1. Introduction
Ladies and gentlemen,
It is a great pleasure for me to address this important conference on the evolution of European government bond markets. As is evident from the conference agenda, these are certainly interesting times for all those who participate in this field – as issuers, investors or service providers. Even from my perspective as a European Commissioner, the recent changes in the functioning of Europe's bond markets have been remarkable.
In many respects, government bond markets now stand among the most integrated of the EU financial markets, far more so than the equity market for example. These developments are not exceptional, but have taken place against a background of rapid progress in the broader process of EU financial integration. This process has been driven by three main forces which I will briefly outline:
- First, there is the development of globalisation in the international financial system, reflecting the interaction of liberalised capital movements, financial deregulation and advances in information technology;
- Second, vital progress has been achieved with the adoption of the Euro. Before 1999, the need to operate in many national currencies was a major obstacle to financial integration in the EU. By eliminating exchange-rate risk, among 12 Member States, the Euro has removed the most significant barrier to the majority of cross-border financial transactions within the Union.
- At the same time, the Euro has highlighted the costs of remaining sources of fragmentation in the system - which leads me to the third main factor fostering financial integration. This is the ongoing process of creating a common regulatory framework for EU financial markets, with the objective of minimising regulatory divergence among the Member States. The Financial Services Action Plan – or FSAP - is the blueprint for this regulatory framework. Since this plan was launched, more than 30 legislative measures have now been adopted at EU level, and we are in the process of transposing into national laws.
Despite these recent advances there remain measures – both technical and structural - that could be taken to integrate and develop the EU government bond market still further. Indeed, many of these measures are being discussed in the various sessions of this conference.
I would like to focus my remarks on the more general context in which EU government bond markets must operate. Beginning with a review of the macroeconomic situation, I will then touch on the implementation of the Stability and Growth pact and the issue of public finance sustainability. Finally I would like to conclude with some additional remarks on the evolution of EU government bond markets and the broader economic benefits of financial market integration.
2. Macro-economic and budgetary situation in the EU
Let me start then with an overview of the macro-economic and budgetary situation. It's a pleasure for me to be able to report improvements not only in growth but also employment and productivity rates. The first half of 2006 has witnessed GDP growth increase to an annualised rate of 3.5%. This figure has not only exceeded our expectations but represents the highest level of growth since the year 2000. Such an upturn is reflective of a surge in domestic demand, supported by the increase in private investment which has risen to an annualised growth rate of 6% during the first two quarters. Moreover, an improving trend in private consumption is beginning to emerge.
Although survey data suggests a slow down in growth rates for the second half of 2006, figures should remain at or above potential. Ultimately, this should give a GDP growth rate of around 2.5% in the euro area and 2.7% in the EU for the year as a whole.
The buoyant growth rates of 2006 have been complemented by progress in the labour markets, resulting in unemployment rates dropping to below 8% in the EU and 7.9% in the euro area. This in turn has been accompanied by a rise in productivity to an annualised rate of 2%, an encouraging development if you consider that over the last 5 years the average productivity rate was below 1%.
Regarding HICP inflation, our interim forecasts predict an average of 2.3% for 2006 in both economic areas. The slight upward revision reflected the high energy prices. The prospects for stable inflation can also be seen in the bond markets, where benchmark yields have risen only modestly despite the strength of the economic recovery.
In the short term, the momentum for strong growth should be maintained for some time. This is, of course, provided that the current favourable conditions continue, but the outlook is largely positive given that the drop in oil prices in recent weeks continues to support real income of households and profits in the private sector.
However, looking further ahead, downside risks appear more marked, stemming largely from the international environment. Above all, the expected slowdown in the US economy is a source of concern. While our baseline scenario is for a 'soft landing' of the US economy in 2007, the possibility of a stronger slowdown than anticipated persists. This then compounds the threat of a disorderly unwinding of global imbalances and their negative consequences to the global growth outlook. Needless to say, a rise in oil prices remains a constant risk in the present situation.
Before I turn to look at the Stability and Growth pact, I'd like to highlight certain improvements in the budgetary sphere, which echo the favourable macroeconomic conditions that I have outlined. In particular, tax revenues are yielding unexpectedly positive results in a number of Member States. Following a significant adjustment in 2005, the government deficits of several EU Member States should record a further decline in 2006.
Indeed, according to our most recent estimates, the general government deficit in the Euro area could be reduced to around 2% in 2006, down from 2.4% in 2005 and 2.8% of GDP in 2004. Moreover, the debt ratio in 2006 could record its first decline since 2002.
3. Implementation of the Stability and Growth Pact
While my message on growth and the budgetary situation is more optimistic, it should not act as disincentive for further consolidation and for implementing the necessary structural reforms and we should take advantage of the good economic cycle.
In such a climate there is always a temptation to allocate tax windfalls to increase expenditure. This is an approach that should be avoided at all costs. We know from experience that favourable economic conditions akin to those we enjoy today must be used to achieve healthy public finances. Such an opportunity was wasted in the period of 1999-2000, when Member States failed to exploit the climate of rapid economic growth and generous tax revenues that prevailed during those two years. As a consequence, these countries found themselves in uncomfortable positions when the cycle entered a less favourable phase. The absence of budgetary margin to let automatic stabilisers operate resulted in a breach of the reference values for maximum deficit and debt levels. Indeed, the inappropriate fiscal stance of this period largely accounts for the flaws in the functioning of the original Stability and Growth pact.
In 2005 an important political effort was embarked upon, finally succeeding in a major reform of the SGP. The revised pact now places particular emphasis on the need to strengthen consolidation efforts when growth conditions are favourable. Member States which have not yet reached sound fiscal positions, as defined by their country-specific medium-term budgetary objectives, must set a clear strategy by which to achieve significant improvements of their structural balance. While ten countries are currently subject to an excessive deficit procedure, deficits in most of them are now moving below 3% of GDP. In any case, close compliance with the revised pact is key to avoiding the policy mistakes of the past, by ensuring that consolidation continues over the medium-term.
This is the main message that I would like to convey regarding the short-term aspects of the budgetary situation; namely that there is a pressing need to achieve sound budgetary positions as soon as possible. This matter becomes imperative when we take into account the longer-term concern of ensuring the sustainability of Member States' public finances.
4. Recent results concerning sustainability
In the coming decades, population ageing will not only curtail growth, but will also have serious implications for fiscal policy throughout the European Union. In light of this, the Commission has recently published a report on the long-term sustainability of public finances in the EU. This report indicates that, in the absence of further structural reforms and budgetary consolidation, public finances will be placed under considerable strain.
The projected figures do not make for comfortable reading. If no measures are taken to address this challenge, government debt is projected to accelerate significantly, eventually reaching almost 200% of GDP in 2050 from an EU average of 63% in 2005.
Ensuring public finance sustainability is a challenge for all the EU Member States. However, the level of risk they face varies between countries.
- Six high-risk countries – the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia – are characterised by a very significant rise in age-related expenditure over the long-term. They will therefore require reform measures to control public spending. Moreover, with the exception of Slovenia, these countries also have large deficits.
- The medium-risk group of countries consists of Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, Slovakia and the United Kingdom. This is a more diverse group. Some of these countries currently have relatively strong budgetary positions, but face significant costs of ageing, for which structural reform measures are required. Others need to consolidate their public finances over the medium term to varying degrees, but are less concerned with the cost of ageing, because they have already reformed their pension systems.
- The third group is the low-risk countries: Denmark, Estonia, Latvia, Lithuania, the Netherlands, Austria, Poland, Finland and Sweden. I should stress here that ‘low’ risk does not mean ‘no’ risk. The circumstances of these Member States depend on the successful implementation of ratified reforms. Moreover, the relatively favourable outlook also presupposes that the current strong budgetary position is maintained or in some cases strengthened.
While the projections concerning demographic change may indicate a daunting challenge ahead, we are in no way unprepared for this task. At EU level we have reached political consensus on a clear strategy aimed at tackling the consequences of ageing. This strategy consists of 3 prongs:
- Firstly, we must reduce debt at a faster pace and improve the budgetary position. We know that even benign financial markets typically react to budgetary behaviour of sovereigns in a non-linear way. Credit risk premiums tend to be small, so long as default risks remain within reasonable ranges. However they could rise rapidly once there is a perception of significant difficulties. We appreciate that currently there is a high degree of confidence by markets on EU governments. It is therefore of utmost importance for governments to maintain such credibility by rapidly addressing risks with an appropriate strategy in order to avoid further accumulation of government debt.
- Secondly, it is essential to raise productivity and employment rates, especially amongst women and older workers. This would raise potential growth, improve future living standards and contribute to sustainability. I should note here that such progress also requires an improvement in the functioning of labour markets and product and service markets.
- Finally, it is necessary to further reform pension, health care and long-term care systems. This is key to containing the projected high increase in age related expenditures and to ensure viable and adequate systems by reconsidering the parameters and incentives approach.
You may notice that these 3 elements also form the core of the Lisbon Strategy for growth and jobs. Several Member States have already made progress in this domain, taking sometimes difficult policy choices and resolutely seeing reforms through to completion. These countries are among those now classified as 'low risk'. Other Member States are beginning to take small steps forward. However, more needs to be done, and done soon: postponing these inevitable policy decisions is not an option at all.
5.Financial integration and economic performance.
Before concluding, I would like to return briefly to the evolution in Europe's bond markets. The introduction of the Euro was a seminal event in integrating the national bond markets of the participating Member States. The result has been a substantially more homogenous market, with significant benefits in terms of efficient functioning.
For example, the greater liquidity and depth of the Euro denominated market has been reflected in higher issuance volumes. Total domestic issuance in Euro since January 1999 has exceeded the combined issuance in legacy currencies during the years immediately preceding EMU. Issuance expanded to nearly €1.8 trillion in 2003 and has stabilised close to this level since.
As issuance volumes have risen, the Euro has simultaneously emerged as the second most important currency for international bond issuance after the US dollar. When we include domestic currency issues targeted at international investors, the Euro has even slightly overtaken the US dollar with regards to the share of outstanding debt securities.
These effects have not only been found in the government bond market. Relative to the pre-EMU situation, there has been a sharp rise in the share of private sector bond issuance in Euro. In particular, the relatively underdeveloped market in non-financial corporate bonds has expanded rapidly. A rise in issuance among lower-rated corporations is further indication of a maturing market, although the share of high yielding issues remains relatively small.
The benefits of a better functioning bond market – and financial markets more generally – are not confined to financial-sector participants. Financial integration is crucial for enhancing the growth potential of the EU economy. In an integrated market, savers and investors benefit from wider choice at lower transaction costs. Crucially, the opportunities for efficient risk distribution are significantly enhanced.
At the macroeconomic level, all of these benefits translate into higher investment and productivity. On this basis, empirical studies on the likely impact of financial integration on the EU economy have concluded that the advantages in terms of growth and employment creation would be substantial and durable. Integrated EU financial markets also promote economic performance by helping to diffuse the impact of so-called asymmetric shocks – namely shocks experienced by one region or Member State in the Union. This stabilising function of integrated financial markets - in addition to the role of allocating capital efficiently over time and space - is essential in delivering a sustainable high-performance economy. Accordingly, the integration of EU financial markets has become a priority in the Lisbon reform strategy.
Conclusions
To conclude I would like to reiterate the impressive progress already made in the field of government bond markets and in the broader process of EU financial integration. These developments are promising, yet the process is only partially complete. Budgetary deficits are declining, but they will not disappear immediately. And although government debt will decrease over the medium term, substantial increases could happen in the long-term due to the challenge of Europe's ageing populations if no action is taken rapidly. I have outlined, there is a clear EU level strategy for tackling these challenges, consisting of a comprehensive program of reforms. In implementing this strategy, we invite markets to reduce the adjustment costs by increasing the efficiency and integration of the bond markets.
Ladies and Gentlemen, I would like to thank you again for the opportunity to share my views with you today. In light of the benefits of financial integration to both the financial sector and the economy as a whole, it is clear that the topic of this conference is highly relevant. I wish you every success for the remaining sessions.
Thank you for your attention.
