The document discusses the euro area sovereign debt crisis and lessons learned from the Baltic states' experience, highlighting causes such as macroeconomic imbalances and ineffective fiscal policies. It emphasizes the importance of structural reforms, fiscal consolidation, and national ownership of reforms for successful economic adjustment. Lastly, it outlines challenges for Latvia to ensure sustainable convergence and its readiness for euro adoption.

1. Economic adjustment in the euro
area and the experience of the
Baltics
Hans-Joachim Klöckers
Deputy Director General Economics
European Central Bank
The views expressed in this presentation are solely those of the presenter and do not necessarily
reflect those of the European Central Bank
Riga, 02 November 2012

2. Outline
1 Euro area sovereign debt crisis: where do we stand?
2 The experience of the Baltics: which lessons to draw?
3 Challenges for Latvia
4 Conclusions
2

3. 1.1 Euro area sovereign debt crisis: causes
Unit labour costs and current account
1999-07 Unit labour costs growth, annual averages
Rapid 4.0
3.5
convergence in 3.0
2.5
terms of financial 2.0
conditions and 1.5
1.0
overly optimistic 0.5
0.0
income -0.5
DE AT FI EA BE FR NL LU IT PT GR ES IE
expectations
contributed to Current account balance as % of GDP annual averages
,
15.0
macro-economic
and financial 10.0
imbalances 5.0
gradually 0.0
accumulating. -5.0
10.0
DE AT FI EA BE FR NL LU IT PT GR ES IE
Source: Eurostat and European Central Bank.
Note: Countries are ranked in ascending order according to the average unit labour costs growth in 1999-2007.
3

4. 1.1 Euro area sovereign debt crisis: causes
Loans to private sector and house prices
1999-07 Loans to the private sector (annual average growth rates)
20.0
Persistently 15.0
low “real” 10.0
interest rates 5.0
in some 0.0
countries -5.0
supported DE AT BE EA FR IT NL LU FI PT ES GR IE
strong credit Residential property prices, annual average growth rates
14.0
growth and 12.0
housing 10.0
booms. 8.0
6.0
4.0
2.0
0.0
-2.0
DE AT BE EA FR IT NL LU* FI PT ES GR IE
Sources: Eurostat and European Central Bank.
Note: Countries are ranked in ascending order according to the average loans growth in 1999-2007. *House prices data for Luxembourg not available.
4

5. 1.1 Euro area sovereign debt crisis: causes
Fiscal policy
Cumulative change in fiscal balance (% of GDP)
Cumulative real GDP growth (%)
30
25 2005-07
During the 20
boom period 15
10
insufficient
5
fiscal buffers 0
were built up. -5
ES IE GR CY FI SI LU BE EA NL FR PT SK IT AT DE MT
When the
crisis came, 5
public finances
2008-09
0
deteriorated
-5
markedly.
-10
-15
ES IE GR CY FI SI LU BE EA NL FR PT SK IT AT DE MT
Sources: European Commission and Eurostat.
Note: Countries are ranked according to the change in the fiscal position over the period 2008-09.
5

6. 1.2 Euro area sovereign debt crisis: consequences
Imbalances are now painfully exposed
10-year government bond spreads
(vs. German bond; daily data; basis points) Greek spreads peaked above
4,000 basis points in March 2012
High public debt
High private sector debt
Structural rigidities Exacerbating factors:
- cross-country spill-overs
Loss of competitiveness
- bank-sovereign linkages
Weak economic activity
and rising unemployment
Source: DataStream. Last observation: 26/10/2012.
6

7. 1.2 Euro area sovereign debt crisis: consequences
Interconnection of fiscal sustainability and financial stability
Five-year Bank and Sovereign CDS (daily data, basis points)
Euro area United States
Sources: Thomson-Reuters and ECB calculations.
1) Average of DE, FR, IT, ES, NL, PT, BE, AT, FI, SK, IE, weighted by ECB capital key. 2) Simple average of 10 large banks in the euro area.
7

8. 1.3 Euro area sovereign debt crisis: lessons
• Insufficient attention was paid to the build up of economic imbalances and
vulnerabilities
• Fiscal policy surveillance was not effective
• Financial markets failed to induce discipline
1) Significant fiscal adjustments and structural reforms had to be implemented
at the national level
2) New EU economic and fiscal governance framework is being put in place to
ensure sound fiscal policies and to prevent the emergence of economic
imbalances and financial vulnerabilities in the future
8

9. 1.4 Euro area sovereign debt crisis: progress
The gaps in economic governance are being filled (i)
Stronger surveillance and enforcement rules
• The “six-pack”:
• Strengthened Stability and Growth Pact
• New Macroeconomic Imbalances Procedure
• Fiscal Compact
• “Two-pack” (in progress)
Improved coordination of economic policies
• European Semester
• Euro Plus Pact
9

10. 1.4 Euro area sovereign debt crisis: progress
The gaps in economic governance are being filled (ii)
European Stability Mechanism (ESM)
• Stability support on the basis of strict conditionality
• Initial maximum lending volume of the ESM is set at € 500 billion
• Inaugural meeting of the ESM-Board of Governors on 8 October
2012
Single Supervisory Mechanism (SSM, in progress)
• European Commission unveiled draft legislation
on 12 September
• Proposal to confer ultimate responsibility for specific supervisory
tasks on the ECB
10

11. 1.4 Euro area sovereign debt crisis: progress
The gaps in economic governance are being filled (iii)
Towards a genuine economic and monetary union
.Interim Report by the Four Presidents to European Council 18-19 October 2012
Market Union
EMU
Fiscal Union
Economic
Financial
Political
Union
Union
Monetary Union
11

12. 1.4 Euro area sovereign debt crisis: progress
Significant reduction in budget deficits in individual Member States
Budget balance path for EA and selected countries
(as a percentage of GDP)
2009 2012
Structural Structural
Budget Primary Budget Primary
Balance Balance Balance Balance
Ireland -14.0 -7.6 -8.3 -4.1
Greece -15.6 -9.6 -7.3 3.4
Spain -11.2 -6.9 -6.4 -1.6
Italy -5.4 0.7 -2.0 4.7
Portugal -10.2 -5.8 -4.7 1.8
Euro area -6.4 -1.7 -3.2 1.1
Source: European Commission Spring 2012 forecast.
12

13. 1.4 Euro area sovereign debt crisis: progress
Structural reform priorities
(I) Increase flexibility of labour market, e.g.
• Increase firm level bargaining
• Reduce employment protection
• Scrutinise minimum wages; abolish wage indexation
(II) Strengthen competition in product markets, e.g.
• Reduce protection of sheltered sectors
• Facilitate entry of new firms
• Reduce red tape
(III) Boosting total factor productivity, e.g.
• Foster innovations
• Improve skills of the labour force
• Improve business environment
13

14. 1.4 Euro area sovereign debt crisis: progress
Adjustment of imbalances is continuing
Components of unit labour costs (cumulative pct. change 2008-2012)
- relative to the euro area average -
Source: European Commission Spring 2012 forecast.
Note: Countries are ranked in ascending order according to the ULC growth since 2008-2012.
14

15. 1.4 Euro area sovereign debt crisis: progress
Compression of domestic demand facilitated CA adjustment
Current account balances (% of GDP)
Source: European Commission Spring 2012 forecast.
Note: Countries are ranked in ascending order according to the avg. balances in 2002-2008.
15

16. 1.5 Euro area sovereign debt crisis: conclusions
• Macroeconomic imbalances and un-sound fiscal policies were at
the core of the crisis
• The lessons from these unsustainable developments have been
learned
• The necessary economic adjustment is under way supported by
national reform agendas and a stronger governance framework
at the EU level
• However, the adjustment will take time and further measures
both at the national level and through EU/EA institutional
deepening have to be taken
16

17. Outline
1 Euro area sovereign debt crisis: where do we stand?
2 The experience of the Baltics: which lessons to draw?
3 Challenges for Latvia
4 Conclusions
17

18. 2 The Baltics experience vs. EA program countries
V-shaped recoveries in the Baltics
Real GDP growth
(year-on-year growth rates; quarterly frequency)
IE GR PT LV EE LT
15 15
10 10
5 5
0 0
-5 -5
-10 -10
-15 -15
-20 -20
-25 -25
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012
Source: Eurostat.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
Data for Greece is not seasonally adjusted.
18

19. 2 The Baltics experience vs. EA program countries
Significantly greater wage flexibility…
Compensation per employee
(Index 2007Q4 = 100, annual quarterly frequency)
IE GR PT LV EE LT
120 120
110 110
100 100
90 90
80 80
70 70
60 60
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012
Source: ECB.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
Data for Greece is not seasonally adjusted, due to lack of data.
19

20. 2 The Baltics experience vs. EA program countries
…supported faster adjustments in competitiveness…
Unit labour cost (nominal)
(Index 2007 = 100, annual frequency)
IE GR PT LV EE LT
130 130
120 120
110 110
100 100
90 90
80 80
70 70
2006 2007 2008 2009 2010 2011 2012 2013 2006 2007 2008 2009 2010 2011 2012 2013
Source: European Commission Spring 2012 forecast.
Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).
20

21. 2 The Baltics experience vs. EA program countries
…and was mirrored in price developments
HICP
(year-on-year growth rates; monthly frequency)
IE GR PT LV EE LT
20 20
15 15
10 10
5 5
0 0
-5 -5
-10 -10
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012
Source: Eurostat.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
21

22. 2 The Baltics experience vs. EA program countries
The Baltics followed more prudent fiscal policies…
General government structural primary balance
(as % of GDP; annual frequency)
IE GR PT LV EE LT
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
2006 2007 2008 2009 2010 2011 2012 2013 2006 2007 2008 2009 2010 2011 2012 2013
Source: European Commission Spring 2012 forecast.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
22

23. 2 The Baltics experience vs. EA program countries
…which helped stabilising debt developments earlier…
General government gross debt
(as % of GDP; annual frequency)
IE GR PT LV EE LT
180 180
160 160
140 140
120 120
100 100
80 80
60 60
40 40
20 20
0 0
2006 2007 2008 2009 2010 2011 2012 2013 2006 2007 2008 2009 2010 2011 2012 2013
Source: European Commission Spring 2012 forecast.
Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).
23

24. 2 The Baltics experience vs. EA program countries
…and helped improving the current account balance rapidly.
Current account as % of GDP
(ratio of 4 quarter moving sums of quarterly observations)
LV EE LT
IE GR PT
20 20
10 10
0 0
-10 -10
-20 -20
-30 -30
-40 -40
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012
Source: NCBs and Eurostat.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
24

25. 2 The Baltics experience vs. EA program countries
The negative trends in unemployment have been reversed…
Unemployment rate
(% of labour force; monthly frequency)
IE GR PT LV EE LT
30 30
25 25
20 20
15 15
10 10
5 5
0 0
2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012
Source: Eurostat.
Note: Vertical lines refer to 2007Q4, when the level of real GDP peaked in most of the shown countries.
25

26. 2 The Baltics experience vs. EA program countries
…but GDP still below pre-crisis levels.
Real GDP levels
(index =100 in 2007; annual frequency)
IRL GRC PRT LVA EST LTU
105 105
100 100
95 95
90 90
85 85
80 80
75 75
70 70
2006 2007 2008 2009 2010 2011 2012 2013 2006 2007 2008 2009 2010 2011 2012 2013
Source: European Commission Spring 2012 forecast.
Note: Vertical lines refer to 2007 (most of the countries concerned had their peak in real GDP in 2007Q4).
26

27. 2 The Baltics experience vs. EA program countries
Broader lessons for successful macroeconomic adjustment
• Flexible wages and prices facilitate adjustment
• As do prudent fiscal policies
• Critical mass of structural reforms is needed
• Preserving financial stability is first order priority
• Success ultimately rooted in strong national
ownership of reforms
• The high cost of the adjustment calls for pre-emptive
policies to avoid build-up of future imbalances
27

28. Outline
1 Euro area sovereign debt crisis: where do we stand?
2 The experience of the Baltics: which lessons to draw?
3 Challenges for Latvia
4 Conclusions
28

29. 3 Challenges for Latvia
2012 Convergence Report recommendations
• Continue fiscal consolidation to meet EDP commitments
• Strengthen fiscal framework to avoid pro-cyclical policies
• Contain unit labor costs increases going forward
• Pursue structural reforms to support rebalancing of economy
towards the tradable sector and improve the functioning the labor
market
• Guard financial sector soundness
– Make further progress in restructuring state-owned banks
– Prevent excessive credit growth in future
– Implement ESRB recommendations on FX lending
– Close cooperation between home and host supervisors
29

30. 3 Challenges for Latvia
Improvement in quality of institutions is also key.
Note: Countries are ranked from one (best performer in the EU) to 27 (worst performer in the EU) and
ordered according to their average position in the rankings.
30

31. 3 Challenges for Latvia
Need for sustainable convergence
• Sustainable convergence is prerequisite for Euro adoption
• Euro area membership requires sound fiscal policies
• Flexible adjustment mechanisms need to be maintained
• Improvement in quality of institutions is important
31

32. Outline
1 Euro area sovereign debt crisis: where do we stand?
2 The experience of the Baltics: which lessons to draw?
3 Challenges for Latvia
4 Conclusions
32

33. 4 Conclusions
• Substantial macroeconomic imbalances and unsustainable fiscal policies
have been root causes of the sovereign debt crisis in the euro area
• The necessary economic adjustment is under way supported by national
reform agendas and a stronger governance framework at the EU level
• However, the adjustment will take time and further measures both on
the national level and through institutional deepening have to be taken
• Baltics experience shows importance of speedy fiscal adjustment, critical
mass of structural reforms, and strong national ownership for successful
adjustment
• Sustainable convergence is key for smooth participation in euro zone
33