand is expected to continue supporting growth. Japan is a lot less dependent on the US market than 10 years ago and this should help the country maintain a solid expansion.
As the EU absorbs almost 15% of Japanese exports, you rely to some extent on the continuing resilience of the European economy. But the outlook for the Japanese economy most critically depends on the growth path in the rest of Asia, which accounts for nearly half of Japanese exports.
Fortunately, the emerging economies of Asia have proved resilient to the volatility in financial markets. In fact, China is now the main engine of growth for the world economy.
Thus there are hopes that economic activity in Asia could escape relatively intact from the US slowdown. This would also signal that Asian growth is re-orienting away from external towards domestic demand, a trend that will contribute to the unwinding of global imbalances.
Tackling global imbalances by implementing policy plans
By global imbalances, I refer to the substantial current account deficit in the US, matched by the huge and still rising trade surplus in China that last year reached 11% (over 250 billion dollars). The trade surplus of Japan – which last year widened to 5% - and of the oil producing countries also contributes to these imbalances.
The scale of the global imbalances we see today is unprecedented and their adjustment poses a serious risk to world economic stability. They can only be reduced in an orderly way if all key economies play an active part.
In April last year the world's major players – the US, China, Saudi Arabia, in representation of the oil producing countries, Japan and the euro area - agreed, in multi lateral consultations organised by the IMF, to take a number of policy actions to tackle these imbalances.
During this process, China announced that it would boost domestic demand, deepen financial sector reform and increase exchange rate flexibility. The US agreed to encourage private and public saving in order to shift the composition of growth away from private consumption and credit, which have had their counterpart in historically low levels of saving.
In our turn, the euro area pledged to raise growth and enhance resilience to economic shocks through structural reforms and better public finances. Japan announced it would strengthen competition in key sectors, promote further labour market reform, advance fiscal consolidation and facilitate inward Foreign Direct Investment. Saudi Arabia agreed to increase investments in its oil sector and in social services and infrastructure.
It must be said that progress to meet these commitments has, so far, been slow and sporadic and global imbalances are generally not expected to decline over the next year. In these uncertain economic times, a concerted effort is required by all actors to minimise the risk of imbalances through reform.
In Europe we are working hard to implement the policies agreed in April - to reform our product, labour and service markets and improve public finances.
The acceleration in growth over the last two years and the creation of 13 million jobs in the last decade are signs that we have made some progress in Europe, and we will continue to deepen our efforts.
The European Union has established a far-reaching programme of reforms known as the Growth and Jobs Strategy that tackles the structural weaknesses that hold back growth in the EU economy.
We are now stepping up pressure to implement these reforms – to increase investment in Research and Development and in education systems in order to raise innovation and productivity. We are calling for a better balancing of protection and flexibility in European labour markets and increased competition in sheltered markets like services.
This year we will take a number of steps to advance completion of the European Single Market and the further integration of financial markets. Already, last month, we launched the Single Euro Payments Area - an initiative of the European banking industry - that will make all electronic payments across the euro area as easy as domestic payments and could save the economy more than 100 billion euro over the next 6 years.
Europe's public finances have also improved noticeably in the last few years, thanks to the positive impact of an economic recovery and to the success of the reformed Stability and Growth Pact - our instrument for budgetary surveillance and coordination in the EU.
The Stability and Growth Pact provides a rules based framework for fiscal policy making in the EU and has proved largely successful at strengthening fiscal discipline. Many countries have pursued budgetary consolidation to good effect, and in 2007, the average government deficit fell for the fourth year in a row to 1.1% of GDP. However, we must increase efforts to reduce government debt in the EU in order to make our public finances sustainable in the long term.
Japan has also gone through a painful yet rewarding period of structural reforms in recent years. But looking forward, further decisive action could be taken to reduce the substantial government debt, strengthen competition and raise productivity, particularly in the non-tradables sectors.
This would not only help Japan fulfil its commitment to reduce global imbalances, but also help this country to become a more dynamic world economy.
Right now, you are facing very similar economic challenges to us in Europe. We too are preparing to cope with the impact of demographic change and the formidable new competition brought by globalisation and the rise of emerging economies.
If this country is to remain a global economic player, Japan, like Europe, will have no choice but to press ahead with structural reforms to raise productivity and potential growth rates.
EU Policy initiatives to strengthen financial stability
I have talked about European reforms to tackle the challenges of globalisation and ageing. But we are also making changes to our financial systems in response the immediate turmoil in credit markets.
Recent events have shown us that action to safeguard financial stability in the future is urgently needed.
This does not mean we need rash measures to try to stem financial globalisation. But we do need a detailed diagnosis of the financial market situation followed by precise intervention.
That is why, last October, Europe's Ministers of Finance agreed on a road map to address the vulnerabilities of the financial system within a precise timetable. Our work programme focuses on enhancing transparency for investors, markets and regulators; it aims at improving valuation standards for complex financial products and improving the functioning of financial markets by scrutinising the role of credit agencies.
Because it is also essential that we update arrangements for safeguarding financial stability, we are looking at strengthening the prudential framework, risk management and supervision in the financial sector. As financial markets in the EU become ever more integrated, it is vital that we can achieve a more coordinated response to market disturbances in the future.
The final deadline for this ambitious work programme is the end of 2008. As the work programme of the Financial Stability Forum overlaps almost completely with these EU initiatives, we will look forward, together with the G7 and G8 members, to build on the recommendations that the Financial Stability Forum produces.
Indeed, financial markets are global markets and the recent turmoil has shown us how quickly a national problem can spread worldwide. Therefore international cooperation on all of these issues is essential.
Establishing common principles and practical guidelines for managing international financial crises would be one way to achieve this. Another would be setting up an early warning system for the global economy.
Developing a global response to the financial instability will be discussed at the G7 meeting tomorrow and will continue to feature on the agenda of future meetings of the G8 and the IMF as well as remaining a top priority for European Finance Ministers.
Conclusion
Ladies and Gentlemen,
Let me conclude. If one striking detail emerges from my comments this afternoon, it is that the major economic challenges of the 21st century are global challenges. Globalisation has transformed us from a collection of nation states into a community of shared interests. And if today's challenges transcend national borders then so must the solutions.
International cooperation is the only way forward if we want to guarantee financial stability and economic prosperity for the future. And good international institutions and multilateral fora are essential to allow countries across the globe to work together effectively. But the world has changed fundamentally over the last decades and international institutions need to adapt too if they are to remain relevant in this new century.
A common global approach calls for increased involvement of the main actors in global surveillance and policy coordination, both in the macroeconomic sphere and in the area of financial supervision and regulation. A new approach must also recognise the growth of the euro as the world's second currency and the place the euro area plays in international decision making.
