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M O N T H LY B U L L E T I N
10 T H A N N I V E R S A RY O F
T H E E C B
In 2008 all ECB
publications
feature a motif
taken from the
€10 banknote.

© European Central Bank 2008
Address
Kaiserstrasse 29
60311 Frankfurt am Main
Germany
Postal address
Postfach 16 03 19
60066 Frankfurt am Main
Germany
Telephone
+49 69 1344 0
Website
http://www.ecb.europa.eu
Fax
+49 69 1344 6000
This Bulletin was produced under the
responsibility of the Executive Board of
the ECB. Translations are prepared and
published by the national central banks.
All rights reserved. Reproduction for
educational and non-commercial purposes
is permitted provided that the source is
acknowledged.
Photographs:
ESKQ
EUMETSAT
Claudio Hils
Martin Joppen
The cut-off date for the statistics included
in this issue was 9 April 2008.
ISSN 1561-0136 (print)
ISSN 1725-2822 (online)

CONTENTS
Boxes:
FOREWORD 5
1 Modelling the euro area economy
3 6
HISTORICAL CONTEXT
8
2 Key communication tools and channels
used by the ECB
5 0
INTRODUCTION 1 1
3 The Eurosystem’s collateral framework 5 4
4 The transmission mechanism of monetary
INSTITUTIONAL SETTING AND WORKINGS
policy
5 9
OF THE EURO AREA
21
5 Understanding inﬂ ation persistence and
THE ECB’S MONETARY POLICY STRATEGY
determinants of wage dynamics
8 0
AND ITS IMPLEMENTATION
33
6 Preliminary ﬁ ndings of the ECB’s work
on ﬁ nancial development
1 0 4
ECONOMIC POLICY CHALLENGES AND
7 Role of the Harmonised Index of
ENLARGEMENT
65
Consumer Prices
1 3 5
THE EURO’S IMPACT ON TRADE AND
CAPITAL FLOWS AND ITS INTERNATIONAL ROLE 89
FINANCIAL INTEGRATION
101
FINANCIAL STABILITY AND OVERSIGHT
1 1 7
STATISTICS 1 3 3
EURO BANKNOTES – A TANGIBLE SYMBOL
OF INTEGRATION
1 3 9
CONCLUDING REMARKS
1 4 5
ANNEX
10 years of euro area statistics and their
comparison with those for other major
economic areas
1 4 9
ECB
Monthly Bulletin
10th Anniversary of the ECB
3

ABBREVIATIONS
COUNTRIES
LU
Luxembourg
BE
Belgium
HU
Hungary
BG
Bulgaria
MT
Malta
CZ Czech
Republic
NL Netherlands
DK
Denmark
AT
Austria
DE
Germany
PL
Poland
EE Estonia
PT Portugal
IE
Ireland
RO
Romania
GR
Greece
SI
Slovenia
ES
Spain
SK
Slovakia
FR
France
FI
Finland
IT
Italy
SE
Sweden
CY
Cyprus
UK
United Kingdom
LV
Latvia
JP
Japan
LT
Lithuania
US
United States
OTHERS
BIS
Bank for International Settlements
b.o.p.
balance of payments
BPM5
IMF Balance of Payments Manual (5th edition)
CD
certiﬁ cate of deposit
c.i.f.
cost, insurance and freight at the importer’s border
CPI
Consumer Price Index
ECB
European Central Bank
EER
effective exchange rate
EMI
European Monetary Institute
EMU
Economic and Monetary Union
ESA 95
European System of Accounts 1995
ESCB
European System of Central Banks
EU
European Union
EUR
euro
f.o.b.
free on board at the exporter’s border
GDP
gross domestic product
HICP
Harmonised Index of Consumer Prices
HWWI
Hamburg Institute of International Economics
ILO
International Labour Organization
IMF
International Monetary Fund
MFI
monetary ﬁ nancial institution
NACE Rev. 1
Statistical classiﬁ cation of economic activities in the European Community
NCB
national central bank
OECD
Organisation for Economic Co-operation and Development
PPI
Producer Price Index
SITC Rev. 3
Standard International Trade Classiﬁ cation (revision 3)
ULCM
unit labour costs in manufacturing
ULCT
unit labour costs in the total economy
In accordance with Community practice, the EU countries are listed in this Bulletin using the
alphabetical order of the country names in the national languages.
ECB
4
Monthly Bulletin
10th Anniversary of the ECB

FOREWORD
by governments, thus ensuring the full
independence of the ECB. It also granted the
ECB the exclusive right to authorise the issue
of banknotes.
The Maastricht Treaty had been negotiated
and ratiﬁ ed by national parliaments on the
assumption that all members of the EU will, in
the fullness of time, adopt the euro and therefore
that the ESCB will carry out all the tasks related
to the single currency. However, until that time,
a group of central banks within the ESCB – the
Eurosystem, comprising the ECB and the central
banks of the countries in the euro area – is the
key actor. The main decision-making body of
the Eurosystem is the Governing Council of the
ECB, which consists of the six members of the
Executive Board of the ECB and the governors
of the national central banks (NCBs) of the euro
area countries.
The Governing Council of the ECB has deﬁ ned
price stability as a positive rate of inﬂ ation of
below 2%, and has announced that it aims to
maintain inﬂ ation below, and close to, 2% over
The European Central Bank (ECB) was founded
the medium term. For nearly ten years, price
on 1 June 1998. It became the independent stability has been broadly achieved despite
central bank for Europe’s single currency, the the fact that strong global commodity price
euro, which was launched in January 1999. A increases – on which monetary policy has no
single currency among a group of countries direct inﬂ uence – have affected Europe and the
cannot exist without a common central bank rest of the world, leading to an average inﬂ ation
and a common system of central banks. So, the rate that has been slightly above 2% since the
ECB and the European System of Central Banks
launch of the euro. This is a remarkable result,
(ESCB), comprising the ECB and the central taking into account all the shocks that have
banks of all European Union (EU) Member marked the period and the track record of the
States, were given the mandate to maintain economies participating in the euro area. In the
price stability and to safeguard the credibility of
decades before the launch of the euro, average
the euro.
annual inﬂ ation rates in the respective countries
were signiﬁ cantly higher than in the euro area
In May 1998 the European Council made one over the last ten years.
of the most far-reaching decisions in the history
of European integration. The leaders of the EU Stable prices are essential. Not only because
decided that 11 Member States had fulﬁ lled the they protect the value of the incomes of all
conditions for adopting the euro. This milestone and particularly of the most vulnerable and the
had its origins in the Maastricht Treaty of 1992, poorest of our fellow citizens, but also because
which set out the institutional framework of delivering price stability and being credible in
the ESCB. The Treaty took monetary policy-
its delivery over the medium term is one of the
making to a supranational level and insulated preconditions for sustainable growth and job
it from any pressures, including those exerted creation. By anchoring expectations of future
ECB
Monthly Bulletin
10th Anniversary of the ECB
5

inﬂ ation to low levels, in line with our deﬁ nition The achievements of the past decade are due to
of price stability, the ECB has reduced inﬂ ation the vision and determination of the Governing
risk premia, securing a ﬁ nancial environment Council members, past and present, and due
favourable to growth and job creation. Between to the energy and efforts of all staff of the
the launch of the euro and the end of 2007, the Eurosystem. On this special occasion, I would
euro area created more than 15 million new jobs like to express my sincere thanks to all those
and the unemployment rate was at its lowest who have helped to build a solid foundation
level since the early 1980s.
for the euro. The single currency has become a
proud symbol of a continent that has grown in
The euro is playing a very important role in stature.
promoting the functioning of our vast continental
market, and therefore in accomplishing a true The Eurosystem works as a team, serving the
Single Market. It has also helped to protect 320 million citizens who live in the 15 countries
the euro area economy from the many global that have decided to share their destinies. The
shocks and considerable turbulence of the last euro is our currency, and the people of Europe
few years.
know that we are faithful to the mandate they
have given us.
These achievements have taken time and
considerable effort, for the ECB has been To all the ECB and NCB staff involved, I express
moving in uncharted waters, making decisions my deepest gratitude for their outstanding
of considerable scale and complexity, and contribution and for making this publication
acting on them together with all the members possible.
of the Eurosystem, the national central banks of
the euro area. Among our many tasks in recent
years, we have needed to understand how the
newly created monetary union would function,
once created, and what the complex dynamics
of a major economic area moving towards full
economic and monetary uniﬁ cation would be.
This special edition looks back at the ECB’s work
over the past ten momentous years, addresses
some of the most difﬁ cult developments over
this period, and also looks at the challenges that
the ECB and the euro area face as they enter
their second decade.
Jean-Claude Trichet, President of the ECB
Those challenges include, above all, making
the euro area more ﬂ exible and adaptable by
improving structural and ﬁ scal policies, as
well as raising its growth potential. There is a
permanent need to understand ongoing changes
in the economy and adapt our tools to this in
order to identify what is driving future inﬂ ation.
To remain credible, monetary policy needs to be
constantly alert, keeping inﬂ ation expectations
in line with our deﬁ nition of price stability. We
also have to work out how best to prepare for
future euro area enlargements.
ECB
6
Monthly Bulletin
10th Anniversary of the ECB

F O R E W O R D
The Executive Board in June 1998:
Back row (left to right):
Tommaso Padoa-Schioppa,
Otmar Issing,
Eugenio Domingo Solans
Front row (left to right):
Christian Noyer (Vice-President),
Wim F. Duisenberg (President),
Sirkka Hämäläinen
The Executive Board in June 2008:
Back row (left to right):
Jürgen Stark,
José Manuel González-Páramo,
Lorenzo Bini Smaghi
Front row (left to right):
Gertrude Tumpel-Gugerell,
Jean-Claude Trichet (President),
Lucas D. Papademos (Vice-President)
ECB
Monthly Bulletin
10th Anniversary of the ECB
7

HISTORICAL CONTEXT
European monetary integration goes back to big strides. The years of experience with the
the early 1960s when the six members of the EMS taught some lessons about the importance
European Economic Community (EEC) started of sustainable nominal convergence and ﬁ scal
cooperating in monetary affairs. The ﬁ rst discipline.
concrete proposal for a European economic and
monetary union also emerged around that time. Towards the end of the 1980s the feasibility
It called for the free trade area set up under the of a European economic and monetary union
Treaty of Rome to lead to an economic union by started being discussed once more. The European
the end of the decade. But no action was taken Council mandated a committee of experts, under
as the international monetary system remained the chairmanship of Jacques Delors, to make
stable for several years thereafter. Only in 1969, proposals for the realisation of Economic and
following a series of exchange rate and balance Monetary Union (EMU). The resultant “Delors
of payments crises, did the leaders of the six Report” mapped out the Maastricht Treaty,
members of the EEC decide to draw up a plan which was signed by the Heads of State or
for an economic and monetary union. Their Government of the EU Member States in 1992
decision led to the Werner Report in 1970, and ratiﬁ ed by all EU countries by 1993. It laid
which envisaged the creation, in three stages, of the foundations for the introduction of the single
such a union by 1980. Interest in this ambitious currency nearly a decade later. The ensuing
plan lapsed in 1971 after the demise of the period was used to move the convergence process
Bretton Woods ﬁ xed exchange rate regime. forward and make the necessary institutional
At the same time, European countries realised arrangements. The European Monetary Institute
that untamed exchange rate ﬂ uctuation could (EMI), which was established in 1994, started
harm further trade integration. An initial step, in preparing the regulatory, organisational and
1972, which was called the “snake”, sought to logistical framework for the new supranational
stabilise exchange rates among some European central banking system. This groundwork was
currencies, but it fell victim to further currency essential for setting up the ECB and the ESCB,
unrest and the international recession that for allowing them to perform their tasks and for
followed the ﬁ rst oil crisis in 1973. By 1977, launching the new single currency.
after various currencies had joined or left the
“snake”, the system was reduced to a “Deutsche In May 1998 the Council of the European
Mark area” consisting of Germany, the Benelux Union decided that 11 countries had fulﬁ lled
countries and Denmark.
the convergence criteria, namely the set of
conditions established for adopting the euro.
In 1979 France and Germany pushed forward 1 June 1998 saw the establishment of the ECB
the cause of monetary integration again, leading and the ESCB. Until all members of the EU
to the creation of the European Monetary adopt the euro, the key actor is the Eurosystem,
System (EMS), which lasted until the launch comprising the ECB and the central banks of the
of the euro in 1999. The emphasis was put on countries in the euro area.
monetary policy coordination and convergence
towards price stability as being supportive From the outset, the European Central Bank
of stable exchange rates. During this period, and the Eurosystem faced some daunting
links between central banks were strengthened challenges. In particular, as a new institution,
further, exchange rate realignments were made the ECB had to gain credibility and win the
conditional on convergence policy commitments
conﬁ dence of the public and the ﬁ nancial
in order to reduce the frequency and impact of markets that it would maintain price stability.
disruptive devaluations (which nevertheless As a brand new institution, it also had to set
occurred from time to time), capital controls up a framework to work effectively with the
were removed, low-inﬂ ation policies prevailed NCBs of the Eurosystem. These tasks were
in every country, and economic integration made
complicated by the entirely new institutional
ECB
8
Monthly Bulletin
10th Anniversary of the ECB

H I S T O R I C A L C O N T E X T
and economic environment. In fact, the euro
banking network, an important factor given
created a new economic and ﬁ nancial entity,
the size of the euro area and the long-
with characteristics that had not been fully
standing relationships between the national
studied, and with implications that were not
banking communities and their NCB. The
fully understood.
framework has functioned smoothly over the
past decade. It has also successfully handled
This special 10th anniversary edition of the
the enlargement of the European Union and
Monthly Bulletin looks back at the ECB’s and
the euro area.
Eurosystem’s work and achievements over the
past ten momentous years. It also looks at a In these ten years, the ECB has attained a high
number of future challenges and ways forward in
degree of credibility worldwide. It will be
the ECB’s areas of responsibility. In reviewing important to maintain this credibility, while
the working of the ECB and the Eurosystem, meeting all future challenges as the euro area
two aspects stand out:
enters its second decade. In this special 10th
anniversary edition of the Monthly Bulletin,
• First, over the years, monetary integration we show that in many ways we now share a
has advanced in parallel with economic common destiny.
integration. In fact, the European path to
EMU is unique in history, as it is based on
the concept of a single market for sovereign
countries. This is quite different from most
monetary unions in the past, where the prior
creation of a political union (a nation state)
paved the way for the establishment of a
single market with homogeneous conditions
for enterprises and households. We expect
the euro to have benign effects in promoting
further economic and ﬁ nancial integration.
This aspect is discussed at some length in
Chapters 4, 5 and 6, which deal respectively
with real economic integration, increasing
trade openness and ﬁ nancial market
integration.
• Second, in the Eurosystem decision-making
is centralised, while implementation is
decentralised. The decentralisation of the
Eurosystem offers three key advantages.
The ﬁ rst is that the ECB beneﬁ ts from the
expertise, infrastructure and operational
capabilities of the NCBs of the Eurosystem.
The second advantage is that the NCBs
facilitate communication between the ECB
and the people of the euro area, as they
speak the language(s) of each country and
know its culture(s). The third advantage is
that the NCBs provide the credit institutions
in each country with access to the central
ECB
Monthly Bulletin
10th Anniversary of the ECB
9

THE EUROPEAN SYSTEM
OF CENTRAL BANKS (ESCB)
THE EUROSYSTEM
ECB
10 Monthly Bulletin
10th Anniversary of the ECB

1 INTRODUCTION
”... to make all men work together, to show them that, beyond their divergences or over and above
frontiers, they have a common interest.”

Jean Monnet
This special edition of the Monthly Bulletin reviews the ﬁ rst ten years of operations of the European
Central Bank (ECB) and of the Eurosystem, which consists of the ECB and the central banks of the
European Union countries that have already adopted the euro. It describes how this new institution
and system have worked during this eventful decade and looks ahead to some of the challenges they
may face in the next ten years and beyond.
The ECB is fulﬁ lling its primary objective to maintain price stability, and its monetary policy
ECB has one overriding
strategy is credible and well understood. While setting a single monetary policy is the most
objective: price stability
visible of the tasks of the ECB, it is by no means the only one. In order to fulﬁ l its objective,
the ECB has to perform diverse tasks and activities, some of which were also speciﬁ ed in the
Maastricht Treaty, while others complement the setting of the single monetary policy. Hence,
this special edition is an aid to better understanding the various other tasks of the ECB and the
Eurosystem.
The creation of the ECB and the ESCB, and the launch of the euro led to a new institutional setting
EMU’s institutional setting
for Economic and Monetary Union (EMU). This setting combines a centralised monetary policy
combines centralised
monetary policy with ...
with decentralised ﬁ scal and structural policies. Chapter 2 explains how the competence for the
single monetary policy was transferred to the supranational level (i.e. to the Community level). The
newly created institution in charge of setting monetary policy, the ECB, was granted a high degree
… decentralised fiscal and
of independence by the Treaty. We explain that this entails a combination of institutional
structural policies …
independence as well as personal, ﬁ nancial and functional independence. The new Lisbon Treaty
lists the ECB as one of the institutions of the Union. This reﬂ ects the fact that monetary policy is
indivisible and that central banks need to be independent to deliver price stability. By contrast,
ﬁ scal policies are more efﬁ ciently set at national level – subject to the parameters of the Stability
and Growth Pact – in order to take into account national characteristics and institutional settings.
Structural policies are also set at national level but are subject to peer review and coordination
within the framework of the Lisbon Strategy.
EMU’s new institutional setting provides appropriate coordination procedures which take account of
… and requires more
the increased interdependence of euro area countries. As a result, the ECB and the Eurosystem need to
exchanges of information
and coordination
exchange information and have frequent interactions with several other European institutions and
bodies, such as the council bringing together the ministers of ﬁ nance (the ECOFIN Council) and its
diverse preparatory committees, the Eurogroup and the European Commission. In addition, the ECB
has to report to the European Parliament. Since September 1998 the practice has been satisfactory.
However, policies deﬁ ned at national level would need to take into consideration the requirements of
the Community as the euro area’s integration makes further progress.
The Governing Council of the ECB is responsible for formulating the monetary policy of the euro
Governing Council sets
area and for setting the guidelines for its implementation. In October 1998 they did precisely that:
monetary policy
they announced a stability-oriented monetary policy strategy designed to achieve the primary
objective of price stability as laid down in the Maastricht Treaty. The strategy – which was further
clariﬁ ed in 2003 – has two main elements: a quantitative deﬁ nition of price stability, and a “two-
pillar framework”. The ﬁ rst element implies that the primary objective of the ECB is to keep
inﬂ ation below but close to 2%. There is in fact a broad consensus that maintaining price stability is
the best contribution that monetary policy can make to economic welfare. The second element is
ECB
Monthly Bulletin
10th Anniversary of the ECB
11

Two-pillar framework for
the “two-pillar framework”, which is based on an economic analysis and a monetary analysis. Both
euro area
are relevant for assessing the different risks to price stability. The economic analysis has a short to
medium-term horizon. It draws on a wide range of economic and ﬁ nancial statistics and indicators
relevant to the outlook for prices. The monetary analysis, by contrast, has a medium to longer-term
horizon, and attaches a prominent role to monetary and credit developments. The two-pillar
framework allows the internal analysis to be well-structured and facilitates communication to the
general public and ﬁ nancial markets.
Eurosystem required
Chapter 3 provides details of the key features and elements of the strategy, its implementation, and of the
unprecedented preparation
conduct of monetary policy since the launch of the euro in 1999. This chapter also draws attention to the
extensive work that was needed to ensure the functionality of the Eurosystem. This work included
establishing the infrastructure for the implementation of the single monetary policy. The ECB also
needed to set up its own organisation and procedures. This chapter also stresses that the ECB and the
Eurosystem started operating with limited knowledge of how the euro area might function once
monetarily integrated. Conducting monetary policy is not easy even in normal times, but with this
unprecedented move from tried-and-tested national policies to a novel supranational one, it was
particularly challenging. Major investments were made in research, analysis and statistics from the outset
and a large range of models and tools continues to be developed today, and helps to generate up-to-the-
minute data. Much of this analysis is public and subject to peer review, so it is a common good.
Economic reforms are key
Chapter 4 reviews the policy challenges and macro-performance of the euro area. Analysis of real
to smooth functioning of
economic trends and economic policies serves diverse purposes, for example, it contributes to the
euro area
above analysis under the two-pillar strategy and to the analysis of the monetary transmission
process; and it permits recognition of the macroeconomic trends for which structural and ﬁ scal
policies, as well as global developments, are mainly responsible and their impact on inﬂ ation
pressures. This chapter covers some euro area trends in real growth, productivity and, labour
markets over these ten years. It is remarkable that, over the last decade, the overall framework of
EMU has supported very sustained employment growth. Fiscal policies are then discussed before
presenting some stylised facts on cross-country differentials in real output growth and inﬂ ation.
Several lessons emerge from this chapter. Looking ahead, structural reforms and sound ﬁ scal
policies are crucial for overall macroeconomic stability as well as a good performance in these
ﬁ elds, i.e. for high employment and output growth, low natural unemployment and the absence of
major differentials in cross-country developments. Cross-country cost and inﬂ ation differentials,
which are due to inappropriate wage developments as well as ﬁ scal and structural rigidities, may
cause losses in competitiveness and adversely impact on employment and output growth. The proper
functioning of adjustments to speciﬁ c shocks should be ensured through ﬂ exible labour and product
markets, completion of the Single Market and well-designed sustainable ﬁ scal policies. Finally,
those countries which aim to adopt the euro in the future are well advised to take into consideration
the above issues in their convergence processes when they choose to join the euro area.
Monetary Union’s effects on
The euro is gradually changing the economies of the euro area. In business, some costs, such as
the economy
exchanging currencies or hedging against volatile exchange rates, have fallen or even disappeared
completely. Information costs, such as the need to compare prices of goods and services
internationally, are on the decline. The euro is also expected to boost the Single Market – i.e. remove
the remaining barriers to the circulation of goods, services and people – by enhancing price
transparency and discouraging price discrimination. This should help to reduce market segmentation
and foster competition. The euro is also more efﬁ cient than the multiple currencies it replaced as a
ECB
12 Monthly Bulletin
10th Anniversary of the ECB

I N T R O D U C T I O N
medium of exchange and unit of account. In this special Monthly Bulletin we consider various
ways in which the euro is helping to change Europe’s ﬁ nancial markets and macro-performance. Of
course, such effects, rendering the euro area more integrated, work slowly and may take several
decades to unfold fully.
One area where change is already quite measurable is the international dimension of the euro. In
Euro’s international
Chapter 5 we cover four dimensions of this change: trade in goods and services, capital ﬂ ows, the
dimension
international role of the euro, and the ECB’s relations with third countries and international
institutions and bodies. We look at developments among euro area countries (i.e. the intra-euro
area) and of the euro area as a whole vis-à-vis the rest of the world (i.e. the extra-euro area).
Anecdotal evidence and economic analysis indicate that the euro has been promoting trade, foreign
direct investment (FDI) and cross-border portfolio investment among euro area countries. This is
tantamount to the euro area investing in itself. While fostering intra-euro area trade, the euro has
enhanced competition within the euro area and the convergence of trade prices. In parallel, the euro
has helped to increase efﬁ ciency in both home and host countries through the reallocation of capital,
particularly in the manufacturing sector. Moreover, by promoting portfolio ﬂ ows among euro area
members, the euro has favoured a diversiﬁ cation of investment and consumption risks. These
phenomena are expected to continue in the future. The international dimension of the euro and its
use as a reserve and transaction currency are on the rise. It has become the second most important
international currency behind the US dollar, which has a more extensive global reach.
Over the past decade the ECB and the ESCB have paid special attention to the adequate functioning
ECB/ESCB pay close
of the ﬁ nancial system. Central banks are interested in the ﬁ nancial system and its stability for two
attention to financial
system
main reasons. The ﬁ rst is that, in order to fulﬁ l their main task, namely to secure price stability, the
ﬁ nancial system has to function properly. Given that the ﬁ nancial system provides the primary
channel through which the single monetary policy is conducted, an integrated, stable and efﬁ cient
ﬁ nancial system is essential for the smooth and effective transmission of monetary policy impulses
throughout the euro area. Moreover, central banks are mainly responsible for the smooth operation
of payment and settlement systems and this objective is closely connected to the safety and
efﬁ ciency of the ﬁ nancial system as a whole. The second reason is that a well-functioning ﬁ nancial
system allocates ﬁ nancial resources more efﬁ ciently across time and space and is therefore
instrumental in achieving higher and more sustainable economic growth. This is an important public
policy objective, and it is actively supported by central banks.
The euro area has a multinational nature. Since the start, one key objective of the Eurosystem has
Eurosystem works
been to enhance the functioning of its ﬁ nancial markets, i.e., to foster European ﬁ nancial integration.
to promote financial
integration …
Chapter 6 reviews the progress which has been made in ﬁ nancial integration since the launch of the
euro, the major driving forces and obstacles in this respect, and the contribution of the ECB and the
Eurosystem to the integration process. It emphasises that the ECB and the Eurosystem have fostered
the ﬁ nancial integration process in four main ways, namely by: (i) enhancing knowledge, raising
awareness and monitoring progress in ﬁ nancial integration; (ii) acting as a catalyst for market-based
initiatives to foster ﬁ nancial integration, for example, with respect to the establishment of the Single
Euro Payments Area (SEPA); (iii) giving advice on the EU legislative and regulatory framework
for ﬁ nancial services, and (iv) providing central banking services, including, for example, the
facilities for the real-time gross settlement of euro payments (called TARGET) and the cross-border
handling of collateral (called CCBM), as well as the TARGET2-Securities initiative, which explores
ways of offering settlement in central bank money for securities transactions.
ECB
Monthly Bulletin
10th Anniversary of the ECB
13

… and to contribute to
Chapter 7 focuses on another core responsibility of the Eurosystem: the safeguarding of ﬁ nancial
financial stability
stability. This task has become increasingly relevant in recent years, as the ﬁ nancial sector has
signiﬁ cantly expanded relative to the real economy, and the economic role of ﬁ nancial stability has
therefore steadily become more important. While delivering price stability is the best contribution
in general terms that the Eurosystem can make to ﬁ nancial stability, it also contributes to this
objective in two speciﬁ c ways. First, the Eurosystem conducts certain ﬁ nancial stability tasks at
euro area level. This includes monitoring and assessing the area’s ﬁ nancial stability – with the ECB
publishing its “Financial Stability Review” twice a year on this subject – as well as performing
market operations to address general ﬁ nancial shocks and to relieve tensions in the euro area money
market. Second, the Eurosystem plays a part in deﬁ ning the ﬁ nancial stability policies of the
competent national and EU authorities, which entails three main activities: (i) supporting national
and EU-wide ﬁ nancial stability monitoring and assessment, (ii) advising on ﬁ nancial regulation and
supervision, and (iii) contributing to ﬁ nancial crisis management. In addition, the Eurosystem has
direct responsibilities for overseeing market infrastructures, notably payment systems, a task which
also strengthens ﬁ nancial system stability. This chapter describes the Eurosystem’s responsibilities
and main achievements in the ﬁ elds of ﬁ nancial stability and oversight.
Good statistics essential to
Chapter 8 explains the importance of high-quality statistics for the euro area and the ECB’s need
in-depth analysis
for a comprehensive set of timely, reliable and coherent monetary, ﬁ nancial and economic statistics
so that it can undertake its tasks and, in particular, assess the risks to price stability. This chapter
also reviews the Harmonised Index of Consumer Prices, which is used by the ECB to assess price
stability. Since 1999, the output of ESCB statistics has nearly tripled. Monetary, ﬁ nancial and
external statistics have been regularly published in accordance with high-quality standards.
Reference documentation is readily available and has contributed to the development of global
statistical standards, e.g. on monetary and ﬁ nancial statistics. Various ECB statistics have now been
integrated into the fully ﬂ edged quarterly ﬁ nancial and non-ﬁ nancial accounts for the euro area. A
statistical annex at the end of this special edition presents some selected international comparisons.
Monetary Union in our
Chapter 9 looks at euro banknotes from various angles and includes a brief account of their
pockets
development in the 1990s and introduction in 2002. The chapter covers the present and future,
reporting on the circulation of the currency and its management. The banknotes are truly a visible
and successful symbol of EMU and represent a signiﬁ cant achievement, considering the scale of the
planning and organisation that went into their introduction.
This special edition of the Monthly Bulletin shows that there are different time horizons at which to
judge the performance of the ECB and the Eurosystem over these ten years. Some common threads,
which also indicate challenges ahead, emerge:
Committees take euro area
•
The Eurosystem combines centralised decision-making with decentralised implementation by
perspective
the national central banks (NCBs). This holds for all tasks and activities discussed in this special
edition. From an organisational standpoint, various technical committees and working groups
bring together expert staff from the ECB and all NCBs. Such committees and working groups
contribute to the regular processing of a vast amount of data and information from across all
euro area countries. This permits a pooling of the best experience and knowledge of the
Eurosystem NCBs. At the same time, all these committees and working groups take a euro area
perspective. This framework is capable of evolving and has handled enlargement successfully.
ECB
14 Monthly Bulletin
10th Anniversary of the ECB

I N T R O D U C T I O N
•
The Eurosystem started out from modest beginnings. There was limited knowledge of how the
Little was known about how
euro area might function once monetarily integrated. While undertaking monetary policy in an
euro area might function
uncertain world buffeted by shocks is a challenge for any central bank, this challenge was
severe in the early years of the euro area due to the sheer element of novelty, as discussed in
Chapter 3. This explains the heavy investment in analytical tools, research and statistics from
the outset, as illustrated in Chapters 3, 4, 5, 6 and 8. A vast range of models and other analytical
tools have been developed and are now in use, and are constantly being improved. The bulk of
this analysis and information is public. It is available on our website and in publications. It is
subject to public scrutiny and peer review.
•
The monetary policy strategy of the ECB is based on the best experience of the NCBs of the
Zone of price stability now
Eurosystem and combines this knowledge with novel elements. Given the mandate to safeguard
wider
price stability by the Treaty, the Governing Council deﬁ ned a clear inﬂ ation objective. This in
turn enhances the transparency and accountability of the ECB. The economic and monetary
analysis – the two-pillar framework – provides two complementary perspectives from which to
assess risks to price stability. It also provides an organising device for the internal analysis and
for the external communication. The strategy is now well understood and credible. Credibility
helps in anchoring longer-term inﬂ ation expectations and lowering inﬂ ation volatility. In
Chapters 2, 7 and 9 of this special edition we show how the smooth functioning of the ECB’s
monetary policy strategy has supported various other tasks of the ECB and the Eurosystem.
•
The euro – broadly meant to encompass market forces, institutional and organisational changes,
Euro as catalyst of
and legislative actions – is expected to act as a catalyst of economic and ﬁ nancial integration.
integration
Such changes may take a long time to unfold. After all, the European process of economic,
ﬁ nancial and monetary integration started back in the 1950s and has advanced gradually since
then. The decision to launch the euro was based on the ﬁ rm belief that the euro area countries
were ready for it and that the new single currency would set in motion benign processes bringing
those countries closer together. At the same time, several challenges remain and are discussed
in this special Monthly Bulletin. In some euro area countries there is still a gap between inﬂ ation
as perceived by the public and that actually measured: an issue addressed in Chapter 3. There is
also room for euro area economies to strengthen their ﬂ exibility and resilience to external
shocks: an issue addressed in Chapter 4. Moreover, European “regional” integration is
advancing in parallel with globalisation, which is also having far-reaching and pervasive
effects, as discussed in Chapters 5 and 6. Hence, the euro area will need to evolve further under
these combined pressures.
•
The fact that the euro area is becoming more interconnected than ever before is changing our
views on Economic and Monetary Union. The euro is also an important symbol of identity for
Europe.
The euro is now used by 320 million people in the euro area, but also has a wider international
Euro has brought price
circulation than the currencies that it replaced and is increasingly used by the international ﬁ nancial
stability and low interest
rates
markets, as discussed in Chapter 5. In this 10th anniversary edition we show that the euro has
already brought several gains, including price stability and low interest rates. These beneﬁ ts are
supporting other positive developments, which are unfolding gradually but persistently, including
more trade in goods and services, and more ﬁ nancial integration, which in turn is spurring ﬁ nancial
deepening and modernisation. There is also a remarkable degree of resilience in a complex
international environment. In our view, these achievements lend great support to meeting all present
ECB
Monthly Bulletin
10th Anniversary of the ECB
15

and future challenges for the euro area, and also support the adaptation of national economies.
Chapter 10 contains some concluding remarks. The table below lists some of the main institutional
events in the history of the Eurosystem.
Key institutional events in the history of the Eurosystem, 1998-2008
1998
May
European Council ﬁ nds that 11 countries have fulﬁ lled the convergence criteria and can
adopt the euro (Stage Three of EMU).
See Foreword
June
The ECB and the ESCB are established.
See Historical context
September
First appearance of the ECB President before the European Parliament.
See Chapter 2
October
First participation of the ECB President in a G7 meeting.
October
Announcement of the monetary policy strategy.
See Chapter 3.1
November
Adoption by the EU Council of Regulation concerning the collection of statistical
information by the ECB.
See Chapter 8
December
Announcement of the quantitative reference value for monetary growth.
December
ECB is granted observer status by the International Monetary Fund (IMF).
December
Conversion rates are ﬁ xed irrevocably.
See Historical context
1999
January
Launch of the ﬁ duciary euro. A single monetary policy is established for the euro area.
See Chapter 2
January
Launch of ERM II with Denmark and Greece as initial members.
See Chapter 2
April
Eurosystem agreement on emergency liquidity assistance.
See Chapter 7
July
Euro banknote production begins in several printing works.
See Chapter 9
November
ECB becomes member of the Bank for International Settlements (BIS).
2000
March
Lisbon Strategy is adopted by European Council.
See Chapter 2
2001
January
Greece joins the euro area.
See Chapter 2
April
EU-wide Memorandum of Understanding (MoU) between payment systems overseers and
banking supervisors is adopted.
See Chapter 7
August
The euro banknotes are unveiled to the public.
See Chapter 9
September
Pre-distribution of euro banknotes and coins starts.
See Chapter 9
2002
January
Euro cash changeover: by the end of February 2002 euro banknotes and coins are sole
See Chapter 9
legal tender in all euro area countries.
November
First publication of the ECB’s report on EU banking structures.
See Chapter 7
2003
February
First publication of the ECB’s report on EU banking sector stability.
See Chapter 7
March
EU-wide MoU on cooperation between supervisory authorities and central banks in
ﬁ nancial crisis situations is adopted.
See Chapter 7
March
MoU setting out the respective responsibilities for economic and ﬁ nancial statistics at
Community level between the ECB and Eurostat.
See Chapter 8
May
Clariﬁ cation of the ECB’s monetary policy strategy.
See Chapter 3.1
2004
March
Changes to the operational framework.
See Chapter 3.3
May
National central banks of the ten new EU Member States join the ESCB.
See Chapter 2
June
The currencies of Estonia, Lithuania and Slovenia enter ERM II.
See Chapter 2
December
First publication of the ECB’s Financial Stability Review.
See Chapter 7
2005
March/April
Lisbon Strategy is relaunched as a result of the review carried out by a high-level group
chaired by Wim Kok.
See Chapter 2
March/June
Reform of the Stability and Growth Pact.
See Chapter 2
ECB
16 Monthly Bulletin
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I N T R O D U C T I O N
Key institutional events in the history of the Eurosystem, 1998-2008
May
EU-wide Memorandum of Understanding on cooperation between supervisory authorities,
central banks and ﬁ nance ministries in ﬁ nancial crisis situations is adopted.
See Chapter 7
May
The currencies of Cyprus, Latvia and Malta enter ERM II.
See Chapter 2
August
Eurosystem publishes contribution to Commission consultation on EU ﬁ nancial services
policy (2005-2010).
See Chapter 7
September
ECB publishes for the ﬁ rst time indicators of ﬁ nancial integration in the euro area.
See Chapter 6
November
The Slovak koruna enters ERM II.
2006
July
TARGET2-Securities initiative launched.
See Chapter 6
2007
January
Slovenia joins the euro area.
See Chapter 2
January
National central banks of Bulgaria and Romania join the ESCB.
See Chapter 2
March
First publication of the ECB’s report on ﬁ nancial integration in Europe.
See Chapter 6
May
Publication of the “Public commitment with respect to the ESCB’s statistical function”.
See Chapter 8
June
First joint publication, by the ECB and Eurostat, of integrated quarterly euro area
economic and ﬁ nancial accounts by institutional sector.
See Chapter 8
November
Eurosystem publishes contribution to the review of the Lamfalussy framework for
ﬁ nancial regulation and supervision.
See Chapter 7
December
Lisbon Treaty signed.
See Chapter 2
2008
January
Malta and Cyprus join the euro area.
See Chapter 2
April
Publication of the “ECB Statistics Quality Framework”.
See Chapter 8
April
Agreement on a new EU-wide Memorandum of Understanding on cooperation between
supervisory authorities, central banks and ﬁ nance ministries in ﬁ nancial crisis situations.
See Chapter 7
ECB
Monthly Bulletin
10th Anniversary of the ECB
17

The Governing Council
in June 1998:
Back row (left to right)
Luis Ángel Rojo,
Alfons Verplaetse,
Antonio Fazio,
Yves Mersch,
António José Fernandes de Sousa,
Matti Vanhala, Klaus Liebscher,
Nout Wellink,
Jean-Claude Trichet,
Maurice O’Connell,
Hans Tietmeyer
Front row (left to right):
Eugenio Domingo Solans,
Otmar Issing, Christian Noyer,
Willem F. Duisenberg,
Sirkka Hämäläinen,
Tommaso Padoa-Schioppa
The Governing Council
in June 2008:
Back row (left to right):
Jürgen Stark, Erkki Liikanen,
Klaus Liebscher,
Nicholas C. Garganas,
Nout Wellink, Marko Kranjec
Middle row (left to right):
John Hurley,
Miguel Fernández Ordóñez,
Christian Noyer, Axel A. Weber,
Lorenzo Bini Smaghi,
Michael C. Bonello
Front row (left to right):
Yves Mersch,
José Manuel González-Páramo,
Lucas D. Papademos,
Jean-Claude Trichet,
Vίtor Constâncio, Mario Draghi and Guy Quaden were not present when the photograph was taken.
Gertrude Tumpel-Gugerell,
Athanasios Orphanides
ECB
18 Monthly Bulletin
10th Anniversary of the ECB

The General Council
in June 1998:
Back row (left to right):
Luis Ángel Rojo, Antonio Fazio,
Urban Bäckström,
António José Fernandes de Sousa,
Matti Vanhala, Klaus Liebscher,
Nout Wellink,
Lucas D. Papademos,
Edward A. J. George,
Maurice O’Connell,
Hans Tietmeyer,
Front row (left to right):
Alfons Verplaetse, Yves Mersch,
Christian Noyer,
Willem F. Duisenberg,
Bodil Nyboe Andersen,
Jean-Claude Trichet
The General Council
in June 2008:
Back row (left to right):
Erkki Liikanen, András Simor,
Klaus Liebscher,
Nicholas C. Garganas,
Axel A. Weber,
Reinoldijus Šarkinas,
Nout Wellink, Andres Lipstok
Middle row (left to right):
John Hurley, Nils Bernstein,
Christian Noyer,
Ilmārs Rimšēvičs,
Zdeněk Tůma,
Stefan Ingves, Marko Kranjec,
Vίtor Constâncio, Mario Draghi, Ivan Iskrov, Mervyn King, Guy Quaden and Sławomir Skrzypek were not present when the
Mugur Constantin Isărescu
photograph was taken.
Front row (left to right):
Miguel Fernández Ordóñez,
Ivan Šramko,
Lucas D. Papademos,
Jean-Claude Trichet,
Michael C. Bonello,
Athanasios Orphanides,
Yves Mersch
ECB
Monthly Bulletin
10th Anniversary of the ECB
19

ENLARGEMENT OF THE EUROPEAN UNION
ENLARGEMENT OF THE EURO AREA 1999-2008
ECB
20 Monthly Bulletin
10th Anniversary of the ECB

2 INSTITUTIONAL SETTING AND WORKINGS
OF THE EURO AREA
Macroeconomic policies are conducted in the euro area on the basis of a well-deﬁ ned allocation of
responsibilities. The competence for monetary policy has been assigned to the supranational level,
i.e. the ECB. By contrast, economic policies largely remain within the remit of Member States while
being subjected to coordination procedures. The Maastricht Treaty endowed the ECB/Eurosystem
with the independence needed for conducting the single monetary policy and carrying out its other
tasks. At the same time, the Treaty imposes upon the ECB a number of reporting requirements vis-à-
vis the general public and its elected representatives, the European Parliament. Moreover, the ECB
participates in a number of European meetings and regularly exchanges views with Community
institutions.
The ﬁ rst decade of EMU has shown that this unprecedented institutional setting, of which the ECB
is an integral part, is fundamentally sound. This is also recognised in the new Lisbon Treaty, which
has left the institutional set-up essentially unchanged. However, important challenges remain.
In particular, national policy-makers should live up to their respective responsibilities under the
current setting, which would further improve the euro area’s macroeconomic performance.
The chapter is structured as follows: Section 2.1 brieﬂ y reviews the euro area’s institutional setting
and some changes that have occurred over this decade, Section 2.2 looks at the ECB’s interaction
with other Community institutions and bodies, and Section 2.3 lists the procedural steps for euro
area and EU enlargement.
2.1 INSTITUTIONAL SETTING
The institutional setting for Economic and Monetary Union (EMU) introduced by the Maastricht Treaty
Clear allocation of
speciﬁ es a clear division of responsibilities between the Community level and the national level. As a
responsibilities
consequence of the introduction of the single currency, the competence for euro area monetary policy has
been transferred to the Community level. In order to fulﬁ l its primary objective of maintaining price stability,
the Eurosystem has been given a high degree of independence from political inﬂ uence. By contrast,
economic policies (such as ﬁ scal or structural policies) remain largely within the remit of the Member
States, embedded within a European framework aimed at ensuring discipline. The main reason for this
dichotomy is that, while monetary policy in a monetary union is indivisible by nature, economic policies
need to take into account national characteristics and national institutional settings and therefore can be
more efﬁ ciently conducted at national level. Moreover, leaving economic policies largely in the competence
of national governments also allows for some degree of policy competition aimed at improving policy
efﬁ ciency and emulating best practices.1
At the same time, the single currency is promoting greater economic integration of national
economies, which is in turn increasing their interdependence (in particular, trade and capital ﬂ ows
have risen over the last ten years, see Chapter 5). Exceedingly decentralised and uncoordinated policy
responses might be counter-productive by not taking enough account of growing interdependence.
In particular, autonomous decision-making is likely to be less effective in coping with common
economic shocks that affect most or all countries in broadly similar ways. Moreover, Member
States must take into account potential spillover effects (i.e. policy decisions in one country might
affect the others). In addition, the economic policies of Member States must be geared towards
stability to ensure compatibility with the primary objective of the single monetary policy. This is
all the more necessary as euro area members no longer have monetary and exchange rate policies
1 For a more detailed description of the current framework, see the article “The economic policy framework in EMU” in the November
2001 issue of the ECB Monthly Bulletin.
ECB
Monthly Bulletin
10th Anniversary of the ECB
21

at their disposal and therefore must rely on other policies to foster competitiveness and adjust to
shocks. These considerations provide a case for coordination in the ﬁ eld of economic policies.
Such coordination may take place either by subjecting policies to a rules-based approach relying on
“hard” laws or procedures or through a “soft” approach based on peer pressure or support among
Member States and dialogue at the Community level.
Three policy-making modes
The Treaty foresees three different modes for policy-making in the various ﬁ elds of EMU: i) full
transfer of competence to the Community level for monetary policy; ii) rules-based coordination
for ﬁ scal policy; iii) “soft” coordination for other economic policies. The following sections will
look at each of these policy areas in turn.
Institutional setting is sound
The main conclusion of this chapter is that the institutional setting of the euro area has provided an
adequate framework for the functioning of EMU during the ﬁ rst ten years. The new Lisbon Treaty
has left the EMU’s institutional arrangements essentially untouched, thus recognising that the
framework is appropriate.2
COMMUNITY LEVEL
Central bank independence, accountability and transparency
Economic theory and historical examples from previous decades represent strong evidence that
central bank independence is a precondition for achieving and maintaining price stability. Against
this background, the multi-dimensional independence of the ECB is stipulated in the Treaty, which
legitimises its independence.
Towards central bank
Over the last few decades, the evolution of monetary policy frameworks around the world has been
independence: a global trend
characterised by a global trend towards central bank independence. As we review below, the latter is a
multifaceted concept. More powers and autonomy require democratic legitimacy, which entails a high
degree of transparency in the conduct of monetary policy, and intensive communication with the
public. Behind this broad development was a radical change in the thinking of economists in the
1970s, which recognised the fundamental role of expectations in economic behaviour.
Rationale for central bank
Central bank independence, i.e. insulating the central bank from political inﬂ uence in its conduct of
independence
monetary policy, ensures the focus of monetary policy on price stability and thereby facilitates the
anchoring of inﬂ ation and inﬂ ation expectations at low levels. Following the high inﬂ ation of the 1970s,
the question arose as to why central banks allowed inﬂ ation to get out of hand, and how such a development
could be prevented in the future. One key explanation which was put forward was that central banks lost
control of inﬂ ation because of their lack of independence. In the absence of central bank independence,
monetary policy cannot be credibly geared to price stability since it can at any time be exposed to political
preferences to boost output in the short run at the expense of higher inﬂ ation in the longer run. The public
will, however, understand this problem and expect higher inﬂ ation from the outset, so that the perceived
short-term trade-off between inﬂ ation and output will be negated and a permanently higher inﬂ ation rate
will ensue as the only certain outcome. The only way out of this dilemma is to delegate monetary policy to
an independent central bank with a clear mandate to safeguard price stability.
2 The Lisbon Treaty was signed by EU Heads of State or Government on 13 December 2007. It amends the Treaty on European Union
and the Treaty establishing the European Community and aims to make an enlarged European Union function more democratically,
more transparently and more effectively. The Lisbon Treaty is scheduled to enter into force in 2009, following ratiﬁ cation by all Member
States.
ECB
22 Monthly Bulletin
10th Anniversary of the ECB

I N S T I T U T I O N A L
S E T T I N G
The economic rationale behind central bank independence has to be translated into a comprehensive and
A N D W O R K I N G S
detailed legal framework. To ensure the necessary independence of the ECB/ESCB, the following
O F T H E E U R O A R E A
dimensions of monetary policy independence can be derived from the Treaty.
The institutional independence of the ECB from any interference, including from governments, is
ECB’s independence
has four dimensions
guaranteed in Article 108 of the Treaty. This provision explicitly stipulates that, when exercising
their powers, neither the ECB nor any member of its decision-making bodies shall seek or take
instructions from Community institutions or bodies, from any government of a Member State or
from any other body. The Treaty further states that the Community institutions and bodies and the
governments of the Member States also have to respect this principle and must not seek to inﬂ uence
the members of the decision-making bodies of the ECB. The ECB’s institutional independence
is complemented by its own legislative powers and its advisory role as regards draft national and
Community legislative provisions falling in its ﬁ elds of competence.
The provisions of the Treaty ensure that the ECB disposes of all necessary competences and
powers to achieve its mandate, thereby granting it functional independence. For example, the ECB
has exclusive competence for monetary policy in the euro area. The ECB’s full control over the
monetary base is ensured by its monopoly on banknote issuing and the requirement that issuance
of coins by the Member States is subject to the ECB’s approval. Also, Article 101 of the Treaty
shields the Eurosystem from pressures to grant monetary ﬁ nancing of public debt by prohibiting
lending by the Eurosystem to the public sector.
Personal independence provides the members of the Governing Council with the necessary security
of tenure and helps avoid any conﬂ icts of interest. In this respect, the ESCB/ECB Statute protects
the personal independence of the ECB decision-making bodies by stipulating relatively long ﬁ xed-
term contracts and ruling out dismissal on the grounds of past policy conduct. A key consideration
in this respect is to ensure that central bankers have signiﬁ cantly longer mandates than politicians,
thus central bankers can look ahead over a longer horizon, focusing on medium-term considerations,
while politicians have shorter-term objectives, in line with the election cycles.
Finally, ﬁ nancial independence, meaning the central bank’s autonomy over its ﬁ nancial resources
and income, is important in that it enables the central bank to effectively perform its tasks. In EMU
this is ensured by the ECB having its own budget, independent from that of the EU, and the full
subscription and payment of the ECB’s capital by the national central banks of the Eurosystem.
In the Lisbon Treaty the ECB is speciﬁ cally listed as one of the institutions of the Union. This
change in the legal status of the ECB has no material impact on its position within the EU
institutional setting, since the Lisbon Treaty does not amend any of the main institutional features
of the ECB, such as its primary objective and tasks, its power to adopt legal acts as well as its own
legal personality and independence.
The far-reaching independence granted to the ECB by the Treaty and the Statute must be adequately
Independence requires
accountability
legitimised to be in line with the democratic fundamentals of the European society. It requires
accountability to the general public and to democratically elected bodies. The democratic legitimacy
of independent central banks is regulated differently in different democratic systems. Their mandates
can also vary on the basis of the number of objectives they have to pursue.
Regarding the democratic legitimacy of the ECB/ESCB, three elements can be highlighted. First,
the ratiﬁ cation of the Treaty and the amendments to the national central bank statutes by national
ECB
Monthly Bulletin
10th Anniversary of the ECB
23

legislation is a major source of democratic legitimacy. Second, the appointment of the Governing
Council members, including the Executive Board members of the ECB and the national central
bank governors, by democratic institutions is also a signiﬁ cant element. Finally, the ECB has to
render account of its policies.
As regards accountability, the ECB has to explain to the citizens and their representatives in the
Parliament how it fulﬁ lled its mandate. In particular, the ECB is required to address an annual report
on its monetary policy and other activities to the European Parliament, the Council, the Commission
and the European Council (for more information on these bodies, see section 2.2 below). The ECB
has to present this report to the European Parliament and the Council. Moreover, the President of
the ECB and the other members of the Executive Board may be heard by the competent committees
of the European Parliament, either at the Parliament’s or their own request (the ECB’s reporting
obligations vis-à-vis the European Parliament are explained in section 2.2).
Rendering account is made easier if a central bank has a clear mandate to fulﬁ l. In the EU, the Treaty
provides the ECB/ESCB with a clear primary objective to maintain price stability. If, by contrast,
the central bank had to pursue several objectives at a time, it would be increasingly difﬁ cult to hold
it accountable for the fulﬁ lment of its mandate. Moreover, the Governing Council of the ECB has
determined a quantiﬁ ed deﬁ nition of the target to be achieved and a suitable and comprehensible strategy
to be pursued, which limits discretionary decisions and personal inﬂ uence on decision-making.
Greater independence brings
The fact that the worldwide reduction of inﬂ ation and the successful anchoring of inﬂ ation
lower inflation
expectations over the last two decades has coincided with a worldwide move towards central bank
independence represents strong evidence that central bank independence is a precondition for
achieving and maintaining price stability. This view is also supported by formal empirical evidence.
A large number of studies have shown that across countries greater central bank independence is
associated with lower average inﬂ ation.3
MONETARY POLICY
The Maastricht Treaty assigns responsibility for the single monetary policy to the ECB and entrusts it
with a primary objective, the maintenance of price stability. Without prejudice to this primary objective,
monetary policy shall support the general economic policies of the Community. This arrangement is
rooted in the principle – supported by empirical evidence and academic research and underpinned
by a broad public consensus – that the maintenance of price stability is the best contribution that
monetary policy can make to achieving the economic policy objectives of the Community, such as
a high level of employment and sustainable and non-inﬂ ationary growth. The main features of the
monetary policy framework and its implementation are dealt with in Chapter 3. The experience of
the past ten years conﬁ rmed the soundness and robustness of this approach, as reﬂ ected in Chapter 4,
which deals with the macroeconomic performance of the euro area.
ECB’s Governing Council sets
In the euro area, monetary policy decisions are taken by the Governing Council of the ECB,
monetary policy
consisting of the six members of the ECB’s Executive Board and the Governors of the national
central banks of the countries that are part of the euro area, on the principle of “one person, one
vote”. As for the operations through which monetary policy decisions are implemented, the
Governing Council, whenever this is possible and appropriate, conducts them through the national
3 See P. Moutot, A. Jung and F. Mongelli (2008), “The workings of the Eurosystem. Monetary policy preparations and decision making”,
Annex 1, ECB Occasional Paper No 79, for a short review of the evidence and re-assessment.
ECB
24 Monthly Bulletin
10th Anniversary of the ECB

I N S T I T U T I O N A L
S E T T I N G
central banks, in line with the principle of operational decentralisation 4 (for instance, while the
A N D W O R K I N G S
minimum rate for bids during the weekly main reﬁ nancing operation is set centrally by the ECB,
O F T H E E U R O A R E A
the tender operations themselves are implemented by the national central banks with their market
counterparties).
A ﬂ exible exchange rate regime has been adopted for the euro. This means that the external value of
Flexible exchange rate
regime for euro
the euro – like that of other major currencies, such as the US dollar – is determined in the markets.
The exchange rate is not an instrument of economic policy. Indeed, it would not have made much
sense to create the euro and then to subject its monetary policy to external rather than internal
requirements. Price stability is an objective for both monetary and exchange rate policies, by
implication there is no exchange rate target. When conducting its monetary policy, the ECB takes
the exchange rate into account to the extent that it affects the economic situation and the outlook for
price stability.
NATIONAL LEVEL
Fiscal policy
Fiscal discipline is required for the smooth functioning of Monetary Union, as unsound ﬁ scal
Sound fiscal policies needed
policies may create expectations or lead to political pressures upon the central bank to accommodate
higher inﬂ ation in order to alleviate the debt of the government sector or to keep interest rates low.
The Treaty therefore contains several provisions to avoid such risks. A more detailed account of
ﬁ scal policies and their outcome is provided in Chapter 4.
First of all, the Treaty explicitly prohibits the ﬁ nancing of government deﬁ cits through central
banks. It also stipulates that the government sector should not have privileged access to ﬁ nancial
institutions. In addition, the Treaty’s so-called “no bail-out clause” makes clear that neither the
Community nor any Member State should be liable for commitments of another Member State.
Beyond that, the Treaty contains an obligation for Member States to avoid excessive deﬁ cits.
For Member States that do not comply with the government deﬁ cit and debt ceilings deﬁ ned in
the Protocol on the Excessive Deﬁ cit Procedure (EDP) annexed to the Treaty, the procedure can
ultimately lead to ﬁ nancial sanctions.
The ﬁ scal framework was signiﬁ cantly enhanced in 1997 through the introduction of the Stability
Fiscal policies coordinated
through Stability and
and Growth Pact 5 (SGP). The preventive arm of the SGP introduces a more concrete procedure of
Growth Pact
multilateral surveillance whereby euro area members submit a stability programme, while non-euro
area members submit a convergence programme. These annual programmes present an overview of
the economic and ﬁ scal developments in each country, a medium-term objective for ﬁ scal policy
(MTO), and an adjustment path towards the MTO. The Council also can deliver an early warning
recommendation. In addition, the SGP has clariﬁ ed and streamlined the different steps and the
timetable of the EDP through its corrective arm.
As for the ‘corrective arm’, the reform of the SGP in 2005 introduced more ﬂ exibility into the
procedures. In particular, the use of discretion in determining an excessive deﬁ cit was widened and
4 For an analysis of the principle of decentralisation and the difference to the subsidiarity principle, see Zilioli, ESZB-Satzung, Artikel 12,
in von der Groeben-Schwarze hrgb., Kommentar zum Vertrag über die Europäische Union, 2003, 6. edition, pages 427-428 and Zilioli,
Selmayr, The Law of the ECB, Hart publishing 2001, p. 70-71.
5 The Stability and Growth Pact, which was adopted in June 1997, consists of a European Council Resolution and Regulations No 1466/97
and No 1467/97. See also J. Stark, (2001), “The genesis of a pact”, in: Brunila, A., M. Buti and D. Franco (eds.), The Stability and Growth
Pact. The architecture of ﬁ scal policy in EMU. Basingstoke: Palgrave.
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procedural deadlines were extended. With regard to the “preventive arm”, the revised SGP also
introduced increased discretion concerning the setting of and progress towards the MTO. Many
observers, including the ECB, expressed concern that these changes would undermine conﬁ dence
in the ﬁ scal framework and the sustainability of public ﬁ nances in the euro area members – and,
overall, make it more complex and less transparent.
Structural policies
“Soft” coordination of
The Treaty requires Member States to consider their economic policies “as a matter of common
structural policies
concern”. The Broad Economic Policy Guidelines (BEPGs) are the cornerstone of this set-up. The
Treaty also establishes a multilateral surveillance framework for employment policies, including
the adoption of Employment Guidelines. However, while the Council may issue recommendations
to Member States that do not comply with the BEPGs, the Treaty does not foresee any enforcement
or sanction mechanism.
Structural policies are an important part of the overall coordination of economic policies and are
subject to a “soft” coordination approach, which relies mostly on peer pressure and support. As
discussed in Chapter 4, highly ﬂ exible and competitive markets are necessary for the smooth
functioning of EMU, as the countries can no longer resort to some of the pre-EMU adjustment
mechanisms to restore their competitiveness (e.g. through currency devaluation). Economic policies
aimed at the supply side of the economy need to take into account the speciﬁ c conditions in each
country and, therefore, only a “soft” coordination of such country-speciﬁ c policies is feasible.
In March 2000, the Lisbon European Council reﬁ ned this approach by adopting the so-called
“Lisbon Strategy”, which set out an ambitious programme of structural reforms to enhance the
European Union’s growth potential. The Strategy introduced two institutional innovations: (i) the
“spring meetings” where the European Council is asked to provide political impetus to and guidance
on economic policies and structural reforms; and (ii) a new “Open Method of Coordination” (a new
form of governance in the EU) as a means of enhancing cooperation through the deﬁ nition of ‘best
practices’.
However, ﬁ ve years after its creation, the results of the Lisbon Strategy were rather mixed.
Following a review carried out by a high-level group chaired by Wim Kok, the former Prime
Minister of the Netherlands, the 2005 Spring European Council agreed to substantially modify the
Lisbon Strategy. In particular, it refocused the Lisbon Strategy on growth and employment, and
streamlined its governance with a view to increasing national ownership of structural reforms and,
thereby, the political legitimacy of the whole process.
The 2005 Spring European Council also agreed to bring the BEPGs and the Employment Guidelines
together into a single package, the Integrated Guidelines, in order to enhance their consistency.
They have now been adopted for a three-year period, with annual updates as appropriate. Moreover,
the large number of earlier reports were replaced by national reform programmes, which allow an
annual assessment of progess achieved so far.
Given the large size of the euro area, divergences in the economic performance of its members
are not surprising (see section 3 in Chapter 4 for a description of cross-country differentials in
macroeconomic performance in the euro area). Similar observations can be made for other large
currency areas, such as the United States. However, the fact that economic divergences in the euro
area tend to be persistent is an indication that euro area economies are not sufﬁ ciently ﬂ exible. It is
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Chart 1 ECB’s relations with other Community institutions/bodies
A N D W O R K I N G S
O F T H E E U R O A R E A
European
European
Council
Parliament
ECOFIN
EFC, EPC,
European
Council
EWG, FSC
Central Bank
European
Eurogroup
Commission
therefore essential that governments remain committed to the objectives of the Lisbon Strategy in
order to reap the beneﬁ ts of EMU.
2.2 ECB’S INTERACTION WITH OTHER COMMUNITY INSTITUTIONS AND BODIES
The institutional setting of EMU that we just described requires more intensive interaction among
Community/supranational institutions. This section complements the above considerations on the
general principles underlying the EMU setting. In particular, we look here at the interaction of the
ECB with key Community institutions.6
RELATIONS WITH THE EUROPEAN PARLIAMENT
As already mentioned, as a counterpart to its independence, the ECB is transparent vis-à-vis the
ECB has reporting
obligations to European
general public and is subject to extensive reporting requirements, in particular vis-à-vis the European
Parliament
Parliament. In this context, the President of the ECB and the other members of the Executive Board
may be heard by the competent committees of the European Parliament, either at the Parliament’s
or their own request. In practice, the President of the ECB appears before the Committee on
Economic and Monetary Affairs on a quarterly basis. The Annual Report of the ECB is presented to
both the Committee on Economic and Monetary Affairs and the plenary of the European
Parliament.
Moreover, going beyond the Treaty requirements, there are a number of other contacts between
the ECB and the European Parliament, such as informal visits. The ECB has also agreed to reply
to written questions by members of the European Parliament. To increase transparency, both the
questions and answers are published in the Ofﬁ cial Journal of the EU.
6 Note that the chart above illustrates only the interactions between the ECB and the other Community institutions/fora, not those among
the latter. For a more comprehensive analysis, see also the article “The ECB’s relation with institutions and bodies of the European
Community” in the October 2000 issue of the ECB Monthly Bulletin.
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This setting allows the ECB to be effectively held accountable to the EU’s elected representatives
and the public.
RELATIONS WITH THE ECOFIN COUNCIL AND ITS PREPARATORY COMMITTEES
ECB President may attend
The ECOFIN Council, i.e. the Council meeting in composition of ﬁ nance ministers, deals with
ECOFIN Council meetings
economic and ﬁ nancial policy issues pertaining to the EU as a whole and (unlike the Eurogroup, see
the following sub-section) can take formal decisions. The Treaty provides for the President of the ECB
to attend Council meetings whenever the Council discusses matters relating to the objectives and tasks
of the ECB/Eurosystem. The Treaty also provides for the President of the Council (de facto, the
President of the Eurogroup) to participate in the meetings of the Governing Council without a right to
vote.
The decisions of the ECOFIN Council are prepared by the Economic and Financial Committee
(EFC), which brings together senior national representatives from ﬁ nance ministries and central
banks, as well as senior ofﬁ cials from the European Commission and the ECB. The EFC plays a key
role in reviewing the economic and ﬁ nancial situation of the Member States and of the Community,
and also coordinates EU positions in international fora. The Financial Services Committee (FSC) is
involved in the preparation of ECOFIN decisions in the ﬁ eld of ﬁ nancial services and supervision.
The ECB is also a member of the Economic Policy Committee (EPC), which plays a key role in
preparing the ECOFIN Council’s deliberations in the area of structural reforms.
RELATIONS WITH THE EUROGROUP
Dialogue within the
Economic governance in the euro area relies largely on the informal discussions taking place in the
Eurogroup …
Eurogroup. This informal body, which was established through a Resolution of the Luxembourg
European Council in December 1997, brings together on a monthly basis the ﬁ nance ministers of
the euro area. Moreover, the Commissioner for Economic and Monetary Affairs and the President
of the ECB are also invited to attend.
In the Eurogroup, a frank and open exchange of views takes place among the key policy-makers of
the euro area. These discussions allow the ECB to obtain ﬁ rst-hand information and to explain its
policy decisions.
… has gained in importance
The Eurogroup has gained in importance over the last ten years. This is reﬂ ected in its agenda,
which has expanded over time. While it mainly used to focus on ﬁ scal policies, the Eurogroup now
also addresses other policy issues, such as structural reforms, developments in the competitiveness
of individual euro area countries, ﬁ nancial stability and exchange rate developments. The
Eurogroup’s informal role is now recognised in a Protocol annexed to the new Lisbon Treaty, which
sets the aim of “developing ever-closer coordination of economic policies within the euro area”.
RELATIONS WITH THE EUROPEAN COMMISSION
Close relations with the
The European Commission assumes an important role in EMU’s institutional setting. In particular,
Commission
the Commission has the right of initiative to propose Community legislation for adoption by the
European Parliament and the Council. It also plays a key role in monitoring the implementation of
decisions and agreements reached at European level. The ECB is in regular contact with the
Commission and exchanges views with Commission representatives in the context of European
meetings. Moreover, the Commissioner for Economic and Monetary Affairs may participate in the
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meetings of the Governing Council without the right to vote. Beyond these formal contacts, the
A N D W O R K I N G S
ECB has established a number of informal working contacts with the Commission services.
O F T H E E U R O A R E A
2.3 ENLARGEMENT PROCESSES
EU ENLARGEMENT
The ﬁ rst ten years of the euro coincided with an unprecedented expansion of the European Union.
Recent sizeable enlargement
of EU
Ten new countries joined the Union on 1 May 2004 and a further two followed on 1 January 2007.
This enlargement was in many respects the largest and most comprehensive in the history of the
European Union. The total number of Member States increased from 15 to 27 and the total
population went up by around 100 million to reach almost 500 million. At the same time, the
economic impact of this growth has all in all been relatively muted. Total GDP increased by less
than 10%, as per capita incomes of most new members were, at the time of accession, signiﬁ cantly
lower than the EU average.
Enlargement is expected to continue in the years to come, although at a slower pace. Three countries
have been granted candidate status: Turkey in 1999, Croatia in 2004 and the Former Yugoslav
Republic of Macedonia in 2005. All other western Balkan countries are potential candidate countries
and therefore have the prospect of eventual EU membership.
Given that all new Member States are expected to adopt the euro at some time, the Eurosystem has
paid close attention to the EU’s expansion and continues to do so. The General Council of the ECB
regularly reviews economic, ﬁ nancial and monetary developments in the candidate and potential
candidate countries. The Eurosystem has also established a close dialogue with central banks of
countries that are preparing to join the EU. In particular, before previous rounds of accession, the
Eurosystem organised together with national central banks a series of seminars on the EU accession
process which helped the central banks of the accession countries to integrate smoothly into the
ESCB. The ECB also has intensive contacts and exchanges of information, including through an
annual high-level policy dialogue, with the central banks of the current candidate countries.
EURO AREA ENLARGEMENT
The euro started out as the single currency of 11 Member States. Ten years later, it has become the
currency of 15 Member States. There have already been three enlargements of the euro area, with
Greece joining in 2001, Slovenia in 2007, and Cyprus and Malta in 2008. Further waves of euro
area enlargement are expected in the future.
EU countries move towards euro adoption in accordance with a well-deﬁ ned procedure consisting
Path to euro adoption …
of a number of phases.
The ﬁ rst phase runs until a Member State joins the exchange rate mechanism ERM II. In this phase,
… joining ERM II …
the monetary and exchange rate policy of the country is subject to three key Treaty requirements.
First, it is required to treat its exchange rate policies as a matter of common interest. Second, price
stability should be pursued as the primary objective of monetary policy. Third, the country has to
avoid excessive deﬁ cits (although ﬁ nancial sanctions under the excessive deﬁ cit procedure can only
apply once a country has adopted the euro).
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… staying within fluctuation
The second phase starts when a Member State joins ERM II. In this mechanism, a country’s
bands …
currency is subject to a regime of ﬁ xed, but adjustable, exchange rates, around a central parity
against the euro and within a ﬂ uctuation band that has a standard width of 15% above and below the
central rate. The mechanism is a direct successor to the original exchange rate mechanism that
existed from 1979 until the introduction of the euro on 1 January 1999. The exchange rate
mechanism plays a stabilising role, helps orient macroeconomic policies towards a sustainable path
and contributes to anchoring inﬂ ation expectations. ERM II is a market test for Member States on
their road towards euro adoption, as countries are expected to pursue stability-oriented policies in
order to foster exchange rate stability and nominal convergence. In this way, participation in ERM II
can be considered as a “training room” to qualify for euro adoption.
… fulfilling convergence
The adoption of the euro, which represents the third phase, only starts after a country has fulﬁ lled
criteria
all the so-called convergence criteria on a sustainable basis (see also section 4.4). These criteria are
laid down in the Maastricht Treaty and speciﬁ ed further in a Protocol annexed to it. They are
intended to ensure the sustainable achievement of nominal convergence in price developments,
long-term interest rates and government deﬁ cit and debt. Moreover, a Member State is expected to
have participated for a period of two years in ERM II within the normal ﬂ uctuation bands without
having experienced severe tensions. During this period, the country in question is required to bring
its national legislation (in particular, the legislation concerning the statute of the respective central
bank) fully in line with the Treaty and the Statute of the ESCB.
The decision whether a Member State has reached the necessary degree of sustainable convergence
to adopt the euro is taken by the ECOFIN Council, following a discussion by Heads of State or
Government. The decision is based on the Convergence Reports prepared by the ECB and the
European Commission, an opinion of the European Parliament and a proposal from the European
Commission. Moreover, the ECOFIN Council adopts the necessary regulations for the introduction
of the euro in a new member country, including a regulation ﬁ xing the irrevocable conversion rate
between the respective national currency and the euro.
Overall, the EU has deﬁ ned a clear-cut procedure which foresees the eventual adoption of the
euro as the endpoint of a structured convergence process within a multilateral framework. As a
consequence, unilateral ofﬁ cial euroisation would not be compatible with the Treaty.
Entry into the euro area has a number of operational implications and requires intensive technical
preparations, especially in respect of the cash changeover, the instruments needed for monetary
policy implementation and participation in euro market infrastructures for the handling of payments
and collateral transactions. The Eurosystem has also launched various information campaigns in
order to familiarise cash handlers and the general public with the visual appearance and security
features of the euro banknotes and coins (for instance, through the distribution of information leaﬂ ets
to households or the organisation of conferences and seminars for the business community). Upon
euro adoption, national central banks become members of the Eurosystem and their Governors join
the Governing Council.
2.4 CONCLUSIONS
The institutional setting introduced by the Maastricht Treaty is unique. It combines a centralised
monetary policy with decentralised ﬁ scal and structural policies. In addition to this clear allocation
of responsibilities, it provides appropriate coordination procedures which take account of the
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increased interdependence among euro area members following the introduction of the single
A N D W O R K I N G S
currency.
O F T H E E U R O A R E A
Experience from the ﬁ rst ten years of EMU suggests that this setting works well. This is also
acknowledged by the new Lisbon Treaty, which has left this set-up in substance unchanged. At
the same time, not all policy-makers have always delivered on their commitments and agreements
reached at the Community level. Therefore, if there is one lesson that may guide EMU’s second
decade, it is that all policy-makers should live up to their respective responsibilities under the EMU
setting. This will make EMU a continued success.
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3 THE ECB’S MONETARY POLICY STRATEGY
AND ITS IMPLEMENTATION
To fulﬁ l its mandate to maintain price stability for the euro area, the Governing Council has relied on
its publicly announced monetary policy strategy from the very outset of Monetary Union. All in all,
over the past ten years, the strategy has served the ECB well. Monetary policy decisions have
securely anchored longer-term inﬂ ation expectations at levels consistent with price stability. At
the same time, the ﬂ exible design of, and the broad range of instruments and procedures within,
the Eurosystem’s operational framework for the implementation of monetary policy has proved
effective and resilient, also in times of ﬁ nancial distress.
The chapter is structured as follows: Section 3.1 brieﬂ y reviews the ECB’s monetary policy
strategy. In particular, it shows how the economic and monetary analyses within the two-pillar
framework for the Governing Council’s assessment of the risks to price stability have evolved
over the past decade. Section 3.2 illustrates how the single monetary policy has been conducted
in practice and how it has managed successfully to guide inﬂ ation expectations in an environment
of constantly changing economic and ﬁ
nancial conditions and challenges. Looking into the
conduct of monetary policy in greater detail, Section 3.2 distinguishes ﬁ ve main phases, namely
the transition to Monetary Union (mid-1998 to mid-1999), monetary policy tightening to contain
inﬂ
ationary pressures (mid-1999 to end-2000), downward adjustments to key ECB interest
rates (early 2001 to mid-2003), maintaining the key ECB interest rates unchanged (mid-2003 to
end-2005) and withdrawal of monetary policy accommodation (since the end of 2005). Section 3.3
describes the operational instruments and procedures used by the ECB to implement monetary policy
decisions. Section 3.4 concludes with some lessons and ways forward.
3.1 THE ECB’S MONETARY POLICY STRATEGY
WHY PRICE STABILITY? WHAT ARE THE BENEFITS?
The Treaty on European Union (also referred to as the “Maastricht Treaty”) establishes a clear
Price stability as the
hierarchy of objectives for the Eurosystem by assigning overriding importance to price stability.
primary objective
This choice is based on both unambiguous historical evidence and economic theory. Price stability
supports higher living standards through various channels.
Price stability protects the real value of income and wealth, while unexpected inﬂ ation inevitably
Benefits of price stability
leads to unintended and arbitrary redistribution. Price stability is to the beneﬁ t of, in particular, the
most vulnerable groups in the society. These groups have a relatively higher share of their savings
invested in cash and savings accounts, the real value of which is easily eroded by inﬂ ation. Typically,
their access to ﬁ nancial markets is rather limited, leaving them with little room to evade the
“inﬂ ation tax”.1 In this respect, pensioners, who have to live on their pension entitlements and the
savings accumulated during their working life, constitute a group that is particularly vulnerable to
inﬂ ation. Price stability thus also contributes to social cohesion.
Moreover, in an environment of stable prices, it is easier for people to disentangle changes in
relative prices (i.e. movements in prices of any individual good or service) from changes in the
general price level. This means that people can fully rely on the signal and information function of
prices of any individual good or service. In such an environment, people know that any movement
of prices is related to changes in the “relative scarcity” of the individual goods and services as a
1 For a more detailed discussion, see W. Easterly and S. Fischer, “Inﬂ ation and the Poor”, World Bank Policy Research Working Paper
No 2335, 2000.
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result of changes in the supply of, and demand for, those goods and services. In this sense, price
stability makes it easier to compare prices and, therefore, to make better informed decisions on
consumption and investment. This contributes to a smooth and efﬁ cient functioning of markets.
Price stability also contributes to lower levels of both nominal and real interest rates. For instance,
inﬂ ation erodes the real value of nominal assets and, in an inﬂ ationary environment, lenders
typically require an inﬂ ation risk premium to compensate them for inﬂ ation risks associated with
their investment. By contrast, lenders do not require such a risk premium in an environment of price
stability. By reducing inﬂ ation risk premia, price stability results in lower levels of real interest
rates, thereby making more investment projects proﬁ table. In this respect, lower interest rates
contribute to higher levels of employment and economic growth.
One instrument,
Furthermore, price stability is the best – and, ultimately, the only – contribution that a credible
one objective
monetary policy can make to economic growth, job creation and social cohesion. This reﬂ ects the fact
that a policy-maker who controls only one instrument cannot meet, and be held accountable for the
fulﬁ lment of, more than one objective. The pursuit of additional objectives would risk overburdening
monetary policy, and would ultimately result in higher inﬂ ation and higher unemployment. Over the
longer term, monetary policy can only inﬂ uence the price level in the economy; it cannot exert a
lasting impact on economic activity. This general principle is referred to as the “long-run neutrality
of money”. It is against this background that the Treaty provides for a clear and efﬁ cient allocation of
responsibilities, with monetary policy being assigned the primary objective of maintaining price
stability.
Recent evidence suggests that the relationship between inﬂ ation and growth might even be negative
in the long run, with a permanent rise in inﬂ ation leading to a net loss of real income.2 This reinforces
the case for assigning central banks clear responsibility for keeping prices stable. In this way,
monetary policy not only minimises the costs of inﬂ ation, but also helps to maximise the long-run
productive potential of the economy.
ELEMENTS OF THE MONETARY POLICY STRATEGY
When the monetary policy strategy was adopted and announced by the Governing Council in
October 1998, i.e. in good time before the start of EMU, one of the key questions was whether the
strategy would be able to embrace all circumstances that the newly formed euro area might face at
inception and thereafter. It is therefore appropriate ﬁ rst to brieﬂ y review the main elements of, and
the rationale behind, the strategy.
The monetary policy strategy was developed on the basis of extensive preparatory work carried out
by the European Monetary Institute (the predecessor of the ECB). The strategy ensures a consistent
and systematic approach to the conduct of monetary policy. It consists of two main components: ﬁ rst,
a quantitative deﬁ nition of the ECB’s primary objective of price stability and, second, a two-pillar
framework as the organising principle for the analysis underlying the assessment of the outlook for
price developments. From the very beginning, the ECB’s monetary policy strategy provided a solid
basis for the conduct and communication of monetary policy. In 2003, in the context of an overall
evaluation of its strategy, the Governing Council conﬁ rmed the main elements of the strategy.
2 See the article entitled “Price stability and growth” in the May 2008 issue of the Monthly Bulletin.
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T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
THE ECB’S QUANTITATIVE DEFINITION OF PRICE STABILITY
While the Treaty clearly identiﬁ es price stability as the primary objective of monetary policy, it
Annual HICP inflation below,
does not give a precise, quantitative deﬁ nition of this objective. To provide a clear yardstick against
but close to, 2% ...
which the public can hold the ECB accountable and with a view to anchoring longer-term inﬂ ation
expectations, the Governing Council adopted a quantitative deﬁ nition of price stability in 1998,
stating that “price stability shall be deﬁ ned as a year-on-year increase in the Harmonised Index of
Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the
medium term.” In addition, following a thorough evaluation of the monetary policy strategy in
2003, the Governing Council clariﬁ ed that, within this deﬁ nition, it aims to keep HICP inﬂ ation
“below, but close to, 2%”. Such an approach is sufﬁ cient to hedge against the risks of both very low
inﬂ ation and deﬂ ation.
When adopting the quantitative deﬁ nition of price stability in 1998, the Governing Council took a
number of speciﬁ c features of the euro area into account:
•
ﬁ rst of all, an area-wide consumer price index – in this case, the HICP (see Box 1 in
Chapter 8) – is the natural choice for the ECB as a reference for price stability, as it focuses on
monetary transactions in the euro area;
• second, the deﬁ nition focuses on the euro area as a whole, reﬂ ecting the fact that, within a
monetary union, monetary policy cannot address country-speciﬁ c issues;
• third, the deﬁ nition makes clear that inﬂ ation above 2% is not consistent with price stability,
the primary objective of the ECB. However, it also implies that very low inﬂ ation rates, and
especially deﬂ ation, are not consistent with price stability either.
In addition, the deﬁ nition of price stability stresses the medium-term orientation of the ECB’s
… over the medium term
monetary policy. Since monetary policy can affect price developments only with signiﬁ cant and
variable time lags, and only to an extent that is uncertain, it is impossible for a central bank to
maintain a speciﬁ c pre-deﬁ ned inﬂ ation rate at all times or to bring it back to a desired level within
a very short period of time. Consequently, monetary policy needs to act in a forward-looking
manner and focus on the medium term. This helps to avoid excessive activism and the introduction
of unnecessary volatility into the real economy. As a result, some short-term volatility in inﬂ ation
rates is inevitable.
THE TWO PILLARS OF THE ECB’S MONETARY POLICY STRATEGY
The ECB’s overall approach to analysing and evaluating the information that is relevant for
Two-pillar framework
assessing the risks to price stability in a forward-looking manner is based on two analytical
perspectives, often referred to as the two pillars. This two-pillar structure is the organising principle
for the internal analysis underlying the ECB’s monetary policy deliberations and decisions, as well
as for its communication to the ﬁ nancial markets and general public.
The economic analysis aims to identify risks to price stability at short to medium-term horizons. To
Economic analysis
this end, it attempts to identify the economic shocks relevant to understanding price developments and
output trends over the short to medium-term horizon, notably in the context of business cycle analysis.
It scrutinises a wide range of economic activity, price and cost indicators, primarily at the aggregate
euro area level but also at sectoral and country levels. All these factors help to assess the dynamics of
real activity and the likely development of prices from the perspective of the interplay between supply
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and demand in the goods, services and factor markets at shorter horizons. A key element in the
economic analysis is the conduct of regular exercises projecting the main macroeconomic variables in
the euro area (see Box 1). To take appropriate policy decisions, the Governing Council needs to have
a comprehensive understanding of the prevailing economic situation and must be aware of the speciﬁ c
nature and magnitude of any economic disturbances threatening price stability.
Box 1
MODELLING THE EURO AREA ECONOMY
Models of the economy are an important tool used for economic analysis in many central banks.
These models are often described as “structural” because they aim to capture the key causal
determinants of economic decisions on consumption, investment, etc. The models are validated
empirically, or “estimated”, by matching their implications for some macroeconomic variables
with observed past outcomes. Once estimated, the models can be used as laboratory tools to
answer various economic questions: they can produce forecasts of future economic conditions;
they help to provide a quantitative interpretation of the impact of particular economic events –
e.g. changes in wage determination or ﬁ scal measures – on the economy as a whole; and they can
be used to assess how economic outcomes are affected by policy actions.
Since early 1999, macroeconomic models at the ECB have undergone substantial further
development. The ﬁ rst model to describe the euro area economy at the aggregate level was the
area-wide model (AWM).1 Developing the AWM posed special challenges, because of the novel
conditions created by EMU. For example, the empirical validation of the model was necessarily
based on pre-Monetary Union data, even if it was reasonable to expect that the Monetary Union
might represent a change in the structure of the euro area economy. In addition, area-wide data
were not readily available from national statistical ofﬁ ces. They had to be created through a
process of aggregating national data, which occasionally required ad hoc assumptions. In spite
of these difﬁ culties, the AWM has proved to serve well as a tool for the quantitative analysis
of euro area macroeconomic developments. Its area-wide approach has been followed in most
subsequent models constructed at the ECB.2
Over the years, the structure of the AWM has been improved in a number of directions. At
the same time, developments in the academic literature led to a more radical rethinking of the
basic requirements to be satisﬁ ed by an economic model. The prototype of a new generation
of economic models, which has subsequently proved to be useful in many central banks, was
developed at the ECB: the Smets and Wouters model of the euro area.3 This model is characterised
by many innovative features. For example, it provides ﬁ rm and household-level explanations
(or “micro-foundations”) for observed aggregate outcomes, such as the sluggish adjustment
of prices to exogenous developments. Households’ and ﬁ rms’ decisions are allowed to react
to changes in the future economic outlook, rather than only to past developments. Finally, the
model is estimated, taking all relevant information jointly into account, and is therefore able to
compete with purely statistical tools in terms of short-term forecasting.
1 See G. Fagan, J. Henry and R. Mestre, “An area-wide model (AWM) for the euro area”, Economic Modelling 22, 2005, pp. 39-59.
2 Alongside the AWM, a multi-country model (MCM) was also developed early on at the ECB, in cooperation with the NCBs. The
structure of the MCM is very similar to that of the AWM, but economic relationships are estimated at the national, rather than at the
area-wide, level. The model can thus provide an important robustness check for AWM-based results.
3 See F. Smets and R. Wouters, “An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area”, Journal of the
European Economic Association 1, 2003, pp. 1123-1175.
ECB
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10th Anniversary of the ECB

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P O L I C Y S T R A T E G Y
A N D I T S
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More recently, the structure of the Smets and Wouters model has been extended further in the
Christiano, Motto and Rostagno model, which devotes special attention to the role of monetary and
ﬁ nancial variables in the structure of the economy.4 This model includes an explicit banking sector
that provides intermediation services between borrowers and lenders, and generates a nontrivial
role for monetary aggregates in the economy. It also allows for an endogenous pass-through of the
policy interest rate to the loan rates charged to ﬁ rms, which incorporate a premium to compensate
banks for the borrowers’ risk of default.
Finally, a new, micro-founded version of the AWM, or a new AWM (NAWM), has been
developed to replace the AWM as the main tool underlying the macroeconomic projection
exercises.5 Compared with previously mentioned models, the NAWM includes open-economy
features to allow for the conditioning of the projections on assumptions regarding, inter alia,
external developments. The NAWM is particularly suited for conducting scenario analysis and
assessing forecast uncertainty. The version of the NAWM used in the projections is complemented
by a more detailed, but calibrated version for addressing a broader range of policy questions.
Mathematical models of the economy have played an important supporting role in the quantitative
assessment of current economic and monetary conditions in the euro area. Nevertheless, all these
models remain highly stylised along some dimensions. A more satisfactory treatment of ﬁ scal
policy and a richer labour market structure are some of the avenues along which existing models
are being extended. In any case, policy simulations in structural models can only represent one
of the many elements taken into account by the Governing Council in its overall assessment of
the outlook for price developments in the euro area.
4 See L. Christiano, R. Motto and M. Rostagno, “The Great Depression and the Friedman-Schwartz Hypothesis,” Journal of Money,
Credit and Banking 35(6), December 2003, and L. Christiano., R. Motto and M. Rostagno, “Shocks, Structures or Policies? The EA
and the US after 2001”, Journal of Economic Dynamics and Control, forthcoming.
5 See K. Christoffel, G. Coenen and A. Warne, “The New Area-Wide Model of the Euro Area: Speciﬁ cation, Estimation Results and
Properties”, mimeo, June 2007, and G. Coenen, P. McAdam and R. Straub, “Tax Reform and Labour-Market Performance in the Euro
Area: A Simulation-Based Analysis Using the New Area-Wide Model”, Journal of Economic Dynamics and Control, forthcoming.
The monetary analysis aims at identifying risks to price stability at medium to longer horizons. In this
Monetary analysis …
context, monetary and credit developments, and their determinants, play a distinct role, given that
monetary growth and inﬂ ation are closely related over the longer term (see Chart 1). This reﬂ ects the
fundamental economic principle that, over the longer term, inﬂ ation is a monetary phenomenon. In
particular, assigning a prominent role to money safeguards the medium-term orientation of the ECB’s
monetary policy. The chart demonstrates the close coherence between the low-frequency components
of inﬂ ation and monetary growth, with monetary dynamics leading (and thus potentially helping to
predict) developments in inﬂ ation.
In fact, monetary analysis draws on a broad set of monetary, ﬁ nancial and economic information
… draws on a broad set of
using a wide range of complementary tools and techniques, which – along with the use of informed
information …
judgement – enables the real-time identiﬁ cation of the underlying trend in monetary developments
and the assessment of its implications for the risks to price stability. In order to signal its commitment
to monetary analysis in the context of its strategy and to provide a benchmark for the assessment of
monetary developments, the ECB announced a reference value of 4½% for the annual growth rate
of the broad monetary aggregate M3 in December 1998.3 A protracted monetary expansion above
3 This aggregate comprises currency in circulation, overnight deposits, deposits with an agreed maturity of up to and including two years
and deposits redeemable at notice of up to and including three months plus repurchase agreements, money market fund shares and units,
as well as debt securities with a maturity of up to and including two years.
ECB
Monthly Bulletin
10th Anniversary of the ECB
37

this benchmark points to upside risks to price
Chart 1 Relationship between the HICP and
stability. The choice of M3 was based on the
M3 in the euro area
evidence that this monetary aggregate exhibits a
close relationship with the price level. At the
(annual rates of growth, low-frequency component reﬂ ects
periodicity > 10 years)
same time, it was made clear from the very
HICP low-frequency component
beginning that monetary policy would not react
HICP
mechanically to deviations of M3 growth from
M3 corrected for the estimated impact of portfolio shifts
M3 low-frequency component
the reference value.
16
16
14
14
… and has evolved over
However, it is important to note that the tools
12
time
12
used for the identiﬁ cation of risks to price
10
10
stability have evolved and improved over time,
8
8
in the light of the challenges posed to monetary
6
6
analysis by various developments, notably the
4
4
rapid pace of ﬁ nancial innovation. Confronted
2
2
with the unrelenting need to improve its
0
0
analytical tools for identifying risks to price
1971
1977
1983
1989
1995
2001
2007
stability, the Governing Council decided in 2007
Notes: Low-frequency components derived from a symmetric
to further enhance its monetary analysis along
ﬁ xed-length Christiano-Fitzgerald band-pass ﬁ lter applied to the
annualised quarter-on-quarter rates of growth.
four avenues:
The peak of money growth leads inﬂ ation by eight to twelve
quarters.
•
First, money demand models are being
reﬁ ned and extended in order to improve the understanding of the behaviour of monetary
aggregates over time and across sectors.
•
Second, the robustness of money-based inﬂ ation risk indicators is being improved so as
to develop further their use as a guide to policy decisions aimed at the maintenance of price
stability.
• Third, structural models that embody an active role for money and credit in the determination
of inﬂ ation dynamics are being developed and reﬁ ned in support of the assessment of monetary
developments.
• Finally, it is important to deepen further the analytical framework to support the cross-checking
of information and analysis stemming from the monetary and economic analyses.
Cross-checking
Overall, the two-pillar framework enhances the robustness of the Governing Council’s monetary
ensures consistency
policy assessment with respect to both data and model uncertainty. In particular, all complementarities
between the two pillars are exploited. This is the best way to ensure that all the relevant information
for assessing risks to price stability is used in a consistent and efﬁ cient manner. The regular cross-
checking of the outcome of the economic analysis with that of the monetary analysis ensures that a
consistent overall assessment is provided, where information pertaining to both shorter and longer-
term horizons is taken into account. Thus, it reduces the risk of policy errors caused by an over-
reliance on a single indicator, forecast or model. Chart 2 summarises the key elements of the two-
pillar approach and its role in policy-making.
Innovative and robust
After almost ten years of practical experience, the ECB’s strategy has provided a reliable and robust
approach
framework for assessing risks to price stability and for effectively communicating the orientation of
ECB
38 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
Chart 2 The two pillars of the ECB’s monetary policy strategy
Primary objective of price stability
Governing Council takes
monetary policy decisions
based on its overall assessment
of the risks to price stability
Economic
Monetary
analysis
analysis
Analysis of
cross-
Analysis of
economic shocks
checking
monetary trends
and dynamics
Full set of information
monetary policy to ﬁ nancial markets and the public. A clear sign of the appropriateness of the
ECB’s monetary policy strategy is the fact that there has been no need to modify its key elements.
In recent years, a number of elements of the ECB’s strategy have been included in the monetary
policy frameworks of other central banks. Orientation to the medium term has become increasingly
popular among inﬂ ation-targeting central banks, which have increasingly recognised the need for a
more ﬂ exible policy horizon.
Similarly, the all-encompassing nature of the two-pillar framework is gaining attractiveness, because
of its ability to integrate all relevant model-based, conjunctural and judgmental information into a
single framework. Moreover, its explicit monetary pillar guarantees that the ECB’s monetary policy
is oriented to the medium term. It also ensures that the ECB develops its expertise in monetary and
credit matters further. The close link between monetary developments and evolving imbalances in
credit and asset markets implies that monetary analysis makes it possible to detect such imbalances
at an early stage and to respond to the implied risk to price stability in a timely and forward-looking
manner. In this respect, monetary analysis has proven to be a particularly valuable asset in times of
ﬁ nancial market stress.
ECB
Monthly Bulletin
10th Anniversary of the ECB
39

3.2 THE CONDUCT OF MONETARY POLICY IN THE EURO AREA AND ITS PERFORMANCE IN TERMS OF
PRICE STABILITY4
This section reviews the track record of the single monetary policy since its inception in
January 1999. To help present the stance of the single monetary policy (see Chart 3) in the context
of changing circumstances and challenges, it is useful to distinguish ﬁ ve phases.
THE CONDUCT OF MONETARY POLICY
PHASE 1 – THE TRANSITION TO MONETARY UNION (MID-1998 TO MID-1999)
Favourable price
The Eurosystem acquired responsibility for the single monetary policy at a time when inﬂ ation rates
and uncertain growth
in the euro area were rather low and the outlook for price developments was favourable
prospects …
(see Chart 4). At the same time, economic activity continued to expand in an environment of very
low interest rates (see Charts 5 and 6), with the conditions for sustained growth remaining in place.
However, during 1998, the ripples of the ﬁ nancial crises in Asia in 1997 and Russia in August 1998,
together with the near collapse of the LTCM hedge fund in September 1998, caused high volatility
in ﬁ nancial markets and considerable swings in investor conﬁ dence. Following these long-lasting
tensions in ﬁ nancial markets, the prospects for economic growth in the euro area became clouded by
a very high level of uncertainty, leading not only to some downward revisions to expectations of
growth for 1998 as a whole, but also to lower projections for growth in 1999.
… led to monetary easing
In the course of 1998, the focus of monetary policy in the euro area countries gradually shifted from
on the eve of EMU
a national to an area-wide perspective. Against the background of a favourable outlook for price
stability, the convergence process took place through gradual reductions of ofﬁ cial interest rates
towards the lowest levels prevailing in the soon-to-be euro area. This convergence process
accelerated in the last few months of 1998. It culminated on 3 December 1998 when all the NCBs
in the euro area lowered their key central bank interest rates to 3% in a coordinated move (with the
4 All data references regarding real GDP growth and HICP inﬂ ation reﬂ ect revised data, as available on the cut-off date of this report
(31 March 2008). The use of updated revised data, rather than real-time data available at the time monetary policy decisions were taken,
does not change the line of reasoning underlying the monetary policy deliberations and decisions presented in this section.
Chart 3 Key ECB interest rates since January 1999
Chart 4 HICP in the euro area
(percentages per annum)
(annual percentage changes)
minimum bid rate of the main refinancing operations
HICP
deposit rate
HICP excluding unprocessed food and energy
marginal lending rate
6.0
6.0
4.0
4.0
5.0
5.0
3.5
3.5
3.0
3.0
4.0
4.0
2.5
2.5
3.0
3.0
2.0
2.0
2.0
2.0
1.5
1.5
1.0
1.0
1.0
1.0
0.0
0.0
0.5
0.5
1999
2001
2003
2005
2007
1996
1998
2000
2002
2004
2006
Source: ECB.
Source: Eurostat.
Note: The rate for the main reﬁ nancing operation refers, for
operations settled before 28 June 2000, to the rate applicable to
ﬁ xed rate tenders. For operations settled after that date, the rate is
the minimum bid rate applicable to variable rate tenders.
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Chart 5 Real euro area GDP
Chart 6 Nominal short and long-term
interest rates in the euro area
(percentage changes)
(percentages per annum)
quarter-on-quarter percentage changes (right-hand scale)
short-term interest rates
annual percentage changes (left-hand scale)
long-term interest rates
5.0
1.5
17
17
15
Monetary Union
15
4.0
1.2
13
13
11
11
3.0
0.9
9
9
2.0
0.6
7
7
5
5
1.0
0.3
3
3
1
1
0.0
0.0
1980
1984
1988
1992
1996
2000
2004
1996
1998
2000
2002
2004
2006
Source: Eurostat and ECB calculations.
Sources: NCBs, Global Financial data, BIS, Reuters and ECB.
exception of the Banca d’Italia, which reduced its discount rate to 3.5%). This coordinated move on
interest rates was to be seen as a de facto decision about the level of interest rates with which the
Eurosystem would start Stage Three of EMU – as such, it was the de facto start of Monetary Union
in Europe.
In early 1999 the Governing Council was faced with some conﬂ icting signals from its economic
With risks to price stability
and monetary analyses. On the one hand, it became increasingly clear that, on balance, the risks to
on the downside …
price stability over the medium term were mainly on the downside. Inﬂ ation rates were very low by
historical standards and signiﬁ cantly below the ceiling of the ECB’s deﬁ nition of price stability
amidst emerging signs of a strong economic slowdown. On the other hand, after a protracted decline
to levels below USD 10 per barrel at the turn of 1998/99, oil prices started rising again as from mid-
Chart 7 Brent crude oil prices
Chart 8 Euro nominal and real effective
exchange rate
(US dollars per barrel)
(monthly data; index calculated against the currencies of 22
main trading partners; 1999=100)
nominal
real (CPI deflated)
100
100
115
115
110
110
80
80
105
105
60
60
100
100
40
40
95
95
90
90
20
20
85
85
0
0
80
80
1996
1998
2000
2002
2004
2006
1993
1995
1997
1999
2001
2003
2005
2007
Sources: IMF and ECB.
Source: ECB.
Note: The weights used for aggregating the pre-1999
“theoretical” euro exchange rates are based on the share of each
euro area country in total manufacturing trade of the euro area
vis-à-vis non-euro area countries (see Appendix II.6 in ECB
Occasional Paper No 2, 2002).
ECB
Monthly Bulletin
10th Anniversary of the ECB
41

February 1999 (see Chart 7). Moreover, in the
Chart 9 M3 and loans to the private sector
ﬁ rst few months of 1999, the euro depreciated in
effective terms (see Chart 8). Both factors had
the potential to exert upward pressure on prices.
(annual growth rates)
M3
loans to the private sector
The growth rate of M3 rose from levels close
14
14
to the reference value – to levels well above
5%, while loans to the private sector continued
12
12
to grow rapidly at around 10% (see Chart 9).
10
10
However, given the relatively modest deviation
8
8
from the reference value and the uncertainties
surrounding the analysis of monetary 6
6
developments at that time (associated with the
4
4
statistical changes necessitated by the transition
2
2
to Monetary Union), higher headline M3 growth
1996
1998
2000
2002
2004
2006
was not necessarily seen as reﬂ ective of the
Source: ECB.
underlying rate of monetary expansion. As a
result, the Governing Council did not interpret
the signals coming from the monetary analysis as implying upward risks to price stability over
medium to longer horizons.
… key ECB rates were
On the basis of this overall picture, the Governing Council reduced the ﬁ xed rate in the Eurosystem’s
lowered in April 1999
main reﬁ nancing operations by 50 basis points on 8 April 1999, from 3.0% to 2.5%. Lowering the
key ECB interest rates was seen as a precautionary measure to preserve price stability over the
medium term and thereby to better exploit the growth potential of the euro area economy.
PHASE 2 – RAISING RATES TO CONTAIN INFLATIONARY PRESSURES (MID-1999 TO END-2000)
Increasing price pressures ...
Over this period, sharp increases in oil prices and a general rise in import prices continued to exert
upward pressure on prices in the short term. By the end of 2000, oil and import prices had risen to
levels not seen since the beginning of the 1990s. As these increases were larger and lasted longer
than previously foreseen, the risks of indirect and second-round effects on consumer price inﬂ ation
via wage-setting rose signiﬁ cantly in the context of robust economic growth. These concerns were
compounded by the development of the euro exchange rate. Its trend depreciation continued over
this period, gaining momentum in, especially, the second half of 2000 when it moved further out of
line with the sound fundamentals of the euro area. As a result, the balance of risks to price stability
over the medium term was shifted upwards.
… in an environment of
Economic activity in the euro area expanded very rapidly in early 2000 and was set to continue
rapid economic growth …
along this path amidst favourable external conditions. It was the strong dynamism of the world
economy in the ﬁ rst half of 2000, in particular, that generated optimism in investor sentiment,
especially in the sectors of the “new economy”. This positive sentiment was reﬂ ected in soaring
stock market indices across major economies, including the euro area, with a peak in the ﬁ rst half of
2000.
… and protracted monetary
As regards the monetary analysis, a protracted monetary expansion above the reference value
expansion …
was increasingly pointing to upside risks to price stability at medium to longer-term horizons
over the course of 1999 and in early 2000. Notwithstanding a gradual slowdown during the
summer of 2000, available data continued to conﬁ rm risks of upward inﬂ ationary pressures in an
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environment of still robust economic growth. Overall, with the exception of the ﬁ rst few months
of 1999, this signal was broadly consistent with that derived from the economic analysis.
Against this background of increasing inﬂ ationary pressures, it became clear that the downside
… led to higher ECB rates
risks to price stability identiﬁ ed at the time of the reduction of the key ECB interest rates in April
between November 1999
and October 2000
1999 no longer prevailed. With the ECB’s economic and monetary analyses both pointing to upside
risks to price stability, the Governing Council raised the key ECB interest rates by a total of
225 basis points in a series of interest rate hikes between November 1999 and October 2000,
bringing the minimum bid rate in the Eurosystem’s main reﬁ nancing operations to a level of 4.75%
in October 2000.
PHASE 3 – DOWNWARD ADJUSTMENTS TO KEY ECB INTEREST RATES (EARLY 2001 TO MID-2003)
In the course of this period, the Governing Council lowered the key ECB interest rates by a total of
Key ECB rates reduced to
275 basis points, with the minimum bid rate in the main reﬁ nancing operations of the Eurosystem
historically low levels
reaching a historically low level of 2% in June 2003. This is the lowest level of interest rates seen in
Europe since the Second World War. The decisions to adjust policy rates downwards were in line
with the aim of keeping HICP inﬂ ation rates below, but close to, 2% over the medium term. By
following a policy of lowering interest rates, the Governing Council responded to a continued
decline in inﬂ ationary pressures, which had been triggered by deteriorating prospects for economic
growth in the wake of severe shocks that hit the world economy and global ﬁ nancial markets. Most
prominently, the terrorist attacks in the United States on 11 September 2001 increased the degree of
economic uncertainty and undermined conﬁ dence. This had the potential not only to reinforce the
already prevailing downward trend in economic activity, but also to disrupt the functioning of
ﬁ nancial markets.5
As regards price developments, annual HICP inﬂ ation rose further in 2000 and the ﬁ rst half of
2001, despite a marked fall in oil prices and a signiﬁ cant appreciation of the euro exchange rate
against all major currencies. The appreciation of the euro took place after concerted central bank
interventions in the foreign exchange market in September and November 2000. The annual rate
of HICP inﬂ ation, which had stood at 2.0% in January 2001, rose to a peak of 3.1% in May 2001.
This increase was mainly due to substantial rises in energy and unprocessed food prices related to
the outbreak of animal diseases in a number of euro area countries. These prices increases implied
upward risks to price stability over the medium term. This was also reﬂ ected in the Eurosystem/
ECB staff macroeconomic projections for HICP inﬂ ation, which were revised signiﬁ cantly upwards
at the time.
However, the concerns about second-round effects gradually dissipated over time as the outlook for
Price pressures receded ...
the euro area economy continued to deteriorate, thereby pointing to some moderation in inﬂ ationary
pressure from domestic demand and lower risks for price stability from wages. In fact, towards the
end of 2001, short-term pressures abated and annual HICP inﬂ ation declined. Overall, average
annual HICP inﬂ ation stood at 2.3% and 2.2% in 2001 and 2002 respectively, compared with 2.1%
in 2000. This picture remained broadly unchanged in the ﬁ rst half of 2003 when HICP inﬂ ation
remained above 2%. However, the subdued pace of economic activity and the signiﬁ cant
appreciation of the euro since spring 2002 were expected to dampen inﬂ ationary pressures. In fact,
there were reasons in June 2003 to expect that annual HICP inﬂ ation would reach levels comfortably
5 Against this background, the Governing Council decided on 17 September 2001 to reduce the key ECB interest rates by 50 basis points.
This decision was taken in concert with an equivalent decision by the Federal Open Market Committee of the US Federal Reserve System,
in order to promptly respond to exceptional circumstances in view of this shock.
ECB
Monthly Bulletin
10th Anniversary of the ECB
43

below 2% over the medium term. This overall picture was also reﬂ ected in the June 2003 Eurosystem
staff macroeconomic projections and in the forecasts of other international institutions produced in
the second quarter of 2003.
… in response to
Following some ﬁ rst indications since the end 2000 that the impact of the rise in oil prices might
decelerating growth …
have contributed to an economic slowdown in the euro area, economic activity there moderated in
the course of 2001. In the aftermath of the terrorist attacks of 11 September, it became increasingly
clear that the economic slowdown in the euro area would be more protracted than previously
expected. External demand was expected to decline further and the high levels of uncertainty
generated by the terrorist attacks were considered likely to delay the recovery in domestic demand.
However, while the beginning of 2002 saw a moderate economic recovery in the euro area, the
recovery lost momentum in the course of the year. Renewed turbulence in the ﬁ nancial markets
over the summer and heightened geopolitical tensions in the second half of the year, with adverse
effects on oil prices and conﬁ dence, were the main drivers behind this development.
Overall, economic growth in the euro area was rather weak in 2002, with annual real GDP rising
by only 0.9%, compared with 1.9% in 2001, thus remaining below potential in both 2001 and 2002.
This performance did not change fundamentally in 2003, with real GDP growth in the ﬁ rst half of
the year stagnating in the wake of both the escalation of geopolitical tensions related to the situation
in Iraq and the uncertainty prevailing in ﬁ nancial markets. Against this background, the risks to the
growth outlook remained on the downside.
… while demand for liquid
Looking at the monetary analysis, annual M3 growth, after a certain moderation in 2000 and early
assets rose at a time of high
2001, accelerated strongly from mid-2001 onwards. However, this increase was not interpreted as
uncertainty
implying risks to price stability at medium to longer horizons for several reasons. First, part of the
rise in M3 growth reﬂ ected the greater need of economic agents for transaction balances in order to
adjust to previous rises in energy and food prices. Second, the relatively ﬂ at yield curve prevailing
at that time and the associated low opportunity cost of holding money enhanced the attractiveness
of holding short-term monetary assets relative to riskier long-term instruments. Finally, and more
fundamentally, the uncertainties surrounding the interpretation of monetary developments were
compounded by the incidence of sizeable shifts in private investors’ portfolios from shares and
other longer-term ﬁ nancial assets towards safe and more liquid monetary assets included in M3.
These portfolio shifts were seen as a response by investors to the persistent uncertainties in the
aftermath of the global stock market correction observed from spring 2000 onwards and the terrorist
attacks of 11 September 2001, supporting precautionary savings. The magnitude and causes of these
portfolio shifts were unprecedented and, as such, associated with an unusually high degree of
uncertainty with regard to their interpretation.
Overall, the portfolio shifts were judged by the Governing Council to be a temporary, albeit
potentially prolonged, phenomenon that would tend to unwind once economic, ﬁ nancial and
geopolitical conditions normalised. This assessment was supported by the fact that annual growth
of loans to the private sector continued to decline, especially to non-ﬁ nancial corporations, in a
context of rather subdued economic activity. Thus, the policy-relevant signal from the monetary
analysis in this phase was rather nuanced. On the one hand, taking portfolio shifts into account, the
strong M3 growth was not seen as implying inﬂ ationary pressures at medium to longer horizons.
On the other hand, growth in M3 corrected for the estimated impact of portfolio shifts remained
rather sustained, thereby implying upside risks to the interpretation of monetary dynamics, and thus
the outlook for price developments over the medium to longer term. This message was particularly
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important in 2002 and 2003, a time when the emergence of deﬂ ationary risks for the euro area were
being discussed in public.6
PHASE 4 – NO CHANGES TO KEY ECB INTEREST RATES (MID-2003 TO END-2005)
As from June 2003, the Governing Council kept interest rates steady for two and a half years, with
Key ECB rates unchanged for
the minimum bid rate on the main reﬁ nancing operations remaining at the historically low level of
2½ years
2.0%.
On the price side, in the second half of 2003, HICP inﬂ ation did not fall as swiftly and strongly as
Domestic price pressures
previously expected, largely due to adverse food price developments and higher than expected oil
contained
prices – although the latter were attenuated by the appreciation of the euro. In addition, increases in
indirect taxes and administered prices in late 2003 and early 2004 affected inﬂ ation rates adversely.
Despite large increases in commodity and energy prices and against the background of recovering
but still relatively moderate economic growth, underlying domestic inﬂ ationary pressures remained
contained throughout 2004 and most of 2005. In particular, wage developments moderated over
this period. Nonetheless, headline inﬂ ation remained somewhat elevated in 2005, mainly on account
of high increases in energy prices and, to a lesser extent, rises in administered prices and indirect
taxes. Overall, annual HICP inﬂ ation stood at 2.2% in 2005, slightly higher than the rate of 2.1%
observed in the two preceding years. As 2005 progressed, the economic analysis suggested that
upside risks were increasing, especially with respect to potential second-round effects in wage and
price-setting that stemmed from higher oil prices.
Where economic activity was concerned, the overall picture brightened during the second half of
Economic recovery
2003 when euro area exports increased signiﬁ cantly as a result of the renewed dynamism of the
underway
world economy. While domestic demand remained weak in the second half of 2003, the conditions
for its recovery were seen to be in place, not least in view of the given low level of interest rates and
the generally favourable ﬁ nancing conditions. Furthermore, ongoing adjustment in the corporate
sector aimed at enhancing productivity and proﬁ tability supported the expectation that business
investment would gradually recover. Overall, all available forecasts and projections produced in the
second half of 2003, including the Eurosystem staff macroeconomic projections published in
December, pointed to a continued strengthening of real GDP growth in 2004 and 2005.
In fact, the recovery in economic activity in the euro area, which started in the second half of 2003,
continued in 2004 and 2005. Real GDP grew, on average, by 0.5%, quarter on quarter, in the ﬁ rst
half of 2004, the highest rate recorded since the ﬁ rst half of 2000. It moderated somewhat in the
second half of 2004 and the ﬁ rst half of 2005. This moderation was partly on account of rising
oil prices, a temporary deceleration in world economic growth and the lagged effects of the past
appreciation of the euro. However, the conditions for a strengthening of economic activity were
seen to have remained in place, despite some downside risks to growth related to low consumer
conﬁ dence, high and volatile oil prices and global imbalances. On the external side, the growth of
the world economy remained strong, thereby supporting euro area exports. On the domestic side,
very favourable ﬁ nancing conditions, robust corporate earnings and business restructuring provided
a positive environment for investment. Private consumption growth was expected to beneﬁ t from
an anticipated increase in real disposable income in the context of stronger growth in employment
and lower inﬂ ation. In fact, in the second half of 2005, the expansion of economic activity in the
euro area regained momentum.
6 In this context, it is important to note that the portfolio shifts observed during this period can also be interpreted as a sign of trust in the
soundness of the European banking sector, thereby dispelling concerns regarding to the possible emergence of debt deﬂ ation in the euro
area.
ECB
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Monetary dynamics
Turning to the monetary analysis, ﬁ nancial and economic uncertainty began to recede and portfolio
moderated in 2003 and
allocation started to normalise, mainly in response to developments in Iraq up to mid-2003. As a
early 2004 …
consequence, annual M3 growth moderated substantially between mid-2003 and mid-2004 as past
portfolio shifts into monetary assets unwound. However, consistent with a symmetric interpretation
of the impact of portfolio shifts on the policy-relevant signal in monetary developments, this fall in
headline M3 growth was not interpreted as implying less inﬂ ationary pressures at medium to longer
horizons. Rather, it was seen as providing evidence from the monetary side, conﬁ rming the view that
the levels of uncertainty and risk aversion were gradually returning to historical norms. In fact, the
M3 series corrected for the estimated impact of portfolio shifts continued to grow at a sustained and
slightly increasing rate through this period, supporting the impression that the underlying rate of
monetary expansion was not being reﬂ ected in the substantially lower rate of headline M3 growth. In
addition, the annual rate of growth of loans to the private sector increased in the second half of 2003.
… before gaining
In the course of 2004, monetary analysis provided evidence of a further unwinding of portfolio
momentum from mid-2004
shifts, albeit at a slower pace than could have been expected on the basis of historical patterns for
onwards
the elimination of accumulated liquidity holdings. Nevertheless, headline annual M3 growth
increased from mid-2004 onwards. In 2005 monetary dynamics gained further momentum and were
assessed as implying increasing upside risks to price stability at medium to longer horizons. In
particular, the robust credit and monetary expansion since mid-2004 reﬂ ected the stimulative effect
of the then prevailing very low level of interest rates in the euro area and, later on, renewed
dynamism of the euro area economy, rather than the portfolio shifts between 2001 and 2003. Strong
monetary growth contributed further to the already ample liquidity in the euro area, thereby
indicating growing upside risks to price stability over the medium to longer term.
PHASE 5 – WITHDRAWAL OF MONETARY POLICY ACCOMMODATION (SINCE END-2005)
Withdrawal of monetary
Since the end of 2005, the Governing Council has raised the key ECB interest rates by a total of
accommodation
200 basis points, bringing the minimum bid rate in the main reﬁ nancing operations of the Eurosystem
to a level of 4% by the end of June 2007. This adjustment of the accommodative monetary policy
stance was warranted in order to address risks to price stability, as identiﬁ ed by both the economic
and the monetary analyses. However, it is important to note that, in December 2005, when the
Governing Council started to gradually increase the key ECB interest rates, the monetary analysis
played a signiﬁ cant role. At the time, it clearly pointed to upside risks to price stability at medium to
longer horizons, whereas the indicators and signals from the economic analysis were rather mixed.
Overall, the gradual withdrawal of monetary accommodation took place against the background of
sound economic growth and continued vigorous money and credit expansion in the euro area.
As regards prices, average annual HICP inﬂ ation was 2.2% in 2006 and 2.1% in 2007, mainly driven
by domestic demand. In both years, the headline inﬂ ation rate ﬂ uctuated signiﬁ cantly, largely on
account of developments in oil prices. In 2006 it followed an increasing trend until August, mainly
as a result of substantial increases in energy prices, while the annual inﬂ ation rate fell below 2% in
the remaining months of the year, largely as a consequence of signiﬁ cantly declining oil prices and
base effects. Until the third quarter of 2007, annual inﬂ ation rates developed in line with the ECB’s
deﬁ nition of price stability, partly because of favourable base effects stemming from energy price
developments a year earlier.
Inflation accelerated ...
Towards the end of 2007 and in early 2008, by contrast, annual inﬂ ation rose sharply. It reached levels
signiﬁ cantly above 2%, driven largely by substantial increases in international oil and food prices in
the second half of 2007. In particular, strong short-term upward pressure on prices has increased since
the fourth quarter of 2007. Notwithstanding these price shocks, wage developments remained rather
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moderate and medium to longer-term inﬂ ation expectations stayed anchored at levels consistent with
price stability throughout this phase, despite the favourable economic environment and tightening
labour markets. While this helped to dampen inﬂ ationary pressures, the risks to price stability over the
medium term remained clearly on the upside. These risks included: the scope for additional rises in
prices of oil and agricultural products (in particular in late 2006 and in 2007); further increases in
administered prices and indirect taxes, over and beyond those foreseen thus far; and the possibility of
increases in ﬁ rms’ pricing power, particularly in sectors sheltered from competition. More
fundamentally, the possible emergence of stronger than expected wage dynamics and, in particular, of
second-round effects in wage and price-setting as a consequence of higher commodity prices and
elevated headline inﬂ ation rates posed substantial upside risks to price stability.
Economic expansion gained momentum in the ﬁ rst half of 2006 and became gradually more broadly
… while economic growth
based and increasingly self-sustaining, with domestic demand as the main driver. Overall,
remained sustained and ...
notwithstanding the impact of high and volatile oil prices, real GDP rose by 2.8% in 2006, compared
with 1.6% in 2005 and 2.1% in 2004. In 2007, economic activity continued to expand at solid rates.
Real GDP grew by 2.7%, driven mainly by domestic demand. Investment remained dynamic,
supported by favourable ﬁ nancing conditions, strong corporate earnings and continued gains in
business efﬁ ciency on account of restructuring made in the corporate sector over an extended period
of time. However, in the second half of 2007, the outlook for economic activity was clouded by
unusually high uncertainty. This uncertainty stemmed from the difﬁ culty of ascertaining the
potential impact on the real economy of the ﬁ nancial turmoil that erupted in August. Nevertheless,
the economic fundamentals of the euro area remained sound, with corporate proﬁ tability sustained,
employment growth robust and the unemployment rate declining to 7.4%, a level not seen for
25 years. The balance of risks to the growth outlook tilted to the downside.
A cross-check with the monetary analysis conﬁ rmed that upside risks to price stability prevailed at
... monetary expansion very
medium to longer horizons. Money and credit expansion remained very vigorous throughout this
vigorous
phase, supported by a persistently strong growth of bank loans to the private sector. Viewed from a
medium-term perspective, the marked dynamism of monetary and credit growth reﬂ ected a
continuation of the persistent upward trend in the underlying rate of monetary expansion observed
since mid-2004. As such, it added further to the accumulation of liquidity which, in an environment
of continued strong monetary and credit growth, pointed to upside risks to price stability over the
medium to longer term. The Governing Council therefore continued to pay particular attention to
monetary developments, also with a view to better understanding the shorter-term response of
ﬁ nancial institutions, households and ﬁ rms to the ﬁ nancial market turmoil in the second half of
2007. Thus far, there has been little evidence that the ﬁ nancial market turmoil has strongly
inﬂ uenced the overall dynamics of money and credit expansion.
THE PERFORMANCE OF THE ECB’S MONETARY POLICY IN TERMS OF PRICE STABILITY
Over now almost a full decade, the euro has been established as a stable currency, appreciated not
The euro – a stable currency
only by the now 320 million fellow citizens in the euro area countries, but also widely accepted and
used in international ﬁ nancial markets (see Chapter 5). With an average annual HICP inﬂ ation rate of
slightly above 2% since the introduction of the euro, prices have been relatively stable, signiﬁ cantly
below the average annual inﬂ ation rates that had prevailed in most of the countries participating in the
euro area in the decades preceding the start of Monetary Union (see Chapter 4). In the same vein,
inﬂ ation volatility has been signiﬁ cantly lower within the euro area than was the case in previous
periods.
ECB
Monthly Bulletin
10th Anniversary of the ECB
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Sustained anchoring of
Moreover, the ECB has been successful in
Chart 10 Expectations of long-term inflation
inflation expectations ...
anchoring longer-term inﬂ ation expectations in
line with its deﬁ nition of price stability (see
Chart 10). This is reﬂ ected in measures of
ten-year break-even inflation rate 1)
inﬂ ation expectations derived from inﬂ ation-
upper bound of the ECB’s definition of price stability
linked bonds and from surveys (Consensus
Consensus Economics forecast six to ten years ahead
ECB Survey of Professional Forecasters five years ahead
Economics Forecasts and ECB Survey of 2.5
2.5
Professional Forecasters). The secure anchoring
of private inﬂ
ation expectations at longer 2.0
2.0
horizons reﬂ ects favourably on the smooth
1.5
1.5
functioning of the ECB’s monetary policy and
its ability to credibly deliver price stability over
1.0
1.0
the medium term. The stability of inﬂ ation
1999 2000 2001 2002 2003 2004 2005 2006 2007
expectations since then has been remarkable.
Sources: Consensus Economics and ECB.
1) Break-even inﬂ ation rates derived from inﬂ ation-linked bonds
This is even more striking against the backdrop
mainly capture market inﬂ ation expectations and inﬂ ation risk
of a sequence of substantial adverse upside price
premia.
shocks that occurred during that time, notably
the more or less continuous increase in oil prices over that period (from around USD 10 per barrel in
1999 to a peak of almost USD 120 per barrel in 2008), substantial rises in international food prices
and, on the domestic side, almost regular increases in indirect taxes and important administered
prices in most euro area countries.
… through medium-term
In sum, the Governing Council of the ECB – based on its regular economic and monetary analyses
orientation …
in the context of its medium-term-oriented monetary policy strategy – has delivered what it is
expected to deliver according to its mandate under the Treaty, which is price stability over the
medium term for the euro area as a whole.
By avoiding frequent adjustments in its policy stance, the ECB’s monetary policy has not itself
become a source of uncertainty in an already uncertain economic environment. This has certainly
helped to stabilise medium to long-term inﬂ ation expectations at a level consistent with price
stability.
TRANSPARENCY, ACCOUNTABILITY AND COMMUNICATION
… and clear communication
To be effective in its monetary policy, the ECB has placed great emphasis from the very outset on
communicating its policy actions and the economic rationale underlying its decisions to ﬁ nancial
market participants and the general public in a transparent and timely manner. This has helped to
anchor inﬂ ation expectations, even at times when they tend to rise.
Overall, the combination of communication and clear decision-making has helped the public to
better understand the ECB’s monetary policy decisions in the context of its publicly announced
strategy. In the same vein, it has helped the ﬁ nancial markets to better understand the systematic
response pattern of the ECB’s monetary policy to economic developments and shocks, and thus
to better anticipate the broad direction of monetary policy over the medium term, thereby making
policy moves more predictable.
Greater transparency
Today, transparency is regarded as an important element of modern central banking, as it helps to
makes monetary policy
increase the credibility and effectiveness of monetary policy in various ways. First of all, transparency
more effective ...
about the goals of monetary policy and how the central bank goes about achieving these goals helps
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a central bank to foster credibility. This, in turn, will enhance the central bank’s ability to steer
long-term inﬂ ation expectations, and to thereby inﬂ uence price and wage-setting behaviour in a way
that is consistent with price stability. In other words, a credible monetary policy can ensure that the
unavoidable ﬁ rst-round effects from price increases, e.g. oil price rises, will not result in
second-round effects on wages and prices, eventually leading to a general increase in inﬂ ation.
Furthermore, transparency about the central bank’s monetary policy strategy and assessment of the
... enhances its predictability
economic situation enhances the ability of ﬁ nancial market participants to anticipate the future
and ...
course of monetary policy, which in turn helps to reduce ﬁ nancial market volatility and increases
the central bank’s leverage over longer-term interest rates. Finally, a strong commitment to
transparency imposes self-discipline on policy-makers, which ensures that their policy decisions
and explanations are consistent and in line with their mandate.
The ability of ﬁ nancial markets to predict monetary policy moves has generally increased over the last
decade.7 This development supports the view that the transparent approach to monetary policy adopted
by central banks worldwide has enhanced the markets’ understanding of monetary policy. The fact
that long-term inﬂ ation expectations have stabilised to an unprecedented degree across countries over
the last decade suggests that transparency has also helped to anchor inﬂ ation expectations.
The central bank faces a trade-off between comprehensiveness and clarity of communication, since
it will not be possible to provide a completely exhaustive description of all the elements and aspects
relevant for policy-making, while, at the same time, being clear. Also, transparency is more than
just releasing information, as this does not by itself translate into a better understanding of monetary
policy. The information needs to be effectively conveyed to the public in order to enhance the overall
effectiveness of monetary policy. Therefore, in order to reap the beneﬁ ts of transparency, central
banks require an effective communication strategy. Central bank communication should aim to
ensure that the information relevant to the public’s understanding of monetary policy is disseminated
in a timely and open, yet clear and unambiguous manner, and that this is done in a way that is adapted
to different environments and audiences, from the general public to ﬁ nancial market participants.
The key elements of the monetary policy strategy enhance transparency and accountability
... fosters accountability
vis-à-vis the general public. The quantitative deﬁ nition of price stability in terms of an annual
increase in the HICP provides a clear yardstick against which the public can hold the ECB
accountable while helping to anchor market expectations. The two-pillar approach sets out a clear
framework for internal decision-making and external communication. Finally, the ECB shares the
information exchanged in the Governing Council with the general public and explains the economic
rationale behind policy decisions in great detail.
Communication must also reﬂ ect the fact that monetary policy has to operate in a complex, uncertain
and constantly evolving environment. The external communication of the monetary policy strategy
places a premium on faithfully reﬂ ecting this aspect. In view of the effects of various unexpected
shocks that can hit the economy and the long and variable time lag with which monetary policy
actions are transmitted to prices, the precise timing, and sometimes even the direction, of an
interest rate decision is difﬁ cult to predict. By publicly announcing its monetary policy strategy and
communicating its regular assessment of economic developments in a transparent manner, the ECB
has achieved a high degree of predictability, making monetary policy more effective (see Box 2).
7 For a survey of the empirical literature on the predictability of monetary policy, see T. Blattner, M. Catenaro, M. Ehrmann, R. Strauch and
J. Turunen, “The predictability of monetary policy”, ECB Occasional Paper No 83, 2008.
ECB
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In the context of a global trend towards more detailed and transparent communications by central
banks, the key elements of the communication strategy of the ECB, notably the introductory
statements of its monthly press conference, which explain its policy decisions almost in real time,
have initiated a move towards an increased real-time disclosure of information.
Box 2
KEY COMMUNICATION TOOLS AND CHANNELS USED BY THE ECB
The introductory statement is at the centre of the monthly press conferences held by the President
and the Vice-President immediately after the ﬁ rst Governing Council meeting of the month. On
this occasion, the introductory statement is presented by the President on behalf of the Governing
Council. It provides a timely and comprehensive summary of the policy-relevant assessment of
economic and monetary developments, as well as the monetary policy stance, and it is structured
along the lines of the ECB’s monetary policy strategy. The monthly press conference includes
a question-and-answer session, which is attended by various media representatives from across
the euro area and beyond, and provides a platform for a timely and even-handed explanation of
monetary policy decisions to the public. The press conference is therefore an effective means of
presenting and explaining in a very timely manner the discussions in the Governing Council, and
thus the monetary policy decision-making process.
Besides the monthly press conference, the Monthly Bulletin is another important communication
channel used by the ECB. The Monthly Bulletin provides the general public and the ﬁ nancial
markets with a detailed and comprehensive analysis of the economic environment and monetary
developments. It is usually published one week after the meeting of the Governing Council
and contains the information that the Governing Council had at its disposal when it took its
policy decisions. The Monthly Bulletin also contains articles which provide insights into long-
term developments, general topics or the analytical tools used by the Eurosystem within the
framework of the monetary policy strategy.
In addition, the President of the ECB appears before the European Parliament’s Committee on
Economic and Monetary Affairs four times a year. On these occasions, the President explains
the ECB’s policy decisions and then answers questions raised by Committee members. The
Committee meetings are open to the public and the transcripts of the President’s testimony are
subsequently published on the websites of both the European Parliament and the ECB. Other
members of the Executive Board of the ECB also appear before the Committee.
To address a variety of audiences, the members of the Governing Council take on a large number
of public engagements. Speeches by the members of the Executive Board and the Governing
Council, as well as interviews granted by Governing Council members, are likewise important
tools for explaining the views of the ECB to the public.
ECB
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I M P L E M E N T A T I O N
3.3 MONETARY POLICY IMPLEMENTATION
Short-term money market rates play an important role in the transmission of monetary policy.
By steering such rates, monetary policy exercises signiﬁ cant inﬂ uence over market interest rates
and, through various channels, over the spending decisions of companies and households, over
monetary developments and, ultimately, over the general price level. This section explains how
the ECB implements monetary policy decisions by steering interest rates at the very short end of
the money market segment. It also highlights the main challenges that the Eurosystem has faced in
implementing monetary policy decisions since the inception of the euro.
SEPARATION OF MONETARY POLICY AND LIQUIDITY MANAGEMENT
To understand the liquidity management of the ECB, it is useful to distinguish the determination of
Setting key ECB rates
the monetary policy stance from its actual implementation. As explained in Section 3.1, the
monetary policy strategy provides a structure for the relevant information on the economy on which
monetary policy decisions are made. Indeed, based on its regular economic and monetary analyses,
the Governing Council decides on the level of key ECB interest rates that best serves the fulﬁ lment
of its price stability objective. The Executive Board of the ECB is then responsible for the
implementation of these monetary policy decisions. Monetary policy decisions are implemented by
steering short-term money market rates towards the interest rate level decided by the Governing
Council. Setting the key ECB interest rates, and communicating on them, certainly plays a key role
in guiding market participants. However, this alone is not sufﬁ cient to bring the short-term market
interest rates into line with the key ECB rate. Steering short-term rates is in fact also achieved by
the liquidity management of the Eurosystem with the support of its operational framework.
The operational framework contains the set of instruments and procedures with which the
Managing liquidity
Eurosystem implements the monetary policy decisions in practice, i.e. with which it steers
short-term money market rates. Another instrumental factor in inﬂ uencing money market rates is
that, overall, the euro area banking system needs liquidity and is therefore reliant on reﬁ nancing by
the Eurosystem. In this environment, the Eurosystem acts as liquidity supplier to banks by means of
its open market operations. In doing so, the Eurosystem manages the amount of liquidity available
within the euro area banking sector with the aim of establishing balanced liquidity conditions and
bringing short-term money market rates as close as possible to the interest rate level decided by the
Governing Council.
To sum up, the Eurosystem makes a clear distinction between, on the one hand, the decision by the
Separation of the
Governing Council of the ECB on the monetary policy and, on the other hand, the implementation
policy stance from its
implementation
of this decision through monetary policy instruments. The clear separation between the decision on
the monetary policy stance and its implementation reduces the risk that economic agents may
mistakenly perceive volatility in short-term money market rates, triggered by temporary and
unpredictable ﬂ uctuations in liquidity demand and supply, to be monetary policy signals of the
Eurosystem. This separation has been particularly important during the ﬁ nancial market turmoil
that started in early August 2007, when short-term money market rates were occasionally very
volatile.
THE OPERATIONAL FRAMEWORK FOR MONETARY POLICY IMPLEMENTATION
The Eurosystem’s operational framework for monetary policy implementation is based on the
The principles guiding the
principles laid down in the Treaty establishing the European Community. Article 105 of the Treaty
operational framework
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states that, in pursuing its objectives, the Eurosystem “(…) shall act in accordance with the principle
of an open market economy with free competition, favouring an efﬁ cient allocation of resources
(…)”.
A number of other “guiding principles” were also formulated to govern the design of the operational
framework. The most important is operational efﬁ ciency. Operational efﬁ ciency can be deﬁ ned as
the capacity of the framework to transmit monetary policy decisions as quickly and precisely as
possible to short-term money market rates. The need to ensure the equal treatment of banks and
the harmonisation of rules and procedures throughout the euro area are other important principles.
Another principle relates to the decentralisation of the implementation of monetary policy.
Accordingly, the monetary policy operations are normally implemented through the NCBs. Finally,
the operational framework has to apply the principles of simplicity, transparency, safety and cost
efﬁ ciency.
Three instrument to steer
To steer the short-term money market rates towards the interest rate level set by the Governing
interest rates
Council, the ECB and the Eurosystem rely on three instruments: (1) minimum reserve requirements;
(2) open market operations; and (3) standing facilities. These instruments inﬂ uence the amount of
liquidity available within the euro area banking sector, which in turn inﬂ uences the level of short-
term rates prevailing in the money market.8 In this context, the Eurosystem acts as liquidity supplier
and – via its operational framework – helps the banks to meet their liquidity needs in a smooth and
well-organised manner.
Banks’ liquidity needs
(1) Banks need a certain amount of liquidity to satisfy liquidity needs arising from so-called
and the minimum reserve
“autonomous liquidity factors”. These factors comprise items on the Eurosystem’s balance sheet
requirements
which are not related to monetary policy instruments.9 The largest autonomous factor is banknotes
in circulation. In addition, banks need liquidity to fulﬁ l their reserve requirements. Indeed, banks
are required to hold minimum reserves with the Eurosystem. Minimum reserve requirements create
a structural demand for liquidity on the side of the euro area banking sector. For each institution,
reserve requirements are determined in relation to its balance sheet. At present, around 6,000 banks
are subject to minimum reserve requirements. The total liquidity needs of the euro area banking
sector averages around €450 billion. The aggregate daily minimum reserves currently account for
around half of this total.
The key function of the minimum reserve system is to stabilise money market rates. Indeed, reserve
requirements have to be fulﬁ lled on average over the maintenance period, where the maintenance
period is the period over which banks’ compliance with the minimum reserve requirements is
calculated. The maintenance period usually starts on the Tuesday following the meeting of the
Governing Council at which the assessment of the monetary policy stance is pre-scheduled. The
averaging mechanism implies that holding reserves on any speciﬁ c day in the maintenance period
is, in principle, a close substitute for holding reserves on any other day in the maintenance period.
This means that reserve holdings are allowed to ﬂ uctuate from day to day and that daily liquidity
ﬂ uctuations are smoothed out. Minimum reserves do not entail a cost for the banking sector as they
are remunerated by the Eurosystem at the average marginal rate of the main reﬁ nancing operation
over the maintenance period.
8 For a complete overview of the Eurosystem’s framework for monetary policy, see ECB, “The implementation of the monetary policy in
the euro area”, as amended in September 2007.
9 See also the articles entitled “The liquidity management of the ECB” and “The Eurosystem’s experience with forecasting autonomous
factors and excess reserves” in the May 2002 and January 2008 issues of the Monthly Bulletin respectively.
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Table 1 Eurosystem open market operations and standing facilities
Types of transaction
Provision of
Absorption of
Monetary policy operations
liquidity
liquidity
Maturity
Frequency
Open market operations
Main reﬁ nancing operations
Reverse transactions
-
One week
Weekly
Longer-term reﬁ nancing operations
Reverse transactions
-
Three months
Monthly
Fine-tuning operations
Reverse transactions
Collection of ﬁ xed-
Non-standardised
Non-regular
term deposits
Standing facilities
Marginal lending facility
Reverse transactions
-
Overnight
Access at the discretion
of counterparties
Deposit facility
Deposits
Overnight
Access at the discretion
of counterparties
(2) Open market operations play the most important role in managing the liquidity conditions of the
The Eurosystem’s supply of
banking sector of the euro area and in steering short-term money market interest rates. Open market
liquidity and open market
operations
operations are carried out in a decentralised manner: the ECB coordinates the operations, but the
transactions themselves are conducted by the NCBs.
Three types of operation have been employed by the Eurosystem: (i) main reﬁ nancing operations
(MROs); (ii) longer-term reﬁ nancing operations (LTROs); and (iii) ﬁ ne-tuning operations (FTOs)
(see Table 1).
Through MROs and LTROs, the Eurosystem lends funds to banks. Lending is always for a given,
short period of time and against collateral in order to protect the Eurosystem against ﬁ nancial risk
(see Box 3). On a daily average basis, the Eurosystem lends a total of around €450 billion to the
euro area banking sector through its open market operations. The Eurosystem’s operations are far
larger than those of the other main central banks.
Both MROs and LTROs are regular operations. MROs are conducted on a weekly basis in the
form of a variable tender rate auction with a minimum bid rate and have a one-week maturity. In a
variable rate tender with a minimum bid rate, banks may submit bids with several interest rates at or
above the pre-announced minimum bid rate. The bids at the highest rates are allotted ﬁ rst, followed
by the next highest until the amount to be allotted is exhausted. The rate at which the amount is
exhausted is the marginal rate and, at this rate, bids are allotted pro rata. LTROs are performed
on a monthly basis in the form of a pure variable rate tender and have a three-month maturity. In
contrast to MROs, the amount of liquidity provided through LTROs is ﬁ xed in advance. In these
operations, the Eurosystem acts as a rate taker. A wide range of banks can participate in the MROs
and LTROs, i.e. around 1,700 banks. This number is fairly large, also when compared with the
operational framework of the other main central banks.
FTOs are not a regular tool for the provision or absorption of liquidity, but are rather conducted
when needed. In order to allow such operations to be conducted ﬂ exibly and rapidly, their maturity
and frequency are not standardised, but can be adapted to any particular situation. Given that these
tenders need to be executed quickly (usually within 90 minutes from the announcement of the
operation), only a limited number of banks can participate in those operations (currently around 130
banks). FTOs are aimed at smoothing the effects unexpected liquidity ﬂ uctuations in the banking
sector have on interest rates.
ECB
Monthly Bulletin
10th Anniversary of the ECB
53

Standing facilities as a
(3) The Eurosystem also offers two standing facilities to banks – a marginal lending facility and a
corridor for short-term
deposit facility (see Table 1). These facilities form a corridor (typically, ± 100 basis points) around
rates
the minimum bid rate, and thereby limit the volatility of the overnight rate (i.e. the short-term
money market interest rate). The marginal lending facility forms the ceiling of the corridor. It can
be used by banks to obtain liquidity overnight against eligible collateral. The deposit facility forms
the ﬂ oor of the corridor. It can be used by banks to make overnight deposits with the Eurosystem.
MONETARY POLICY IMPLEMENTATION SINCE THE INCEPTION OF THE EURO
The operational framework
Since the introduction of the euro, the operational framework for monetary policy implementation
has served the
has served the Eurosystem well. The main operational objective, namely to steer very short-term
Eurosystem well
money market rates close to the minimum bid rate of the MRO (determined by the Governing
Box 3
THE EUROSYSTEM’S COLLATERAL FRAMEWORK
In line with central bank practice worldwide, all liquidity-providing operations of the Eurosystem
need to be based on adequate collateral to protect the Eurosystem from incurring losses. At the
same time, the collateral framework needs to ensure that sufﬁ cient collateral is available to
a broad range of banks, so that the Eurosystem can provide the amount of liquidity it deems
necessary. To facilitate this, the Eurosystem accepts a broad range of assets as collateral.1 This
feature of the Eurosystem’s collateral framework has recently gained widespread recognition as
it has been one stabilising feature in the recent ﬁ nancial market turmoil. Indeed, it ensured that
banks had enough collateral at their disposal to access the Eurosystem’s open market operations.
This box provides a brief overview of the Eurosystem’s collateral framework and of the main
reﬁ nements undertaken over the past 9½ years.
In 1998, a “two-tier collateral framework” was adopted to ensure a smooth transition to Monetary
Union. A “two-tier collateral framework” meant that eligible assets were divided into two groups,
i.e. two “tiers”. This aimed to accommodate differences in ﬁ nancial structures between Member
States at the beginning of EMU. Indeed, while tier one assets consisted of marketable debt
instruments that fulﬁ lled euro area-wide eligibility criteria, tier two assets comprised assets that
were important for certain national ﬁ nancial markets and banking systems and fulﬁ lled national
eligibility criteria only. In principle, all assets could be used on a cross-border basis throughout
the euro area. This framework served the Eurosystem well and proved resilient to cope also
with substantial temporary increases in the demand for collateral during times of market stress
(e.g. the millennium change).
However, the two-tier collateral framework also had drawbacks. For example, the fact that some
asset classes were eligible only in some countries, and not in all, was considered potentially
to undermine the level playing ﬁ eld in the euro area, which is one important principle of the
Eurosystem’s monetary policy framework. Therefore, and as a result of two public consultations
(conducted in June 2003 and May 2004), the Eurosystem decided to establish a single-list
1 See Chapter 6 of the ECB publication entitled “The implementation of monetary policy in the euro area”, as amended in September
2007, which covers in detail the eligibility criteria and risk control measures of eligible assets for Eurosystem credit operations.
ECB
54 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
framework (referred to as the “single list”) for common use in all the Eurosystem’s liquidity-
providing operations. The single list aimed to further improve the efﬁ ciency of the collateral
framework. The single list was implemented in two steps. In the ﬁ rst step, which was completed
in May 2005, some amendments were made in relation to marketable assets.2 In the second step,
in January 2007, non-marketable assets and, in particular, credit claims (i.e. bank loans) became
eligible as collateral in all euro area countries. However, owing to technical lead times, a fully
uniﬁ ed regime for credit claims will only be in place in January 2012.3
The acceptance of a diverse range of asset categories as collateral for Eurosystem credit
operations has meant that it is not possible to apply a uniform set of eligibility criteria across
asset categories. Therefore, two sets of eligibility criteria and risk control measures 4 broadly
apply, one relating to marketable assets and the other to non-marketable assets. However,
both sets of criteria ensure a comparable degree of risk protection for the Eurosystem. Only
high-credit-quality assets are accepted as collateral. The eligibility criteria for marketable assets
have been kept sufﬁ ciently general and, as a result, the collateral framework has remained
responsive to market innovations and follows market developments. As ﬁ nancial markets
evolve, further reﬁ nements of the eligibility criteria and risk control measures will continue to be
deﬁ ned, also in the years to come.
In 2007, the average amount of eligible collateral amounted to €9.5 trillion, showing an increase
of 73% from around €5.5 trillion in 1999. As regards the composition of collateral, general
government debt accounted for 49% of the total, with the remainder of marketable collateral
consisting of credit institutions’ covered and uncovered bonds (12% and 17% respectively),
corporate bonds (9%), asset-backed securities (8%) and other bonds such as those issued by
supranational organisations (4%). Around 12% of these total eligible assets, i.e. €1.1 trillion,
was deposited for use with the Eurosystem in 2007. The composition of the deposited asset pool
differs from the composition of euro debt markets as banks tend to deposit less liquid collateral
in credit operations with the Eurosystem. The average volume of credit claims represented 10%
of the overall posted collateral in 2007. However, the full potential of this additional collateral
source has not yet been reaped, since the range of credit claims whose creditworthiness could be
assessed is gradually increasing. The cross-border use of collateral, whereby a counterparty in a
given country of the euro area uses collateral originating from another country of the euro area,
is one indication of the progress of ﬁ nancial integration. In 2007, 51% of collateral was used on
a cross-border basis, compared with 12% in 1999.
2 These amendments included (i) the elimination of equities from the eligible assets, (ii) the speciﬁ cation of the non-regulated markets
that are acceptable to the Eurosystem from a collateral management point of view, (iii) a reﬁ nement of the criterion regarding debt
instruments issued by credit institutions and (iv) the introduction of euro-denominated debt instruments issued by entities established in
the G10 countries that are not part of the European Economic Area.
3 A long lead time is necessary for the development of operational systems and procedures for assessing, evaluating and mobilising
credit claims, since they differ from marketable instruments in several important respects. Credit claims lack standardisation and
uniform documentation due to their diversity, they usually lack credit ratings by credit agencies and external price sources, they may
have legal prohibitions for sale to other parties, and the continued existence of a particular loan is not easily veriﬁ able. The Eurosystem
created a credit assessment framework (ECAF) in 2006 to allow additional credit assessment sources other than rating agencies to cope
with newer asset classes in the single list.
4 Risk control measures are applied to the assets underlying the Eurosystem’s liquidity-providing operations in order to protect the
Eurosystem against the risk of ﬁ nancial loss if underlying assets have to be realised owing to the default of a bank. The Eurosystem
applies a minimum rating requirement for all kind of issuers and assets equivalent to a single A- rating, which is the Eurosystem’s
deﬁ ned benchmark for high credit standards. For more details, please see ECB, “The implementation of monetary policy in the euro
area”, as amended in September 2007.
ECB
Monthly Bulletin
10th Anniversary of the ECB
55

Chart 11 Key ECB interest rates and the
Chart 12 The development of the allotment
EONIA since January 1999
ratio, January 1999 – November 2006
(percentages)
(percentage of bids)
marginal lending rate
allotment ratio
deposit rate
June 2000: shift to the variable rate tender procedure
marginal rate in the main refinancing operations
March 2004: changes to the operational framework
minimum bid rate
EONIA
6.00
6.00
100
100
5.50
5.50
5.00
5.00
80
80
4.50
4.50
4.00
4.00
60
60
3.50
3.50
3.00
3.00
40
40
2.50
2.50
2.00
2.00
1.50
1.50
20
20
1.00
1.00
0.50
0.50
0
0
1999 2000 2001 2002 2003 2004 2005 2006 2007
1999 2000 2001 2002 2003 2004 2005 2006
Source: ECB.
Source: ECB.
Note: The rate for the MRO refers, for operations settled before
28 June 2000, to the rate applicable to ﬁ xed rate tenders. For
operations settled after that date, the rate is the minimum bid rate
applicable to variable rate tenders.
Council), has been achieved. Moreover, the operational framework has proved robust and resilient
even when faced with exceptional challenges such as the millennium change, the terrorist attacks of
11 September 2001 or the recent ﬁ nancial market turmoil in 2007/08. In none of these cases has the
Eurosystem had to resort to exceptional measures not foreseen in its operational framework.
Chart 11 demonstrates that the overnight market interest rate (the EONIA) 10 has generally remained
close to the minimum bid rate. It also shows that the interest rates on standing facilities have
provided a ceiling and a ﬂ oor to the EONIA. The ﬂ uctuations seen in the chart largely reﬂ ect
temporarily tight or loose liquidity conditions in the money market. The efﬁ ciency of the
Eurosystem’s monetary policy framework has to some extent set an example and has inspired other
central banks to set up a corridor system.
Refinements to the
The reﬁ nements introduced since 1999 have certainly been instrumental in fostering the good performance
operational framework
of the operational framework. In the past 9½ years, three reﬁ nements have been carried out.
Shift to the variable rate
First, a variable rate tender procedure was introduced in June 2000 to replace the ﬁ xed rate tenders
tender procedure
that had been used at the outset of Monetary Union. This reﬁ nement did not per se constitute a
change to the operational framework as the framework allows both variable rate and ﬁ xed rate
tender procedures to be applied. The shift to the variable rate tender procedure was in response to
so-called “overbidding” by banks in the Eurosystem’s operations, which had become particularly
acute during the ﬁ rst half of 2000. Overbidding refers to the situation where banks submit high and
ever-increasing bids in MROs. In such cases, the ratio between the allotment and bid amounts falls
to a very low level (see Chart 12). Overbidding occurred at times when banks expected an increase
in the key ECB rates to take place in the prevailing maintenance period. Indeed, in expectation of
10 EONIA stands for euro overnight index average and is a measure of the effective interest rate prevailing in the euro interbank overnight
market.
11 In a ﬁ xed rate tender procedure, the ECB speciﬁ es the interest rate in advance and banks bid the amount of money they want to transact at
the ﬁ xed interest rate. Bids are then allotted on a pro rata basis.
ECB
56 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
an increase in interest rates, the overnight market
Chart 13 EONIA standard deviation per
maintenance period (day to day) -
rate would rise to the expected level, i.e. above
April 2004 - January 2007
the ﬁ xed rate applied in the MRO.11 Then, banks
(basis points)
would have a particularly strong incentive to get
entire maintenance period
funds through the MRO, and would thus
days before last MRO
days after last MRO
overbid.
30
30
25
25
On 8 June 2000, the Governing Council of the
20
20
ECB decided to shift from a ﬁ xed rate tender to
15
15
variable rate tender procedure for the MROs as
10
10
of 28 June. The Governing Council also decided
5
5
to set a minimum bid rate for these operations to
0
0
signal its monetary policy stance. The minimum
Apr. Aug. Dec. Apr. Aug. Dec. Apr. Aug. Dec.
bid rate would take over the role played by the
2004
2005
2006
rate applied to ﬁ xed rate tenders. The new tender
Source: ECB.
procedure immediately solved the problem of
overbidding.
Second, the shift to the variable rate tenders procedure did not shield the Eurosystem from so-called
Structural changes of March
“underbidding” by banks. Underbidding refers to the situation where banks’ total bids are lower
2004
than the intended allotment amount. In that case, banks face the risk of running short of liquidity at
the end of the maintenance period, and thus have to take recourse to the marginal lending facility,
driving up the overnight market interest rate. Starting in 2001, in an environment where reductions
in key ECB rates were expected, underbidding occurred on eight occasions. Indeed, in expectation
of a decrease in interest rates in the prevailing maintenance period, the overnight market rate would
decline to the expected level, i.e. below the minimum bid rate. Thus, the incentive for banks to get
funds through the MROs would be reduced.
To prevent expectations of changes in key ECB rates from affecting the bidding of banks already
in the prevailing maintenance period, the Governing Council decided in January 2003 to implement
two changes to its operational framework, which became effective in March 2004. The ﬁ rst change
altered the timing of reserve maintenance periods so that these would always start after the Governing
Council meeting at which the monthly assessment of the monetary policy stance is pre-scheduled.
Changes to the standing facility rates were aligned with the start of the new reserve maintenance
period. The second change referred to the maturity of the MROs, which was shortened from two
weeks to one week. This implied that MROs would no longer straddle two maintenance periods. The
implementation of the changes went smoothly and banks quickly adapted their bidding behaviour.
Finally, as a consequence of the alignment of the timing of the maintenance period with the Governing
More frequent fine-tuning
Council meeting schedule, the average time span between the last MRO of a reserve maintenance
operations at the end of the
maintenance period
period and the last day of that period increased to six business days. Prior to March 2004, it had varied
from one to six days. A side effect of this was the occasional emergence of large liquidity imbalances
at the end of maintenance periods, which created some increase in the volatility of overnight market
interest rates. In response, since October 2004, the ECB has more frequently counteracted the resulting
large liquidity imbalances at the end of maintenance periods by conducting a ﬁ ne-tuning operation on
the last day of the maintenance period. This has served the ECB well in reducing the interest rate
volatility sometimes seen in the last week of the maintenance period (see Chart 13).
ECB
Monthly Bulletin
10th Anniversary of the ECB
57

Operational framework
The recent period of ﬁ nancial market turmoil, which started in August 2007 when the US sub-prime
challenged by recent
mortgage market crisis spilled over to the euro area money market, marks the greatest challenge to
financial turmoil
the Eurosystem’s operational framework seen thus far. In this turbulent episode, the operational
framework continued to serve the Eurosystem well, and the ability to steer the overnight rate was
maintained (see Chart 11).
In order to steer the overnight rate close to the minimum bid rate, the ECB applied four categories
of measures in the face of the ﬁ nancial turmoil. 12
First, the timing of the supply of liquidity in the course of a maintenance period was changed by
making use of both MROs and FTOs. Before the turmoil, the ECB used to supply liquidity smoothly
in the course of the maintenance period, but since the onset of recent ﬁ nancial market volatility, it
has increased its supply of liquidity at the beginning of the maintenance period, thereby allowing
banks to fulﬁ l the bulk of their minimum reserve requirements relatively early in the maintenance
period. The overall supply of liquidity, however, has not changed: the Eurosystem still aims at
providing the amount of liquidity that enables bank to exactly meet their reserve requirements.
Second, the share of reﬁ nancing provided by the Eurosystem via LTROs has been increased, with
the share provided via the one-week MROs being reduced accordingly. This has served to lengthen
the average maturity of outstanding monetary policy operations.
Third, special tender procedures with full allotment have been used on occasion, notably to alleviate
market tensions around the year-end. Such procedures allowed the market to determine the exact
allotment amount in circumstances where assessing the demand for liquidity was difﬁ cult and
required the conduct of FTOs in order to absorb the resulting excess liquidity.
No structural change to
These three categories of measures have allowed the ECB to maintain control over short-term money
operational framework
market rates. None of these measures required a structural change to the Eurosystem’s operational
required
framework for monetary policy implementation. Nor were changes needed in the collateral framework,
which is viewed to have played an important role in supporting the functioning of the money market.
Finally, the ECB agreed on a currency arrangement (swap line) with the Federal Reserve System in
connection with the latter’s US dollar Term Auction Facility. The ECB conducted a series of term
auction facilities in which it provided US dollar liquidity, on behalf of the Federal Reserve System,
to euro area banks.
To conclude, the ﬂ exible design of, and the broad range of instruments and procedures within,
the Eurosystem’s operational framework for the implementation of monetary policy has proved
effective and resilient.
In connection with the implementation of monetary policy, it should be noted that, by steering
short-term money market interest rates, monetary policy exerts signiﬁ cant inﬂ uence on market rates
and, through various channels, on spending and investment decisions, monetary developments and,
ultimately, the development of the price level. The process through which monetary policy decisions
inﬂ uence the economy in general, and the price level in particular, is known as the monetary policy
12 See also the article entitled “The Eurosystem’s open market operations during the recent period of ﬁ nancial market volatility” in the
May 2008 issue of the Monthly Bulletin.
ECB
58 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
transmission mechanism. This process is complex, may be changing over time and could exhibit
differences across economies. Box 4 below presents some empirical evidence for the euro area.
Box 4
THE TRANSMISSION MECHANISM OF MONETARY POLICY
Looking at the euro area, empirical evidence has shown that the monetary transmission
mechanism operates in a broadly similar way across all euro area countries. Banks play a key
role in transmitting changes in policy rates to bank lending rates, given the high dependence of
ﬁ rms and households on bank ﬁ nancing and the still relatively limited degree of stock market
capitalisation in the euro area. Remaining country-speciﬁ c differences mainly relate to the
emergence of new ﬁ nancial products and new players, the changing nature of competition among
banks and different degrees of ﬁ nancial market integration in individual euro area countries.
For the euro area as a whole, the classic interest rate channel plays a dominant role in transmitting
monetary impulses to the economy. Other major channels of relevance for the euro area are the
money and credit channel and the expectation channel (see Chart A).1
As regards the interest rate channel and the money and credit channel, the analyses conducted
by the ECB and the Eurosystem have indicated a remarkable degree of convergence in the euro
area since 1999. However, differences in terms of levels and movements in bank interest rates
still exist across countries. There are also indications that some degree of heterogeneity remains
in the pass-through of market rates to bank rates.2
Charts B and C provide some evidence on the extent of heterogeneity across countries. The
columns compare the changes in the rates on loans to households and ﬁ rms at a country level with
the changes in the three-month EURIBOR over the period 2003-2008 (see column 13 in Charts
B and C), for which harmonised data on bank interest rates are available. In the presence of a
complete pass-through, the changes in bank rates should be equal to the changes in the market
rates. From the data, it appears, however, that the response of banks in different countries to
changes in market rates tends to vary widely, and seems only in some cases to move close to one-
to-one. Available evidence shows that, with respect to bank interest rate changes, convergence
over time has been greater in the case of loans to households for house purchase than in that of
short-term loans to non-ﬁ nancial corporations (or other product categories).
Competition in the ﬁ
nancial services industry, bank-customer relations, preferences
regarding the maturity of credit contracts or the variability of interest rates, risk premia
and the administrative cost of effectively changing interest rates are all likely to inﬂ uence
1 A more detailed overview of the mechanisms of monetary policy transmission can be found in the article entitled “Monetary policy
transmission in the euro area” in the July 2000 issue of the Monthly Bulletin and in the ECB’s booklet “The monetary policy of the
ECB”, 2003. See also A.K. .Kashyap and J.C. Stein, “What Do a Million Observations on Banks Say About the Transmission of
Monetary Policy”, The American Economic Review, Vol. 90, No. 3, 2000, pp. 407-428.
2 This is also conﬁ rmed by econometric studies. See, among others, H. Sander et al., “Convergence in euro-zone retail banking?
What interest rate pass-through tells us about monetary policy transmission, competition and integration”, Journal of International
Money and Finance, 23, 2004, pp. 461-492; G. de Bondt, “Interest rate pass-through: Empirical results for the euro area”, German
Economic Review, 6 (1), 2005, pp. 37-78; and C. Kok Sørensen et al., “Bank interest rate pass-through in the euro area: A cross-country
comparison”, ECB Working Paper No 580, 2006.
ECB
Monthly Bulletin
10th Anniversary of the ECB
59

Chart A Schematic presentation of the monetary transmission mechanism
Official
interest rates
Money and credit
channel
Interest rate channel
Inflationary
Money (i.e. cash balances)
expectations
and credit aggregates
Market interest rates
Exchange rates
(uncertainty)
Bank interest rates
Asset prices
Wealth effects
Income effects
Wage and price-
Supply and demand in goods and labour markets
Import prices
setting
Price developments
Source: ECB.
Chart B Changes in rates on loans to
Chart C Changes in rates on loans to
households for house purchase
non-financial corporations
(percentage points)
(percentage points)
Jan. 2003-Dec. 2005
Jan. 2003-Dec. 2005
Jan. 2006-Jan. 2008
Jan. 2006-Jan. 2008
2.5
2.5
2.5
2.5
2.0
2.0
2.0
2.0
1.5
1.5
1.5
1.5
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.0
0.0
-0.5
-0.5
0.0
0.0
-1.0
-1.0
-0.5
-0.5
-1.5
-1.5
-1.0
-1.0
1
2
3
4
5
6
7
8
9
10 11 12 13
1
2
3
4
5
6
7
8
9
10 11 12 13
1 Belgium
6 France
11 Portugal
1 Belgium
6 France
11 Portugal
2 Germany
7 Italy
12 Finland
2 Germany
7 Italy
12 Finland
3 Ireland
8 Luxembourg
13 Three-month
3 Ireland
8 Luxembourg
13 Three-month
4 Greece
9 Netherlands
EURIBOR
4 Greece
9 Netherlands
EURIBOR
5 Spain
10 Austria
5 Spain
10 Austria
Source: ECB.
Source: ECB
Note: The rates used for loans to households for house purchase
Note: The rates used are ﬂ oating rates on loans of over €1 million
are ﬂ oating rates with an initial period of rate ﬁ xation of up to
to non-ﬁ nancial corporations with a an initial period of rate
one year.
ﬁ xation of up to one year.
ECB
60 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
the effectiveness of monetary policy actions
Chart D Debt-to-GDP ratios of non-financial
corporations
via their impact on the bank lending rate
pass-through.3
(1999 and 2006)
1999
Overall, given the prominent role played by
2006
banks in lending to households and ﬁ rms, the
160
160
credit channel seems of relevance for the euro
140
140
120
120
area, albeit with a varying degree of importance
100
100
across euro area countries.4 This channel typically
80
80
60
60
includes a balance sheet and a bank lending
40
40
channel.5
20
20
0
0
1
2
3
4
5
6
7
8
9
10
11
With respect to at the balance sheet channel,
1 Belgium
5 Spain
9 Austria
the analysis has found that, in some euro
2 Germany
6 France
10 Portugal
area countries, liquidity and cash ﬂ ow effects
3 Ireland*
7 Italy
11 Finland
4 Greece*
8 Netherlands
appear to be important, whereas they appear
Sources: Eurostat and ECB calculations.
hardly to matter in others.6 The importance of
Notes: Debt ﬁ gures for Belgium include inter-company loans.
the balance sheet channel may be indirectly
*) In the case of Greece and Ireland, the ﬁ rst column refers to
2001.
derived by analysing cross-country differences
with respect to the degree of the leverage of
non-ﬁ nancial corporations or the nature of their ﬁ nancing sources. Chart D shows that there
are differences in terms of the debt level of ﬁ rms across euro area countries. In some countries,
ﬁ rms appear to be more sensitive to changes in interest rates, as their debt burden is relatively
high from a euro area perspective.
With respect to the bank lending channel, the analysis found mixed evidence that the supply of
loans has an effect on the transmission of monetary policy in a number of euro area countries.
Analyses using bank micro-data have concluded that the usual indicators of the degree of
asymmetric information (such as bank size) were only of minor importance for the reaction of
bank loans to monetary policy in the euro area. Instead, in most euro area countries the reaction
of banks to monetary policy appears to depend on their liquidity.
Overall, there is some degree of heterogeneity across countries with regard to the nature of
the ﬁ nancing sources of ﬁ rms. Banks are predominant in some countries, and capital market-
based ﬁ nance in others. This may reﬂ ect differences in ﬁ rms’ characteristics within countries
(for instance, the presence of small and medium-sized enterprises, or whether ﬁ rms are mostly
private or public). However, this might also reﬂ ect the different possibilities for ﬁ rms in terms of
accessing alternative sources of external ﬁ nance. In this respect, the signiﬁ cant changes that have
occurred in the ﬁ nancial sector since the start of Monetary Union should be stressed.
3 See ECB, “Differences in MFI interest rates across euro area countries”, September 2006.
4 See J.B. Chatelain et al., “Firm investment and monetary transmission in the euro area”, I. Angeloni, A. Kashyap and B. Mojon,
Monetary Policy Transmission in the Euro Area, Cambridge University Press, Cambridge, 2003.
5 See also B.S. Bernanke and M. Gertler, “Inside the black box: The credit channel of monetary policy transmission”, Journal of
Economic Perspectives, 9 (4), 1995, pp. 27-48.
6 See Table 24.6 in I. Angeloni, A. Kashyap and B. Mojon, op. cit., and L. Gambacorta and P. E. Mistrulli, “Does Bank Capital Affect
Lending Behavior?”, Journal of Financial Intermediation, Vol. 13, No 4, 2004, pp. 436-457.
ECB
Monthly Bulletin
10th Anniversary of the ECB
61

3.4 LOOKING AHEAD, CHALLENGES REMAIN
Chart 14 Measured HICP inflation and
inflation perceptions in the euro area
Since its inception, the ECB has weathered
a number of challenges that stemmed A) Annual HICP (percentage changes)
predominantly from a series of substantial upside
4.0
4.0
price shocks. By taking ﬁ rm and timely action
whenever needed, the Governing Council of the
3.0
3.0
ECB has proved its ability and commitment to
2.0
2.0
credibly delivering what it is expected to deliver
under its mandate, namely price stability. This
1.0
1.0
is also reﬂ ected in the secure and sustained
0.0
0.0
anchoring of longer-term inﬂ ation expectations.
1999 2000 2001 2002 2003 2004 2005 2006 2007
B) Inﬂ ation perceptions 1)
However, there is no room for complacency. While
inflation perceptions
the ECB has been successful in maintaining a high
historical average (1991-2008)
degree of price stability in the euro area over now
70
70
almost a full decade, average annual HICP inﬂ ation
60
60
50
50
rates have remained elevated at levels that have
40
40
persistently exceeded the upper limit of the ECB’s
30
30
deﬁ nition of price stability since 2000. While this
20
20
10
10
can be explained by the aforementioned series of
0
0
adverse upward price shocks, the outcome does not
-10
-10
1999 2000 2001 2002 2003 2004 2005 2006 2007
comply with the aim of the Governing Council to
keep the annual increase in HICP inﬂ ation below,
Sources: Eurostat and European Commission Business and
Consumer Surveys.
but close to, 2%.
1) Between 2002 and 2003 there was a strong increase in
perceptions. The share of consumers considering that prices had
“risen a lot” rose from 14% in 1999-2001 to 38% in 2002-2003.
Chart 15 Average annual price changes in HICP sub-indices, with selected products marked, in
the period 1996-2007
(Average annual increase in HICP1))
10.0
10.0
liquid fuels
tobacco
gas
fish
restaurants and cafés
5.0
5.0
housing rents meat
shoes
cars
clothes
0.0
0.0
carpets
railway travel
car insurance
-5.0
telephone calls
-5.0
cameras
-10.0
-10.0
computers
-15.0
-15.0
Source: ECB calculations based on Eurostat data.
Note: The solid line shows the average annual increase in the HICP, which was 1.9% in the period under review.
ECB
62 Monthly Bulletin
10th Anniversary of the ECB

T H E E C B ’ S M O N E T A R Y
P O L I C Y S T R A T E G Y
A N D I T S
I M P L E M E N T A T I O N
In the same vein, the ECB has faced challenging periods in which inﬂ ation expectations derived from
ﬁ nancial market instruments, such as bond yields, temporarily rose considerably above the levels
consistent with price stability over the medium term. Thus far, the ECB has been in a position to
dampen inﬂ ation expectations, bringing them back again to relatively well-anchored levels in line
with price stability. However, some signs are emerging that inﬂ ation expectations have been trending
up recently. Thus, it cannot be excluded that they will tend to be lastingly higher nowadays than in
the initial years of the single monetary policy. It is in this respect that a ﬁ rm anchoring of inﬂ ation
expectations remains of the essence and is given highest priority by the Governing Council.
Finally, while average actual HICP inﬂ ation rates have been broadly consistent with price stability,
surveys suggest protracted divergences in the evolution of ofﬁ cial inﬂ ation ﬁ gures and inﬂ ation as
perceived by the general public in the euro area (see Chart 14). A number of factors may have been
behind these divergent developments. One important argument in this respect is that consumers may
attach higher importance to the development of prices of goods and services that they buy more
frequently. According to this view, these items have a stronger impact on consumers’ inﬂ ation
sentiment than the amount of money actually spent on them.13
While overall HICP inﬂ ation has, on average, been at 1.9% since 1996, there have been some quite
Divergent developments in
divergent developments underlying the overall rate. Chart 15 shows the average annual percentage
HICP components
changes in the most detailed HICP sub-indices since 1996. It has tended to be the case that
infrequently purchased durable products (e.g. computers and cars) have exhibited much lower price
increases than more frequently purchased items (such as petrol and food in restaurants and cafés).
Thus, explaining the differences between perceived inﬂ ation and actual inﬂ ation, and maintaining
public conﬁ dence in the ofﬁ cial inﬂ ation statistics, remains a major challenge for, in particular, the
communication policy of the ECB and the Eurosystem.
13 For further details, see the article entitled “Measured inﬂ ation and inﬂ ation perceptions in the euro area”, in particular Box 1, entitled “The
European Commission’s survey of consumers’ inﬂ ation perceptions”, in the May 2007 issue of the Monthly Bulletin.
ECB
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10th Anniversary of the ECB
63

THREE STAGES TO ECONOMIC AND
MONETARY UNION (EMU)
CONVERGENCE CRITERIA
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64 Monthly Bulletin
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4 ECONOMIC POLICY CHALLENGES
AND ENLARGEMENT
As discussed in Chapter 3, monetary policy makes its best contribution to real economic growth by
maintaining price stability. While this contribution is very important, structural and ﬁ scal policies
are mainly responsible for the macroeconomic trends that are analysed in this chapter.
Looking back over the past decade, since the introduction of EMU the euro area has witnessed
an increase of more than 15 million in the number of people employed. In the period 1990-98,
the number increased by only around 5 million. These are encouraging developments, resulting
from past re-structuring in the corporate sector, labour market reforms, immigration and wage
moderation. However, hourly labour productivity in the euro area has been relatively low since the
mid-1990s.
The overall assessment of ﬁ scal policy is nuanced. On the one hand, the overall ﬁ scal position of the
euro area has improved signiﬁ cantly in recent years. On the other hand, some euro area countries
have still to achieve and maintain sound ﬁ scal positions and reduce government debt ratios to more
sustainable levels. In this respect, the failure in many cases to consolidate public ﬁ nances more
rapidly in good times has been especially disappointing.
Cross-country differentials in real output growth and inﬂ ation are not particularly large when
compared with those across US states and regions. As in any currency area, they are to a certain
extent natural – for instance, if they are related to catching-up effects. However, differences may
also reﬂ ect inappropriate national economic policies and structural rigidities, which should be
addressed by national policy-makers.
This chapter also describes how the euro area has grown from originally 11 countries to now 15.
Enlargement of the euro area is an irrevocable step and therefore needs to be well prepared. For
any future expansion, it is crucial that convergence is achieved on a sustainable basis.
All in all, good progress has been made. But a lot remains to be done, and recent signs of a
slowdown or even back-tracking in terms of structural reforms and ﬁ scal consolidation are a
concern, also from a monetary policy point of view. Ill-designed structural policies, economic
rigidities and undisciplined ﬁ scal policies may contribute to increased inﬂ ationary pressures or
higher inﬂ ation persistence, which monetary policy would need to take into account. Economic
policies and reforms that enhance competition and ﬂ exibility in goods, capital and labour markets,
as well as the completion of the Single Market, promote growth and job creation, curb price
pressures and hence increase welfare. Such policies also contribute to the smooth functioning of
adjustment mechanisms in EMU.
This chapter is structured as follows. Section 4.1 covers trends in real growth, productivity and
labour markets. Section 4.2 discusses ﬁ scal policies. Section 4.3 presents some stylised facts on
cross-country differentials in real output growth and inﬂ ation. Section 4.4 describes how the euro
area has been enlarged from originally 11 countries to now 15. Section 4.5 summarises the policy
challenges looking ahead.
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65

4.1 REAL EURO AREA MACRO-DEVELOPMENTS AND STRUCTURAL POLICIES
This section reviews real macroeconomic developments, as well as the main challenges to structural
economic policies in the euro area. First, the relevance of structural reforms in EMU is brieﬂ y
discussed. Second, output, employment and productivity growth are reviewed. Over the longer
term, the structural and institutional features of the euro area economy determine to a large extent
its capability to realise productivity and employment gains and to sustain strong economic growth.
Third, the main structural economic policy issues and challenges in labour and product markets are
assessed.
RELEVANCE OF STRUCTURAL REFORMS IN A MONETARY UNION
Competitive markets
Economic reforms in the goods, capital and labour markets, as well as the completion of the Single
enhance resilience to shocks
Market, aim to remove barriers to competition, increase market ﬂ exibility and allow more intense
national and cross-border competition. In general, such structural reforms are very relevant to
monetary policy, as they are important for mitigating inﬂ ationary pressures and inﬂ ation persistence
in response to adverse shocks. More speciﬁ cally, rigidities in the wage and price-setting mechanisms
or ongoing excessive wage developments may delay the necessary adjustments of relative prices to
economic shocks and thereby give rise to inﬂ ation persistence. Flexible and competitive markets,
which would adjust smoothly to economic changes and absorb economic shocks 1 – also across
national borders – are of particular importance in a monetary union such as the euro area, in which
adjustments to national monetary and exchange rate policies are no longer available to respond to
economic changes.2
Competition promotes
Furthermore, economic reforms that remove barriers to competition not only enhance the resilience
growth and curbs inflation
of the euro area to economic changes, but also contribute to curbing price pressures, since greater
pressures
competition is generally found to exert downward pressure on costs and prices.3
In view of Europe’s weak economic performance over the past decade, the European Council has
launched a wide-ranging and ambitious economic reform agenda – the Lisbon Strategy for Growth
and Jobs (see also Chapter 2). Among other objectives, the Lisbon Strategy aims to increase
economic growth, productivity and labour utilisation in the European economy.4 The Lisbon
Strategy, as mentioned in Chapter 2, is a fundamental and ambitious programme to draw Europe’s
attention to the urgency of structural reforms. It is a comprehensive approach to reform, which
aims to enhance competition and ﬂ exibility in product and labour markets. The strategy exploits the
complementary and beneﬁ cial effects of economic reforms for, on the one hand, long-term growth
prospects in the euro area by positively affecting labour participation and, on the other hand, labour
productivity growth by promoting innovation and technological change.
In the following sub-section, macroeconomic developments relating to output, productivity and
employment over the past two decades will be reviewed.
1 Smooth adjustment to shocks in the euro area is also enhanced by ﬁ nancial integration (see Chapter 6).

2 See N. Leiner-Killinger, V. López Pérez, R. Stiegert and G. Vitale, “Structural Reforms in EMU and the Role of Monetary Policy”, ECB
Occasional Paper No 66, July 2007.
3 See, for example, P. Cavelaars, “Does competition enhancement have permanent inﬂ ation effects?”, Kyklos, Vol. 56, No 1, 2003,
pp. 69-94, and M. Przybyla and M. Roma, “Does product market competition reduce inﬂ ation? Evidence from EU countries and sectors”,
ECB Working Paper No 453, March 2005.
4 See the European Commission’s internet site (http://ec.europa.eu/growthandjobs/index_en.htm) for further information.
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66 Monthly Bulletin
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E C O N O M I C P O L I C Y
C H A L L E N G E S
Chart 1 Euro area compared with the United States
REAL GROWTH AND PRODUCTIVITY
A N D E N L A R G E M E N T
DEVELOPMENTS IN THE EURO AREA
euro area
US
Since 1996 the growth rate of the euro area
euro area average
US average
has averaged 2.2% per year, almost unchanged
from the average rate of growth in the period
Real GDP per hour worked 1
(annual percentage changes)
1980-95. However, this masks two quite
4
4
different trends: while employment growth has
improved signiﬁ cantly during the last decade,
3
3
average productivity growth has experienced a
2
2
signiﬁ cant slowdown since the mid-1990s.
1
1
Growth in labour productivity is generally one of
Strong employment growth,
0
0
the main drivers of output growth over a longer
but weak productivity
growth
-1
-1
horizon. All in all, long-term developments in the
1982
1986
1990
1994
1998
2002
2006
euro area are characterised by a break in the mid-
Real GDP per person employed 1
1990s, following a period of prolonged growth.
(annual percentage changes)
Between 1980 and 1995, average growth in
4
4
output per hours worked in the euro area reached
3
3
2.3%, whereas output grew by 2.2%. From the
mid-1990s onwards, there has been a pronounced
2
2
slowdown in productivity growth. From 1996 to
1
1
2007, average productivity growth in the euro
area measured as output per hours worked
0
0
weakened, amounting to just 1.3% over the
-1
-1
period (see Chart 1), while average output growth
1982
1986
1990
1994
1998
2002
2006
remained roughly unchanged from the previous
Source: European Commission’s AMECO database.
Note: German data prior to 1991 are inferred from West
period. The productivity slowdown has been
Germany only.
1) Averages calculated over the periods 1980-95 and 1996-2006.
accompanied by a pronounced increase in the
annual growth rate of total hours worked. During
the period 1980-95, annual total hours worked actually declined on average by 0.2%, while between
1996 and 2007 the ﬁ gure rose by 0.9% per year. In the period 1999-2007, productivity per hour grew
by 1.2% on average per annum in the euro area, compared with 1.9% in the period 1990-98.
These euro area developments contrast with developments in the United States, where the rate of
growth in total hours worked fell slightly from 1.4% on average over the period 1980-95 to 1.3%
on average in the period 1996-2007, and the rate of growth in productivity in increased signiﬁ cantly
from 1.4% to 2.1%. Thus, in the euro area, higher growth in employment and hours worked has
been offset by losses in productivity growth, leaving the rate of output growth roughly unchanged.
In contrast, productivity gains in the United States more than compensated for the deceleration in
labour input, giving rise to strengthened output growth.
A sectoral analysis shows that productivity growth has declined, especially in market services that
Modest productivity gains in
make more intensive use of information and communication technologies (ICT), such as those
market services
provided by the distribution, ﬁ nancial and business services sectors 5. At the same time, while
productivity in these sectors signiﬁ cantly accelerated in the United States, it lost steam in the euro
5 See the article entitled “Productivity developments and monetary policy” in the January 2008 issue of the Monthly Bulletin, which
provides a detailed analysis of productivity developments in the euro area.
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10th Anniversary of the ECB
67

area. This suggests that the weak productivity growth in the euro area is related to the fact that
ﬁ rms do not seem to have exploited the beneﬁ ts of the new ICTs. These technologies exert the
largest impact on productivity growth by sparking efﬁ ciency gains in managerial processes,
procedures and organisational structures, and by facilitating complementary technological
innovations. For instance, computers and the internet reduce communication costs and allow more
ﬂ exible and decentralised organisational structures. However, the full beneﬁ ts of the productivity
acceleration brought by ICTs can only be reaped if there are no obstacles, such as regulatory
High degree of regulation
restrictions, to organisational change. In line with this hypothesis, a few studies ﬁ nd that highly
and other structural
regulated environments tend to be associated with lower investment and productivity growth.6
rigidities
These studies point to institutional rigidities that reduce the capacity of ﬁ rms to adjust, smoothly
and quickly, to their new environments as important determinants of productivity growth in the
euro area economies.
LABOUR MARKETS IN THE EURO AREA
Labour markets improved in
Labour utilisation, deﬁ ned as the total number of annual hours worked divided by the total
euro area
population, increased over the period 1999-2007 by 0.2% per year on average in the euro area.7
This reﬂ ects the expansion in labour market participation and employment. The participation rate
stood at 67.2% in 1999, increasing to almost 71% by 2007. Most importantly, since the beginning
of EMU in 1999, the euro area has witnessed an increase of more than 15 million in the number of
people employed, whereas between 1990 and 1998 the number increased by only around 5 million.
In the period 1999-2007, the overall employment rate increased from 60.3% to 65.5%. The
expansion in employment is most visible in terms of increased employment among women and
older workers, as well as in temporary and part-time employment (see Table 1). These developments
reﬂ ect the impact of past economic reforms, immigration and wage moderation. Nevertheless, the
overall employment rate in the euro area remains low compared with 73.3% in the United States
(2007), and is still far from the Lisbon target of 70% for 2010.
6 See, for example, A. Alesina, S. Ardagna, G. Nicoletti and F. Schiantarelli (2005), “Regulation and investment”, Journal of the European
Economic Association, Vol. 3, pp. 791-825, in which the authors ﬁ nd that regulatory reforms have had a signiﬁ cant positive impact on
capital accumulation in the transport, communication and utilities sectors, especially in the long run. In G. Nicoletti and S. Scarpetta
(2003), “Regulation, productivity and growth”, Economic Policy, April, the authors ﬁ nd that various anti-competitive product market
regulations signiﬁ cantly reduce total factor productivity growth at industry level.
7 For a review of the structural developments in the euro area labour markets over the last ten years, see the article entitled “Developments
in the structural features of the euro area labour markets over the last decade” in the January 2007 issue of the Monthly Bulletin.
Table 1 Key labour market statistics
Average
1998-2007
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Employment
growth
1.70
-
2.2 2.2 1.6 0.9 1.0 0.6 2.5 2.0 2.7
Total hours worked 1)
0.90
-
0.0 1.9 2.5 1.2 -0.9 0.0 0.6 1.1 1.3
Employment
rate
(age
15-64)
62.50
59.1 60.3 61.4 62.0 62.4 62.7 62.8 63.9 64.8 65.5
Female
53.40
48.6 50.1 51.5 52.2 52.9 53.8 54.3 55.8 56.8 57.8
Male
71.60
69.6 70.5 71.4 71.9 71.8 71.6 71.3 71.9 72.7 73.2
Age
15-24
36.49
34.1 35.6 37.0 37.2 37.1 36.8 36.2 36.6 37.0 37.3
Age
25-54
76.30
73.2 74.4 75.5 76.0 76.2 76.4 76.6 77.4 78.4 79.1
Age
55-64
37.30
33.3 33.6 34.0 34.7 36.1 37.5 38.3 40.5 41.8 43.4
Unemployment rate (age >15) 2)
8.60 10.0 9.1
8.20 7.8 8.2 8.7 8.8 8.9 8.3 7.5
Participation
rate
(age
15-64)
68.70
66.6 67.2 67.6 67.5 68.1 68.8 69.2 70.1 70.6 70.8
Temporary
ratio
(age
15-64)
15.44
14.3 14.9 15.4 15.1 14.8 14.8 15.3 16.2 16.8 16.8
Part-time
ratio
(age
15-64)
17.10
15.4 15.9 16.2 16.0 16.1 16.5 17.5 18.7 19.3 19.3
Sources: Eurostat (Labour Force Survey) and ECB calculations.
1) Data refer to euro area 12.
2) Averages of monthly data.
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E C O N O M I C P O L I C Y
C H A L L E N G E S
At the same time, unemployment among persons
Chart 2 Employment and unemployment in
A N D E N L A R G E M E N T
the euro area in the period 1991-2007
aged 15-64 declined – from 9.1% in 1999 to 7.5% in
2007 – to its lowest level for 25 years (see Chart 2).
Unemployment rates declined particularly among
unemployment (left-hand scale; as a percentage
of labour)
the young (from 23.9% to 16.6%), women (from
employment (right-hand scale; index: 1999 = 100)
12.7% to 9.4%) and, by educational level, the low-
11
112
skilled (from 13.3% to 9.9%).8
10
107
These are encouraging developments, which
Despite these important
show that past labour market reforms, improvements …
9
102
immigration and wage moderation have helped
to overcome some of the constraints on growth
8
97
stemming from rigid and over-regulated labour
markets. It also conﬁ rms that monetary policy
7
92
1991 1993 1995 1997 1999 2001 2003 2005 2007
geared towards price stability is fully
consistent with job creation and low
Sources: EUROSTAT and ECB calculations.
unemployment. However, despite this progress,
most euro area countries are still far from having exhausted the potential for further increases in
participation rates and employment. Structural impediments emerging from rigid legal and
regulatory environments, high taxes on labour and distortions associated with regulations such as
minimum wages still prevent or discourage many people from actively participating in the labour
market and thus keep employment rates low and unemployment high.
Empirical evidence points to employment protection legislation and tax wedges as important
… there are still obstacles
to full employment
obstacles to employment performance.9 Over the last decade, euro area countries have, on average,
made progress in increasing the incentives to work, particularly by reducing both disincentives to
work longer and the ﬁ nancial incentives to retire early. For the period 2001-06, tax wedges, which
capture the amount of income tax paid plus employee and employer social security contributions,
have declined for various groups (see Table 2). By contrast, euro area countries have, on average,
8 Source: Eurostat (Labour Force Survey).
9 See also the article entitled “Developments in the structural features of the euro area labour markets over the last decade” in the January
2007 issue of the Monthly Bulletin.
Table 2 Development of tax wedges and the unemployment trap in the euro area in the
period 2001-06
(percentage points)
Level in 2006
Change over 2001-06
Tax Wedges 1)
Single Earner
38.2
-0.6
One earner, married couple
32.1
-0.3
Two earners
33.4
-0.7
Unemployment trap 2)
78.3
2.6
Low wage trap 3)
48.3
4.7
Sources: OECD (2007), “Taxing wages 2006-2007”. Eurostat Structural indicators database 2008; unweighted averages. Data only
available for 2001-06.
1) The tax wedge captures income tax plus employee and employer social security contributions less cash beneﬁ ts as a percentage of
labour costs. The ﬁ gures for a single person without children with 67% of the average worker wage, for a one-earner married couple with
two children aged 4 and 6 at 100% of the average worker wage and a two-earner married couple with two children, where one earner has
100% of the average worker wage and the other 33%.
2) The “unemployment trap” is deﬁ ned as the percentage of gross earnings taxed away through higher taxes and social security
contributions, as well as the beneﬁ t withdrawal when an unemployed person takes up a job. It is measured here for a single person without
children with 67% of the average earnings of a full-time production worker in the manufacturing industry.
3) The “low wage trap” is deﬁ ned as the percentage of gross earnings taxed away by higher taxes and reduced beneﬁ ts when taking up a
higher paid job. It is measured here for a single person without children, moving from 33% to 67% of the average earnings of a production
worker.
ECB
Monthly Bulletin
10th Anniversary of the ECB
69

been comparably less successful in increasing the incentives for the unemployed to take up work
opportunities.
Lower taxes on labour
In this regard, net replacement rates 10 increased between 2001 and 2005. At the same time, the indicator
support employment
of the so-called “unemployment trap”, which measures the amount of taxes and the withdrawal of
government transfers when an unemployed person takes up a job, also increased signiﬁ cantly to a level
of 78.3% of gross income in 2006 (see Table 2 for details). Further reforms in income tax and beneﬁ t
systems would help to increase incentives to work. Reducing disincentives to work, such as high
marginal tax rates, high unemployment beneﬁ ts and encouraging people to work longer, can stimulate
the labour supply and employment of all workers, particularly those with a generally more tenuous
attachment to the labour market, such as women and younger and older workers.
But there is still progress to
All in all, while some progress has been made over the past decade, in many euro area countries
be made
there still seems to be a long way to go to implement reforms that ensure employment rates in line
with the best-performing countries. The euro area is still far from exhausting the growth potential of
a more intense use of labour in the production process. In many countries the labour market still
features an “insider-outsider” characterisation, with structural impediments – owing to the legal and
regulatory environment, high taxes on labour and rigidities associated with wage regulations –
creating obstacles for certain groups to participate actively in the labour market.
Wage flexibility and prudent
A high degree of labour market ﬂ exibility would help national labour markets to adjust to economic
market competition support
shocks and would facilitate the efﬁ cient allocation of labour and other resources. Sufﬁ cient wage
job creation
differentiation would improve employment opportunities for less-skilled workers and in regions or
sectors with high unemployment. Furthermore, empirical evidence points to the signiﬁ cant potential
of labour and product markets to cross-fertilise: deregulating labour markets would generate higher
employment growth, especially when product markets are more competitive, and vice versa.11 This
leads to the issue of efﬁ cient and well-functioning product markets as a second prerequisite for
higher potential growth in the euro area.
COMPETITION AND INNOVATION IN PRODUCT MARKETS
Increasing economic
In the European Union, progress has been made in strengthening competition and increasing
integration
economic integration over the last two decades. In particular, the Single Market has brought major
beneﬁ ts for the EU’s economy. According to a European Commission estimate, the Single Market
created 2.75 million jobs and led to an increase in welfare of around €500 per head in 2006, which
corresponds to a 2.15% increase in the EU’s GDP over the period 1992-2006.12
Increasing competition,
Increasing product market competition – at EU and national levels – gives rise to more
deregulation and
efﬁ cient production structures. The empirical literature generally ﬁ nds that competition in markets
liberalisation
is an important factor in explaining both labour productivity and relative price developments.
Deregulation and liberalisation contribute to higher levels and rates of growth in labour
productivity.13 For instance, the beneﬁ ts of opening up network industries to competition can be
seen in the telecommunications sector. Hourly labour productivity in this particular sector saw a
10 Net replacement rates measure the amount of beneﬁ ts – comprising unemployment beneﬁ ts, social assistance, and family and housing
beneﬁ ts – net of taxes as a ratio to the net wage income that the worker or household obtained before unemployment.
11 See, for example, H. Berger and S. Danninger (2007), “The employment effects of labor and product market deregulation and their
implications for structural reform”, International Monetary Fund Staff Paper Vol. 54, No 3.
12 European Commission, “The single market: review of achievements”, November 2007.
13 See P. Conway, D. De Rosa, G. Nicoletti and F. Steiner (2006), “Regulation, Competition and Productivity Convergence”, OECD
Economics Department Working Paper No 509, and the literature quoted therein.
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E C O N O M I C P O L I C Y
C H A L L E N G E S
signiﬁ cant acceleration from 4.5% to 7.3% in the periods 1980-95 and 1995-2005, and telephone
A N D E N L A R G E M E N T
prices charged by the former monopolies for national and international calls fell by more than 40%,
on average, in Europe between 2000 and 2006. This boosted the purchasing power of consumers,
who now have more of their income available to spend on other goods and services.
However, much remains to be done, particularly in some areas of market services, which account
Greater competition in
for around 70% of the euro area’s total nominal value added and total employment.14 A broader and
services remains key
deeper EU internal market clearly remains a priority in the pursuit of effective competition in the
energy market and the implementation of the Services Directive15. The growing economic
importance of services suggests that improvements in European living standards are, to a great
extent, likely to depend on a high degree of competition and on productivity improvements in the
services sector.
In order to exploit the productivity potential fully, product market reforms need to be accompanied
by policies that support innovation and technological change. These include the unlocking of
business potential by creating an entrepreneur-friendly economic environment, measures to support
innovation through higher investment in research and development (R&D), and policies geared
towards improving human capital.
An entrepreneur-friendly economic environment would imply fewer and more efﬁ cient regulations,
particularly helping small and medium-sized enterprises to develop at home and across borders,
as well as positive action to ease access to the ﬁ nance that these enterprises need. Europe is still
lagging behind in this ﬁ eld. For instance, venture capital ﬁ nancing in Europe is only a fraction
of what it is in the United States relative to the size of each economy. The promotion of R&D
investment is also a major issue. In 2005 R&D investment amounted to 1.9% of euro area GDP,
compared with 2.7% in the case of the United States.
In addition to structural reforms, stability-oriented ﬁ scal policies are a pre-condition for the smooth
functioning of EMU. The next section considers ﬁ scal policy issues.
4.2 FISCAL POLICIES
This section recalls the importance of sound public ﬁ nances. It also provides an overview of
ﬁ scal developments before and during Stage Three of EMU, the implementation of the Stability
and Growth Pact, and medium to longer-term ﬁ scal challenges (see Chapter 2 for details of the
institutional framework for ﬁ scal policies in EMU).
Fiscal policies can have a signiﬁ cant impact on economic growth and inﬂ ationary pressures through the
Stability-oriented fiscal
policies are essential to EMU
level and composition of government revenue and expenditure, as well as budget deﬁ cits and public
debt.16 High deﬁ cits can give rise to demand and inﬂ ationary pressures, potentially forcing the monetary
authority to keep short-term interest rates at a higher level than would otherwise be necessary. Fiscal
may also undermine conﬁ dence in a stability-oriented monetary policy if private agents come to expect
14 For a detailed analysis of the degree of competition in the euro area services sector and its effects on labour productivity and prices,
see the article entitled “Competition and economic performance of the euro area services sector” in the May 2008 issue of the Monthly
Bulletin.
15 The Directive on services in the internal market, which aims to bolster the freedom of EU companies to establish themselves in other
Member States and the free movement of services, was adopted by the European Parliament and the Council in December 2006 and must
now be transposed by the Member States into national law by the end of 2009.
16 See the article entitled “Fiscal policy inﬂ uences on macroeconomic stability and prices” in the April 2004 issue of the Monthly Bulletin.
ECB
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71

that excessive government borrowing will Chart 3 Euro area general government fiscal
ultimately be accommodated by the central bank.
developments in the period 1980-2007
Sound and sustainable ﬁ scal policies are therefore
a pre-condition for sustainable economic growth
(as a percentage of GDP)
and a smooth functioning of monetary union,
consolidated gross debt (right-hand scale)
deficit (left-hand scale)
including the avoidance of imbalances across
6
100
countries (see Section 4.3).
Stage Three of EMU 90
5
80
A number of institutional arrangements have
70
been established at EU level in order to ensure
4
60
appropriate medium-term-oriented national 3
50
ﬁ scal policies and sustainable public ﬁ nances
40
in EMU. In particular, Member States adopting
2
30
the euro are obliged by the Treaty on European
20
Union to avoid excessive government deﬁ cits.
1
10
These are assessed against reference values of
0
0
3% and 60% of GDP for general government
1980
1984
1988
1992
1996
2000
2004
2008
deﬁ cit and debt ratios respectively. Furthermore,
interest expenditure
the Stability and Growth Pact, adopted in 1997
primary expenditure
and revised in 2005, obliges EU Member States
total revenue
to pursue appropriate “close to balance or in
53
53
Stage Three of EMU
surplus” budgetary objectives over the medium
51
51
term. Countries with such positions should have
49
49
room to allow the operation of the “automatic
47
47
ﬁ scal stabilisers” without breaching the 3%
45
45
deﬁ cit ceiling, thereby mitigating the impact
43
43
of the business cycle and contributing to the
41
41
smooth functioning of EMU.17
39
39
37
37
FISCAL DEVELOPMENTS IN THE EURO AREA
BEFORE AND DURING STAGE THREE OF EMU
35
35
1980
1984
1988
1992
1996
2000
2004
2008
Sources: European Commission, NCBs and ECB calculations.
Fiscal positions have
In the decades preceding EMU, ﬁ scal policies in
Note: Data exclude proceeds from the sale of Universal Mobile
improved …
many European countries were characterised by
Telecommunications System (UMTS) licences.
unsustainable rates of spending growth, rising
tax burdens and the steady build-up of government debt. During the 1980s and early 1990s, the
euro area general government deﬁ cit ratio was, on average, in the range of 4-5% of GDP and the
government debt-to-GDP ratio rose from below 40% to around 70% (see Chart 3 and Table 3).
Since then, the aggregate ﬁ scal position of the euro area countries has improved markedly. Notably,
in the run-up to Stage Three of EMU, government borrowing fell signiﬁ cantly and, by 2000, the
deﬁ cit ratio (net of proceeds from the sale of UMTS licences) reached a low of 1% of GDP. The
euro area government deﬁ cit ratio increased again, reaching 3.1% of GDP in 2003, but thereafter an
improvement has seen it decline to 0.6% of GDP in 2007, its lowest level since the early 1970s.
17 See the article entitled “EMU and the conduct of ﬁ scal policies” in the January 2004 issue of the Monthly Bulletin.
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C H A L L E N G E S
Table 3 General government budget balances in euro area countries in the period 1990-2007
A N D E N L A R G E M E N T
(as a percentage of GDP)
1990-1998
1999-2007
1999
2000
2001
2002
2003
2004
2005
2006
2007
Belgium
-5.0
-0.2
-0.5
0.1
0.4
0.0
0.0
0.0
-2.3
0.3
-0.2
Germany
-
-2.4
-1.5
-1.1
-2.8
-3.7
-4.0
-3.8
-3.4
-1.6
0.0
Ireland
-
1.6
2.7
4.7
0.9
-0.6
0.4
1.4
1.6
3.0
0.3
Greece
-
-4.5
-3.4
-3.7
-4.9
-4.7
-5.6
-7.4
-5.1
-2.6
-2.8
Spain
-
0.1
-1.4
-1.1
-0.6
-0.5
-0.2
-0.3
1.0
1.8
2.2
France
-
-2.6
-1.8
-1.5
-1.6
-3.2
-4.1
-3.6
-2.9
-2.4
-2.7
Italy
-
-2.9
-1.7
-2.0
-3.1
-2.9
-3.5
-3.5
-4.2
-3.4
-1.9
Cyprus
-
-2.7
-4.3
-2.3
-2.2
-4.4
-6.5
-4.4
-2.4
-1.2
3.3
Luxemburg
-
2.3
3.4
6.0
6.1
2.1
0.5
-1.2
-0.1
1.3
2.9
Malta
-
-5.3
-7.7
-6.2
-6.4
-5.5
-9.8
-4.6
-3.2
-2.5
-1.8
Neterlands
-3.0
-0.5
0.4
1.3
-0.2
-2.0
-3.1
-1.7
-0.3
0.5
0.4
Austria
-
-1.5
-2.2
-2.1
0.0
-0.6
-1.4
-3.7
-1.5
-1.5
-0.5
Portugal
-
-3.6
-2.8
-3.2
-4.3
-2.9
-2.9
-3.4
-6.1
-3.9
-2.6
Slovenia
-
-2.4
-3.1
-3.8
-4.5
-2.5
-2.7
-2.3
-1.5
-1.2
-0.1
Finland
-
3.9
1.6
6.9
5.0
4.1
2.6
2.4
2.9
4.1
5.3
Euro Area
-
-1.9
-1.4
-1.0
-1.9
-2.5
-3.1
-2.9
-2.5
-1.3
-0.6
Sources: European Commision, NCBs and ECB calculations.
Notes: Figures for the periods 1990-98 and 1999-2007 are annual averages. Germany data for 1990 refer to West Germany. Data exclude
proceeds from the sale of universal mobile telecommunications system (UMTS) licences.
The lower euro area government deﬁ cit ratios of recent years can be attributed, in large part, to a
… largely owing to lower
signiﬁ cant decline in interest rates and thus in the burden of interest payments, which have fallen
interest payments
from around 5.5% of GDP in the early 1990s to slightly less than 3% of GDP since 2005. Beyond
this, an assessment of the relative contributions of government revenues and primary expenditure to
ﬁ scal consolidation is complicated by the responsiveness of these variables to cyclical developments.
Looking at longer trends, the ratio of primary government spending to GDP in the euro area has
remained broadly constant since the mid-1980s, whereas the revenue-to-GDP ratio witnessed a
structural increase prior to Stage Three of EMU. Since 1999, both the government revenue and
primary expenditure-to-GDP ratios have ﬂ uctuated around high but broadly constant levels,
indicating that the trend towards ever higher government spending and revenue ratios of previous
decades has come to a halt.
The improvement in the aggregate euro area ﬁ scal position over the past two decades reﬂ ects a
Further reductions in some
signiﬁ cant degree of convergence towards sustainable public ﬁ nances among the participating
debt-to-GDP ratios needed
countries. Notably, the very high budget deﬁ cits observed in some countries in the 1980s and early
1990s have largely been eliminated. In the high debt countries in particular, the interest burden has
fallen considerably on account of the much lower interest rates now being paid on outstanding
government debt. This can be seen largely as a beneﬁ t resulting from the elimination of exchange
rate risk and the transition to more stability-oriented macroeconomic policies in EMU.18 However,
this implies that primary deﬁ cit measures have improved less. Moreover, there has been only a
limited improvement in government debt-to-GDP ratios, and the fact that some euro area member
countries still have debt ratios well above the reference value of 60% of GDP in 2007 (see Table 4)
is a cause for concern.
18 See the article entitled “Fiscal policies and ﬁ nancial markets” in the February 2006 issue of the Monthly Bulletin.
ECB
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73

Table 4 Euro area general government fiscal positions in the period 1990-2007
(as a percentage of GDP)
Debt
Primary expenditure
Interest expenditure
1990-1998 1999-2007
1998
2007 1990-1998 1999-2007
1998
2007 1990-1998 1999-2007
1998
2007
Belgium
127.0 98.8
117.1
84.6
42.9 44.4
43.0
44.9
9.6
5.4
7.4
3.9
Germany
n.a.
63.3 60.3 65.0
n.a.
44.1
44.7
41.1
n.a.
2.9
3.4
2.8
Ireland
n.a.
32.4 54.0 25.5
n.a.
32.4
31.1
35.4
5.8
1.4
3.3
0.9
Greece n.a.
100.5
105.8
94.5
n.a.
39.6
41.0
39.4
n.a.
5.5
8.5
3.9
Spain n.a.
49.3
64.1
36.2
n.a.
36.4
36.9
37.2
4.5
2.4
4.2
1.6
France
48.7
61.5 59.4 64.2
49.8
49.8
49.4
50.0
3.2
2.8
3.3
2.6
Italy
n.a.
106.9 114.9 104.0
n.a.
42.7
41.3
43.8
n.a.
5.4
7.9
4.7
Cyprus
n.a.
64.0 58.4 59.8
n.a.
37.9
33.7
40.0
3.1
3.3
3.1
3.1
Luxembourg
n.a.
6.4 7.4 6.8
n.a.
39.6
40.6
37.3
n.a.
0.2
0.4
0.2
Malta
n.a.
63.8 53.4 62.6
n.a.
40.4
39.8
39.3
2.6
3.5
3.2
3.3
Netherlands
74.6
51.8 65.7 45.4
46.7
43.0
42.0
43.8
5.6
2.8
4.7
2.2
Austria
n.a.
64.1 64.3 59.1
n.a.
47.7
50.0
45.6
n.a.
3.0
3.5
2.6
Portugal
56.5
57.5 52.1 63.6
n.a.
42.4
39.5
42.9
n.a.
2.8
3.3
2.9
Slovenia
n.a.
26.8 23.1 24.1
n.a.
44.6
44.1
41.9
2.3
1.9
2.3
1.4
Finland
n.a.
41.9 48.2 35.4
n.a.
47.2
49.0
46.1
n.a.
2.0
3.5
1.4
Euro area
n.a.
69.0
72.8
66.4
n.a.
44.0
44.0
43.3
n.a.
3.4
4.6
3.0
Sources: European Commission, NCBs and ECB calculations.
Notes: Data exclude proceeds from the sale of universal mobile telecommunications system (UMTS) licences. Germany data for 1990 refer
to West Germany.
IMPLEMENTATION OF THE STABILITY AND GROWTH PACT
The EMU fiscal rules have
The implementation of the EMU ﬁ scal surveillance framework has faced many challenges related
faced challenges
to ﬁ scal developments in euro area countries since 1999. While several member countries have
managed to reach and/or maintain “close to balance or in surplus” ﬁ scal positions as prescribed by
the “preventive arm” of the Stability and Growth Pact (i.e. the procedures that aim to prevent the
emergence of excessive deﬁ cits), others have failed to do so. In some countries, medium-term
budgetary targets set in annual stability programmes have been regularly missed owing to over-
optimistic macroeconomic and ﬁ scal assumptions, a lack of consolidation efforts and expenditure
overruns partly reﬂ ecting a lack of political will to abide by commitments.
Consequently, during the economic downturn of 2001-03, deﬁ cits in several countries (Germany,
Greece, France, Italy, the Netherlands and Portugal) reached or exceeded the 3% of GDP reference
value (see Table 3). In this context, views were split on the appropriate implementation of the
“corrective arm” of the Pact (i.e. the procedures that aim to ensure a rapid correction of excessive
deﬁ cits). This culminated in a decision by the ECOFIN Council in November 2003 to suspend the
excessive deﬁ cit procedures against Germany and France. Discussions followed that led to a reform
of the Pact, which was concluded in spring 2005 (see Chapter 2).
Overall implementation
Since 2005, the implementation of the reformed Stability and Growth Pact has been facilitated by
could be improved
the onset of more favourable economic conditions and particularly buoyant government revenue
growth. As a result, budget deﬁ cits have been brought back to 3% of GDP or less in all euro area
countries. However, considerable differences remain in terms of the extent to which “good times”
have been used to speed up ﬁ scal consolidation. For example, while higher tax revenues led to
Germany achieving a balanced budget in 2007, in France and Italy revenue windfalls have been
largely used to increase spending or cut taxes. Consequently, these countries’ deﬁ cits remain
relatively close to 3% of GDP, leaving little or no ﬁ scal room for manoeuvre in the event of a
downturn. Overall, therefore, the implementation of the Pact, even since its reform, can be described
as being only a mixed success, and the real test is still to come.
ECB
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E C O N O M I C P O L I C Y
C H A L L E N G E S
MEDIUM TO LONGER-TERM FISCAL CHALLENGES
A N D E N L A R G E M E N T
The failure of many euro area countries to achieve more rapidly or maintain sound ﬁ scal positions
Ageing populations are a
and to reduce government debt ratios is of particular concern in view of the future ﬁ scal challenges
major challenge
posed by ageing populations. According to the latest estimates by the European Commission and the
EU’s Economic Policy Committee, government spending on pensions, health and long-term care is
projected to increase by 4.7% of GDP between 2004 and 2050 for the euro area as a whole, with
estimates for some countries being signiﬁ cantly higher than this.19 Only a relatively small proportion
of this additional spending is expected to be offset by lower spending on unemployment beneﬁ ts and
education. More recent estimates by the OECD suggest that the age-related ﬁ scal burden may be
even higher than previously assumed, especially in the ﬁ eld of health and long-term care (see Table
5).20 In most countries, ﬁ scal consolidation alone is clearly not sufﬁ cient to address such challenges,
and further systemic and/or parametric reforms, especially of pension systems, are also necessary.21
Beyond this, improving the quality of public ﬁ nances to promote economic growth remains
a key challenge for euro area countries. Reforms to tax and beneﬁ t systems can support higher
employment and productivity growth. Moreover, prioritising and increasing the efﬁ ciency of public
spending could create room to alleviate the still high tax burdens in many member countries.22
Stability-oriented ﬁ scal policies are a pre-condition for sustainable economic growth and the
smooth functioning of Monetary Union, as well as for avoiding unnecessary differentials across
countries. The next section will present some stylised facts on cross-country differentials in real
output growth and inﬂ ation.
19 See European Commission (2006), “The long-term sustainability of public ﬁ nances in the European Union”, European Economy No 4.
20 See OECD Economic Outlook, June 2007.
21 See the article entitled “Demographic change in the euro area: projections and consequences” in the October 2006 issue of the Monthly
Bulletin. See also A. Maddaloni, A. Musso, P. C. Rother, M. Ward-Warmedinger and T. Westermann, “Macroeconomic implications of
demographic developments in the euro area”, ECB Occasional Paper No 51.
22 See the article entitled “The importance of public expenditure reform for economic growth and stability” in the April 2006 issue of the
Monthly Bulletin.
Table 5 Projected changes in selected age-related expenditure-to-GDP ratios between 2004
and 2050 1)
Pensions (1)
Health (2)
Long-term care (3)
Total (1+2+3)
EC/EPC
OECD
EC/EPC
OECD
EC/EPC
OECD
EC/EPC
OECD
Belgium
5.1
5.1
1.4
3.3
0.9
1.9
7.4
10.3
Germany
1.7
2.0
1.2
3.6
1.0
1.9
3.9
7.5
Ireland
6.4
6.5
2.0
4.0
0.6
3.8
9.0
14.3
Greece
-
3.9
1.7
3.9
-
2.7
1.7
10.5
Spain
7.1
7.0
2.2
4.1
0.5
2.4
9.8
13.5
France
2.0
2.1
1.8
3.5
0.2
1.7
4.0
7.3
Italy
0.4
0.4
1.3
3.8
0.7
2.9
2.4
7.1
Cyprus
12.9
n.a.
1.1
n.a.
n.a.
n.a.
14.0
n.a.
Luxembourg
7.4
7.4
1.2
1.4
0.6
3.1
9.2
11.9
Malta
-0.4
n.a.
1.8
n.a.
0.2
n.a.
1.6
n.a.
Netherlands
3.5
3.8
1.3
3.8
0.6
2.0
5.4
9.6
Austria
-1.2
-1.0
1.6
3.8
0.9
2.0
1.3
4.8
Portugal
9.7
9.3
0.5
4.2
0.4
2.0
10.6
15.5
Slovenia
7.3
n.a.
1.6
n.a.
1.2
n.a.
10.1
n.a.
Finland
3.1
3.3
1.4
3.6
1.8
2.4
6.3
9.3
Euro area 2)
2.6

3.0 1.5 3.7 0.6

2.2 4.7 8.9
Sources: Economic Policy Committee, Ageing Working Group, January 2006 and OECD (2007) Economic Outlook.
Note: n.a. = not available.
1) Small expenditure reductions may be expected owing to lower spending on education and unemployment.
2) Excluding Greece, Cyprus, Malta and Slovenia.
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4.3 CROSS-COUNTRY DIFFERENTIALS
The overall macroeconomic developments of the euro area, described also in Section 4.1, mask
some diversity across the euro area countries. This section addresses such diversity, ﬁ rst, in terms
of differentials in real GDP and, second, in terms of price and cost developments across the euro
area countries.23
Macroeconomic differentials
Some differentials in real output growth and inﬂ ation in the euro area, as in any currency union, are
are natural in a currency
natural, for instance those related to catching-up effects, occurring when a country’s income level is
union
catching up with those of other more developed countries in the monetary union. Other differentials
may present some challenges if protracted. For example, such differences may reﬂ ect inappropriate
national economic policies, structural rigidities or malfunctioning adjustment mechanisms in
individual countries, which should be addressed by national policy-makers. Differentials that are
due to a lack of cross-border trade and integration must be addressed by fully implementing the
Single Market. In order to avoid a situation where a country or a region in the euro area – after
suffering a country or region-speciﬁ c shock – enters either a period of protracted low growth and
high unemployment or a long period of overheating, efﬁ cient adjustment mechanisms need to be in
place. The ECB’s single monetary policy cannot directly address growth and inﬂ ation differentials,
rather it contributes to the smooth functioning of EMU by maintaining price stability in the euro
area as a whole.
DEVELOPMENTS IN REAL GDP GROWTH ACROSS EURO AREA COUNTRIES
Output growth differentials
The current degree of differences in output growth across the euro area countries is not large by
in the euro area are
either historical standards or comparison with other large currency areas.
moderate
As can be seen from Chart 4, the dispersion of real GDP growth rates across the group of 12
countries that formed the euro area in 2001, measured by the standard deviation in unweighted
terms, has been ﬂ uctuating around 2 percentage points and has shown no apparent upward or
downward trend over the past 35 years.
The current degree of output growth dispersion within the euro area does not appear to differ
signiﬁ cantly from that observed across regions or states within the United States (see Chart 4).24
The growth differentials are
Looking at developments in individual countries (see Table 6), growth rates in some countries have
persistent …
persistently been above the euro area average since the early 1990s. More generally, differentials in
real GDP growth across the euro area countries have largely reﬂ ected lasting trend growth
differences and, to a lesser extent, cyclical differences. In contrast, the degree of business cycle
synchronisation across the euro area countries seems to have increased since the beginning of the
1990s.
Reasons for protracted output growth differentials in the euro area may be related, for instance, to
structural policies (including the design of institutions), different evolutions in supply factors and
convergence processes, as well as the combination of country-speciﬁ c shocks and the working of
adjustment mechanisms.
23 See the article entitled “Output growth differentials in the euro area: sources and implications” in the April 2007 issue of the Monthly
Bulletin.
.
24 For a comprehensive review of the evidence on output growth differentials, see N. Benalal, J. L. Diaz del Hoyo, B. Pierluigi and N. Vidalis,
“Output growth differentials across the euro area countries: some stylised facts”, ECB Occasional Paper No 45, 2006.
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E C O N O M I C P O L I C Y
C H A L L E N G E S
Chart 4 GDP growth dispersion across euro
Table 6 GDP growth rates across euro area
A N D E N L A R G E M E N T
area countries and US regions and states
countries
(unweighted standard deviation, percentage points)
(average annual percentage changes)
euro area (12 countries)
1980-1989
1990-1998
1999-2007
US (50 States & D. Columbia)
US (8 regions)
Euro area
2.3
2.0
2.2
Belgium
2.2 3.4 2.3
5.0
5.0
Germany
2.0 2.3 1.5
Ireland
3.1 6.7 6.4
4.0
4.0
Spain
2.7 2.5 3.8
Greece
0.8 1.7 4.1
France
2.5 1.7 2.1
3.0
3.0
Italy
2.6 1.4 1.4
Cyprus -
4.5
3.7
2.0
2.0
Luxembourg
4.6 4.4 5.2
Malta -
4.8
2.4
Netherlands
1.7 3.0 2.3
1.0
1.0
Austria
2.0 2.5 2.3
Portugal
3.4 2.8 1.7
0.0
0.0
Slovenia -
1.4
4.4
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Finland
3.6 1.3 3.4
Sources: European Commission and US Bureau of Economic
Sources: Eurostat and European Commission.
Analysis.
Note: 2007 data are European Commission estimates (autumn
Note: There is a break in the two US series in the period 1997-99
2007 forecasts).
(no data are available for 1998).
Output growth differentials may partly reﬂ ect a long-lasting catching-up process of lower-income
… partly due to catching-up
and adjustment rigidities …
countries. Among the low-income group of euro area countries in the 1980s, Ireland, Greece and
Spain have subsequently made considerable progress, whereas GDP per capita relative to the euro
area in Portugal has fallen since the euro changeover. Ireland already attained the euro area average
in the late 1990s and has even gone well beyond it in recent years.
The presence of persistent output growth differences may, to some extent, reﬂ ect the long-lasting impact
… but also to fiscal and
structural policies
of economic shocks and structural policies. There is little evidence that any of the major common shocks
over recent years has, by itself, been a relevant factor in persistent real GDP growth differentials. In
contrast, the available empirical literature shows that country-speciﬁ c shocks and policy changes, such as
ﬁ scal policies and structural reforms, have played a greater role in generating output growth differentials
in recent years than common shocks, and that the effects of those factors can be highly persistent.25
The slow functioning of adjustment mechanisms can further reinforce output growth differentials
stemming from country-speciﬁ c shocks. In a monetary union such as the euro area, with a single
currency and a single monetary policy, the main adjustment mechanism – in the absence of
a high degree of labour mobility and ﬁ scal transfers across countries – is the cross-border trade
or competitiveness channel.26 An additional channel of a somewhat different nature is the “risk-
sharing channel”.27 Available evidence shows that the competitiveness channel appears, as a result
of structural rigidities and a lack of full implementation of the Single Market, to require a relatively
long period to work through in the euro area. This implies that in response to asymmetric shocks,
25 Recent analyses of this issue are provided in D. Giannone and L. Reichlin, “Trends and cycles in the euro area: how much heterogeneity
and should we worry about it?”, ECB Working Paper No 595, 2006, and in A. Buisán and F. Restoy, “Cross-country macroeconomic
heterogeneity in EMU”, Banco de España Occasional Paper No 0504, 2005.
26 The competitiveness channel works as follows: following a wage shock, or a shock that drives a country’s output above its potential,
domestic inﬂ ationary pressures – on wages and other domestic costs – will give rise to a deterioration in external competitiveness. This
will, in turn, gradually reduce foreign demand for the country’s exports, such that lower external demand will tend to restore output to its
potential level and to dampen previous inﬂ ationary pressures.
27 In essence, this mechanism implies that consumption need not follow movements in output because consumers can borrow abroad.
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larger price and inﬂ ation differentials, as well as higher regional unemployment, may be observed
than would be the case with a higher degree of cross-border competition and economic integration.
INFLATION AND LABOUR COST GROWTH DIFFERENTIALS ACROSS EURO AREA COUNTRIES
The process of real convergence has been accompanied by a declining dispersion of inﬂ ation and
labour cost growth within the euro area. Inﬂ ation differentials have diminished across the euro area
countries and are currently at levels similar to those observed within the United States. Inﬂ ation
dispersion may be due to equilibrium adjustments and price level convergence. However, they may
also be due to structural rigidities and excessive wage growth, and thus could, if protracted, lead to
losses in competitiveness with adverse effects on output and employment.
Overall euro area inflation
Since the 1990s, the degree of inﬂ ation dispersion in the group of 12 countries that formed the euro
declined
area in 2001 has been characterised by a strong downward trend, which has stabilised from 1998
onwards (see Chart 5).
Inflation differentials are
Drawing a comparison with the United States, a long-standing monetary union, Chart 5 shows that
modest
the dispersion of inﬂ ation rates across 14 US metropolitan statistical areas has been ﬂ uctuating
close to the level observed across the euro area countries since 2004.28
Overall inﬂ ation fell in all euro area countries in the period 1999-2007, compared with the
period 1990-98, except in Ireland, Luxembourg and the Netherlands, where it rose (see Table 7).
A breakdown of price developments shows that domestic costs in a majority of the euro area
28 The 14 MSAs considered are New York, Philadelphia, Boston, Washington, Chicago, Detroit, Cleveland, Dallas, Houston, Atlanta,
Miami, Los Angeles, San Francisco and Seattle.
Chart 5 Dispersion of annual inflation
Table 7 CPI/HICP inflation rates across euro
rates across euro area countries and 14 US
area countries
metropolitan statistical areas (MSAs) since 1990
(unweighted standard deviation, percentage points)
(average annual percentage changes)
euro area (12 countries)
1980-1989
1990-1998
1999-2007
United States (14 MSAs)
Euro area
7.6
3.0
2.1
7.0
7.0
Belgium 4.9
2.1
2.0
Stage I
Stage II
Stage III
Germany 2.9
2.2
1.6
of EMU
of EMU
of EMU
Ireland 9.3
2.5
3.4
6.0
6.0
Greece
19.5
11.8
3.2
Spain
10.2 4.4 3.1
France 7.4
2.1
1.8
5.0
5.0
Italy 11.2
4.4
2.3
Cyprus -
-
2.6
4.0
4.0
Luxembourg 4.8
2.4
2.7
Malta -
-
2.3
Netherlands 2.9
2.2
2.4
3.0
3.0
Austria 3.8
2.4
1.7
Portugal 17.7
6.1
2.9
Slovenia -
-
5.5
2.0
2.0
Finland 7.3
2.5
1.6
Source: ECB.
1.0
1.0
Notes: Data refer to HICP inﬂ ation, as far back as available, and
CPI inﬂ ation prior to that. Data for Slovenia are available from
1996 onwards, and for Cyprus and Malta from 1997 onwards.
“Euro area” refers to the euro area in changing composition.
0.0
0.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: ECB calculations based on Eurostat and US Bureau of
Labor Statistics.
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C H A L L E N G E S
Table 8 Inflation accounting for the period 1999-2007
A N D E N L A R G E M E N T
(average annual percentage points; relative to the euro area)
Final demand deﬂ ator
Unit labour costs
Contribution to total change
Contribution to total change
Domestic
Import
Inverse labour
Total change
costs
costs
Total change
Compensation
productivity
Belgium
0.3
-0.2
0.5 -0.1 0.4 -0.5
Germany -1.2
-1.2
0.0
-1.4
-1.2
-0.2
Ireland
0.8 1.0 -0.1
1.5
3.7 -2.1
Greece 1.5
1.7
-0.2
1.3
4.1
-2.7
Spain
1.5 1.4 0.1
1.2
0.4
0.8
France
-0.5 -0.1 -0.4
0.3
0.5
-0.3
Italy
1.7 0.6 1.1
1.0
0.0
0.9
Cyprus
-1.9 -0.8 -1.1
1.6
1.8
-0.2
Luxembourg
1.6 0.1 1.6
1.0
3.5 -2.5
Malta
0.4 0.1 0.3
0.6
1.0 -0.5
Netherlands
0.1 0.0 0.1
0.7
1.1 -0.4
Austria
-0.5 -0.5 0.0
-1.2
-0.5
-0.7
Portugal
0.9 1.1 -0.3
1.6
1.7 -0.1
Slovenia
3.2 1.7 1.5
3.4
6.1 -2.6
Finland
-0.8 -0.7 -0.1
-0.4
0.9
-1.2
Source: ECB calculations based on European Commission and Eurostat data.
Notes: This table shows deviations in the average growth rate of each variable from the euro area average. The numbers in the table can be
interpreted as follows: taking Belgium as an example, the total change in the ﬁ nal demand deﬂ ator was 0.3 percentage point higher than
in the euro area as a whole per annum in the period 1999-2007. The contribution from average import cost in Belgium relative to the euro
area was 0.5 percentage point per annum, while the contribution from relative domestic costs was -0.2 percentage point per annum to the
relative change in the ﬁ nal demand deﬂ ator.
countries appear to be the most important factor related to the inﬂ ation differentials vis-à-vis the
euro area average in the period 1999-2006 (see Table 8). Among the domestic factors, differences
in unit labour cost growth – in turn more closely associated with diverging wage developments
than differences in labour productivity growth – seem to have played an important role. However,
changes in import costs seem to have also contributed to inﬂ ation differentials.
Some inﬂ ation and cost differentials are normal in a monetary union. The process of equilibrium
Differentials are normal in a
price and cost adjustment in a currency union is typically associated with an adjustment of relative
monetary union
prices across regions and sectors. Such a mechanism, which to a certain extent is a normal feature
of a catching-up process or, more generally, of trend productivity differentials, may give rise to
inﬂ ation differentials across the regions and sectors of a monetary union.29
Inﬂ ation differentials in the euro area have been rather persistent, in the sense that many countries
have systematically maintained either a positive or a negative inﬂ ation gap against the euro area
average over a protracted period (see Box 1).
Several factors – which are intrinsically interlinked – may explain the existence of long-lasting
inﬂ ation and labour cost growth differentials in the euro area.30 In particular, a distinction can be
made between factors related to convergence and economic integration processes, those related to
long-lasting or permanent differences in national economic structures, and policy-induced factors
29 See, among others, I. Angeloni and M. Ehrmann (2004), “Euro area inﬂ ation differentials”, ECB Working Paper No 388, and F. Altissimo,
P. Benigno and D. Rodríguez-Palenzuela (2004), “Inﬂ ation differentials in a currency area: facts, explanations and policies”, presented at
the ECB workshop “Monetary policy implications of heterogeneity in a currency area”, Frankfurt, 13-14 December 2004, available on the
ECB’s website (www.ecb.europa.eu).
.
30 See the article entitled “Monetary policy and inﬂ ation differentials in a heterogeneous currency area” in the May 2005 issue of the
Monthly Bulletin.
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related to the conduct and operation of national ﬁ scal, structural and wage policies or to the various
regional responses to euro area-wide policies.
Some differentials are due
Turning ﬁ rst to the factors related to convergence and economic integration, the implementation of
to price level convergence
Europe’s Single Market in the ﬁ rst half of the 1990s and the subsequent introduction of the single
currency in 1999 have contributed to a marked decline in price level dispersion, mainly for tradable
goods. The price convergence of tradable goods towards a common long-term level is likely to have
accounted for some of the inﬂ ation differentials in the ﬁ rst years of the euro.
Inﬂ ation differentials across the euro area countries may also result from the convergence of price
levels for non-tradable goods and services 31. This catching-up effect is often associated with growth
differentials between traded and non-traded sector productivity or, more generally, with the process
of convergence in living standards in GDP per capita across economies. For example, according to
the Balassa-Samuelson effect, countries that display pronounced sectoral differences in productivity
developments relative to other countries (with relatively higher productivity growth in the tradable
sector) would tend to experience relatively higher wage growth and inﬂ ation in the non-tradable
sector. Within a currency union, where a nominal exchange rate appreciation is not possible, such
a country would experience higher overall relative inﬂ ation. However, empirical evidence of this
effect is mixed.
Second, inﬂ ation or price level differentials may also emanate from normal structural differences,
such as heterogeneity in consumer preferences and differences in national exposure to changes in
the exchange rate of the euro and the price of raw materials. In particular, differences in the degree
of openness and in the composition of international trade could be factors explaining inﬂ ation
differentials.
Some differentials are due
Third, both area-wide and regional policies might themselves shape the degree of heterogeneity in a
to inappropriate policies
currency union. For instance, ﬁ scal policy may reinforce inﬂ ation differentials through the
inappropriate use of ﬁ scal instruments (see Section 4.2). Structural rigidities and a lack of full
implementation of the Single Market may imply that larger price differentials are likely to be
observed than in the case of a higher degree of cross-border competition and economic integration.
Structural and wage policies conducted at national or regional level can also be a source of inﬂ ation
differentials. For example, the fact that indexation clauses in collective wage-bargaining agreements
are present in some euro area countries may, for instance, delay necessary adjustments and
contribute to the persistence of inﬂ ation differentials by increasing inﬂ ation inertia in those
countries.
31 Non-tradables are goods and services that, to a large extent, are traded locally.
Box 1
UNDERSTANDING INFLATION PERSISTENCE AND DETERMINANTS OF WAGE DYNAMICS
In addition to country-speciﬁ c shocks, an important source of inﬂ ation and growth differentials
are the potential differences in the ﬂ exibility of prices and wages across countries. In any case,
a deep understanding of the determinants of price and wage dynamics across the euro area
countries is crucial for the conduct of monetary policy. In view of the importance of issue, two
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C H A L L E N G E S
A N D E N L A R G E M E N T
ESCB-wide networks, namely the Inﬂ ation Persistence Network (IPN) and the Wage Dynamics
Network (WDN), have been set up. This box presents the main ﬁ ndings of these two networks.
The IPN started its work in 2003 and reported the results of its research at a conference
in December 2004 1. The IPN adopted three approaches to tackling this issue: analysis of
macroeconomic data, detailed analysis of micro data on individual price changes for both
consumer and producer prices, and surveys of ﬁ rms with the aim of identifying the main factors
that inﬂ uence their price-setting behaviour.
The main conclusions of these analyses were as follows. First, under the current monetary regime,
the degree of persistence of inﬂ ation is found to be moderate. This contrasts with experience in the
earlier era of high inﬂ ation, when expectations were less well anchored, with the result that shocks
to inﬂ ation tended to lead to more protracted changes in inﬂ ation. Second, on the basis of micro data
on price changes, consumer prices in the euro area appear to be stickier than in the United States. For
example, individual prices in the euro area are typically changed every 12 to 15 months, as opposed
to every six months in the United States. Third, there is considerable cross-sectoral heterogeneity in
price-setting, but there do not appear to be important differences across countries in the frequency of
price changes. For example, food and energy prices are changed much more frequently than services
prices. Fourth, price decreases are rather common (some 40% of consumer price changes are price
cuts), suggesting that prices are not as subject to downward nominal rigidity as was previously
believed. Fifth, the survey evidence reveals that the price adjustment process typically takes place in
two steps: price reviews by ﬁ rms and subsequently price changes. In fact, price reviews are found to
be much more frequent than actual price changes. With regard to the determinants of price changes,
the survey results show that around one-third of euro area ﬁ rms follow a regular timetable in setting
prices (“time-dependent pricing”), while one-ﬁ fth change their prices when speciﬁ c events lead to a
sufﬁ ciently large deviation between the actual price and the desired price (“state-dependent pricing”).
The remainder follow a mixed strategy. Both the survey evidence and the analysis of individual price
changes suggest that an important determinant of the frequency of price changes is the volatility of
ﬁ rms’ costs. For example, prices tend to be changed much less frequently in sectors where wages,
which themselves tend to be rather sticky, represent a high share of ﬁ rms’ total costs.
The ﬁ ndings of the IPN highlighted the need for a deeper understanding of the determinants of wage
dynamics. Therefore, in 2006, the WDN was launched. In addition to researchers from the euro area,
the WDN also includes researchers from non-participating central banks. Four lines of research are
being pursued. The ﬁ rst focuses on the analysis of aggregate and sectoral wages and labour costs
and their interaction with price dynamics. The second line of research focuses on the analysis of
micro data on wages and, inter alia, aims to determine the nature and magnitude of wage and labour
market rigidities. Third, the WDN has launched a survey of ﬁ rms to identify the main mechanisms
underlying their wage-setting practices. Finally, a meta-analysis of the ﬁ ndings aims to draw the main
conclusions from the research and identify relevant policy implications. The results of the WDN will
be presented at a conference in June 2008.
1 See F. Altissimo, M. Ehrmann and F. Smets (2005), “Inﬂ ation persistence and price-setting behaviour in the euro area – a summary of
the IPN evidence”, ECB Occasional Paper No 46.
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Chart 6 Harmonised competitiveness indicators
Chart 7 Current account positions in 2007
across the euro area countries in the period
and cumulated changes across the euro area
1999-2007
countries in the period 1999-2007
(cumulated percentage changes)
(levels as a percentage of GDP and cumulated changes in
percentage points as a percentage of GDP)
level in 2007
change in the period 1999-2007
25
25
12
12
9
9
20
20
6
6
3
3
15
15
0
0
10
10
-3
-3
-6
-6
5
5
-9
-9
0
0
-12
-12
FI AT DE FR SI BE IT GR PT NL CY LU ES IE
DE AT NL LU FI PT BE SI IT FR IE GR ES CY
Source: ECB calculations based on Eurostat data.
Source: ECB calculations based on European Commission data.
Notes: ECB CPI-deﬂ ated weighted averages of relative inﬂ ation
rates versus a group of 44 trading partners and euro area countries.
An increase reﬂ ects a real effective appreciation, i.e. a decline in
this indicator of national competitiveness. Countries are sorted by
ascending indicator growth.
Differentials may cause
As a result of the persistent inﬂ ation differentials observed, the euro area countries have experienced
losses in competitiveness
marked differences in terms of the evolution of national price competitiveness indicators. Harmonised
and output growth
competitiveness indices (HCI), based on weighted averages of relative prices deﬂ ated by the HICP,
provide one comparable measure of individual euro area countries’ price competitiveness.32 Chart 6
shows that, in the period 1999-2007, Germany, Austria and Finland experienced very modest increases
in their HCIs, indicating only slight losses in this measure of price competitiveness, whereas rises were
particularly strong in the HCIs of Ireland and Spain. Relative unit labour cost developments give a
similarly heterogeneous picture of competitiveness developments across the euro area countries. Changes
in relative prices or costs are one of the key channels for adjustment within the euro area. Reducing unit
labour costs is not a “beggar thy neighbour” policy. On the contrary, labour cost moderation reduces
inﬂ ationary pressures, which tends to contribute to lower interest rates for the whole euro area. Sustained
cost moderation has a favourable impact on structural employment beyond the positive effect of improved
competitiveness and better trade performance. Protracted losses in price and cost competitiveness, if not
associated with equilibrium price and cost adjustments, may adversely affect output and employment, as
well as trade and current account balances (see Chart 7).33
32 See the box entitled “The introduction of harmonised competitiveness indicators for euro area countries” in the February 2007 issue of
the Monthly Bulletin. In future extensions of this set of HCIs, it will be useful to compare the present set of HCIs based on consumer
price developments with indicators based on deﬂ ators that include fewer non-traded products and services, which may have a greater
association with the competitiveness of the countries’ external sectors.
33 See the box entitled “Current account balances across the euro area countries from a savings and investment perspective” in the July 2007
issue of the Monthly Bulletin.
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E C O N O M I C P O L I C Y
C H A L L E N G E S
To conclude, the persistence of inﬂ ation and growth differentials over longer periods of time may,
A N D E N L A R G E M E N T
in many cases, be an equilibrium phenomenon determined by catching-up processes and/or trend
differentials in potential growth. However, if induced by structural inefﬁ ciencies or misaligned
Persistent differentials must
national policies (including wage-setting policies), such differentials may be worrisome. As national
be addressed
monetary and exchange rate policies are no longer available options within the euro area, it is
important to ensure that the remaining mechanisms of adjustment to shocks function properly.
Rigidities in wage and price-setting mechanisms or ongoing excessive wage developments may
delay the necessary adjustments of relative prices to economic shocks and give rise to a prolonged
period of relatively high inﬂ ation in some countries. This, in turn, could contribute to an
accumulation of internal imbalances and losses in price and cost competitiveness within the euro
area, which could also dampen output and employment. The efﬁ cient and smooth functioning of
economic adjustments within the euro area requires the removal of institutional barriers to ﬂ exible
wage and price-setting mechanisms, the completion of the Single Market and thus greater domestic
and cross-border competition [see Section 4.1], as well as prudent ﬁ scal policies.
Sound policies are also of great importance for those countries aiming to join the euro area in the
future. Euro area enlargement will be dealt with in the next section.
4.4 EURO AREA ENLARGEMENT
This section reports on the enlargement of the euro area since 1999, describes the current state
of play with respect to further euro area enlargements and highlights the need for sustainable
convergence as a precondition for joining the euro area (see also Chapter 2).
THREE ROUNDS OF EURO AREA ENLARGEMENT
As mentioned in Chapter 2, since the introduction of the euro in 1999 by 11 EU Member States,
the euro area has undergone three rounds of enlargement that have brought the number of euro area
countries to 15.
FUTURE EURO AREA ENLARGEMENTS
Currently, there are 12 EU countries that have not yet introduced the euro, with notable differences
12 EU countries have not
in their legal status and the stage of their convergence. In particular, Denmark and the
yet introduced the euro
United Kingdom have a special status based on an “opt-out clause”, whereby the degree of
convergence achieved for entering the euro area will only be assessed if they so request.
All of the ten remaining countries (Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania,
Hungary, Poland, Romania, Slovakia and Sweden) are EU Member States with a derogation. This
means that they are committed to eventually adopting the euro. However, the actual timing and the
optimal convergence path to the adoption of the euro will have to be looked at on a country-by-
country basis.
The adoption of the euro requires a prospective country’s currency to remain in ERM II for at least
two years with no severe tensions prior to the convergence assessment and subject to compliance
with the other “Maastricht criteria”.
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Table 9 Monetary integration plans of EU Member States outside the euro area
Country
Intentions for ERM II
Intentions for euro adoption
Bulgaria
As soon as possible.
Aims to adopt the euro as soon as possible.
Czech
Republic
ERM II participation for only the minimum The latest update of the “Czech Republic’s euro
period of two years ahead of EMU entry. Inﬂ ation
area accession strategy”, approved by the Czech
targeting will be retained until monetary integration
authorities in August 2007, states that some of
completed. The readiness to join ERM II and the
the preconditions needed for beneﬁ ting from the
euro area is assessed on a yearly basis jointly by the
adoption of the euro have yet to achieve satisfactory
government and the national central bank.
parameters. The main obstacles relate to the need
to enhance the ﬂ exibility of the economy and
ﬁ scal policy consolidation.
Denmark
Participating.
No current plans. Referendum on euro adoption in
September 2000 resulted in a 53% “no” vote.
Estonia
Participating.
Aims to adopt the euro as soon as possible.
Latvia
Participating.
Aims to adopt the euro as soon as possible.
Lithuania
Participating.
Aims to adopt the euro as soon as possible.
Hungary
The Convergence Programme update does not The Convergence Programme does not contain any
contain any desired ERM II entry date. It only states
desired euro area entry date.
that participation in ERM II should be made
conditional upon the restoration of ﬁ scal credibility.
Poland
ERM II participation for only the minimum period of
The Convergence Programme does not specify the
two years. No explicit target date for ERM II entry.
target date for euro adoption.
Romania
According to the 2007 Convergence Programme
Not before 2014.
there are no intentions to join ERM II before 2012.
Aims to stay in the ERM II for the minimum required
period before adopting the euro.
Slovakia
Participating.
Aims to meet the ﬁ scal reference value in 2007 and
to join the euro area in 2009.
Sweden
No current plans.
No current plans. Referendum in September 2003 on
euro adoption resulted in a 56% “no” vote.
United Kingdom
No current plans.
As soon as government’s ﬁ ve tests are fulﬁ lled.
Source: ESCB.
Five countries in ERM II
Five EU Member States currently outside the euro area are participating in ERM II. The two
countries joined the mechanism on different dates, some of them with unilateral exchange rate
commitments. On 1 January 1999, Denmark entered ERM II with a ﬂ uctuation band of +/- 2.25%
around its currency’s central exchange rate. On 28 June 2004, Estonia, Lithuania (and also Slovenia)
joined. Both Estonia and Lithuania joined with a +/- 15% ﬂ uctuation band. These countries
additionally decided to continue with their currency board arrangements as a unilateral commitment.
On 2 May 2005, Latvia joined ERM II (together with Cyprus and Malta). Latvia also decided to
join with a +/- 15% ﬂ uctuation band, but has continued to keep a ﬂ uctuation band of +/- 1% as a
unilateral commitment. Finally, on 25 November 2005, Slovakia joined ERM II, participating with
a +/- 15% ﬂ uctuation band.
Currently, Bulgaria, the Czech Republic, Hungary, Poland, Romania and Sweden are the only EU
Member States with a derogation that have not yet entered ERM II (see Table 9).
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E C O N O M I C P O L I C Y
C H A L L E N G E S
NEED FOR SUSTAINABLE CONVERGENCE
A N D E N L A R G E M E N T
To join the euro area, Member States must fulﬁ l a number of legal and economic convergence
Benefits of sustainable
criteria. Fulﬁ lling the convergence criteria in a sustainable way ensures that the country can integrate
convergence
smoothly into the Monetary Union. This approach is ﬁ rmly based on economic arguments. Once a
country joins the Monetary Union, it loses the possibility to use interest rate policy. As monetary
policy decisions in EMU are taken in the light of the economic conditions prevailing in the
euro area as a whole, sustained economic convergence is required to ensure that a country’s
economy is sufﬁ ciently prepared for monetary union.
Introducing the euro can substantially beneﬁ t a country that has achieved sustainable convergence.
Such beneﬁ ts include the elimination of exchange rate risks in relation to its main trade partners,
reduced transaction and information costs, higher protection against certain ﬁ nancial disturbances,
and a decrease in risk premia and lower long-term interest rates due to a credible framework for
ﬁ scal and monetary policy. For the euro area as a whole – and the EU as well – the main beneﬁ t
of euro area enlargement is the completion of the internal market for goods, services and capital.
However, these beneﬁ ts would not apply in the case of premature euro adoption, which could harm
a country in many ways. Differences in business cycles could lead to “sub-optimal” interest rates in
a national context (from the perspective of both economic stabilisation and resource allocation) and
the emergence of local “bubbles” or “crises.” Unless convergence is sustainable, a country might run
into competitiveness problems, which it could no longer solve through exchange rate adjustments.
If there were insufﬁ cient wage and price ﬂ exibility to adjust to changes in competitiveness and/
or shocks, there would also be a risk of protracted economic losses. For the euro area as a whole,
premature adoptions of the euro could lead to the loss of the credibility of the EMU project.
The ECB’s Convergence Reports 34 emphasise that convergence must be achieved on a lasting basis
Need for sustainable
and not just at a given point in time. For this reason, the country examinations describe in detail the
convergence
sustainability of convergence. In this respect, economic developments in the countries concerned
are reviewed from a backward-looking perspective covering, in principle, the past ten years. This
helps to better determine the extent to which current achievements are the result of genuine structural
adjustments, which in turn should lead to a better assessment of the sustainability of economic
convergence. In addition, and to the extent appropriate, a forward-looking perspective is adopted.
In this context, particular attention is drawn to the fact that the sustainability of favourable economic
developments hinges critically on appropriate and lasting policy responses to existing and future
challenges. Overall, it is emphasised that ensuring the sustainability of economic convergence
depends both on the achievement of a sound starting position and on the policies pursued after the
adoption of the euro.
The legal convergence criteria oblige prospective euro area countries to put in place the legal
foundations for participation in the Monetary Union, of which central bank independence is a
cornerstone.
The economic convergence criteria ensure that the applicant countries have established economic
conditions that are conducive to maintaining price stability and the coherence of the euro
area. The framework of analysis comprises developments in prices, ﬁ scal balances and debt ratios,
34 See the ECB’s May 2008 Convergence Report.
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exchange rates and long-term interest rates, as well as other factors. A number of general rules are
used in the application of these criteria:
1. The individual criteria are strictly interpreted and applied.
2. The criteria constitute a coherent and integrated approach. They must all be satisﬁ ed. The Treaty
lists the criteria on an equal footing and does not suggest a hierarchy.
3. The criteria must be met on the basis of hard data.
4. The application of the criteria should be consistent, transparent and simple.
5. Convergence must be achieved on a sustainable basis and not just at a given point in time.
Once a country fulﬁ ls these legal and economic criteria in a sustainable manner, it joins the euro
area. However, the adoption of the euro is not the end of the story. Indeed, joining the euro area
is not in itself a recipe for success. After adopting the euro, countries still need to pursue the right
policies in order to thrive in the euro area (see Sections 4.1, 4.2 and 4.3).
4.5 CHALLENGES AND WAY FORWARD
Adjustment mechanisms
The previous sections show that economic ﬂ exibility and integration is a clear prerequisite for the
must be more efficient …
smooth functioning of the euro area, as individual euro area economies or regions may be affected
by speciﬁ c developments. Furthermore, the euro area is continuously confronted with shocks and
… for smooth functioning of
challenges, for instance, in the ﬁ elds of global competition or energy price developments. At the
euro area
same time, national monetary and exchange rate policies are no longer available policy options in a
monetary union. In order to avoid a situation where, after suffering a speciﬁ c or asymmetric shock,
a country or a region in the euro area enters either a period of protracted low growth and high
unemployment or a long period of overheating, other efﬁ cient adjustment mechanisms need to be in
place.
Gains thus far, but further
The recent increases in labour market participation and employment are encouraging developments,
reforms needed
which show that past labour market reforms, immigration and wage moderation have helped to
overcome some of the constraints on growth stemming from rigid and over-regulated labour
markets. They also conﬁ rm that monetary policy geared towards price stability is in no way
inconsistent with job creation and low unemployment; on the contrary. However, despite this
progress, most euro area countries are still far from having exhausted the potential for further
increases in participation rates and employment. Structural impediments, triggered by a rigid legal
and regulatory environment, high taxes on labour and rigidities associated with wage regulations,
still prevent or discourage far too many people from actively participating in the labour market and
thus keep participation rates too low and unemployment too high.
Wage differentiation
Therefore, in order to enhance employment, productivity and the resilience to economic shocks, it
supports employment
is particularly important for economic policy in the euro area countries to be developed further
along the following dimensions. First, with respect to labour market policies, governments and
social partners must share responsibility for ensuring that wage determination pays sufﬁ cient
attention to labour market conditions and does not jeopardise competitiveness and employment.
This requires the social partners to take into account the different conditions at ﬁ rm and sectoral
level and to dampen the repercussions of wage settlements on competitiveness, and thus employment,
at their company and in their industry, sector or region. Sufﬁ cient wage differentiation would
improve employment opportunities for less skilled workers and in regions or sectors with high
unemployment. In this respect, excessive regulations, such as minimum wages, are undermining
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E C O N O M I C P O L I C Y
C H A L L E N G E S
job creation, particularly for the young and less qualiﬁ ed workers, as well as for all those who face
A N D E N L A R G E M E N T
problems entering the labour market.
Second, the proper functioning of adjustments through labour markets has to be complemented by
Single Market must be
completed
the completion of the Single Market, particularly in services and network industries. A deeper
integration of markets would stimulate price ﬂ exibility by fostering competition and open product
markets. Greater cross-border competition and the integration of markets across the euro area
countries would contribute to lower prices. They could also enhance the adjustment processes in the
individual countries in the event of region or country-speciﬁ c shocks or differing cyclical
developments, thereby avoiding too high levels of regional unemployment.
Third, national authorities can make a substantial contribution to ensuring a proper functioning of
Sound fiscal policies and low
taxes are important
adjustment mechanisms within the euro area when they conduct a well-designed sustainable ﬁ scal
policy, in line with the orientations provided by the Stability and Growth Pact. Moreover, ﬁ scal
policy can, and should, also help to support long-run growth by improving the quality of spending
and minimising economic disincentives in tax policies. In this context, it is particularly important
that ﬁ scal authorities prepare for the challenges posed by demographic ageing. High and inefﬁ cient
public expenditure can put a brake on economic activity by imposing a high tax burden on the
economy and by channelling resources into unproductive uses. Similarly, higher administered
prices, indirect taxes and minimum wages tend to add to inﬂ ationary pressures, making the conduct
of monetary policy more difﬁ cult.
Fourth, in the context of the Lisbon Strategy the necessary reforms that aim to improve long-term
Lisbon strategy still central
growth prospects in the euro area and enhance employment and productivity must be implemented.
This would improve the adjustment mechanisms in individual countries, regions or sectors and is
therefore an important factor in improving the overall resilience to economic shocks of the euro
area economy.
Fifth, developments in price competitiveness and unit labour cost competitiveness across the euro
area economies must be closely monitored. Persistent losses in relative cost competitiveness can
also relate to a number of structural rigidities leading to inertia in price and wage formation and
excessive increases in labour costs. If and when such phenomena are identiﬁ ed, it is important for
all parties concerned – the private sector, social partners and the national public authorities – to be
as lucid as possible in their own decision-making in order to avoid relative losses of competitiveness
that would not be economically justiﬁ ed and that would thus undermine growth and job creation in
the future.
Finally, those countries aiming to join the euro area in the future are well advised to take the above
Changes in competitiveness
must be monitored
challenges seriously in their convergence process and to be well prepared when joining.
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5 THE EURO’S IMPACT ON TRADE AND CAPITAL
FLOWS AND ITS INTERNATIONAL ROLE
Since 1998, the euro area has become even more open to the rest of the world, as measured by trade
and its international asset and liability investment positions. At the same time, trade and capital
ﬂ ows among euro area countries have also risen. Intra-euro area trade in goods and services has
increased by about 10 percentage points relative to GDP, which can be partly attributed to the
creation of the euro. The single currency has also promoted an increase in the degree of intra-euro
area competition and convergence of intra-euro area trade prices, phenomena which are expected
to continue in the future. As for capital ﬂ ows, the euro has boosted foreign direct investment (FDI),
in particular cross-border merger and acquisition (M&A) activity in manufacturing, and portfolio
ﬂ ows across euro area countries. A number of factors associated with the euro favoured these higher
capital movements among euro area countries, including the elimination of exchange rate risk, the
reduction of the cost of capital, the use of common trading platforms, and the cross-border merger
of stock exchanges (e.g. Euronext). Another dimension of the euro relates to its use beyond the
euro area’s borders. Over the past ten years, the euro’s role in international markets has increased
somewhat, but the pace of change has been gradual and appears to have levelled off in some market
segments. Moreover, the currency’s international role is geographically concentrated in regions
that are close to the euro area. These international dimensions of the euro area underscore the
need for close dialogue between the Eurosystem and central banks elsewhere in the world. This
dialogue takes place through various bilateral and multilateral channels. This chapter is structured
as follows: Section 5.1 looks at the trade and competitiveness effects of the euro, while Section 5.2
focuses on the impact of the euro on international capital ﬂ ows. Section 5.3 reviews developments
in the international role of the euro and Section 5.4 discusses the international cooperation of the
euro area, focusing on the role of the ECB.
5.1 TRADE IN GOODS AND SERVICES OF THE EURO AREA
The euro area economy is relatively open, particularly when compared with the world’s two other
Euro area economy
relatively open compared
leading economies, the United States and Japan. In 2006, the combined value of imports and exports
with the United States and
of goods and services was equivalent to around 42% of GDP, compared with around 32% and 28%
Japan
for Japan and the United States, respectively. The euro area also accounted for 18% of the value of
world exports, compared with approximately 12% for the United States, 6% for Japan and 10% for
the ten largest oil exporting countries. Moreover, the trade openness of the euro area has increased
noticeably since 1998 (by 11 percentage points), particularly as a result of rapidly growing trade
with new EU members and China.
Since 1998 trade among euro area countries has risen strongly. The value of exports and imports of
Trade among euro area
goods within the euro area has increased from about 26% of GDP in 1998, the year before the euro
countries sharply increased
since 1998
was introduced, to 33% of GDP in 2007. Meanwhile, intra-euro area services trade has also gone
up, from 5% to 7% of GDP. In 2007, trade within euro area countries represented about one-half of
total euro area trade.
Developments in euro area trade with Denmark, Sweden and the United Kingdom show that the
euro has pushed up trade across the euro area countries over and above the positive effects generated
by the continuing process of EU integration in a single market. Since 1998 the year-on-year growth
of euro area exports of goods to the three EU15 countries that have not adopted the euro has been
on average 3% lower than the year-on-year growth of exports within the euro area. At the same
time, the growth of imports from these countries has been on average 2% lower than imports from
within the area. In services, the yearly growth of intra-euro area ﬂ ows has in fact been lower than
the growth of trade with the three non-euro area countries, possibly reﬂ ecting in part a stronger
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Chart 1 Developments in intra-euro area trade vs. euro area trade with Denmark, Sweden and
the United Kingdom, 1996-2007
(values; year-on-year growth)
Exports
Imports
intra-euro area exports of goods
intra-euro area imports of goods
euro area exports of goods to DK, SE, UK
euro area imports of goods from DK, SE, UK
intra-euro area exports of services
intra-euro area imports of services
euro area exports of services to DK, SE, UK
euro area imports of services from DK, SE, UK
20
20
20
20
15
15
15
15
10
10
10
10
5
5
5
5
0
0
0
0
-5
-5
-5
-5
-10
-10
-10
-10
1997
1999
2001
2003
2005
2007
1997
1999
2001
2003
2005
2007
Sources: Eurostat and ECB calculations.
Notes: Estimates for 2007 are based on data for the ﬁ rst half of 2007. Data on trade in services are only available since 2002.
specialisation of the United Kingdom in services and an EU internal market for services which is
still very fragmented. See Chart 1.
Below we investigate the impacts of Economic and Monetary Union (EMU) in further detail by
drawing on various empirical studies in order to distinguish the trade-creating effects of the euro
from those of other major developments over the past decade (including, for example, the EU’s
continuing integration and the ongoing rapid pace of globalisation).
TRADE-CREATING EFFECTS OF THE EURO ON TRADE IN GOODS
Trade among euro area
Ceteris paribus, the formation of a monetary union is expected to stimulate trade between its
countries is on average
members by eliminating exchange rate volatility, thereby removing uncertainty in returns and
2 to 3% higher due to euro
proﬁ ts due to exchange rate ﬂ uctuations. In addition to the exchange rate volatility impact, there
might also be an additional boost to intra-trade, due to the formation of a monetary and currency
union – the so-called Rose effect.1
In the last few years, a growing body of empirical research has investigated the impact of the euro
on trade in goods, with the effect on services not having been quantiﬁ ed yet due to the scarce
availability of necessary data. There is a broad agreement that the euro has had a positive bearing
on euro area trade. Yet, estimates on the size of the effect have provided very heterogeneous results,
largely due to the adoption of different methodologies of analysis. Economists now seem to have
reached the consensus view that the single currency has boosted the growth of euro area countries’
trade on average by 2 to 3 percentage points.2 This assessment is consistent with the preliminary
indications of Chart 1. By contrast, earlier estimates of larger effects may be somewhat upward
biased. The previous small number of available observations for the EMU period made it difﬁ cult,
1 The “Rose effect” is named after Andrew Rose, an economist who ﬁ rst suggested that monetary unions might increase trade beyond the
positive effect due to the elimination of exchange rate volatility. Rose, Andrew K., 2000, “One money, one market: the effect of currency
unions on trade,” Economic Policy 30, 7-46.
2 See, for example, Bun M. and Klassen F. (2007) “The euro effect on trade is not as large as commonly thought”, Oxford Bulletin of
Economics and Statistics, Vol. 69, 4.
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T H E E U R O ’ S I M P A C T
O N T R A D E A N D
C A P I T A L F L O W S A N D
I T S I N T E R N A T I O N A L
R O L E
until recently, to distinguish the trade effects of the euro, the EU Single Market and the general
increase in trade between the euro area and the rest of the world.
Regarding individual sectors, the removal among the euro area countries of the uncertainty due to
exchange rate ﬂ uctuations has beneﬁ ted trade across all industries. By contrast, the Rose effect, i.e.
the additional boost arising from the creation of a single currency, occurs mainly in areas such as
machinery and highly differentiated consumer goods such as food and related products.3 Most of
these sectors have high market entry costs associated with the decision to start exporting, thereby
suggesting that a reduction of such costs is a channel through which the euro may have contributed
to euro area trade ﬂ ows.
Ongoing analysis of exports by ﬁ rms lends support to this view, indicating that the euro has
Euro may have led to cost
reductions for euro area
primarily helped to increase the number of products and varieties exported within the euro area
firms and to lower prices for
rather than increasing the volumes of items already exported before 1999. Moreover, the single
traded goods
currency may have affected trade also by changing the pricing behaviour of euro area exporters.
Available evidence suggests that following the creation of the euro, the incentive for companies to
segment markets within the euro area by applying country-speciﬁ c prices has diminished.4 In
parallel, the euro has also contributed to price convergence among members of the euro area.5
Overall, the euro seems to have lowered the transaction and ﬁ xed costs faced by euro area ﬁ rms,
with the savings partly passed on to consumers, via lower trade prices.
THE EURO AND EURO AREA COMPETITIVENESS
As for the impact of EMU on the competitiveness of euro area ﬁ rms and their capacity to play a
Euro has made firms more
leading role in world markets, recent research indicates that the euro has contributed to enhancing
competitive
ﬁ rms’ competitiveness by facilitating euro area countries’ trade and by contributing to the integration
of the EU Single Market. Euro area countries are seen as better export bases, attracting a greater
number of ﬁ rms from neighbouring countries. A larger and more integrated euro area, while
allowing ﬁ rms to beneﬁ t from increasing their scale of operations at declining marginal cost, also
tends to be associated with tougher competition and, therefore, richer product variety, higher
productivity and lower prices.6
Hence – other things being equal – the euro has promoted efﬁ ciency in the euro area, enhancing its
ability to compete in the world markets. Yet, the impact across the euro area countries may vary due
to differences in the quality of institutions and access to technology, research and development.
Against this background of greater competition within the euro area, the emergence worldwide of
Euro area countries face
more cost competition
cost-competitive countries as major exporters has also increased the degree of external competition
worldwide
faced by euro area countries.7 For example, over the last decade China has been increasing its world
3 For evidence on sectoral studies, see, for example: Baldwin R., Skudelny F. and Taglioni D. (2005) “The Effect of the Euro: Evidence
from Sectoral Studies” ECB Working Paper No 446; De Nardis S., De Santis R. and Vicarelli C. (2007) “The single currency’s effects on
eurozone sectoral trade: winners and losers?” ISAE.
4 See, for example, Berthou A. and Fontagné L. (2008) “The Euro and the Intensive and Extensive Margins of Trade: Evidence from French
Firm Level Data”, CEPII; as well as Méjean I. and Schwellnus C. (2007) “Does European Integration have an Effect on the Pricing
Behaviour of French Exporters?” CEPII.
5 See, for example, Allington N., Kattuman P. and Waldman F. (2005) “One market, one money, one price?” Journal of Central Banking
pp. 73-115.
6 Ottaviano G., Taglioni D. and di Mauro F. (2007) “Deeper, Wider and More Competitive? Monetary Integration, Eastern Enlargement
and Competitiveness in the European Union”, ECB Working Paper No 847.
7 See, for example, ECB Monthly Bulletin January (2008) “Globalisation, trade and the euro area macroeconomy” and F. di Mauro and
R. Anderton (2007) “The external dimension of the euro area: assessing the linkages”, Cambridge University Press.
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export market share, at an average pace of
Chart 2 Annual changes in export market
almost 13% per year (see Chart 2). This seems
shares: euro area, United Kingdom, United
States, Japan and China
to be the counterpart to the declines in export
market share experienced by the euro area (1.7%
(volumes; percentage points)
yearly) and the other major trading countries
United States
United Kingdom
over the same period (with yearly declines
Japan
ranging from 1.2 to 1.7%). However, losses for
Euro area
China
the euro area have not been uniform. There are
25.0
25.0
differences among individual euro area
20.0
20.0
economies, with Ireland and Germany being the
notable exception as their market shares have
15.0
15.0
risen over the past decade. There are also
10.0
10.0
differences across years, with the largest losses
5.0
5.0
concentrated in the period 2002-2004, 0.0
0.0
corresponding to China’s accession to the World
-5.0
-5.0
Trade Organization.
-10.0
-10.0
Larger market shares
The euro area export market share losses are
-15.0
-15.0
for the euro area in the
1996
1998
2000
2002
2004
2006
partly a mechanical adjustment to the emergence
high-end and traditional
Source: ECB calculations.
goods segments
of the new lower-income competitors. However,
Notes: The changes in export market shares are calculated as the
to some extent they may also reﬂ ect the export
difference between the annual growth rate of exports and foreign
demand (where foreign demand is deﬁ ned as a country-speciﬁ c
specialisation of the euro area. In particular,
export-weighted sum of foreign import volumes of goods and
services). Last observation refers to 2007.
some euro area countries seem somewhat
overweight in labour-intensive sectors where
emerging economies have a relative comparative advantage. On a more positive note, recent
analyses show that in the past decade euro area and other EU Member States have also gained
market shares in the higher-price and higher-quality segments of mature industries and products,
thereby contrasting with their relatively weaker performance in other types of export.8
5.2 INTERNATIONAL CAPITAL FLOWS
Euro area is financially
The euro area is also relatively open from a ﬁ nancial perspective, with international assets and
“open”, especially since euro
liabilities exceeding 150% of GDP in 2006 compared with about 115% for the United States and
launch
90% for Japan. In addition, the external ﬁ nancial openness of the euro area has been growing
signiﬁ cantly in recent years with external assets and liabilities rising by about 60% of GDP over the
period 1999-2006.
The individual euro area countries are considerably more open than the euro area as a whole given
the large foreign direct investment (FDI) and portfolio activity that has also occurred between euro
area members. For example, the euro area countries – either as recipients or as sources of investment
– accounted for as much as 57% of world FDI ﬂ ows between 2000 and 2005. Meanwhile, euro area
residents held 34% and 44% of the world international equity and bond portfolios from 2001 to
2006. Given that euro area GDP is only about one-quarter the size of world GDP, these stylised facts
suggest that the euro might have played an important role in these capital movements, particularly
between euro area countries.
8 L. Fontagné, G. Gaulier and S. Zignago (2008) “Specialization Across Varieties and North-south Competition”, Economic Policy, Vol. 23
issue 53, pp. 51-91.
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T H E E U R O ’ S I M P A C T
O N T R A D E A N D
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R O L E
The next two subsections document the possible
Chart 3 Intra-euro area FDI as a share of
effects of the euro on FDI, M&A activity and
total euro area FDI, 1999-2006
portfolio investment.
(percentages)
IMPACT OF EMU ON FOREIGN DIRECT INVESTMENT
FDI stock
FDI flows
AND MERGERS AND ACQUISITIONS
60
60
Firms can expand abroad by making a physical
Strong rise in FDI flows
55
55
between euro area countries
investment in another country or by merging or
since 1999 ...
acquiring an existing foreign ﬁ rm. FDI,
50
50
therefore, can provide a ﬁ rm with new markets
and marketing channels as well as access to new
45
45
technology, products and skills. For a host
country or the foreign ﬁ rm which receives the
40
40
investment, it can provide a source of new
technologies, capital, processes, products, 35
35
organisational technologies and management
skills, and as such can provide a strong impetus
30
30
1999
2000
2001
2002
2003
2004
2005
2006
to economic development. Overall, FDI can
raise efﬁ ciency in both the home and host
Source: ECB.
Note: Intra-FDI inﬂ ows (stocks) plus intra-FDI outﬂ ows (stocks)
countries.
as a percentage of twice the total euro area FDI ﬂ ows (stocks).
European economic and ﬁ
nancial integration seems to have been a magnet for FDI
activity particularly in the manufacturing sector, while an increasing share of FDI
ﬂ
ows is taking place between euro area countries. For example, intra-euro area FDI
ﬂ ows as a share of total euro area FDI increased from 35% in 1999 to 45% in 2006
(see Chart 3). A positive trend can also be observed when looking at FDI stocks, as the intra-euro
area FDI stock as a proportion of the total euro area FDI stock increased from almost 43% in 1999
to 45% in 2006.
Since most FDI activity takes the form of M&As, with the EU15 countries and the United States
being the largest players, looking at cross-border M&As gives additional information on the impact
of the euro on FDI activity.
Intra-euro area cross-border M&As in the manufacturing sector as a share of total euro area
… particularly with M&As in
cross-border manufacturing M&As have increased from 20% during the six years before EMU
manufacturing
(1993-1998) to 35% in the six-year period after EMU (1999 to 2004). Also, manufacturing ﬁ rms
from Canada, Japan, Norway and the United States have increased their share of mergers with euro
area ﬁ rms. By contrast, when looking at services, the share of intra-euro area M&As declined from
37% to 27% over the same period, while other countries increased their share of M&As invested in
euro area assets (see Chart 4).
The key question is whether EMU played a role in such developments. In addition to the elimination
of exchange rate risk, some of the possible FDI-inducing mechanisms resulting from the introduction
of the euro are: (i) the reduction of transaction and ﬁ xed costs, (ii) the reduction in the cost of
both equity capital and bond and bank ﬁ nancing, and (iii) the inﬂ uence of trade on FDI, insofar as
intra and extra-FDI ﬂ ows are interrelated with trade. All of these factors may have facilitated the
reallocation of capital among euro area countries.
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Chart 4 Cross-border M&As in manufacturing and services purchasing euro area assets
(1993-2004)
(percentages)
1993-1998
1999-2004
Manufacturing
Services
60
60
60
60
50
50
50
50
40
40
40
40
30
30
30
30
20
20
20
20
10
10
10
10
0
0
0
0
Euro area
Denmark,
Rest of
Euro area
Denmark,
Rest of
Sweden, UK
developed world
Sweden, UK
developed world
Source: Thomson Financial.
Note: “Euro area” is the ratio between intra-euro area cross-border M&As and the sum of intra and extra-euro area cross-border M&As.
“Denmark, Sweden and UK” is the ratio between Denmark, Sweden and UK M&As vis-à-vis euro area ﬁ rms divided by their total
cross-border M&As. “Rest of developed world” is the ratio between Canada, Japan, Norway and US M&As vis-à-vis euro area ﬁ rms
divided by their total cross-border M&As.
Intra-euro area FDI flows
Several empirical studies have investigated the impact of the euro on FDI.9 The results suggest that
estimated to be about 15%
the euro has increased FDI across the euro area countries over and above the positive effects
higher due to euro
generated by the EU Single Market. Overall, it seems that the positive average effect of the euro on
aggregate FDI ﬂ ows within the euro area is about 15%, while the impact of the euro on FDI ﬂ ows
from outside the euro area to the euro area countries is about 7%. These results seem consistent
with those reported in Chart 3.
The euro seems to have had most effect in the manufacturing sector. Estimates suggest that on
average the euro has increased intra-euro area cross-border M&A activity in manufacturing by about
160%.10 Moreover, the estimated effect of the euro on euro area M&As from non-euro to euro area
countries corresponds to about an 80% increase. The sectors that expanded most in the euro area
countries compared with external FDI in the euro area are chemicals and petroleum, coal, rubber
and plastic products, and transport equipment. Conversely, the share of merger activity among euro
area countries in machinery and equipment has actually declined.
As for services, the estimated impact of the euro on cross-border M&As seems marginal, suggesting
that such activities may be negatively affected by the barriers to cross-border trade in services and
product market regulations in the target country.11 These results are consistent with Chart 4 as well as
the subdued growth observed in intra-euro area trade in services relative to extra-euro area trade.
9 See, for example, Petroulas, P., 2007, “The effect of the euro on foreign direct investment”, European Economic Review, 51: 1468-1491;
Schiavo S., 2007, “Common currencies and FDI ﬂ ows”, Oxford Economic Papers, 59: 536-560; De Sousa, J. and J. Lochard, 2006, “Does
the single currency affect FDI? A gravity-like approach”, University of Paris 1, mimeo; Flam, H. and H. Nordström, 2007, “The Euro and
Single Market Impact on Trade and FDI,” 2007, Institute for International Economic Studies, Stockholm University, mimeo.
10 See Coeurdacier, N., De Santis, R.A. and A. Aviat, 2008, “Cross-border mergers and acquisitions: Institutional and ﬁ nancial forces” (paper
presented at the 47th Economic Policy Panel meeting in Ljubljana, April 2008). These estimates are consistent with other studies relating
to total FDI, as cross-border M&As in manufacturing between developed countries are only about 30% of their total cross-border activity,
and they exclude some categories of total FDI, such as greenﬁ eld investment, reinvested earnings and inter-company loans.
11 Since services regulations still fall within the competence of individual EU Member States, the EU internal market for services remains
to date very fragmented. Restrictions in services might therefore have limited the investment decisions of entrepreneurs, thereby affecting
the efﬁ cient allocation of capital internationally and within the euro area.
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C A P I T A L F L O W S A N D
I T S I N T E R N A T I O N A L
R O L E
IMPACT OF EMU ON CROSS-BORDER PORTFOLIO
Chart 5 Holdings of euro area portfolio
INVESTMENT
assets relative to total international
portfolio holdings, 1997-2006
Individual wealth often takes the form of
(percentages)
portfolio investments in stocks,
stocks, which are
1997
2004
2001
2005
investments in individual businesses; bonds,
2002
2006
which are investments in debt that are designed
2003
to earn interest; and mutual funds, which 60
60
are essentially pools of money managed by
50
50
professionals on behalf of investors. If such
40
40
instruments are issued in a country other than
30
30
that where the investor is resident, then the
20
20
investment is of a cross-border nature and 10
10
subject, inter alia, to foreign currency risk.
0
0
Euro area
Denmark,
Euro area
Denmark,
(equities)
Sweden,
(bonds)
Sweden,
The euro has boosted cross-border portfolio
UK (equities)
UK (bonds)
Euro area cross-border
portfolio investments up
investment activity between euro area countries
Sources: BIS, IMF, Thomson DataStream, ECB calculations.
strongly since 1999 …
by eliminating the exchange rate risk, and favouring
Note: “Euro area” is intra-euro area cross-border (equity or
bond) assets divided by the sum of intra and extra-euro area
the creation of common trading platforms (e.g.
cross-border (equity or bond) assets. “Denmark, Sweden, UK”
is euro area (equity or bond) assets held by Denmark, Sweden
the creation of Euronext through the cross-border
and the UK divided by their total cross-border (equity or bond)
holdings.
merger of the Amsterdam, Brussels, Lisbon and
Paris exchanges) and integration in post-trading
market infrastructure, which have all further
reduced portfolio investment trade barriers.
In most countries, portfolio funds are often subject to some form of restriction on the level of their
… also due to lifting of
restrictions on non-domestic
non-domestic investment. Currency matching rules for portfolio funds, for example, are set to
investment
ensure that foreign currency risk is reduced. Since the introduction of the euro in January 1999, the
intra-euro area currency matching rule has shifted from national currencies to the euro. The resulting
greater ﬂ exibility allowed individual euro area country portfolios to secure better diversiﬁ cation of
investment risk by purchasing more non-domestic euro area assets.
In fact, euro area portfolio assets held in the euro area as a share of total international asset holdings
of euro area residents has increased markedly over the period 1997-2006: by 16 percentage points for
equities and by 46 percentage points for ﬁ xed income securities (see Chart 5). Moreover, all major
regions of the world, and Denmark, Sweden and the United Kingdom, increased their holdings of
euro area assets (as a share of their international portfolio) over this period, but by a smaller extent. This
suggests that the euro might have strongly stimulated portfolio transactions between euro area countries.
There may be many reasons why the reallocation of portfolio holdings towards the euro area has
Euro has increased portfolio
flows between individual
occurred since the launch of the euro, e.g. the elimination of the exchange rate risk among euro area
euro area countries
countries, the elimination of technical trading barriers, the diversiﬁ cation beneﬁ ts arising from
holding a variety of foreign assets and the fact that international holdings of euro area assets in
1998 may have already been below optimal levels as indicated by economic principles.12 Empirical
estimates provide support for the notion that the adoption of the euro played a key role in the
reallocation of portfolios among countries worldwide as well as among euro area members. After
12 Other factors that could have affected the reallocation of portfolios worldwide are: expected returns and volatility of assets across
economies, the tendency to invest in domestic assets (namely, the degree of countries’ home bias), expected economic growth performance,
the institutional framework, country population ageing proﬁ les, bilateral trade intensity, cultural linkages, etc.
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controlling for the variables mentioned above, the total impact of the euro for bilateral transactions
between individual euro area countries has been estimated to be an increase of 3.5% in equity
securities and 4.2% in bonds and notes of their respective total international holdings.13 Moreover,
non-euro area countries have on average increased their relative investment in euro area bonds and
notes. These results seem consistent with developments in Chart 5.
Overall, the euro promoted the ﬂ ow of capital among euro area members, thereby permitting a
better diversiﬁ cation of investment and consumption risks.
5.3 INTERNATIONAL ROLE OF THE EURO
Euro is used widely outside
A third international dimension of the euro relates to its use outside the euro area. While it was
the euro area
introduced for the beneﬁ t of the euro area population, it clearly also has implications for people
and ﬁ rms outside the euro area. Households, enterprises and governments outside the euro area
can choose to use the euro in many of their daily economic and ﬁ nancial transactions. They may
hold euro banknotes and coins. They may open bank accounts denominated in euro or take out
bank loans in euro. They may issue ﬁ nancial instruments, such as bonds and notes, denominated
in euro. They may invoice and pay in euro internationally. Authorities in third countries may also
choose the euro as an anchor in their exchange rate regime or decide to invest part of their foreign
exchange reserves in euro.
Euro use by non-residents
From a policy perspective, the Eurosystem has adopted a neutral stance on the international use of its
not a Eurosystem policy goal
currency. It does not pursue the internationalisation of the euro as a policy goal and neither fosters nor
discourages its use by non-residents of the euro area. The currency’s use outside the euro area’s borders
is and should remain the outcome of economic and ﬁ nancial developments, based on free private (and
sometimes public) decisions. In any case, in a globalised world with deeply integrated and market-based
ﬁ nancial systems, policy-makers have limited scope to inﬂ uence the internationalisation of a currency,
even if they want to do so. Deepening ﬁ nancial markets, fostering ﬁ nancial market integration, and
promoting price stability are examples of policies that can indirectly promote the use of a currency
abroad. For example, the use of a currency as a reserve currency appears to be related to such policies.14
But it is also clear that such policies have domestic, rather than international, objectives.
ECB closely monitors
The neutral policy towards the euro’s international role does not imply a lack of interest by the
international role of euro
Eurosystem. The ECB has monitored and analysed the international role of the euro and published
the main ﬁ ndings in annual reviews from 2001 onwards. Why has there been such steady interest?
One reason is that the use of the single currency outside the euro area may have an impact on
monetary policy transmission and on the information content of indicators used under the monetary
policy strategy. Another reason is that the international role of the euro could affect the transmission
of global ﬁ nancial and exchange rate shocks to the euro area. Finally, the ECB’s monitoring of the
international role of the euro has provided the general public and academic researchers with an
interest in international currencies with a unique and expanding dataset on the use of the euro by
non-residents.
13 De Santis, R. and B. Gerard (2006), “Financial integration, international portfolio choice and the European Monetary Union”,
ECB Working Paper Series, No 626. De Santis, R. (2006), “The geography of international portfolio ﬂ ows, international CAPM and the
role of monetary policy frameworks”, ECB Working Paper Series, No 678.
14 See Chinn, M. and J. Frankel (2006), “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?”, in G7
Current Account Imbalances: Sustainability and Adjustment, Richard Clarida (ed.), The University of Chicago Press, Chicago; and Chinn,
M. and J. Frankel (2008), “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Currency”, NBER Working
Paper No 13909, April 2008.
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T H E E U R O ’ S I M P A C T
O N T R A D E A N D
C A P I T A L F L O W S A N D
I T S I N T E R N A T I O N A L
R O L E
The annual reviews of the international role
Chart 6 Share of the euro in global foreign
of the euro have been marked by three broad
exchange reserves
themes. First, its role in international markets
has increased somewhat over the years, but the
(as a percentage of allocated reserves)
pace of change has been gradual and appears
in current exchange rates
in constant exchange rates
to have levelled off in some market segments.
35
35
Second, the international dimension is also 30
30
partly driven by the euro area itself. Third,
this role is geographically concentrated in the
25
25
regions that are close to the euro area.
20
20
15
15
From the start in 1999, the euro was 10
10
Euro’s role abroad has
“international” simply because it replaced 11
increased, but pace of
5
5
change gradual
existing currencies. As a successor to the
0
0
Deutsche Mark and the French franc, the euro
1999 2000 2001 2002 2003 2004 2005 2006
was used immediately as a reserve currency by
Source: IMF/COFER database and ECB calculations.
central banks and as an anchor for the exchange
Note: The shares in constant exchange rates are reported in
Q3 2007 exchange rates.
rate policy of some countries. However, the
international role of the euro has grown beyond
this legacy. For example, the current share of the euro in global ofﬁ cial reserves is higher than the
share of the sum of all legacy currencies of the euro – notably that of the Deutsche Mark – in global
ofﬁ cial reserves at the end of 1998, which was about 18%. In fact, according to the IMF, the share
of the euro in global foreign exchange reserves with a known currency composition increased
during the ﬁ rst ﬁ ve years of Economic and
Monetary Union to around 25%. Since then, the
Chart 7 Share of the euro in stock of
euro’s share has remained relatively stable
outstanding international debt securities
(Chart 6). In response to its use as an
international reserve currency, in January 2005
(as a percentage at constant exchange rates)
the Eurosystem introduced a framework for
narrow measure
reserve management services for central banks
broad measure
global measure
and monetary authorities located outside the
50
50
euro area as well as international organisations.
40
40
A second feature of the international role of the
Euro area residents also
affect international role
euro is that it is partly driven by the euro area
30
30
itself. In other words, the domestic users of the
euro, that is, euro area citizens, also inﬂ uence
20
20
the status of their currency internationally. For
example, borrowers outside the euro area are
10
10
increasingly issuing bonds in euro. In fact, the
1999
2001
2003
2005
2007
share of the euro in the “narrow measure” of
March
international debt securities, i.e. excluding home
Sources: BIS and ECB calculations.
Note: The shares in constant exchange rates are reported in
currency issuance, increased to around 31% as
2007 Q3 exchange rates. The narrow measure of international
debt securities is deﬁ ned as the issuance of bonds and notes as
at June 2007 (Chart 7). However, these bonds
well as money market instruments in a currency other than the
have not been chieﬂ y purchased by investors
home currency of the borrower. The broad measure adds to the
narrow measure the issuance of debt securities denominated in
outside the euro area. Indeed, more than half of
the home currency of the borrower, provided that this issuance
“targets” the international ﬁ nancial market. The global measure
these euro-denominated securities issued by
of debt securities adds to the broad measure all domestic issues
targeting the domestic market. For a more detailed discussion of
non-residents are targeted at, and purchased by,
these measures, see the ECB publication entitled “Review of the
International Role of the Euro”, June 2007.
euro area investors.
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Outstanding volume of international bonds and notes by region
(percentages, 2007 Q2)
Euro
Denmark,
New
Non-EU
North
Asia &
Latin
Offshore
International
Other
area
Sweden,
Member
Europe
America
Paciﬁ c
America
centres
organisations
United Kingdom
States
EUR
44.7
3.1
3.8
23.6
5.5
2.0
10.0
6.3
1.0
USD
23.7 19.0
0.3
2.4
4.9
10.8
6.6
23.1
5.0
4.2
JPY
30.0 12.7
1.2
2.9
18.6
4.9
0.6
21.1
7.6
0.5
Sources: BIS and ECB calculations.
Euro’s international role is
The last and perhaps most distinctive feature of the international role of the euro is its regional
geographically concentrated
character. In international ﬁ nancial markets, for instance, it is natural for countries close to the euro
near the euro area
area to choose the euro as a ﬁ nancing currency. For example, issuers resident in Denmark, Sweden
and the United Kingdom account for a signiﬁ cant part of euro-denominated debt issuance by non-
residents (see table) and the City of London, as a major international ﬁ nancial centre, has developed
its transactions in euro along with those in US dollars.15 Likewise, all countries running a euro-related
exchange rate policy are near the euro area. Finally, the degree of currency substitution is highest in
the new non-euro area EU Member States as well as in the EU candidate and potential candidate
countries in south-eastern Europe (Chart 8). In this context, the Eurosystem has stressed that any
unilateral adoption of the single currency by means of “euroisation” outside the Treaty framework
would run counter to the economic reasoning
underlying Economic and Monetary Union, Chart 8 Euro-denominated deposits/loans in
which foresees the eventual adoption of the euro
central, eastern and south-eastern Europe
as the end-point of a structured convergence
process within a multilateral framework.16 The
(as a percentage of total deposits/loans)
ECB has also carefully studied the determinants
deposits
loans
of the rise in foreign currency borrowing in
100
100
central, eastern and south-eastern Europe 17 and
the Eurosystem is permanently monitoring the
90
90
extent to which such borrowing may have an
80
78.5
80
72.7
72.1
impact on ﬁ nancial stability in these countries.18
70
67.8
68.4
70
65.7
64.0
59.9
60
60
The regional character of the euro’s international
50
50
use reﬂ
ects a combination of historical,
40
40
institutional and economic factors. Historically,
the euro built on a long tradition of its legacy
30
30
currencies, in particular the Deutsche Mark,
20
20
as a currency that was widely used in certain
10
10
parts of the European continent and nearby.
0
0
Institutionally, many of the countries around
2003
2004
2005
2006
the euro area are moving towards the adoption
Sources: National central banks and ECB staff calculations.
Notes: Unweighted average for Albania, Bosnia and Herzegovina,
of the euro. This applies to the non-euro area
Croatia, the Czech Republic, Estonia, Hungary, Latvia, the former
Yugoslav Republic of Macedonia, Serbia, Slovakia and Turkey.
members without an opt-out clause, which are
For Bosnia and Herzegovina, data up to end-2004 do not include
loans indexed to euro.
expected to join the euro area at some point. It
15 The role of the euro in the City of London is analysed in ECB (2003), Review of the International Role of the Euro, December.
16 See ECB (2003), Policy Position on Exchange Rate Issues Relating to the Acceding Countries, December.
17 A detailed analysis of currency substitution in central, eastern and south-eastern Europe is provided in ECB (2007), Review of the
International Role of the Euro, June.
18 See, for instance, ECB (2006), Macroeconomic and Financial Stability Challenges for Acceding and Candidate Countries, Occasional
Paper Series, No 48, July.
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C A P I T A L F L O W S A N D
I T S I N T E R N A T I O N A L
R O L E
applies also to the candidate countries that have a medium to long-term perspective of joining the
European Union and ultimately adopting the euro. Economically, the euro area is a major trade and
ﬁ nancial partner for the countries concerned. However, it will depend very much on the country-
speciﬁ c situation whether it is of beneﬁ t to follow a policy of targeting a ﬁ xed exchange rate to
the euro at an early stage of the convergence process. As the convergence process implies a trend
towards real appreciation of the exchange rate over time, several countries have chosen to focus
their monetary policy on domestic price stability while allowing their nominal exchange rate to
appreciate to the euro.
5.4 INTERNATIONAL COOPERATION
The ECB has developed close relations with central banks and organisations outside the euro area.
Multilateral and bilateral
cooperation
Such international cooperation takes place both through multilateral institutions and bilateral
contacts. The international cooperation activities help the ECB in its monitoring of economic and
ﬁ nancial developments outside the euro area. International meetings provide a platform for an
exchange of information on recent developments, economic prospects, and economic policy
challenges outside the euro area.
The Eurosystem has developed a series of tools to intensify its cooperation with major central
banks across the world. It has set up a series of high-level seminars with central banks of speciﬁ c
regions, including with the Bank of Russia, the Mediterranean central banks participating in the
EU Barcelona process, the central banks and monetary authorities of the Gulf Cooperation Council
(GCC), and central banks from Latin America and from the East Asia-Paciﬁ c region. The ECB
also provides technical assistance and policy advice on request and is ready to share its expertise in
various policy areas, including monetary policy implementation, banking supervision and payment
systems. In that context, the European path to Economic and Monetary Union, in particular the
setting-up of a supranational central banking system, often serves as an example and source of
inspiration for other regions.
The ECB plays a key role in various multilateral organisations and fora. At the International
IMF, G7, G20, FSF and BIS
Monetary Fund (IMF), which is a country-based institution, the ECB has been granted observer
status, meaning that it may attend IMF board meetings whenever matters of relevance to the
Eurosystem are discussed. Moreover, the President of the ECB is invited to attend – as an observer
– the biannual meetings of the International Monetary and Financial Committee, which provides
political guidance to the work of the IMF. The ECB President also participates, alongside the
President of the Eurogroup, in the G7 Ministers and Governors meetings. The ECB also attends the
meetings of two fora created by the G7 in 1999: the group of 20 ﬁ nance ministers and central bank
governors (G20), which brings together representatives of key advanced and emerging market
economies to discuss international economic and ﬁ nancial policy issues, and the Financial Stability
Forum (FSF), which assesses potential vulnerabilities in the international ﬁ nancial system. In
addition, the ECB attends relevant meetings of the Organisation for Economic Co-operation and
Development (OECD), also a country-based institution, as part of the EU delegation.
Of particular importance is the Bank for International Settlements (BIS), the “central bankers’ bank”,
which acts as the secretariat and host for various meetings of central banks, including the governors
of the Group of Ten. The ECB became a member of the relevant BIS committees in November
1999 and has been a shareholder since 2005. The ECB President participates in G10
governors’ meetings and, since end-2003, has chaired these meetings in his personal capacity.
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The G10 in turn has a number of permanent committees and ad hoc working groups to which the
ECB also belongs.19
5.5 LESSONS AND WAY FORWARD
Since 1998, the degree of openness of the euro area to external global trade and ﬁ nancial markets
has been steadily increasing, while intra euro-area trade and investment have also expanded
signiﬁ cantly. The euro has had a positive effect on euro area trade, stimulating the export of new
products, and reducing somewhat the costs of exporting. These results are consistent with evidence
of euro-induced changes in the trade pricing behaviour of ﬁ rms, which appear to have encouraged
price convergence within the euro area, a development which in turn has also put downward
pressure on intra-euro area export prices. Finally, the euro has increased domestic competition in
the countries that have adopted the single currency, leading to an overall increased competitiveness
of their ﬁ rms and suggesting that ﬁ ercer competition may also have been the trigger for the observed
increase in convergence of trade prices.
As regards capital ﬂ ows, the establishment of EMU has been a fundamental institutional change
which could help explain the large reallocation of capital that has taken place. With respect to
direct investment, empirical results suggest that the euro has favoured FDI ﬂ ows across euro area
countries and acted as a catalyst generating waves in cross-border M&As in manufacturing. Euro
area countries have enjoyed an extraordinary increase in intra-area M&As in the manufacturing
sector, while the services sector has not yet fully beneﬁ ted from European ﬁ nancial integration.
Looking ahead, this also implies that further M&As will most likely occur if cross-border
barriers are dismantled in the service industries. Turning to portfolio investment, in addition to
the elimination of the exchange rate risk, the adoption of the euro has facilitated the cross-border
allocation of portfolio activity among euro area members in both equity and bonds markets, helped
by factors such as cost reductions in both equity capital and bond and bank ﬁ nancing, the use of
common trading platforms as well as the cross-border merger of the Amsterdam, Brussels and Paris
exchanges (forming Euronext).
The introduction of the euro has also had an impact on the international ﬁ nancial system as it created
a new currency that can be used in international markets. From its introduction in 1999, the euro
immediately gained international status as it took over the international role of its legacy currencies.
Since then, its role in international markets has increased somewhat, but the pace of change has been
very gradual. This is in line with the ﬁ ndings of the economic literature: the international role of
currencies tends to be slow moving, reﬂ ects historical and institutional factors, and is characterised
by network effects.
These international dimensions of the euro area underscore the need for international cooperation
with central banks across the world. Over the past ten years, the Eurosystem has therefore
developed a close dialogue with central banks in various regions by, for example, organising high-
level Eurosystem seminars and developing close bilateral relations with major central banks such
as the US Federal Reserve and the Bank of Japan. Likewise, the ECB attends meetings of various
international organisations and fora, including the IMF, the G7, the G20 and the BIS.
19 The four most prominent of these are the Basel Committee on Banking Supervision; the Committee on Payment and Settlement Systems;
the Committee on the Global Financial System; and the Markets Committee.
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6 FINANCIAL INTEGRATION
There are several reasons, related to its core tasks, why the Eurosystem has a keen interest in
ﬁ nancial integration. First and foremost, a well-integrated ﬁ nancial system contributes to a
smooth and effective transmission of monetary policy throughout the euro area. Second, ﬁ nancial
integration is of great importance to the Eurosystem’s task of contributing to ﬁ nancial stability as
it enhances opportunities for sharing and diversifying risk and increases the liquidity of ﬁ nancial
markets. At the same time, a more integrated ﬁ nancial system increases the scope for spillover
effects and contagion across borders. Third, the ﬁ nancial integration objective is closely related to
the Eurosystem’s task of ensuring the smooth functioning of payment systems, which also relates
to securities clearing and settlement systems. More integrated payment and settlement systems will
operate both more efﬁ ciently and more effectively and are, at the same time, given the central
function of payment systems in the transfer of ﬁ nancial ﬂ ows, key to the ﬁ nancial integration
process. Finally, ﬁ nancial integration plays an important role in ensuring that the ﬁ nancial system
allocates, efﬁ ciently across time and space, resources from market participants with a surplus of
funds to those with a shortage, ultimately leading to higher and sustainable economic growth.
The Eurosystem therefore strongly supports further ﬁ nancial integration in Europe and, particularly,
in the euro area. More speciﬁ cally, the Eurosystem aims to make progress – in line with the ECB’s
deﬁ nition of ﬁ nancial integration – towards a single ﬁ nancial market in the euro area in which
all potential market participants (i) are subject to a single set of rules when they decide to buy or
sell the underlying ﬁ nancial instruments or services, (ii) have equal access to the same ﬁ nancial
instruments or services, and (iii) are treated equally when they operate in the market.
This chapter reviews the progress in ﬁ nancial integration in the euro area and the respective
contribution of the Eurosystem. It is structured as follows. Section 6.1 describes the Eurosystem’s
activities to promote ﬁ nancial integration. Section 6.2 reviews the state of ﬁ nancial integration in
Europe ten years after the introduction of the euro. Section 6.3 assesses the major driving forces and
barriers in the integration process, focusing on the role of the Eurosystem. Section 6.4 concludes.
6.1 EUROSYSTEM ACTIVITIES FOR FINANCIAL INTEGRATION
In the Eurosystem’s view ﬁ nancial integration is ﬁ rst and foremost a market-driven process.
Financial integration is
According to the general provision set out in Article 105 (1) of the Treaty on European Union, the
market-led process …
Eurosystem should act “in accordance with the principle of an open market economy with free
competition, favouring an efﬁ cient allocation of resources”. Given its central banking tasks and its
role as an active market participant with numerous relationships with other market actors, the
Eurosystem can act to promote ﬁ nancial integration.
In line with its position that the ﬁ nancial integration process should be market-led, the Eurosystem
… but public policy can
considers that the role of public policy in fostering ﬁ nancial integration should be limited. In
promote progress
particular, policy measures should not promote a speciﬁ c level or type of cross-border activity, as
only market participants themselves are in a position to develop the underlying business strategies,
take the respective investment decisions and assume responsibility for the economic consequences.
The process of ﬁ nancial integration is, in addition, affected by a number of factors that lie beyond
the remit of public policy, such as geographical distance (and the related information barriers),
differences in culture and language, and consumer preferences. Nevertheless, the public sector has
an important contribution to make to ﬁ nancial integration through the reduction of policy-related
obstacles. The public sector should provide a legal, regulatory, supervisory and ﬁ scal framework
that fosters the equal treatment of, and equal access for, market participants across the EU.
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Eurosystem fosters financial
The Eurosystem fosters the ﬁ nancial integration process in four main ways, namely by (i) enhancing
integration …
knowledge, raising awareness and monitoring progress in ﬁ nancial integration in the euro area, (ii)
giving advice on the legislative and regulatory framework for the ﬁ nancial system, (iii) acting as a
catalyst for private sector activities by facilitating collective action, and (iv) providing central
banking services that also promote ﬁ nancial integration.
… by enhancing knowledge,
Prerequisites for targeted action to foster ﬁ nancial integration are a precise analysis of the state of
raising awareness and
European ﬁ nancial integration and a close monitoring of progress over time. The ECB has therefore
monitoring progress ...
sought to measure the state of ﬁ nancial integration in the euro area by means of price-based and
quantity-based indicators. Price-based indicators measure discrepancies in asset prices based on
their geographical origin. In a perfectly integrated market, prices of assets with similar characteristics
should be inﬂ uenced primarily by common factors. Quantity-based indicators are used to investigate
to what extent investors have internationalised their portfolios to fully reap the beneﬁ ts from the
diversiﬁ cation possibilities that follow from increased ﬁ nancial integration.1
In September 2005 the ECB published an initial set of 20 indicators, which has since been extended.
In March 2007 they were presented in the ﬁ rst publication of the ECB’s annual report entitled
“Financial integration in Europe” 2; the indicators are updated semi-annually on the ECB’s website.
Work to extend the list further, on the basis of advances in research and economic analysis and
subject to the improved availability of statistics, is under way, notably with respect to investment
funds, securitisation vehicles, insurance corporations and pension funds.
In addition to the ECB’s annual report on ﬁ nancial integration, a number of other regular and ad
hoc publications provide information about developments. For instance, the ECB’s annual report
entitled “EU banking structures”, prepared by the ESCB’s Banking Supervision Committee,
offers an analysis of structural developments in cross-border banking. Based on its experience and
knowledge as an active market participant, the ECB also sponsors coordinated research with other
members of the Eurosystem and academics. An important example of this is the joint research
network on capital markets and ﬁ nancial integration in Europe sponsored by the ECB and the
Frankfurt-based Center for Financial Studies.3
… by giving advice on
With a view to ensuring that the legislative and regulatory framework for ﬁ nancial services reduces
legislative and regulatory
obstacles to cross-border ﬁ nance and safeguards a level playing-ﬁ eld among market participants,
framework ...
the Eurosystem actively contributes to the development of the EU framework for ﬁ nancial services
by advising on the main policy reﬂ ections and initiatives. This work focuses on issues relating to
the Eurosystem’s statutory tasks set out in Article 105 of the Treaty, namely to support, without
prejudice to the objective of price stability, the general economic policies in the Community, to
promote the smooth operation of payment systems, and to contribute to the smooth conduct of
policies relating to the prudential supervision of credit institutions and the stability of the ﬁ nancial
system.
… by acting as catalyst for
While the public framework should be conducive to ﬁ nancial integration, progress with integration
private sector activities ...
ultimately depends on private-sector action making full use of the existing cross-border business
opportunities. Competition among market players is a major driving force in this respect. At the
1 See L. Baele et al., “Measuring ﬁ nancial integration in the euro area”, ECB Occasional Paper No 14, May 2004.
2 Previously, the ECB had explained its work in the ﬁ eld of ﬁ nancial integration in two Monthly Bulletin articles entitled “The integration
of Europe’s ﬁ nancial markets” (October 2003) and “The contribution of the ECB and the Eurosystem to European ﬁ nancial integration”
(May 2006).
3 See
http://www.eu-ﬁ nancial-system.org.
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F I N A N C I A L
I N T E G R A T I O N
same time, effective collective action can also be important, especially where heterogeneous market
standards and practices hamper the ﬁ nancial integration process. The Eurosystem can help market
participants to overcome coordination difﬁ culties in this regard.
Providing central bank services is another way in which the Eurosystem seeks to advance ﬁ nancial
… and by providing central
integration. While the main purpose of such services is to enable the Eurosystem to perform its
bank services that foster
financial integration
basic central banking tasks, the Eurosystem also pays close attention to ensure that, where possible,
these services are speciﬁ ed in a way that favours ﬁ nancial integration.
Table 1 provides an overview of some key examples of Eurosystem activities for ﬁ nancial
integration. 4
4 More comprehensive information is provided in the ECB’s annual report entitled “Financial integration in Europe”.
Table 1 Key Eurosystem activities for financial integration
Subject
Main objectives and state of play
Enhancing knowledge, raising awareness and monitoring progress
ECB’s annual report entitled “Financial integration
First issued in 2007 with the aim of informing about the state of ﬁ nancial
in Europe”
integration in Europe, promoting its advancement and raising public awareness
concerning the Eurosystem’s role in supporting the integration process.
Development of indicators of ﬁ nancial integration
First set of indicators published in 2005 with the aim of assessing and monitoring
in the euro area
the state of ﬁ nancial integration in the euro area. Semi-annual updates and
extensions of the set of indicators since then. Further enhancements underway.
Providing advice on the legislative and regulatory framework
Overall EU ﬁ nancial services policy strategy
To develop and implement (i) the 1999 Financial Services Action Plan to update
and enhance the EU regulatory framework and (ii) the respective follow-up
strategy for the period 2005-10. The implementation of the latter is still ongoing.
EU institutional setting for ﬁ nancial regulation and
To ensure the smooth functioning of the Lamfalussy framework. A ﬁ rst full
supervision
review of the Lamfalussy framework was concluded in 2007; the development of
follow-up measures is underway.
EU securities clearing and settlement infrastructure
To achieve an integrated, safe and efﬁ cient post-trading market infrastructure
and remove cross-border obstacles. Various ongoing initiatives that e.g. aim to
develop a common framework for the regulation, supervision and oversight of
securities clearing and settlement systems (ESCB-CESR).
Acting as a catalyst for private sector activities
Single Euro Payments Area (SEPA)
Initiative to achieve a fully integrated market for retail payment services in the
euro area with no distinction between cross-border and national payments by
2010. The ofﬁ cial start of SEPA was in January 2008.
Short-Term European Paper Initiative (STEP)
Development of a pan-European short-term paper market through market
participants’ voluntary compliance with a core set of common standards. STEP
went live in June 2006.
Euro Overnight Index Average (EONIA)
Establishment of a reference interest rate for unsecured overnight interbank
deposits. Computed on an ongoing basis since 1999.
Providing central bank services that also foster ﬁ nancial integration
TARGET and TARGET2
Establishment of a Eurosystem facility for the real-time gross settlement of
large-value payments in the euro area with TARGET in 1999; subsequent move
towards a single shared technical platform with the launch of TARGET2 in 2007.
TARGET2-Securities
Eurosystem initiative, launched in 2006, to provide a single platform enabling
settlement of securities in central bank money in Europe. A ﬁ nal decision on the
project will be taken in mid-2008.
Correspondent Central Banking Model (CCBM)
Scheme for the cross-border transfer of collateral within the Eurosystem,
introduced in 1999, whereby NCBs act as “correspondents” for each other and for
the ECB. Initiative for a single shared platform (CCBM2) underway since 2007.
ECB
Monthly Bulletin
10th Anniversary of the ECB 103

Table 2 State of financial integration in the euro area: overview of the main financial
segments
Market
State of integration
Related infrastructures
Money markets
Unsecured money market
“Near perfect”
Uncollateralised money market: fully integrated
Collateralised money market
Advanced
Collateralised money market: cash leg fully integrated;
collateral leg hampered by fragmentation (see bond markets)
Bond markets
Government bond markets
Very well advanced
Fragmented
Corporate bond markets
Fair
Fragmented
Equity markets
Low
Highly fragmented
Banking markets
Wholesale activities
Well advanced
Fully integrated
Capital-market related activities
Advanced
Fragmented
Retail banking
Very low
Highly fragmented
6.2 FINANCIAL INTEGRATION TEN YEARS AFTER THE INTRODUCTION OF THE EURO
OVERVIEW
Considerable progress in
The ECB’s ﬁ nancial integration indicators reveal that the progress achieved in the euro area varies
financial integration
considerably across market segments. In particular, integration is more advanced in the areas closer
to the single monetary policy. Furthermore, it also depends on the degree of integration of the
respective market infrastructure. Table 2 above gives an overview of the state of ﬁ nancial integration
in the euro area in the main market segments.
The following sections provide a more in-depth assessment of the progress achieved in ﬁ nancial
integration in the money markets, bond and equity markets and the banking markets, and highlight
the main shortcomings.
Box 1
PRELIMINARY FINDINGS OF THE ECB’S WORK ON FINANCIAL DEVELOPMENT
Complementary assessment
Some frictions in ﬁ nancial markets can persist even if ﬁ nancial integration is complete. Financial
of state of financial
development helps to overcome these frictions. It can be understood as a process of ﬁ nancial
development
innovation and institutional and organisational improvement in the ﬁ nancial system that reduces
asymmetric information, increases the completeness of markets, lowers transaction costs and
strengthens competition.
While ﬁ nancial development and ﬁ nancial integration are interrelated, and both of them affect
ﬁ nancial efﬁ ciency favourably, they are also distinct as they describe different economic
processes. For example, adverse selection problems among investors that impair the allocation
of capital may persist even in a fully integrated market. Thus, ﬁ nancial development is
complementary to ﬁ nancial integration in fostering ﬁ nancial market efﬁ ciency.
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F I N A N C I A L
I N T E G R A T I O N
Against this background, the ECB has launched an analytical work stream to specify the concept
of ﬁ nancial development and to establish quantitative indicators for measuring the state of
ﬁ nancial development in the ﬁ nancial system. A ﬁ rst set of such indicators was presented in the
2008 edition of the ECB’s report “Financial integration in Europe”1.
Financial development is an area of ongoing research and, consequently, not all aspects of a
ﬁ nancial system may be fully captured by quantitative indicators. For instance, while formal
laws and rules are easier to measure, informal rules and practices may be just as important.
In addition, information is often available on wholesale, market-based transactions, but not on
retail, relationship-based activities.
These caveats notwithstanding, the available indicators suggest a fair degree of heterogeneity
across markets and countries in the euro area. The main differences are related to the degree of
legal efﬁ ciency, the type and extent of securitisation, the level of stock market trading activities
and the number of cashless transactions per capita.
Relative to the group of benchmark countries, the euro area ﬁ nancial system compares well on
average, except perhaps relative to the United Kingdom and the United States, which perform
well across most of the indicators. These results suggest that there is further scope for structural
reforms of ﬁ nancial sectors in the euro area and that it is beneﬁ cial to look at ﬁ nancial integration
as well as at ﬁ nancial development.
1 See the special feature entitled “Financial development: concepts and measures” in the 2008 edition of the report, which built on earlier
ECB publications in this ﬁ eld, namely P. Hartmann, F. Heider, E.. Papaioannou and M. Lo Duca, “The role of ﬁ nancial markets and
innovation in productivity and growth in Europe”, ECB Occasional Paper No 72, September 2007, and the article entitled “Assessing
the performance of ﬁ nancial systems” in the October 2005 issue of the ECB’s Monthly Bulletin.
MONEY MARKETS
The euro area money market – the market segment closest to the single monetary policy – reached a
Money markets almost fully
stage of “near perfect” integration almost immediately after the introduction of the euro. The cross-
integrated …
sectional standard deviation of the EONIA lending rates across euro area countries fell sharply to
close to zero following the introduction of the euro and has remained stable since (see Chart 1).
A signiﬁ cant exception to the overall high level of integration of euro area money markets is the
… except for short-term
segment for short-term debt securities (i.e. commercial paper and certiﬁ cates of deposit), which has
debt securities segment
remained much more fragmented.
The emergence of liquidity problems in the short-term money markets in the context of the global
ﬁ nancial market turbulence during the second half of 2007 has had an impact on the volatility of
very short-term money market rates, notably the overnight rates. A probable explanation for this
lies in the increased variability in credit risk among banks, rather than in the higher fragmentation,
or lesser integration, of the market.
BOND AND EQUITY MARKETS
Before the introduction of the euro, several factors acted as disincentives to cross-border ﬁ nancial
Clear signs of integration …
activities, including especially the exchange rate risk, cross-country differences in inﬂ ation and
interest rates, the substantial transaction costs of operating in different currencies and currency
restrictions for investors and intermediaries. The adoption of the euro removed these obstacles and
ECB
Monthly Bulletin
10th Anniversary of the ECB 105

gave momentum to securities market integration,
Chart 1 Cross-country standard deviation of
average unsecured interbank lending rates
although to different degrees depending on the
across euro area countries
market segment.
(61-day moving average; basis points)
overnight
… especially in government
Progress in ﬁ nancial integration has been fastest
1-month maturity
bond markets
12-month maturity
in the government bond market, where yields
300
300
have converged and are increasingly driven by
250
250
common factors, although local factors – such
200
200
as differences in liquidity and the availability of
developed derivatives markets tied to the various
150
150
individual bond markets – continue to play a
100
100
role. The remaining divergences may also reﬂ ect
50
50
(perceived) differences in credit risk, but this
0
0
1994
1996
1998
2000
2002
2004
2005
should not be seen as an indication of a lack of
integration.5
overnight
one-month maturity
Progress also in corporate
twelve-month maturity
Similarly, the advent of monetary union has also
bond markets …
5.0
5.0
brought progress in the integration of the
4.5
4.5
4.0
4.0
corporate bond market, as the various markets
3.5
3.5
previously segmented by currency have merged
3.0
3.0
into a single, diversiﬁ ed euro market. As a
2.5
2.5
2.0
2.0
result, country-speciﬁ c factors have become less
1.5
1.5
important in determining corporate bond prices
1.0
1.0
0.5
0.5
and spreads.
0.0
0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007
The share of cross-border holdings also conﬁ rms
Sources: EBF and ECB calculations.
the ﬁ nding that government and corporate bond
markets are quite well integrated. For instance,
cross-border holdings of long-term debt securities have signiﬁ cantly increased during the last ten
years. In the case of monetary ﬁ nancial institutions (MFIs) 6, they grew from about 15% in 1999 to
nearly 40% in 2007 (see Chart 2). Moreover, the holdings of debt securities issued by non-ﬁ nancial
corporations have risen markedly from a very low level, suggesting that investors are increasingly
diversifying their portfolios across the euro area.
… and to a lesser degree in
Integration in the equity markets is less advanced but shows signs of improvement. Since the
equity markets
beginning of the 1990s, equity market integration has proceeded more quickly in the euro area than
worldwide, although local shocks still explain the bulk of the variance in equity returns (see Chart 3).
Between 1997 and 2005, euro area investors doubled their holdings of equity issued in other euro
area countries to 29% of their total portfolio of euro area equity assets, whereas the share of euro
area equity assets held outside the euro area remained at a much lower level and increased only
slightly.
5 In particular, the substantial increase in euro area sovereign spreads to the German benchmark since July 2007 seems to have been driven
mainly by liquidity concerns related to the ﬁ nancial market turmoil, rather than by differences in sovereign credit risk.
6 Monetary
ﬁ nancial institutions comprise the ﬁ nancial institutions that together form the money-issuing sector of the euro area. These
include the Eurosystem, credit institutions resident in the euro area and all other ﬁ nancial institutions resident in the euro area whose
business is to receive deposits and/or close substitutes for deposits from entities other than monetary ﬁ nancial institutions and, for their
own account (at least in economic terms), to grant credit and/or invest in securities. The latter group consists predominantly of money
market funds.
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Chart 2 Share of MFIs’ cross-border holdings of debt
Chart 3 Proportion of variance in local
securities issued by euro area and EU non-MFIs:
equity returns explained by euro area and
outstanding amounts by residency of the issuer
US shocks
(as a share of total holdings, excluding the Eurosystem;
(percentages)
percentages)
other euro area-government and corporate bonds
US shocks
other euro area-corporate bonds
EU shocks
other euro area-government bonds
rest of EU-government and corporate bonds
45
45
45
45
40
40
40
40
35
35
35
35
30
30
30
30
25
25
25
25
20
20
20
20
15
15
15
15
10
10
10
10
5
5
5
5
0
0
0
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
1973-1985
1986-1991
1992-1998
1999-2007
Source: ECB.
Sources: Thomson Financial Datastream and ECB calculations.
BANKING MARKETS
Chart 4 Cross-country standard deviation of
MFI interest rates on loans to households
While the euro area banking markets for
Overall progress, but retail
(basis points)
wholesale and capital market-related activities
integration lagging behind
show clear signs of increasing integration, the
consumer credit: over one year and up to five years
house purchase: with floating rate and initial rate
retail banking segment has remained more
fixation up to one year
fragmented. In particular, the euro area cross-
house purchase: with initial rate fixation over
five and up to ten years
country dispersion of bank interest rates, 160
160
especially of interest rates on consumer loans,
140
140
has remained relatively high (see Chart 4).
120
120
100
100
80
80
Differences in bank interest rates can reﬂ ect
60
60
several factors, such as different conditions
40
40
in national economies (e.g. credit and interest
20
20
0
0
rate risk, size of ﬁ rms, industrial structure
2003
2004
2005
2006
2007
and degree of capital market development),
Source: ECB.
institutional factors (e.g. taxation, regulation,
supervision and consumer protection) and
ﬁ nancial structures (e.g. degree of bank/capital market ﬁ nancing and competitiveness).7 Despite the
signiﬁ cant differences, there are nevertheless indications of a gradual convergence process.
7 See the ECB report entitled “Differences in MFI interest rates across euro area countries”, published in September 2006.
ECB
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6.3 DRIVING FORCES AND BARRIERS IN FINANCIAL INTEGRATION
6.3.1 MONEY MARKETS
MARKET INFRASTRUCTURE INTEGRATION AS A STIMULUS FOR PROGRESS
A key factor in achieving and sustaining money market integration has been the high degree of
integration of euro large-value payment systems, which has allowed the safe and efﬁ cient euro
area-wide handling of interbank payment transactions.
Eurosystem’s TARGET and
Before the launch of the euro, each country in the soon-to-be euro area had its own currency,
CCBM services support euro
monetary policy, national money markets and payment and settlement infrastructure. While such
and money market
national markets and infrastructures had served those countries well for many decades, from the
perspective of the new euro area they were not sufﬁ cient. Fragmentation and a lack of common
infrastructures hampered cross-border activities. It was evident that such a fragmented market
infrastructure would not sufﬁ ciently support the ECB’s monetary policy and the euro money market.
Thus, it was decided to set up new facilities for the settlement of euro payments in central bank
money and for the cross-border delivery of collateral in Eurosystem credit operations. These
Eurosystem facilities were named the TARGET 8 system and the Correspondent Central Banking
Model (CCBM).
TARGET facilitates safe and
The central bank is “the bank of the banks”. When banks make large payments to one another, they
efficient settlement …
prefer to settle such transactions in the books of the central bank to avoid interbank credit risk
exposures. In a real-time gross settlement system payments are received in central bank money,
with intraday ﬁ nality, and such funds are immediately available for re-use. With the introduction of
TARGET by the Eurosystem in January 1999, such a service was made available for the euro.
… and monetary policy
Since its launch, the system has become a benchmark for processing euro payments in terms of
implementation
speed, reliability, opening times and service level. Payments directly related to operations
involving the Eurosystem are settled through TARGET. Thus, the settlement of a monetary policy
operation affects the accounts of those counterparties taking part in the operation concerned. Not
all credit institutions take part in operations with the Eurosystem and therefore the liquidity effect
of such operations is subsequently re-distributed within the banking system through the money
market. Money market transactions result in payments that, again, are largely settled through
TARGET. The open access to the system ensures that all credit institutions can have direct access
to a common set of settlement facilities in central bank money without having to rely on
commercial competitors. Thus, counterparts throughout the euro area can transfer central bank
funds directly between one another, with immediate intraday ﬁ nality. This service is also available
in some non-euro area EU countries, the central banks of which have connected to the system on
a voluntary basis.
As the infrastructure backbone for large-value and time-critical interbank payments, and in order
to meet the needs of its customers and those of ﬁ nancial markets in general, TARGET has long
opening hours and is open every day except Saturdays and Sundays and six other days in the year.
The operating days are, de facto, the settlement days for the ﬁ nancial markets in euro, as well as for
foreign exchange transactions involving the euro.
8 Trans-European Automated Real-time Gross settlement Express Transfer.
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I N T E G R A T I O N
The initial design of TARGET was based on the principle of minimum harmonisation and on a
decentralised architecture, linking together the different systems that existed at national level.
Move to single platform
However, in response to the growing demand from ﬁ nancial institutions for more advanced and
completed
harmonised services, the Eurosystem started in October 2002 to develop an enhanced application,
which would make it possible to change from a “system of systems” to a single shared platform.
This second generation system, TARGET2, was launched on 19 November 2007 and fully replaced
the former TARGET system on 19 May 2008.
The new system is expected to further enhance the integration of wholesale payments by providing
TARGET2 to render
its participants with a harmonised service level, a single price structure for both domestic and cross-
wholesale payments even
more integrated and
border transactions, and a harmonised set of cash settlement services in central bank money for the
efficient
ﬁ nal settlement of the large majority of payment and securities transfer systems operating in euro.
Moreover, the new facility allows banks to further optimise payment and liquidity management.
Whereas multi-country users had to maintain a large number of technical communication interfaces
with the previous system, they are now able to monitor the accounts of their branches in different
countries from one central location. In addition, these users can also centralise their payment
operations, a step that should provide them with further beneﬁ ts stemming from economies of scale,
possible efﬁ ciency gains in speed and quality, and a better ability to cope with a rapidly evolving
payment market environment.
The rapid integration of euro area money markets in January 1999 was greatly facilitated by the
Daily value €2,400 billion
settlement services offered by, and the smooth operation of, TARGET. Moreover, while in 1999
there were 21 large-value payment systems in euro, in 2008 there are only three. The establishment,
smooth operation and continuous enhancement of the system provides an example of the successful
role of Eurosystem services in fostering the integration of market infrastructures and, consequently,
the respective ﬁ nancial market segments. Among the current systems, TARGET2 accounts for the
highest market share in terms of both value and volume of payments. 9 It currently has a daily
turnover of some €2,400 billion. Thus, the turnover of 3½ working days corresponds to the annual
total GDP of the euro area! The highest turnover recorded on a single day was €3,387 billion.
Another important Eurosystem service contributing to money market integration is the CCBM for
CCBM facilitated cross-border
the cross-border transfer of collateral within the euro area. According to its Statute, all Eurosystem
transfer of collateral ...
credit operations have to be based on adequate collateral. Moreover, the Eurosystem operational
framework stipulates that all assets eligible for Eurosystem credit operations can be used as
collateral by all Eurosystem counterparties, regardless of the location of the asset or the
counterparty.
At the time the euro was introduced, the infrastructures of the European securities markets were
highly segmented and, in particular, the network of links between securities settlement systems was
incomplete. In the absence of an adequate market arrangement for the cross-border mobilisation
of collateral, the Eurosystem in 1999 introduced the CCBM as an interim solution, based on the
expectation that market solutions would develop over time. With this arrangement, counterparties
obtain credit from their “home” central bank based on collateral transferred to another Eurosystem
central bank (the “correspondent central bank”). In the meantime, this service has become the main
channel for the use of collateral on a cross-border basis in Eurosystem credit operations.
9 TARGET2 accounts for 89% of the value and 60% of the volume of trafﬁ c that ﬂ ows through all the large-value payment systems
operating in euro. It processes a daily average in excess of 360,000 payments and is one of the largest wholesale payment systems in
the world, alongside Fedwire in the United States and Continuous Linked Settlement (CLS), the international system for settling foreign
exchange transactions.
ECB
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10th Anniversary of the ECB 109

… supporting growing use
The CCBM service has provided an invaluable
Chart 5 Value of collateral transferred by
of cross-border collateral
contribution to the functioning of the Eurosystem
the counterparties for Eurosystem credit
operations
collateral framework and has greatly supported
the increasing use of collateral on a cross-border
(EUR billions)
basis. Indeed, Eurosystem counterparties have
domestic
CCBM
diversiﬁ ed their collateral portfolios by increasing
links
the share of their collateral investments in assets
800
800
originating from other euro area countries.
700
700
Moreover, multi-country banking groups have
600
600
500
500
increasingly centralised liquidity and collateral
400
400
management at group level. Collateral transferred
300
300
through the service has increased from 200
200
100
100
€162.7 billion in 1999 to €557.9 billion in
0
0
December 2007, the latter value amounting to
1999 2000 2001 2002 2003 2004 2005 2006 2007
39.6% of the total collateral transferred to the
Sources: ECB.
Eurosystem at the time (see Chart 5). In 2006 the
cross-border use of collateral represented 50.2%
of total collateral delivered to the Eurosystem, overtaking domestic use for the ﬁ rst time. In 2007, in
relative terms, 81.5% of cross-border collateral deliveries were channelled through the CCBM, while
the share of collateral transferred using links amounted to 18.5%.
Work under way to further
Efforts are currently under way to further enhance the Eurosystem’s service by establishing a single
enhance collateral delivery
technical platform (CCBM2) with a view to providing a uniform service for both domestic and
services
cross-border collateral operations. This platform will provide, ﬁ rst and foremost, an enhanced
collateral management facility for the Eurosystem, but it will also open up signiﬁ cant opportunities
for Eurosystem counterparties to further reduce back-ofﬁ ce complexity and cost, and to optimise
collateral and liquidity management. In addition, the new system will also provide synergy gains
with the TARGET2 and TARGET2-Securities services (see the section on bond and equity markets
below). In order to take full account of the counterparties’ needs, the Eurosystem is developing the
new system in close cooperation with market participants.
ACTION TO OVERCOME THE FRAGMENTATION OF THE MARKET FOR SHORT-TERM SECURITIES
STEP initiative to establish
The euro area market for short-term debt securities has remained rather fragmented, as mentioned
common market standards …
earlier. Differences in market standards have played an important role in obstructing the emergence
of a pan-European market. Against this background, in 2001 Euribor ACI 10 launched the Short-
Term European Paper (STEP) initiative with the objective of (i) identifying a set of common market
standards and practices suitable to promote market integration and (ii) fostering the voluntary
compliance of market participants with these standards by granting a common label to compliant
issuance programmes.
… went live in June 2006
In June 2006 Euribor ACI and the Euribor European Banking Federation 11 signed the STEP Market
Convention, which lays down the criteria and procedures for granting and withdrawing the STEP
label to short-term debt securities issued. The new market has been rapidly accepted. For instance,
in September 2007 euro-denominated STEP-labelled securities already accounted for about 30% of
all euro-denominated short-term paper placed by non-government issuers worldwide. Similarly,
10 Euribor ACI is one of the ﬁ nancial market associations that manage the EURIBOR and EONIA indices.
11 The Euribor European Banking Federation had supported Euribor ACI in the development of the project from May 2005.
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I N T E G R A T I O N
in December 2007, the volumes of the respective programmes reached €320 billion, up from
€60 billion in July 2006, one month after the signature of the market convention.
While the STEP project has been a market-led initiative to foster integration with the short-term debt
Catalytic role of
securities segment, the Eurosystem has played a key role in making it a success. Following its initial
Eurosystem instrumental
in this success
impetus for the launch of the project, the ECB also contributed to its development and implementation.
During the preparatory phase, the ECB facilitated coordination among the market players involved,
contributed to the development of the market convention and provided legal assistance. The ECB also
took action to make the project better known by the market and the public. Since the formal launch of
the new market, the ECB and nine Eurosystem NCBs have provided technical assistance to the STEP
Secretariat. Furthermore, the ECB has produced regular statistics on yields and volumes in the STEP
market and has published the respective information on its website. These statistics, which have been
continuously enhanced over time, are fundamental in improving market transparency. This will play
an important part in fostering further progress in the integration of the European short-term securities
market during the coming years.
6.3.2 BOND AND EQUITY MARKETS
PROGRESS IN THE EU FRAMEWORK FOR FINANCIAL REGULATION AND SUPERVISION
The progress in the integration of euro area bond and equities markets provides an example of how
Progress fostered by
the public sector can tackle policy-related obstacles to cross-border ﬁ nance. The introduction of the
effective public sector
action …
euro revealed that the full potential of the single currency in fostering ﬁ nancial integration could only
be reaped if it were to be complemented by an enhanced EU framework that removed the barriers to
cross-border activities and safeguarded the stability of the single market. Two key initiatives in this
respect have been pursued in recent years: the Financial Services Action Plan (FSAP) and the
establishment of the “Lamfalussy framework” for ﬁ nancial regulation and supervision.
The FSAP, launched in 1999, constituted a major overhaul of EU legislation for ﬁ nancial services.
… including the Financial
It contained 42 key legislative initiatives proposed by the European Commission to update existing
Services Action Plan …
EU rules in the light of market developments and to extend the level of EU regulatory harmonisation
in line with the single market objective. While the FSAP targeted the entire ﬁ nancial sector, most of
the initiatives related to securities markets. Major measures in this respect included the Markets in
Financial Instruments Directive (MiFID), the Transparency Directive, the Market Abuse Directive,
and the Prospectus Directive 12.
Building on the achievements under the FSAP, in December 2005 the Commission adopted a White
… the follow-up policy
Paper on EU ﬁ nancial services policy for the years 2005-10. The White Paper states that the main
strategy 2005-10 …
EU ﬁ nancial services policy priority in the coming years, especially in the ﬁ eld of securities markets,
will be to ensure the effective and consistent implementation of the FSAP measures and to
consolidate and simplify existing EU legislation. Possible further policy initiatives are only
envisaged in a limited number of carefully targeted areas, notably clearing and settlement and retail
ﬁ nancial services.
The Lamfalussy framework for ﬁ nancial regulation and supervision was implemented in the securities
… and the introduction of
ﬁ eld in 2001 and has signiﬁ cantly enhanced the speed and ﬂ exibility of the EU regulatory process. It has
the Lamfalussy framework
also fostered the consistent implementation of EU rules at national level, especially with respect to the
12 The article entitled “Developments in the EU framework for ﬁ nancial regulation, supervision and stability” in the November 2004 issue of
the Monthly Bulletin provides an overview of the main FSAP measures.
ECB
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10th Anniversary of the ECB 111

securities markets directives adopted under the FSAP. The Lamfalussy framework is based on an
innovative four-level approach to ﬁ nancial legislation: the basic principles of the legislation are still laid
down by way of the normal legislative process, with adoption by the European Parliament and the
Council (level 1). However, technical details of legislation that would need to be kept in line with market
and regulatory developments can be adopted by the Commission through a simpliﬁ ed and accelerated
procedure (level 2), with the involvement of sectoral regulatory committees, comprising the relevant
national and European authorities. Level 3 encompasses the efforts of sectoral committees of national
supervisors to ensure a consistent and timely implementation of level 1 and level 2 measures at national
level. Finally, level 4 relates to Commission measures to strengthen the enforcement of EU law,
underpinned by enhanced cooperation between Member States, their regulatory bodies and the private
sector 13.
The practical functioning of the Lamfalussy framework – which since 2003 has also been
implemented in the banking and insurance sectors – has been closely monitored and a number
of improvements have already been introduced or are currently under development. The main
objective of these measures is to reap the full beneﬁ ts of the framework in terms of fostering closer
supervisory convergence and cooperation in the implementation of EU rules.
Eurosystem has contributed
The ECB and the Eurosystem have actively contributed to the establishment and implementation of
through its advisory role
both the FSAP and the Lamfalussy framework and to the respective follow-up initiatives, as set out
in Chapter 7.
NEED TO FURTHER ENHANCE THE INTEGRATION OF THE SECURITIES MARKET INFRASTRUCTURE
Limited integration
The integration of bond and equity markets relies on the integration of the underlying infrastructure,
of securities market
particularly that of the securities settlement systems and central counterparties. However, progress
infrastructure …
in integrating securities infrastructures has not kept pace with that of large-value payment
infrastructures. This is largely because of the much greater intrinsic complexities of securities,
which have led to differences in national market practices and legal, regulatory and ﬁ scal regimes.
Since the TARGET system was launched in 1999, payments across national borders have
represented approximately 20-25% of total volumes and 35% of total values. By contrast, while
securities settlement systems have made a special effort to set up links among themselves, their use
has been scarce (less than 1% of total volumes/values).
While the post-trading infrastructure is fragmented for bonds, it is even more fragmented for
equities. The cross-border settlement for bonds is largely concentrated within two international
central securities depositories, whereas the cross-border settlement of equities still relies heavily on
national central securities depositories.
… results in high
The high degree of fragmentation implies substantial post-trading costs for EU cross-border
transaction fees
securities transactions, reduces the potential for economies of scale and hampers the emergence of a
European level playing-ﬁ eld. Although Europe is comparable with the United States in terms of its
economic size, it lags behind in terms of both the volume and cost of securities transactions. The
cost gap is particularly large in cross-border settlement.
Several initiatives to
A number of important and complementary public and private sector initiatives have been put
improve situation
forward to improve the situation. First, barriers to integration stemming from differences in market
13 See the previously mentioned article for a more detailed description of the Lamfalussy framework.
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practices and legal, regulatory and ﬁ scal provisions have been identiﬁ ed and efforts to remove them
are under way. Second, to facilitate integration and competition a “Code of Conduct for Clearing
and Settlement” was signed by industry stakeholder groups in November 2006 and its implementation
is now being closely monitored. Third, to promote closer convergence of national securities clearing
and settlement systems towards the highest standards of safety and efﬁ ciency, the ESCB and the
Committee of European Securities Regulators are developing joint recommendations for the safety
and soundness of the EU post-trading infrastructures.
A missing element in the current strategy for an integrated securities infrastructure for the Single
Eurosystem settlement
Market is the establishment of a common, neutral settlement platform to foster effective
platform (T2S) to
complement efforts
interoperability and competition between the service providers. Tapping into its capability of
promoting ﬁ nancial integration through the provision of central bank services, the Eurosystem has
recently proposed its TARGET2-Securities (T2S) initiative to close this gap.
This initiative builds on the fact that the services of central securities depositories and central banks
are closely associated in the ﬁ eld of securities. A securities trade typically results in the delivery
of securities (securities leg) and the transfer of cash funds (cash leg). If the cash leg is settled in a
central bank settlement facility, it is referred to as settlement in central bank money. To avoid credit
risk, the completion of one leg is conditional on the completion of the other (known as “delivery-
versus-payment”). However, while this service is very effective within each country, it is so far
barely available at cross-border level in Europe.
Holding securities accounts and central bank money accounts on the same platform for settlement
purposes is considered the most efﬁ cient way of settling the two legs (securities and cash) of securities
trades. With the launch of TARGET2, the Eurosystem now offers a single platform for settling payments
(the cash leg) in central bank money. However, securities are still held on multiple platforms (central
securities depositories). Outsourcing the central bank money accounts to multiple securities platforms
would have largely undone the beneﬁ ts achieved in moving to a single platform for payments.
Consequently, with the T2S initiative the Eurosystem is proposing that securities platforms
T2S to render cross-border
outsource their securities accounts to a neutral single platform (the single platform for payments),
settlement as cheap and
efficient as domestic
which it would operate. Each securities platform will be invited to agree to move its settlement to
settlement …
T2S in order to fully integrate all settlement activities and thereby make cross-border settlement as
cheap and efﬁ cient as domestic settlement is today.
T2S would bring the beneﬁ ts of both scale and competition. Scale effects would result from the use
… enable more efficient use
of a single platform for securities and central bank money settlement. This would not only result in
of liquidity and collateral …
lower fees, particularly for cross-border settlement, but also allow market participants to pool their
liquidity and collateral, thus reducing their opportunity costs. As regards competition, securities
… and stimulate
platforms would continue to provide services other than settlement. However, the use of a common
competition
settlement engine would make it easier for market participants and investors to determine where
they wish to hold a given security. T2S will encourage securities platforms to offer their participants
the opportunity to centralise their securities holdings in one place. It would therefore be easier to
choose the service provider on the basis of costs and service level rather than location of the security.
This increased competition is expected to drive fees down.
In moving the initiative forward, the Eurosystem seeks to ensure that all relevant stakeholders are
Final decision on project in
involved and have a say. The deliverables of the project so far are the result of months of intensive
mid-2008
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cooperation by hundreds of experts from securities depositories, banks and central banks. This way
of working is highly appreciated by the industry and will continue in the next phase of the project.
The Governing Council is expected to decide in summer 2008 whether to proceed to the next phase
of the project. The expected launch date of T2S is in 2013.
6.3.3 BANKING MARKETS
IMPROVEMENTS IN THE REGULATORY AND SUPERVISORY FRAMEWORK FOR CROSS-BORDER BANKS
Cross-border banking to
Cross-border banking groups are key to the integration process, as they enhance competition and
evolve as market-led process
spread innovation in ﬁ nancial products and services as a result of their expansion across jurisdictions.
The removal of policy-related obstacles to cross-border banking has therefore become an important
issue in recent years. The main priorities in this respect are to remove impediments to cross-border
mergers and acquisitions (M&As) and to support the efﬁ cient operation of cross-border banking
groups on an ongoing basis.
Several EU measures to
Several initiatives have been adopted to enhance the EU framework for cross-border banks in the
remove policy-related
areas of banking regulation and supervision, market conduct supervision, taxation and company
obstacles …
law 14. An important strand of work has related to streamlining the supervision of cross-border
groups and fostering convergence of national requirements. The strengthened framework for home-
host interaction adopted in 2006 under the Capital Requirements Directive (CRD) 15 and the above-
mentioned extension of the Lamfalussy framework to the banking sector constitute two milestones
in this respect. In the meantime, initiatives to further strengthen the EU supervisory arrangements
are already under way (see chapter 7).
Furthermore, the Commission’s ﬁ nancial services strategy 2005-10 contains a number of carefully
targeted measures to facilitate cross-border activities in the retail banking segment, for instance,
with respect to mortgage credit, customer mobility in relation to bank accounts and cross-border
access to credit data.
… actively supported by
Besides providing input to the work to strengthen the EU framework for cross-border banks, the
Eurosystem
ECB and the Eurosystem also collect information on developments in banking groups with
signiﬁ cant cross-border activities in the EU. In particular, since 2002 the Banking Supervision
Committee has conducted a biennial survey of such groups. The three surveys have pointed to a
growing internationalisation in recent years, largely as a result of cross-border M&As. While the
number of groups included in the analysis has increased only slightly – from 41 to 46 between 2001
and 2006 – the consolidated assets of the sample grew by 54% during this period and its share in the
consolidated EU banking assets increased to 68%. The banks with signiﬁ cant cross-border activities
thus hold a sizable – and rising – share of total EU banking assets 16.
14 A special feature entitled “Strengthening the EU framework for cross-border banks” in the 2007 edition of the ECB’s “Financial
Integration in Europe” provides an overview of the respective policy initiatives.
15 The CRD implemented the international Basel II landmark agreement on more comprehensive and risk-sensitive capital adequacy
requirements for banks at EU level. In this context, it introduced a number of additional elements taking into account the speciﬁ cities
of the EU setting. In particular, considering the advanced state of ﬁ nancial integration in the EU and the correspondingly high degree of
systemic linkages and interdependencies between authorities, the CRD introduced strengthened requirements for cooperation between
home and host supervisors.
16 Further information on the scope and results of the 2001 and 2003 mapping exercises is provided in the article entitled “International activities
of large EU banking groups” in the ECB’s 2005 report on EU banking structures. The 2006 edition of the report lists the main results of
the 2005 mapping exercise. The 2005 ﬁ ndings are also assessed in the publication “Review of the Lamfalussy framework: Eurosystem
contribution”, which is available on the ECB’s website at: http://www.ecb.europa.eu/pub/pdf/other/lamfalussy-review2007en.pdf.
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TOWARDS AN INTEGRATED EURO AREA INFRASTRUCTURE FOR RETAIL PAYMENTS
Cross-border banking has been hampered by the relatively high level of fragmentation of the retail
Retail payments market
payments infrastructure. Each country has its own national payment instruments and different
remains fragmented
standards for payments made by credit transfers, direct debits and card payments. For the Eurosystem
the establishment of an integrated retail payments market, with a common set of payment instruments
for the euro area, is highly desirable, as it is the logical consequence of the introduction of the euro.
During the last ten years, the Eurosystem has acted as a catalyst in the reforms and produced several
Eurosystem has acted as
reports on the causes of, and possible remedies to, the fragmentation and set out the objectives to be
catalyst for reform
achieved. Back in 1999 the Eurosystem highlighted that, especially for cross-border credit transfers,
prices were substantially higher and the execution time was substantially longer than for domestic
transfers.17 These inefﬁ ciencies were partially linked to the predominant use of correspondent
banking and the lack of adequate euro area-wide interbank infrastructures. In 2000 18 the Eurosystem
noted that, despite some progress by the banking industry, customer prices had not decreased for
cross-border payments. To provide more guidance, the ECB also published a concrete road map for
the development of a modern retail payment infrastructure for euro credit transfers.19
In December 2001 the European Parliament and the Council adopted a Regulation that included an
Industry agreed on creation
obligation of equal pricing of cross-border and national euro payments for consumers. While the
of SEPA
Regulation brought about some improvements from a customer perspective, the banking sector still
had considerable work to do in building the pan-European service infrastructure. In early 2002 the
banking industry founded the European Payments Council, which consequently formulated a
strategy to create the Single Euro Payments Area (SEPA) 20.
Since 2002 the Eurosystem has strongly supported the industry and provided a direction and
Deliverables and legal
timelines for implementing a modern payment infrastructure that responds to the needs of euro area
framework have been
defined
customers.21 The European banking sector has made substantial efforts to increase the efﬁ ciency of
retail cross-border payments. These have resulted in three main deliverables: a single set of rules
for credit transfer, direct debit and card payments for all participants in the euro payments market;
equal access for service providers and users throughout Europe; and equal treatment of market
participants. In all, transparency on rules and conditions has been clearly enhanced.
The Payment Services Directive, adopted at the end of 2007, forms the legal framework for payments
in SEPA and is to be implemented by all EU Member States by 1 November 2009. The Directive
aims to generate more competition in payment markets by removing market entry barriers. It also
provides a simpliﬁ ed and fully harmonised legal framework with regard to information requirements
and the rights and obligations linked to the provision and use of payment services.
On 28 January 2008, SEPA was launched with the introduction of a common credit transfer for all
SEPA launched in January
euro payments in Europe. Cards were also rolled out for SEPA-wide use. SEPA Direct Debit will
2008
be launched in 2009. Thus, ten years after the introduction of the euro, the retail payments
17 See the ECB publication of 13 September 1999 entitled “Improving cross-border retail payment services – the Eurosystem’s view”.
18 See the ECB publication of 14 September 2000 entitled “Improving cross-border retail payment services – Progress report”.
19 See the ECB publication of November 2001 entitled “Towards an integrated infrastructure for credit transfers in euro”.
20 See the European Payments Council’s White Paper “Euroland: Our Single Payment Area!” (May 2002).
21 The Eurosystem has issued several progress reports to guide the industry: 26 June 2003, “Towards a Single Euro Payments Area – progress
report”; 2 December 2004, “Towards a Single Euro Payments Area – third progress report”; 17 February 2006, “Towards a Single Euro
Payments Area – Objectives and deadlines” (fourth progress report); 20 July 2007 “Single Euro Payments Area (SEPA) – From concept
to reality” (ﬁ fth progress report). For more information on the impact of SEPA on ﬁ nancial integration, please refer to the 2007 edition of
the ECB’s “Financial integration in Europe”.
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infrastructure for the euro is ﬁ nally being put into place. The national payment instruments are
gradually being phased out over the next few years and more innovative solutions will be introduced.
In the following years, SEPA is expected to bring further integration and efﬁ ciencies in the retail
banking market.
6.4 LESSONS AND WAY FORWARD
Financial integration helps
Over the past ten years, considerable progress in ﬁ nancial integration has been achieved in the euro
Eurosystem to achieve its
area. More integrated ﬁ nancial markets help the Eurosystem to fulﬁ l its mandate effectively and to
objectives
achieve its objectives, namely by contributing to the preservation of price stability, ﬁ nancial
stability, the smooth operation of payment systems and economic growth. The introduction of the
euro has already acted as a major driving force for ﬁ nancial integration. Furthermore, the Eurosystem
has made a signiﬁ cant contribution to ﬁ nancial integration over the past decade in four main ways.
Eurosystem action has
First, the ECB has developed a conceptual framework for assessing and monitoring the state of
fostered integration process
ﬁ nancial integration in the euro area and it regularly reviews ﬁ nancial integration in its annual report
on ﬁ nancial integration in Europe. In this way, the ECB provides a sound empirical basis for targeted
action to foster ﬁ nancial integration, contributes to the respective policy discussion, and raises
awareness of ﬁ nancial integration and the respective role of the Eurosystem among the public.
Second, the Eurosystem has successfully acted as a catalyst for market-based initiatives for ﬁ nancial
integration in a number of important ﬁ elds by fostering, for example, a closer integration of short-
term debt securities markets (via the STEP project) and of retail banking markets (via SEPA).
Third, the Eurosystem has contributed to the development of various EU measures to reduce
policy-related obstacles to ﬁ nancial integration. Such measures have, for example, aimed to foster
securities and banking market integration through the establishment of a more comprehensive
and coherent EU legislative, regulatory and supervisory framework for ﬁ nancial services and for
securities clearing and settlement.
Fourth, the Eurosystem has effectively used the provision of central bank services, primarily aimed
at supporting the performance of its central banking tasks, as a channel also to promote ﬁ nancial
integration. Key examples of this work have related to the integration of the market infrastructure
for large-value payments (TARGET and TARGET2) and the establishment of a common system for
the cross-border transfer of collateral (CCBM), both of which have been instrumental in achieving
and sustaining the near-perfect integration of money markets.
Future priorities
The Eurosystem will continue using these tools, especially in those areas that are still lagging
behind in ﬁ nancial integration, namely the corporate bond, equity and retail banking markets.
Priorities in this respect include (i) the provision of advice on possible further enhancements of the
EU framework for ﬁ nancial services, namely as regards ﬁ nancial supervision, retail banking and
the removal of obstacles to cross-border securities clearing and settlement; (ii) the envisaged
establishment of a Eurosystem service (TARGET2-Securities) for the settlement of securities
transactions; and (iii) support for the full implementation of SEPA. Finally, the ECB will work to
further develop its conceptual framework on ﬁ nancial integration and to extend it over time to
include the assessment of progress in ﬁ nancial development.
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7 FINANCIAL STABILITY AND OVERSIGHT
Contributing to ﬁ nancial stability is one of the core responsibilities of the Eurosystem for several
reasons. Given their role as issuers of money, central banks need to monitor the quality of the
ﬁ nancial institutions that are their monetary policy counterparties. Another reason is that a stable
ﬁ nancial system is needed for the effective transmission of monetary policy. Furthermore, central
banks act as ultimate providers of a safe medium for the settlement of ﬁ nancial transactions and of
liquidity in the ﬁ nancial system. Finally, ﬁ nancial stability also supports economic performance.
In recent decades the link between economic growth and ﬁ nancial stability has also become
increasingly important given the signiﬁ cant expansion of the ﬁ nancial sector relative to the real
economy. In particular, severe disruptions in the ﬁ nancial intermediation process are more likely
to have macroeconomic repercussions.1
Over the last ten years the Eurosystem has made an important contribution to safeguarding
ﬁ nancial stability in the euro area by pursuing its primary objective of maintaining price stability.
The medium-term orientation of the ECB’s monetary policy strategy has ensured that price stability
could be pursued without introducing unnecessary volatility into economic activity and ﬁ nancial
markets. Moreover, the Eurosystem has contributed to ﬁ nancial stability in two main ways: ﬁ rst,
the Eurosystem has carried out a number of tasks to foster the stability of the euro area ﬁ nancial
system. Second, the Eurosystem has supported the competent national and EU authorities in their
tasks relating to ﬁ nancial stability. In addition, the Eurosystem has assumed direct responsibilities
for overseeing market infrastructures, notably payment systems, a task which also contributes to
ﬁ nancial system stability.
This chapter provides an overview of the main achievements of the Eurosystem within these areas.
Section 7.1 describes the common background for the respective activities with a brief review of
the concept of ﬁ nancial stability and the respective role of the Eurosystem. Section 7.2 assesses the
contribution of the Eurosystem to ﬁ nancial stability, while Section 7.3 considers the oversight role
of the Eurosystem.
7.1 FINANCIAL STABILITY AND THE ROLE OF THE EUROSYSTEM
To date, there is no shared deﬁ nition of ﬁ nancial stability. It is particularly difﬁ cult to identify with
Financial stability is a
reasonable precision an instance of ﬁ nancial instability apart from an obvious ﬁ nancial crisis.
complex concept…
According to the deﬁ nition used by the ECB, ﬁ nancial stability is a condition in which the ﬁ nancial
system – comprising ﬁ nancial intermediaries, markets and market infrastructures – is capable of
withstanding shocks and the unravelling of ﬁ nancial imbalances.2
Achieving and maintaining ﬁ nancial stability is ﬁ rst and foremost the responsibility of market
… and primarily a private-
participants, who are expected to assess and manage their risks effectively and to bear the ﬁ nancial
sector responsibility
consequences of their transactions. However, market participants do not take into account possible
systemic risks that may result from their activities. Therefore, a public framework to prevent and
manage potential ﬁ nancial crises is also in place that aims to prevent ﬁ nancial problems from
threatening the overall stability of the ﬁ nancial and economic system, while minimising as far as
possible distortions in the market mechanism. This framework includes the regular monitoring and
1 Padoa-Schioppa, Tommaso (2002), “Central banks and ﬁ nancial stability: exploring a land in between”. Policy panel introductory paper at
the Second ECB Central Banking Conference, “The transformation of the European ﬁ nancial system”, held on 24 and 25 October 2002.
2 See the special feature entitled “Assessing Financial Stability: Conceptual Boundaries and Challenges”, in the June 2005 ECB Financial
Stability Review.
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assessment of ﬁ nancial stability, ﬁ nancial regulation and supervision, the oversight of market
infrastructures and a number of possible measures for crisis management.
Role of the Eurosystem
The Eurosystem carries out two main functions in these areas. First, it conducts certain ﬁ nancial
stability tasks at euro area level, like the monitoring and assessment of ﬁ nancial stability in the euro
area as well as market operations that aim to address general ﬁ nancial shocks and relieve tensions
in the euro area money market. Second, the Eurosystem contributes to the deﬁ nition of the ﬁ nancial
stability policies of the competent national and EU authorities pertaining to ﬁ nancial stability
monitoring and assessment, ﬁ nancial regulation and supervision, and crisis management. In
addition, the Eurosystem oversees market infrastructures as part of its basic task to promote the
smooth operation of payment systems. The following sections assess in detail the Eurosystem’s
contribution to ﬁ nancial stability and its role in overseeing market infrastructures.
7.2 CONTRIBUTION TO FINANCIAL STABILITY
INSTITUTIONAL SETTING
National competence for
The establishment of Economic and Monetary Union (EMU) introduced different institutional
financial stability …
set-ups for monetary policy and ﬁ nancial stability within the euro area. While responsibility for the
former was transferred from national to supranational level (see Chapter 2), responsibility for the
arrangements safeguarding ﬁ nancial stability has remained at national level. Moreover, unlike the
situation in several Eurosystem countries, where central banks are responsible for, or closely
involved in, prudential supervision,3 central banking and supervisory functions were separated in
EMU as the ECB and the Eurosystem were not given direct supervisory competencies.
… heightens need for cross-
This speciﬁ c institutional framework, inherently more complex than the monetary policy set-up,
border cooperation
created a need for close cooperation (i) within the Eurosystem, between the ECB and the NCBs, in
order to monitor and address potential area-wide risks to ﬁ nancial stability effectively, and
(ii) between the Eurosystem and national supervisors in order to ensure the close coordination of
central banking and supervisory functions in safeguarding ﬁ nancial stability.
Cooperation mechanisms
The Treaty on European Union (Maastricht Treaty) provides for speciﬁ c cooperation mechanisms
specified in the Treaty …
in this respect. First, the Eurosystem has to “contribute to the smooth conduct of policies pursued
by the competent authorities relating to the prudential supervision of credit institutions and the
stability of the ﬁ nancial system”.4 Second, the ECB must be consulted on any proposed
Community act or any draft legislative provision of the national authorities that relates to its
ﬁ elds of competence. Similarly, the ECB may offer advice to, and be consulted by, the Council,
the Commission and the competent national authorities on the scope and implementation of
Community legislation relating to the prudential supervision of credit institutions and the stability
of the ﬁ nancial system 5. Finally, the Treaty foresees the possibility of transferring speciﬁ c
supervisory tasks to the ECB following a simpliﬁ ed procedure without the need to amend the
3 The supervisory structures in EU Member States differ widely in terms of both central banking involvement and the assignment of
supervisory responsibility across ﬁ nancial sectors. For instance, while in some countries supervisory responsibilities are divided up by
sector, other countries have centralised ﬁ nancial supervision for the banking, insurance and securities sectors within a single authority.
A recent overview (2006) of the arrangements in EU countries is provided in the ECB publication entitled “Recent developments in
supervisory structures in EU and acceding countries”, which is available on the ECB’s website (http://www.ecb.europa.eu/pub/pdf/other/
report_on_supervisory_structuresen.pdf).
4 Article 105 (5) of the Treaty on European Union.
5 Article 25.1 of the ESCB Statute.
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Treaty.6 This provision, which has not been invoked so far, would be an option should the
institutional mechanisms for cooperation fail to achieve a smooth and effective interaction
between the authorities.
The Eurosystem carries out its mandate in the ﬁ eld of ﬁ nancial stability with the assistance of the
… performed with support
Banking Supervision Committee (BSC), which was established by the ECB’s Governing Council in
of the BSC
1998. The BSC comprises high-level representatives of the ECB and the NCBs of the Eurosystem
as well as representatives of the national banking supervisory authorities in those Eurosystem
countries where the NCB’s mandate does not include banking supervision. In addition, the BSC
includes the central bank and supervisory representatives of those EU countries that have not
adopted the single currency. This wide scope of membership reﬂ ects the fact that the national
responsibilities for ﬁ nancial stability and supervision are fulﬁ lled in accordance with the harmonised
regulatory framework and the Single Market of the European Union.7
MARKET ENVIRONMENT
The role and tasks of the ECB and the Eurosystem in ﬁ nancial stability have evolved against the
background of the overall progress in cross-border ﬁ nancial integration (as discussed in Chapter 6)
and the increasingly dynamic character and growing complexity of the ﬁ nancial system.
Financial integration enhances the possibilities for risk-sharing and diversiﬁ cation, and increases
Financial integration calls
the liquidity and depth of ﬁ nancial markets, thus contributing to the resilience of the ﬁ nancial
for closer cross-border
cooperation
system. However, it also renders the ﬁ nancial system more prone to disturbances that may be cross-
border in origin or nature. This calls for a continuous strengthening of cross-border information-
sharing and cooperation among central banks and supervisory authorities, namely with respect to
the growing number of large multinational EU banking groups.
Furthermore, the rapid pace of ﬁ nancial innovation, coupled with the deepening of ﬁ nancial
Dynamic and complex
integration, has blurred the boundaries between ﬁ nancial intermediaries, markets and market
financial system …
infrastructures as well as between the various ﬁ nancial market segments. Important developments
in this respect include the greater participation of banks in capital markets (e.g. through the
securitisation of bank loans, credit risk transfer instruments and complex structured ﬁ nance
products), the growing role of ﬁ nancial conglomerates, the increasing role of commercial banks in
providing infrastructure services and the rising participation of non-regulated entities in ﬁ nancial
markets and infrastructures.
As a result, there is a constant need to develop and update the framework for monitoring, analysing
… makes safeguarding
and responding to potential risks in the ﬁ nancial system, taking into account the various interlinkages
financial stability more
demanding
between its components and the corresponding changes. This task is becoming increasingly
demanding.
6 Article 105 (6) of the Treaty and Article 25.2 of the ESCB Statute.
7 For more information on the BSC, see Papademos, Lucas (2007), “The Banking Supervision Committee of the ESCB and its contribution
to ﬁ nancial stability in the EU”, in: Kreditwesen, Vol. 8, pp.28-31.
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MAIN ACHIEVEMENTS OF THE EUROSYSTEM
FINANCIAL STABILITY MONITORING AND ASSESSMENT
Forward-looking perspective
The ECB considers that safeguarding ﬁ nancial stability has an important forward-looking
on financial stability
dimension: potential sources of ﬁ nancial risks or vulnerabilities – such as inefﬁ ciencies in the
allocation of ﬁ nancial resources and the mispricing or mismanagement of ﬁ nancial risks – should
be identiﬁ ed, as far as possible, before they lead to unsustainable and potentially damaging
imbalances within the ﬁ nancial system. At the same time, it is useful to attempt to assess the extent
of such ﬁ nancial weaknesses and their potential effects on the overall stability of the ﬁ nancial
system. In particular, this helps to enhance the focus of actions of the private and public sectors on
those risks that are more likely to impair ﬁ nancial stability.
Therefore, the Eurosystem regularly monitors and assesses possible sources of risks and
vulnerabilities in the ﬁ nancial system in order to recognise emerging imbalances at an early stage
and to provide a basis for targeted remedial action, such as intensiﬁ ed ﬁ nancial supervision or
market surveillance.
All financial system
In this context, the Eurosystem pays close attention to the resilience of the banking sector, which
components are considered
has a crucial role in the conduct and transmission of monetary policy, in the payment system, and in
channelling funds from savers to investors. At the same time, this analysis is complemented by a
broader assessment, taking into account the other components of the ﬁ nancial system, such as
markets, non-bank ﬁ nancial intermediaries and infrastructures, given the increasing role of these
Macro and micro-prudential
components within the system and their close linkages with banks. Moreover, the Eurosystem
insights are combined
attaches great importance to close cooperation with the supervisory authorities in the monitoring of
ﬁ nancial stability in order to combine macro- and micro-prudential insights. The role of the BSC in
providing a forum for sharing central banking and supervisory expertise is crucial in this respect.
Activities of the Eurosystem
The activities of the Eurosystem in the monitoring and assessment of ﬁ nancial stability are based on
have three pillars:
three pillars.
Semi-annual review of
First, in 2000 the ECB launched the development of a comprehensive framework for assessing potential
financial stability
risks and vulnerabilities in the euro area ﬁ nancial system as a whole. This assessment aims to determine
in euro area …
the individual and collective robustness of the euro area institutions, markets and infrastructures; to
identify the main sources of risk and vulnerability that could pose problems for the future stability of
the ﬁ nancial system; and to appraise the ability of the ﬁ nancial system to cope, should these risks
materialise. Since December 2004, the results of this systematic assessment have been presented in the
semi-annual “Financial Stability Review” (FSR), which beneﬁ ts from input from the BSC. Like the
publications of the same kind issued by other central banks worldwide, the main purpose of the FSR is
to promote awareness in the ﬁ nancial industry and among the public of developments that are relevant
to the stability of the euro area ﬁ nancial system. Furthermore, by providing an overview of sources of
risk and vulnerability that could potentially affect ﬁ nancial stability, the report also aims to play a role
in easing ﬁ nancial tensions or preventing them in the ﬁ rst place.
… annual macro-prudential
Second, since 1999 the BSC has performed regular macro-prudential analyses of the EU banking
and structural analysis of EU
sector, the ﬁ ndings of which have been published in an annual report entitled “EU banking sector
banking sector …
stability” since 2003. Furthermore, the BSC regularly reviews structural developments in the EU
banking sector that are relevant to central banks and supervisory authorities. The annual report
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entitled “EU banking structures”, ﬁ rst published in 2002, is the result of this work. The BSC’s
macro-prudential and structural analyses are based on a combination of aggregate statistical
information obtained from central banks and supervisory authorities in the EU, complemented by
qualitative and, as far as possible, forward-looking information from the BSC’s members.
Third, the ECB and the Eurosystem, together with other EU central banks, are also closely involved
… contribution to EU and
in, and contribute to, the work of other institutions and bodies that monitor ﬁ nancial stability in
global financial stability
monitoring
Europe and worldwide. At EU level, this relates in particular to supporting the Economic and
Financial Committee (EFC), which has reviewed ﬁ nancial stability issues semi-annually in its
Financial Stability Table (FST) format since 2003 and is responsible for preparing the ECOFIN
Council’s discussions on those matters.8 At global level, the ECB and the Eurosystem’s NCBs,
again together with other EU central banks, actively participate in the monitoring activity of the
International Monetary Fund, the Financial Stability Forum, the Committee on the Global Financial
System, and the Bank for International Settlements.
Notwithstanding these substantial achievements, the Eurosystem’s framework for monitoring and
Quantitative challenges of
assessing ﬁ nancial stability requires further improvements. An important challenge in this regard –
assessing financial
stability …
not only for the Eurosystem but also for central banks and supervisory authorities worldwide –
relates to the development of enhanced quantitative approaches to identifying ﬁ nancial stability
risks and to assessing the potential impact of the materialisation of these risks. This is a difﬁ cult
task because quantifying the ﬁ nancial stability objective is not straightforward, and an adequate
analytical framework, involving appropriate indicators, models and methodologies, is inherently
extremely complex. Moreover, the continuous and rapid transformation of the ﬁ nancial system
together with ﬁ nancial innovation present additional challenges to the development of an appropriate
analytical framework. In particular, the complexity of some of the new ﬁ nancial instruments, the
cross-sectoral redistribution of risks and the opaqueness of the transactions of a growing number of
non-bank ﬁ nancial institutions have rendered the modelling of the ﬁ nancial system as well as the
monitoring and assessment of risks much more difﬁ cult.9 Although these assessment challenges are
formidable, it is important to acknowledge that signiﬁ cant progress has been made in recent years.
The semi-annual FSR has gradually gained in analytical depth, particularly regarding the analysis
… require steady
of ﬁ nancial markets and institutions. Examples include methods of quantifying the exposures of
improvements in
Eurosystem’s approaches
large and complex banking groups to corporate sector credit risk, the development of various
indicators of other risks faced by banks, hedge funds and insurance companies, as well as indicators
of ﬁ nancial market activities that aim to depict potential ﬁ nancial imbalances. Another important
element of this endeavour is the development of methodologies for conducting macro stress-tests of
the euro area ﬁ nancial system. The main objective of such tests is to assess the potential effects of
extreme events or sizeable shocks on the ﬁ nancial system in terms of economic cost. Ultimately,
such a framework for stress-testing would help to quantify and prioritise risks by their importance
and would allow the monitoring and assessment of ﬁ nancial stability to be more focused.
Furthermore, once fully implemented, macro stress-tests could help the Eurosystem to improve the
internal consistency, and thereby the forward-looking dimension, of its ﬁ nancial stability monitoring.
Over the past few years, the ECB has worked closely with the BSC to identify methods to enhance,
in particular, the cross-border dimension of stress-testing, an aspect that gains in relevance as the
8 Whereas the EFC comprises within its normal composition representatives of EU ﬁ nance ministries, national central banks, the ECB
and the Commission, in its FST format it is extended to include the Chairs of the BSC and of the EU supervisory committees, the latter
established under the Lamfalussy approach (see the following section on ﬁ nancial regulation and supervision).
9 See the special feature entitled “Measurement challenges in assessing ﬁ nancial stability” in the December 2005 ECB Financial Stability
Review.
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euro area becomes increasingly ﬁ nancially integrated and the cross-border activities of ﬁ nancial
institutions grow in importance.10
Need to enhance availability
Another important challenge has been the development of an adequate information infrastructure to
and quality of information
support the monitoring and assessment of ﬁ nancial stability and, especially, the enhancement of the
information exchange through the BSC and the Statistics Committee, including an annual collection
of consolidated banking data for the entire EU banking system. The limited availability and quality
of data have been identiﬁ ed as major obstacles to the further development of quantitative frameworks
for the assessment of ﬁ nancial stability. It is therefore very important to extend the set of available
high-quality data.
Objective to ensure overall
FINANCIAL REGULATION AND SUPERVISION
safety and soundness of
financial institutions
On the assumption that private sector action may fail to prevent the emergence of ﬁ nancial
imbalances, the EU regulatory and supervisory framework aims to promote the overall safety and
soundness of ﬁ nancial institutions. Prudential requirements relating to capital buffers, best risk
management practices and public disclosure provide the main tools in this respect.
ECB/Eurosystem advice and
The Eurosystem is closely involved in this work as its macro-prudential and structural analysis of
input …
the ﬁ nancial system and the micro-prudential assessment of supervisors are mutually reinforcing.
Accordingly, the ECB and the Eurosystem provide advice on, and contribute to, the development of
the EU regulatory and supervisory framework. The ECB also plays an advisory role with respect to
proposed legislative changes to ﬁ nancial regulation and supervision at national level.
… on EU regulatory
In recent years, the ECB and the Eurosystem have provided important contributions regarding the
framework for financial
enhancement of the EU regulatory framework for ﬁ nancial services. One such contribution related to
services
the 1999 Financial Services Action Plan (FSAP), which established a modernised and more
comprehensive EU regulatory framework for ﬁ nancial services (see Chapter 6). The ECB gave input
on the development of the FSAP in the form of formal opinions on the Commission’s various legislative
proposals and participation in technical committees. Following up on this work, the Eurosystem
contributed to the formulation of the EU ﬁ nancial services policy strategy for the years 2005-10, which
was published as a Commission White Paper in December 2005.11 The ECB and the Eurosystem
continue to provide their input and expertise during the implementation of the White Paper.12
… and on EU setting for
The Eurosystem has also been actively involved in the ongoing development of the EU institutional
financial regulation and
setting for ﬁ nancial regulation and supervision. In particular, it has been a strong supporter of the
supervision
“Lamfalussy framework” for ﬁ nancial regulation and supervision, which aims to make the EU’s
legislative decision-making process more efﬁ cient and ﬂ exible, and to establish a more coherent
regulatory and supervisory framework across Member States (see Chapter 6). The ECB also plays
an active role in the functioning of the Lamfalussy framework as an observer on the Level 2
committees in the banking and securities sectors, and as a member of the Level 3 committee in the
10 See Fell, John (2007), “Challenges for EU-wide macro stress-testing”, presentation given at the ECB conference on stress-testing and
ﬁ nancial crisis simulation exercises held on 12-13 July 2007, which is available on the ECB’s website at: http://www.ecb.europa.eu/
events/pdf/conferences/sﬁ /Fell.pdf
11 See the publication “European Commission’s Green Paper on Financial Services Policy (2005-2010). Eurosystem contribution to
the public consultation” of 1 August 2005, which is available on the ECB’s website at: http://www.ecb.europa.eu/pub/pdf/other/
ecgreenpaperﬁ nancialservicespolicy2005en.pdf
12 For example, the Eurosystem responded to the Commission’s consultations on possible action regarding investment funds and mortgage
credit.
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banking sector. Finally, the Eurosystem has contributed to the continuous monitoring of the
functioning of the Lamfalussy framework.13
A ﬁ rst full review of the Lamfalussy approach across ﬁ nancial sectors was conducted by ECOFIN
in December 2007. Various EU committees and fora, as well as the Eurosystem, have provided
input in this assessment. The review emphasised that the Lamfalussy framework has fostered
signiﬁ cant progress in terms of the efﬁ ciency and transparency of the EU legislative process and in
achieving a more consistent regulatory and supervisory framework. However, supervisory outcomes
still need to become more congruent across Member States. Therefore, it is deemed necessary to
enhance the functioning of the Lamfalussy approach by (i) giving national supervisors a European
mandate; (ii) reducing national options and discretions in EU rules and achieving closer convergence
of ﬁ nancial reporting requirements; (iii) strengthening the role of the Lamfalussy Level 3 committees
in pursuing supervisory convergence and cooperation, and enhancing the role of colleges of
supervisors in the supervision of cross-border groups.14 ECOFIN will decide on practical measures
to implement these priorities at its meeting in June 2008.
FINANCIAL CRISIS MANAGEMENT
Despite the substantial improvements in cross-border ﬁ nancial crisis prevention, the emergence of
Private sector as first line
ﬁ nancial disturbances with potential cross-border ﬁ nancial stability implications cannot be excluded.
of defence
A private-sector solution to resolve the respective ﬁ nancial difﬁ culties is again the main line of
recourse. Should private action prove insufﬁ cient to contain the crisis, complementary public measures
may also be considered. However, such possible involvement is at the discretion of the public sector
and based on the concept of “constructive ambiguity” in order to counter the risk of moral hazard.
The allocation of crisis management responsibilities among the Eurosystem, national central banks,
Role of the Eurosystem …
supervisory authorities and ﬁ nance ministries depends on whether the crisis is one of liquidity or
solvency.
During a general liquidity crisis, the ECB may contribute through its liquidity operations
… during liquidity crises…
(see Chapter 3) to an orderly functioning of the money market, based on operational procedures agreed
at Eurosystem level. Furthermore, the NCBs may provide – temporarily and against adequate
collateral – emergency liquidity assistance (ELA) to illiquid but solvent credit institutions. The
possible provision of ELA is undertaken at the discretion of the competent NCB, subject to the
conditions set out in the Treaty relating to the prohibition of monetary ﬁ nancing, and only in
exceptional circumstances. NCBs may consider such assistance justiﬁ ed particularly on the grounds
of preventing or mitigating potential systemic effects as a result of contagion through other ﬁ nancial
institutions or market infrastructures. In 1999, the Eurosystem agreed on speciﬁ c procedures for
information-sharing when ELA is granted by a Eurosystem NCB. These procedures aim to ensure that
13 An important element of this contribution related to the Commission’s 2005 review of the functioning of the Lamfalussy framework in
respect of securities markets legislation, see the document “Review of the application of the Lamfalussy framework to EU securities
markets legislation. Contribution to the Commission’s Public Consultation” of 17 February 2005, which is available on the ECB’s
website at: http://www.ecb.europa.eu/pub/pdf/other/lamfalussy-reviewen.pdf. The Eurosystem was also involved in the preparation of
the Financial Services Committee’s Report on Financial Supervision, ﬁ nalised in February 2006 and endorsed by ECOFIN in May 2006.
Most recently, the Eurosystem contributed to the ﬁ rst full review of the Lamfalussy framework across ﬁ nancial sectors. See the document
“Review of the Lamfalussy framework. Eurosystem contribution” of 30 November 2007, which is available on the ECB’s website at:
http://www.ecb.europa.eu/pub/pdf/other/lamfalussy-review2007en.pdf.
14 These priorities were also highlighted in the previously mentioned contribution by the Eurosystem to the Lamfalussy review. See the article
“Developments in the EU arrangements for ﬁ nancial stability” in the ECB’s Monthly Bulletin of April 2008 for further information.
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the impact of an intervention of this type by an NCB – which carries the related costs and risks – can
be managed in a way consistent with maintaining an appropriate single monetary policy stance.
… and solvency crises
During a solvency crisis, the main responsibility for crisis management and resolution is borne by
the ﬁ nance ministries that decide on the possible provision of ﬁ nancial support, and by the
supervisory authorities that may take exceptional supervisory measures to stabilise the troubled
institution or decide to wind it down.
Regardless of whether a ﬁ nancial crisis is a liquidity or solvency crisis, the Eurosystem may
support the crisis management efforts by drawing on its analytical expertise and knowledge
gathered in monitoring ﬁ nancial stability and assessing potential channels for the propagation
of ﬁ nancial disturbances within the ﬁ nancial system and the potential implications for its
stability. Furthermore, should a liquidity or solvency crisis impact on the operation of market
infrastructures, the Eurosystem may take action to ensure that these infrastructures continue to
function smoothly.
Effective interplay among
Given the need for very timely and well-targeted action during a ﬁ nancial crisis, a smooth and
authorities is crucial
effective interplay among all the competent authorities – central banks, supervisory authorities and
ﬁ nance ministries – is crucial. This presents a substantial challenge in the EU context given the
large number of authorities involved. Furthermore, while a clear deﬁ nition of responsibilities and a
structure to facilitate information-sharing and cooperation are required, no universal blueprint for
crisis management can be designed, as every ﬁ nancial crisis is unique. Flexibility and discretion are
also essential in order to guard against the risk of moral hazard.
EU crisis management has
However, much has been done during the past decade to strengthen the EU arrangements for
been strengthened …
crisis management. The Eurosystem has actively contributed to three main areas of action in this
respect relating to: (i) the clariﬁ cation of the legislative framework for crisis management, namely
the 2006 Capital Requirements Directive (CRD) and the 2002 Financial Conglomerates Directive;
(ii) the development and continuous enhancement of arrangements for voluntary cooperation
among authorities in the form of Memoranda of Understanding (MoU) at EU level; and (iii)
crisis simulation exercises at both EU and Eurosystem level to reinforce existing legislative and
informal arrangements and to enhance the overall level of preparedness in addressing crises.15
… and further initiatives
An important step in the further enhancement of EU arrangements for crisis management was
are under way
reached in October 2007, when ECOFIN set out a strategic roadmap for the EU ﬁ nancial stability
arrangements.16 The main elements of this roadmap are (i) the endorsement of a set of common
principles for cross-border crisis management as well as of a common analytical framework for
assessing ﬁ nancial crises developed by the BSC and the Committee of European Banking
Supervisors (CEBS); formally, this was achieved by the signing of a new MoU by EU ﬁ nance
ministers, central bank governors and banking supervisors in April 2008; (ii) the additional
reinforcement of this framework through speciﬁ c cooperation arrangements regarding cross-border
institutions between the authorities concerned; (iii) an invitation to the Commission to assess, in
15 The article “The EU arrangements for ﬁ nancial crisis management” in the ECB’s Monthly Bulletin of February 2007 provides an overview
of these three strands of work.
16 This roadmap was based on the recommendations of the EFC ad hoc working group on EU ﬁ nancial stability arrangements – composed
of high-level representatives from ﬁ nance ministries, NCBs, supervisory authorities, the ECB and the Commission – established in
September 2006 to consider the possible scope for clarifying and enhancing the existing arrangements for resolving cross-border ﬁ nancial
crises in the EU, taking into particular account the lessons learned from the EU-wide crisis simulation exercise organised in April 2006.
For more detailed information on ECOFIN’s roadmap and the respective follow-up measures, see the article “Developments in the EU
arrangements for ﬁ nancial stability” in the ECB’s Monthly Bulletin of April 2008.
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Table 1 Main contributions of the Eurosystem in the field of financial stability
Area
Level
Main activities of the Eurosystem
Monitoring and assessment of ﬁ nancial stability
Assessment of euro area ﬁ nancial system
Euro area
Semi-annual ECB “Financial Stability Review”
Macro-prudential analysis of EU banking sector
EU
Annual ECB report entitled “EU banking sector stability”
Structural analysis of EU banking sector
EU
Annual ECB report entitled “EU banking structures”
EU ﬁ nancial stability monitoring
EU
Contribution to discussions of EFC-FST and ECOFIN
Macro stress-testing
EU/euro area
Contribution to developing area-wide macro stress-testing
Financial regulation and supervision
Overall EU strategy for ﬁ nancial services
EU
Contribution to public policy debate (e.g. regarding EU ﬁ nancial
services policy strategy 2005-10)
Speciﬁ c legislative initiatives
EU
Formal ECB opinions and technical input (via the Lamfalussy
Level 2 committees in the securities and banking sectors)
Consistent implementation of EU rules
EU
Contribution to development of common supervisory standards
and practices in banking sector (via the Lamfalussy Level 3
committee, the CEBS)
Enhancement of EU supervisory framework
EU
Contribution to public policy debate (e.g. 2007 review of
Lamfalussy framework)
Financial crisis management
Enhancement of EU legislative framework
EU
Formal ECB opinions and technical input (via Lamfalussy
‘level 2’ committees)
Emergency liquidity assistance (ELA)
Euro area
Assessment by Eurosystem of compatibility of relevant ELA
operations to be undertaken by NCBs with prevailing monetary
policy stance
Systemic assessment of a ﬁ nancial crisis
EU
BSC-CEBS common analytical framework
Cooperation among EU central banks, ﬁ nance
EU
Contribution to development of Memoranda of Understanding
ministries and supervisory authorities
agreed in 2003, 2005 and 2008
Active participation in development of overall strategy for
enhancing EU ﬁ nancial stability arrangements (e.g. with respect
to ECOFIN’s 2007 roadmap)
Involvement in design and conduct of EU crisis simulation
exercises
Preparedness of Eurosystem for ﬁ nancial crises
Euro area
Eurosystem ﬁ nancial crisis simulation exercises
close cooperation with the Member States, possible further clariﬁ cations of the home-host
arrangements for crisis management within the CRD and to submit proposals in this respect by the
end of 2008; and (iv) a request to the Commission to assess possible regulatory enhancements as
regards the transfer of assets within banking groups, the EU Winding-Up Directive, and the role of
deposit guarantee schemes and public sector support in crises.
LESSONS AND WAY FORWARD
A large number of measures to strengthen the arrangements for ﬁ nancial stability in the euro area
Significant achievements
and the EU have been taken during the past ten years. The Eurosystem has played a major role in
of Eurosystem
this regard. First, the Eurosystem has pursued various actions at euro area level to foster and
safeguard the stability of the euro area ﬁ nancial system, relating especially to the monitoring and
assessment of ﬁ nancial stability and to market operations that aim to address general ﬁ nancial
shocks and relieve tensions in the euro area money market. Second, the Eurosystem has supported
national and EU authorities in their policies relating to the monitoring and assessment of ﬁ nancial
stability, ﬁ nancial regulation and supervision, and crisis management. Despite the substantial
achievements, the EU framework for ﬁ nancial stability is still evolving and requires further
improvements to keep pace with progress in ﬁ nancial integration and innovation.
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Four main challenges for
First, as regards the monitoring and assessment of ﬁ nancial stability, it will be important to further
the future
improve our understanding of the complex and rapidly changing ﬁ nancial system and to contribute
actively to the development of enhanced quantitative approaches. These will include the
development of measures for a more comprehensive analysis of inter-relationships across economic
and ﬁ nancial sectors and further advances in macro-stress testing.
Second, the Eurosystem will need to continue to play a very active role in providing high-quality
advice on the ongoing development of the EU arrangements for ﬁ nancial regulation and supervision.
Ensuring the effective and efﬁ cient functioning of the Lamfalussy framework will be a key issue,
both with a view to exploiting the full potential of the enhanced EU regulatory framework put
in place with the FSAP and to ensuring that the EU supervisory arrangements keep pace with
the activities of ﬁ nancial groups with signiﬁ cant cross-border activities, which are increasingly
prominent in the Single Market, and with their requirements for a streamlined and consistent
supervisory interface.
Third, the momentum for enhancing the EU arrangements for crisis management should be
maintained. The 2008 Memorandum of Understanding signed by EU ﬁ nance ministries, central banks,
and supervisory authorities has been a major achievement in this respect. Efforts will be needed to
implement and test this agreement effectively so as to render it as operational as possible. For its part,
the Eurosystem will continue testing and, if need be, improving its own ﬁ nancial crisis arrangements.
Finally, the Eurosystem should contribute to reinforcing further the cooperation between central
banks and supervisory authorities in the EU, particularly with respect to the major cross-border
ﬁ nancial groups. Intensiﬁ ed information-sharing on major developments in the activities and the
risk proﬁ le of such groups is required both on an ongoing basis and in terms of the management of
stress situations.
7.3 OVERSIGHT OF MARKET INFRASTRUCTURES
Financial market
Financial market infrastructures facilitate the ﬂ ow of funds, securities and other ﬁ nancial instruments
infrastructures and oversight
among economic agents, and thus constitute a key component of the ﬁ nancial system as a whole.
Market infrastructures encompass the various payments and securities trading, clearing and
settlement systems, the set of arrangements, institutions, rules and procedures governing them, as
well as the payment instruments they process. Owing to their extensive role and network
characteristics, payments and securities infrastructures are often described as the “vascular system”
of the ﬁ nancial system. The major stakeholders affected by market infrastructures include system
operators, participants (ﬁ nancial institutions), service providers, central banks, regulatory bodies
and, ultimately, all economic agents as end-users of payment and settlement services.
In parallel with the increasing complexity of the ﬁ nancial market infrastructures, as well as with
the rapidly growing values and volumes of ﬁ nancial transactions handled by them, the importance
of the smooth functioning of these infrastructures in the maintenance of ﬁ nancial stability has
been recognised by central banks for a long time. Obviously, the system owners and operators
have the primary responsibility of ensuring the reliable functioning of the market infrastructures
and of providing safe and efﬁ cient payment and settlement services. However, considering its
responsibilities in monetary policy and ﬁ nancial stability, its role in providing settlement accounts
for payment system participants and its interest in preserving public conﬁ dence in the payment
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instruments used, the Eurosystem, like central banks in general, has developed market infrastructure
oversight as one of its basic functions. The ultimate policy objective of oversight is to promote the
smooth functioning of the ﬁ nancial market infrastructures with the aim of forestalling any spillover
of disturbances in these infrastructures into the ﬁ nancial system and the economy as a whole. The
main oversight activities include the development of oversight standards, the continuous monitoring
of the performance of the market infrastructures and the regular assessment of their compliance
with the standards based on a deﬁ ned methodology.
ROLE OF THE ECB AND EUROSYSTEM
The Treaty and the Statute recognise oversight as one of the basic tasks of the Eurosystem. Article
Oversight as core central
105 (2) of the Treaty and Article 3 of the Statute state that “The basic tasks to be carried out through
bank function: role and
scope
the ESCB shall be [….] to promote the smooth operation of payment systems.” In addition, Article
22 of the Statute states that “The ECB and national central banks may provide facilities, and the
ECB may make regulations, to ensure efﬁ cient and sound clearing and payment systems within the
Community and with other countries”.
The oversight role of the Eurosystem covers payment and settlement systems – both large-value
and retail payment systems – that process the euro. In order to ensure a level playing-ﬁ eld, the same
minimum standards are applied to the systems managed by the Eurosystem (e.g. TARGET2) as
those applied to privately operated payment systems.
In accordance with their relevance to ﬁ nancial stability, the oversight function originally focused
mainly on large-value euro payment systems. Nevertheless, the overseers have been gradually
extending their activities to retail payment systems, payment instruments and third-party service
providers.
PAYMENT SYSTEMS, INSTRUMENTS AND INFRASTRUCTURE SERVICE PROVIDERS
In accordance with the common oversight framework, the NCBs are responsible for the
implementation of the ECB oversight policy in relation to payment systems legally incorporated
in their jurisdiction. Moreover, the Governing Council can decide to assign the ECB oversight
responsibilities for systems that have special characteristics.
Against this background, the ECB has been responsible for the oversight of the ECB Payment
ECB as lead overseer
Mechanism (EPM) as the TARGET component operated by the ECB.17 The integrated structure of
TARGET2 as a new platform gradually replacing TARGET over the period 2007-2008 has made it
necessary to modify the structure of its oversight framework. The Governing Council is the ultimate
overseer of the system, assisted by the Payment and Settlement System Committee. All TARGET2
oversight activities are led and coordinated by the ECB oversight function with the close involvement
of the national central banks of the euro area.
In addition, the ECB performs oversight activities for the three systems operated by the EBA
Clearing Company of the Euro Banking Association (EBA CLEARING): EURO1 for large-
value payments, STEP1 for individual low-value customer payments and STEP2, a new platform
providing batch processing services for cross-border retail payments.
17 In accordance with the principles agreed at Eurosystem level, the ECB has established separate organisational structures for the operation
function and the oversight function in order to avoid any possible conﬂ ict of interest.
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Cooperative oversight for
There are payment systems processing euro-denominated transactions located outside the euro area
CLS
(so-called offshore systems). Among them, the most important one is the CLS system, in which the
ECB – applying the rules of cooperative oversight 18 in close cooperation with the Federal Reserve
System as primary overseer – plays the role of overseer in respect of settlements in euro.
Retail payment systems and
According to the common oversight framework of the Eurosystem, the oversight of retail payment
instruments
systems is performed mainly at NCB level. Nevertheless, in order to apply a harmonised approach,
the Eurosystem deﬁ ned its policy stance on the oversight of retail payment systems and performed
a detailed oversight assessment of these systems in 2005.
As regards the oversight of payment instruments, in 2007 the Eurosystem established an oversight
framework for card payment schemes that process euro payments. After a market consultation, the
framework was published in January 2008.
Risk-based oversight
The operation of the ﬁ nancial market infrastructure is supported by a number of third-party service
framework for SWIFT
providers. Among them, SWIFT, the global provider of secure ﬁ nancial messaging services for the
ﬁ nancial industry, is by far the most important player and, although not a payment system in itself,
calls for special attention from overseers. In accordance with the agreement of the G10 central
banks, SWIFT has been subject to cooperative oversight since the end of 1997 with the Nationale
Bank van België/Banque Nationale de Belgique acting as lead overseer. In the context of its
participation in the cooperative framework of SWIFT, the ECB has helped to develop a set of high-
level oversight expectations suitable for the assessment of SWIFT. This initiative was ﬁ nalised in
June 2007 and integrated into the risk-based oversight framework applied to SWIFT.
SECURITIES CLEARING AND SETTLEMENT SYSTEMS
Strong interest in securities
Securities settlement systems (SSSs) and central counterparty clearing systems (CCPs) are closely
settlement
intertwined with payment systems,19 hence their secure functioning has clear implications for
ﬁ nancial stability. Furthermore, the SSSs are interrelated with monetary policy through their role in
providing settlement services for collateral eligible in Eurosystem credit operations. To this end,
although no common oversight framework has been applied by the Eurosystem for SSSs, central
banks have a strong interest in the smooth functioning of SSSs in the euro area.
Assessments from user
In 1998 the Eurosystem adopted a set of standards to assess the eligibility of SSSs in providing
perspective
settlement services in Eurosystem credit operations from the user perspective (so-called “user
standards”). Regular assessments of the SSSs, including the links between them on their compliance
with the user standards, are performed in order to ensure the same level of safety for credit operations
throughout the euro area. The positive result of these assessments is a precondition for those SSSs
and links to become eligible for use in the collateralisation of Eurosystem credit operations.
18 As set out in the “Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries” in 1990 (the
so-called Lamfalussy Report) and updated in the CPSS report “Central Bank Oversight of Payment and Settlement Systems” (May 2005).
19 The settlement of securities transactions involve two legs, a cash leg and a securities leg. The settlement of the cash leg of the securities
transactions takes place mostly in central bank RTGS systems, in parallel with the settlement in a central securities depository of the
security leg, based on the delivery-versus-payment method.
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COOPERATION WITH OTHER AUTHORITIES
As a contribution to fulﬁ lling its oversight objectives, the Eurosystem has built up and maintained
Frameworks for cooperation
ties with the other authorities that are responsible for market infrastructure-related issues.
To this end, the framework for cooperation between EU central bank overseers and banking
supervisors is deﬁ ned in Memoranda of Understanding addressing cooperation and exchanges of
information in three different sets of circumstances: (i) the establishment of a payment system and
applications for access to such system; (ii) ongoing activities; and (iii) crisis situations.
Moreover, a framework for cooperation on securities clearing and settlement systems between the
ESCB and the Committee of European Securities Regulators (CESR) was set up in 2001. An ESCB-
CESR working group started to work on the adaptation to the EU environment of the so-called
CPSS-IOSCO recommendations for SSSs and CCPs.20 Although the ESCB-CESR has made
substantial progress in this ﬁ eld, there are still some issues to be addressed in order to complete the
preparation of the oversight standards envisaged for SSSs and CCPs in the EU.
POLICY DEVELOPMENTS AND MAIN ACTIVITIES
The oversight policies and objectives of the Eurosystem have been laid down in a number of
Transparency of policies and
published documents, high-level standards and in policy statements on speciﬁ c topics approved by
activities
the Governing Council. The oversight function performs regular assessments on the compliance of
the market infrastructures with the standards applicable. The stepping stones of the policy
developments, as well as the main activities performed in this area during the past decade, are
highlighted in Table 2 in chronological order.
20 CPSS stands for the G10 Committee on Payment and Settlement Systems. IOSCO stands for the International Organization of Securities
Commissions. The reports on Recommendations for SSSs and for CCPs are available on the BIS website.
Table 2 Main achievements of ECB/Eurosystem oversight function
Policy developments
In August 1998 the ECB published the “Report on electronic money”, building on the analysis conducted under the aegis of the EMI. The
report addresses the reasons why the issuance of electronic money should be regulated and states the minimum requirements for electronic
money issuers and desirable objectives.
In November 1998 the Eurosystem outlined its policy principles in relation to the development of payment and securities clearing and
settlement infrastructures providing services for euro-denominated transactions from outside the euro area.
In its statement of June 2000 the Governing Council of the ECB clariﬁ ed the role of the Eurosystem in the ﬁ eld of payment systems
oversight and explained its objectives and principles 1.
In February 2001 the Governing Council of the ECB adopted the Core Principles for Systemically Important Payment Systems 2 (Core
Principles) as the set of minimum standards that the Eurosystem uses for its common oversight policy on payment systems. These
principles give guidance for the design and operation of the respective payment systems by deﬁ ning general requirements for the key
features of these infrastructures, including a sound legal basis, adequate management of ﬁ nancial risks, security and operational reliability,
efﬁ ciency and governance arrangements. The Core Principles apply to systemically important payment systems 3 of all types.
In September 2001 the ECB released a document entitled “The Eurosystem’s policy line with regard to consolidation in central counterparty
clearing”, presenting the policy stance on the possible implications of the consolidation process in central counterparty clearing.
1) “Role of the Eurosystem in the ﬁ eld of payment systems oversight” published on the website of the ECB.
2) CPSS report “Core Principles for Systemically Important Payment Systems” published on the BIS website.
3) A payment system is considered to be systemically important if disruptions within it could trigger or transmit further disruptions to the
wider ﬁ nancial system. The Eurosystem takes the view that every large-value payment system operating in euro is systemically important.
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Table 2 Main achievements of ECB/Eurosystem oversight function (cont’d)
In May 2003 the “Electronic money system security objectives” (EMSSO) report was published. It presents the expectations of the
Eurosystem with regard to the technical security of e-money schemes. The report contains a general description of e-money schemes, a
comprehensive risk/threat analysis and a list of security objectives that should be met by e-money schemes in order to cover these risks/
threats.
In June 2003 an oversight framework for retail payment systems operating in euro was adopted. This framework is intended to ensure
that retail payment systems cannot become vectors of systemic risks or economic malfunctioning in the euro area. The framework
contained criteria for classifying retail payment systems in line with their systemic relevance.
The “Business continuity oversight expectations for systemically important payment systems” (BCOE for SIPS) report was published
in May 2006. As a response to the new types of threat that have emerged in recent years, the basic aim of the report was to establish a
harmonised oversight framework for business continuity in the euro area. The BCOE for SIPS provides guidance to SIPS operators in
order to achieve sufﬁ cient and consistent levels of resilience, focusing on business continuity strategy, planning and testing, as well as
crisis management.
In July 2007 the ECB published the “Eurosystem policy principles on the location and operation of infrastructures settling euro-
denominated payment transactions”. These principles apply to any existing or potential payments infrastructure located outside the
euro area that settles euro transactions. They also specify the position of the Eurosystem in this ﬁ eld, which aims to retain, in any event,
ultimate control over its currency.
In January 2008 the Governing Council of the ECB approved the report entitled “Oversight framework for card payment schemes
– Standards”, which lays down common oversight standards with regard to card payment schemes operating in the euro area. These
standards focus on ensuring the safety and efﬁ ciency of the card payment schemes.
Assessment of key payment infrastructures
In 2001, at the request of the ECB, the IMF prepared Reports on the Observance of Standards and Codes (ROSCs) for the euro area in the
context of its Financial Sector Assessment Program (FSAP). In the ﬁ eld of payment systems the assessment covered TARGET and the
EURO1 system .4
Prior to the start of CLS system in 2002, the ECB, together with other central banks of currencies eligible for CLS settlement, performed a
joint risk assessment of the system. In view of the positive results of the assessment, the ECB approved the inclusion of the euro in CLS.
In the course of 2003, 19 euro large-value payment systems, including all TARGET components, have been assessed against the Core
Principles. The results of this assessment were published on the ECB’s website in 2004.5
In early 2005 the TARGET overseers carried out an oversight assessment of SORBNET-EURO, Narodowy Bank Polski’s euro RTGS
system, in view of its intention to connect to TARGET via the BIREL system operated by the Banca d’Italia.
In August 2005 the result of a detailed oversight assessment of 15 euro retail payment systems against the applicable Core Principles was
outlined on the ECB’s website.
In 2006 an in-depth oversight assessment was performed on the impact of connecting Eesti Pank’s euro RTGS system to TARGET via
the BIREL system.
Prior to its implementation in November 2007, the design of TARGET2 was subject to a comprehensive oversight assessment against the
Core Principles. The ﬁ nal version of the detailed assessment report on TARGET2 is intended to be published in the course of 2009.
Other main activities
In cooperation with the NCBs, a comprehensive description of the various payment and securities settlement systems operating in the
EU countries has been prepared regularly and made available in the ECB publication “Payment systems in the European Union” (known
as the “Blue Book”), together with the Addendum to the Blue Book containing detailed statistical data on the systems. The last (fourth)
edition of the Blue Book was published in 2007.
The oversight function has been closely monitoring the developments under way in the correspondent banking business. Regular surveys
are performed (most recently in 2005) among a sample of banks to assess the characteristics of this particular area of payment arrangements
from a systemic risk perspective. Owing to the conﬁ dential nature of the data provided by the banks, the results of the surveys can only be
accessed by the participants.
In 2007 the former assessment methodology was renewed and a common methodology developed for the oversight of systemically and
prominently important euro payment systems. Following a public consultation carried out in the second half of the year, the ﬁ nal version
of the new methodology was made available on the ECB’s website in November 2007.
4) Published on the IMF’s website in October 2001.
5) See the report entitled “Assessment of euro large-value payment systems against the Core Principles”.
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F I N A N C I A L S T A B I L I T Y
A N D O V E R S I G H T
LESSONS AND WAY FORWARD
The oversight function of central banks operates in a dynamic environment. Changes in ﬁ nancial
Oversight evolves in a
markets at European level and globally, in the legal environment and in the individual market
dynamic environment
infrastructures themselves, as well as in the interrelations between them, need to be reﬂ ected in
central banks’ oversight policies and activities. The past ten years have shown that the ECB’s
oversight function, in close cooperation with national central banks in the Eurosystem and the
ESCB, and at international level, has been able to cope with these challenges. Oversight policies
and standards have contributed to sound and efﬁ cient payment and settlement systems. The close
interaction between overseers and the relevant system operators and participants have signiﬁ cantly
contributed to the acceptance of the Eurosystem’s oversight policies and standards in the market
and their smooth implementation by the overseen entities.
In the context of future developments, and in addition to its ongoing oversight of euro market
Some future priorities
infrastructures, the ECB and Eurosystem overseers envisage inter alia focusing on (i) a further
enhancement of transparency in respect of oversight objectives and activities by updating the public
Eurosystem’s oversight policy statement of June 2000 and by publishing a regular oversight report,
(ii) a further contribution to the work of the ESCB-CESR working group, (iii) participation in the
consultations among the members of the CLS and SWIFT cooperative oversight, (iv) joint work
with other EU central banks in the ﬁ eld of business continuity, and (v) the development of a risk-
based oversight framework. Considering the steady integration of ﬁ nancial markets and market
infrastructures, particularly in the euro area, but also globally, the ECB will continue to attach great
importance to close cooperation between overseers within the Eurosystem and the ESCB, as well as
between overseers and other relevant public authorities, such as banking supervisors and securities
regulators.
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10th Anniversary of the ECB 131

KEY CHARACTERISTICS
OF THE EURO AREA *
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8 STATISTICS
High-quality statistics are a key ingredient for the policy analysis, research and the decision-
making of the ECB. Many of the functions of the ECB, as described in previous chapters, could not
be properly fulﬁ lled without the availability of timely, reliable and coherent statistical information.
In addition, ECB statistics serve users such as ﬁ nancial market analysts, academics and the public.
The statistics provided by the ECB help in understanding the decisions taken by the Governing
Council and may support appropriate investment and lending decisions by the public.
The ECB needs an array of high-quality monetary, ﬁ nancial and economic statistics (including an
Over the past ten years,
accurate aggregate measure of price developments) in order to fulﬁ l its prime responsibility for
significant progress in the
availability of statistics for
maintaining price stability in the euro area. An accurate picture of the current economic situation
the euro area
and of the structure of the euro area economy is a necessary precondition for good analysis and
policy-making. At the very beginning, statistics covering the entire euro area were scarce. Over the
past ten years, signiﬁ cant efforts have been devoted to developing new statistics and to improving
existing statistics (in terms of harmonisation of concepts, frequency and timeliness required).
Statistical work in Europe has beneﬁ ted from close cooperation between the ECB and Eurostat.
Close coorperation between
The ECB is responsible for monetary and ﬁ nancial statistics and Eurostat is responsible for general
ECB and Eurostat
economic statistics. The latter include the Harmonised Index of Consumer Prices (HICP), which
represents the ECB’s benchmark for price stability. Responsibility for external statistics (balance
of payments and the international investment position) and for the euro area accounts is shared
with Eurostat.1
European statistics, i.e. both the statistics produced by the ESCB and those produced by Eurostat
and national statistical institutes have improved remarkably over the last decade, in terms both
of availability and quality. The wide range of statistics now available at the ECB has also been
integrated into a single framework which provides a consistent overview of the interlinkages
among the transactions and positions of the various actors classiﬁ ed by their role in the economy
(e.g. households, non-ﬁ nancial corporations, ﬁ nancial corporations, government). These so-
called euro area accounts provide a comprehensive quarterly overview of euro area economic and
ﬁ nancial developments.
Section 8.1 sets out the development by the ECB of reliable and timely euro area monetary, ﬁ nancial
and external statistics for the ECB’s analysis, research, decisions and communication. Section 8.2
reviews the economic statistics compiled by Eurostat. Section 8.3 focuses on the quality standards
applied by the ECB when compiling its statistics. Section 8.4 sets out the way forward.
8.1 ECB STATISTICS
Preparing euro area statistics during the mid-1990s was a challenge, as there were signiﬁ cant gaps
Many imperfections and
and weaknesses in the statistics available at the time.2 Even the concepts, deﬁ nitions and
little standardisation at the
outset
classiﬁ cations underlying the statistics were far from being standardised.
1 For more details on the exact division of labour for statistics at the European level, please refer to the “Memorandum of Understanding
on economic and ﬁ nancial statistics between the Directorate General Statistics of the ECB (DG Statistics) and the Statistical Ofﬁ ce of the
European Communities (Eurostat)”.
(http://www.ecb.europa.eu/ecb/legal/pdf/en_mou_with_eurostat1.pdf)
2 For more details on the development of euro area statistics, please refer to “The development of statistics for Economic and Monetary
Union”, by Peter Bull (2004).
(http://www.ecb.europa.eu/pub/pdf/other/developmentstatisticsemu200406en.pdf)
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Monetary, financial and
The initial set of euro area statistics available to the ECB in 1999 comprised the bare essentials:
balance of payments
harmonised balance sheets for monetary ﬁ nancial institutions (MFIs) from which monetary aggregates
statistics have steadily
and the main counterparts to money (including MFI loans) could be calculated, a limited range of
improved
non-harmonised retail interest rates, some ﬁ nancial market information drawn from commercial
sources and key balance of payments (b.o.p.) items, as no geographical breakdown of counterpart
countries existed. Only annual government ﬁ nance statistics and some limited annual data on saving,
investment and ﬁ nancing in the newly established euro area were additionally available. In most cases,
the length of the time series was very short.
In November 1999, statistics on securities issuance by euro area governments and ﬁ nancial and
non-ﬁ nancial corporations were added. From early 2003, MFI balance sheet statistics comprised
more detailed breakdowns of instruments, maturities and counterpart sectors. At the same time,
harmonised MFI interest rates statistics were introduced, covering both a breakdown of deposits and
loans by maturity and purpose. In the near future, the investment fund statistics will be harmonised
and they will cover the whole euro area and better serve user needs. The ECB took over from
Eurostat the release of the daily yield curves for euro area central government bonds.
Concerning external statistics, the ECB has gradually enhanced the balance of payments data (b.o.p.)
for the euro area by providing more breakdowns, by showing debits and credits separately and by
offering a geographical breakdown of major counterparts (e.g. United States, United Kingdom, EU
countries outside the euro area, Japan, China). The ECB now also publishes a quarterly international
investment position (i.i.p.) which can be considered as the ﬁ nancial balance sheet of the euro area
as a whole, as well as a breakdown of the changes in the i.i.p. (in addition to the b.o.p. transactions,
which mainly concern valuation changes of ﬁ nancial assets and liabilities due to price and exchange
rate developments). Moreover, statistics on the nominal and real effective exchange rate and on
the international role of the euro have been made available, recently supplemented by monthly
harmonised national competitiveness indicators based on consumer price indices.
Many statistics and statistical indicators are also compiled to assess ﬁ nancial markets developments,
ﬁ nancial integration in Europe, ﬁ nancial stability overall and within the EU banking sector, and the
development of payments, payment infrastructures and securities trading, clearing and settlement.
First euro area accounts
An important milestone was reached in June 2007, when the ECB released, jointly with Eurostat,
published in 2007
the ﬁ rst integrated quarterly euro area economic and ﬁ nancial accounts by institutional sector.3
These accounts provide a comprehensive and coherent overview of euro area ﬁ nancial and economic
developments and of interrelations between the different sectors in the euro area (households,
corporations and general government) and between them and the rest of the world. Euro area
accounts can be considered as the national accounts for the euro area. The full integration and
almost complete consistency of these accounts as well as their joint, simultaneous compilation
every quarter by two institutions (the ECB and Eurostat) is a unique achievement.4
8.2 OTHER ECONOMIC STATISTICS
Significant progress in
By the start of the Economic and Monetary Union, Eurostat (in collaboration with national statistical
economic statistics but
institutes) had developed the HICP as a harmonised price index as well as some other statistics on
challenges remain
prices, costs, labour markets and other economic developments. Limited national accounts data for
3 See article in ECB Monthly Bulletin, November 2007.
4 For a complete overview of statistics available and compiled by the ECB, please refer to “ECB statistics: an overview”, ECB, 2008.
ECB
134 Monthly Bulletin
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S T A T I S T I C S
the euro area were available. However, the timeliness of these statistics was not satisfactory for
monetary policy purposes. Since then, the timeliness of the relevant euro area statistics provided by
Eurostat has improved signiﬁ cantly, following in particular the adoption of the Action Plan for
EMU Statistics (2000) by the ECOFIN Council and the establishment of a list of monthly and
quarterly Principal European Economic Indicators (PEEIs) in 2002. As an example, timely ﬂ ash
estimates for the HICP and for the quarterly GDP volume changes are important achievements and
these data feed into the monetary policy and economic analyses. In addition, the range of available
government ﬁ nance statistics, both annual and quarterly, has signiﬁ cantly expanded. Methodological
standards have been further improved in all areas.
However, further work in the area of statistics is still required (in terms of new statistics, frequency
Further improvements
and/or quality of statistics available).5 Improvements are still needed, mainly in the area of services,
in timeliness and quality
necessary
labour markets (integrating labour market statistics into the national accounts to serve growth and
productivity analyses) and housing markets. Further timeliness and other quality improvements are
also needed for some other statistics. This might involve a closer coordination of statistical processes
among European statistical institutes and include coordinated releases of national data responding
to European timeliness targets and aligned revision policies. Finally, an appropriate communication
of statistics is crucial. In particular, this relates to the HICP (see Box 1).
5 See “EFC 2007 Status Report on Information Requirements in EMU”, October 2007. (http://www.ecb.europa.eu/stats/pdf/
statusreport2007.pdf)
Box 1
ROLE OF THE HARMONISED INDEX OF CONSUMER PRICES
In view of the ECB’s primary responsibility to maintain price stability, it needs high-quality
High-quality HICP an
statistics on price developments. In this context, it has given a prominent role to the Harmonised
indicator of price stability
Index of Consumer Prices (HICP) for the euro area, compiled monthly by Eurostat. The HICP is
also used to assess whether other EU countries are ready to adopt the euro as a currency. In fact,
harmonised consumer price indices are produced for all EU countries.
The HICP captures the price changes relating to consumption expenditure on goods and services
HICP based on 1.7 million
by all households. It is a good measure of consumer price inﬂ ation compiled according to the
individual observations
every month
best international standards. The HICP for the euro area is compiled on the basis of over
1.7 million individual price observations of goods and services every month, in 200,000 outlets
in some 1,500 towns and cities throughout the euro area.
For each product, prices are collected from different outlets and in different regions. For
instance, the sub-index for book prices takes account of various types of books (ﬁ ction, non-
ﬁ ction, reference books, etc.) sold in book shops, supermarkets and by internet suppliers. Product
groups within the index are weighted according to their relative importance in total household
consumption expenditure. These weights are updated regularly so as to capture changes in
spending patterns over time and to keep the index representative. Much effort has been devoted
to the harmonised treatment of complex issues, such as prices of insurance, health and education
services and to including new or substantially changed products.
ECB
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Room for further
There is always room for improvement. One priority is a more harmonised treatment of changes
harmonisation
in the quality of products. For example, a car manufacturer may add additional safety features,
such as airbags, to a new model and at the same time increase the price. To correctly measure the
pure price change, it is necessary to estimate how much of the car price increase reﬂ ects the
quality added to the car by installing airbags. Work is under way to further develop and harmonise
the methods for quality adjustments used across countries. A second priority is the treatment of
owner-occupied housing. Whereas changes in housing rents faced by tenants are included in the
HICP, most of the expenditures faced by households related to owning their property are not. As
the proportion of households owning or renting a house varies substantially across euro area
countries, the inclusion of owner-occupied housing would increase both the comparability of the
HICP across euro area countries and the coverage of the price index.
8.3 FRAMEWORK FOR HIGH-QUALITY STATISTICS
Statistics have many
High-quality statistics lie at the heart of the ECB’s policy analyses, decisions and communication.
purposes and users
In the EU, the quality, reliability and impartiality of statistics are particularly important because of
their use by national authorities. The monitoring of the Stability and Growth Pact, decisions on euro
area enlargements, and national contributions to the EU budget and EU regional policy all depend
on the high quality of the underlying statistical data.
Quality and governance are
ECB statistics adhere to widely agreed global and European statistical standards. Moreover, the
top priorities in statistics
ECB actively participates in the further development of these standards (e.g. System of National
Accounts, European System of Accounts, Balance of Payments Manual) and, in general, cooperates
closely with the relevant international organisations (European Commission, IMF, BIS, OECD, UN)
to achieve worldwide harmonisation of standards and deﬁ nitions for economic and ﬁ nancial
statistics.
In 2007, the “Public commitment with respect to the ESCB’s statistical func