Remarks by Athanasios Orphanides, Governor of the Central Bank of Cyprus, at a panel discussion on "Financial Crisis: Global and Local Perspectives" organised by the University of Cyprus
Nicosia, 12 September 2011
It is a pleasure to participate in this discussion on global and local perspectives of the crisis and I would like to thank the organisers for the kind invitation to be part of this distinguished panel. In my brief intervention, I will focus on the sovereign debt crisis that has engulfed the euro area―the global perspective―and say a few words about how this is affecting us in Cyprus―the local angle.
Back in 2007, when the financial turbulence we associate with the ongoing crisis first became evident, few could have anticipated how the crisis would morph into the various stages we have been through. By the end of 2008, what was originally seen as a difficulty with subprime lending confined to the United States had become a full-blown global banking crisis. The sharp recession that followed exposed additional weaknesses in some regions of the global economy. In the euro area, in particular, over the past year or so the crisis has evolved into a sovereign debt crisis which has challenged the economies of a number of member states where the soundness of fiscal balances were not deemed entirely credible. As a result, the creditworthiness of the sovereigns has been brought into question. These difficulties are reflected in the widening of sovereign spreads for a number of euro area sovereigns and the spillover into banks, especially those operating in member states where the sovereigns are most challenged.
What is the underlying cause of these difficulties in the euro area? In short, it is shortcomings in the economic governance of the euro area that has failed to live up to the original design of the common currency area. More precisely, contrary to the original design, economic governance arrangements in the euro area have failed to discipline member states to undertake sound fiscal policies and accountability for and penalisation of bad policies by member states has been grossly deficient.
The importance of sound fiscal policies for preserving the stability of the euro was recognised in the original Stability and Growth Pact (SGP). The SGP was meant to provide a mechanism that would prevent excessive deficits from emerging and quickly correct them if they materialised so that government debt would remain at manageably low levels. However, the Pact has in the main failed as member states have demonstrated little ownership of the fiscal targets to which they were committed. Euro area governments failed to exhibit sufficient discipline to stay within the bounds of the original SGP. Peer pressure within the euro group failed to impose restraint on members pursuing untoward policies. Unfortunately, peer protection rather than peer pressure prevailed.
There has been a failure in budgetary reporting and surveillance. In this regard, particularly damaging to the euro area as a whole has been the revelation of the enormous size of the fiscal imbalances and government debt in the Greek economy that was hidden until the situation became critical.
There has also been a failure of enforcement of commonly agreed fiscal rules. Without proper incentives to ensure that it is respected, no framework, however well designed, can be effective. The development of a credible enforcement mechanism is an indispensable element of improved governance. Fiscal frameworks and rules must be binding.
Recognition of these difficulties has been the first step towards strengthening euro area governance to ensure stability of the framework going forward. A number of important steps are in process. Based on the recommendations of the final report of the Van Rompuy task force for reinforcing economic governance in the Union (Van Rompuy, 2010), six legislative proposals have been put forward by the Commission. These include proposals aimed at improving fiscal surveillance and the implementation of the SGP as well as revamping national budgetary frameworks and strengthening fiscal discipline by member states. Following deliberations by the European Parliament and an agreement by the heads of state of the European Union on 21 July, this legislation is very close to being enacted.
However, there have been serious delays in moving ahead, which has been extremely costly for the euro area. These delays associated both with the handling of the ongoing crisis as well as with effectively putting into practice strengthened economic governance arrangements, have exacerbated the sovereign debt crisis.
Let me now briefly turn to the situation in Cyprus. Although Cyprus was in a quite solid fiscal position at the beginning of the global crisis, its public finances have deteriorated rapidly since the beginning of the crisis, becoming engulfed in the euro area sovereign crisis. Following the deterioration of its fiscal finances, the credibility of our government was severely challenged in the first half of this year, and the creditworthiness of our sovereign put into question. Continuation of the downward spiral of deteriorating public finances in the broader context of the euro area sovereign crisis poses an extreme danger for the health of our economy, and especially our financial services sector where confidence is a prerequisite. It is of the essence to reverse this trend as rapidly as possible. It is critical to restore the credibility of our government’s fiscal affairs and its creditworthiness.
In this light, I would like to support the positive and encouraging developments observed over the past several weeks. Having recognised the problem, it is reassuring to observe the efforts of the Minister of Finance, Mr Kikis Kazamias, aimed at putting the fiscal affairs of our country back in order. I believe it is important for all involved, including political parties and social partners, to help in this effort. To be sure, there is always some disappointment when overindulgent government spending based on unrealistic expectations needs to be curtailed. The short-term pain experienced during the adjustment is unfortunate but it is unavoidable in order to ensure a restoration of the country’s fiscal credibility and solid long-term growth prospects. The more the adjustment is delayed, the greater the accumulated cost to the Cypriot economy and its citizens.
A convincing fiscal consolidation is necessary to restore confidence in Cyprus. But our job will not be completed with this. As already mentioned, going forward Cyprus will be called to implement European legislation that will require revamping our national budgetary frameworks and strengthening fiscal discipline. Some other euro area member states have already moved towards the adoption of fiscal rules and constitutional amendments ensuring balanced budgets. As a financial centre, Cyprus should be a leader in reforming economic governance and should adopt the best fiscal practices at an early juncture.
Striving to be ahead of the curve may be the best defense against the next sequence of events that we may subsequently call a crisis.
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REFERENCES:
Van Rompuy, H (2010) Strengthening Economic Governance in the EU: Report of the Task Force to the European Council, Brussels, 21 October