Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at the University of Nicosia
Nicosia, 31 October 2012
Ladies and gentlemen,
I would first like to thank you for inviting me to give this speech at the University of Nicosia. It is a pleasure to talk about a subject that I have a lot of interest in. As many of you know, before taking up my current appointment I spent 22 years as an academic in the UK. During that period I published a number of academic papers on economic growth (out of 35 journal articles 11 have ‘growth’ in their title).
It may, in some sense, sound odd to talk about the way to growth when much of the public debate in Europe these days relates to managing the current crisis in the euro area, a crisis that has hit Cyprus particularly badly in light of the losses suffered by our two largest banks as a result of the Greek PSI (which amounted to over 25% of Cyprus’s GDP) and the contagion effects from the Greek crisis (through our banking system’s exposure to Greece, which amounts to 145% of Cyprus’ GDP).
Getting out of the current crisis and returning Europe to healthy growth rates are of course interconnected. Without a return to positive growth rates, concerns relating to sovereign debt sustainability will remain present and may even be aggravated, even if we succeed in reducing public deficits. Simple debt dynamics suggest that the debt-to-GDP ratio will continue to rise even if a government manages to turn fiscal deficits into primary surpluses - which is extremely challenging in recessionary times, not least because it entails serious social costs - even if those are sufficient to cover interest payments on existing debt. As long as GDP continues to decline, the debt-to-GDP ratio will continue to rise, even if the level of public debt remains constant. Moreover, without a return to positive growth rates, the banking crisis will continue to deepen as the number of firms and households unable to service their debts continues to rise. This will result in increased capital shortfalls and deleveraging, reducing further the ability of banks to support new private investment and growth. Add to this the links between sovereign and bank ratings and the pro-cyclicality of the ratings themselves and one can see how a vicious cycle of negative growth rates, deteriorating public finances and worsening bank problems, fuelled by rating downgrades, will continue unless policymakers manage to break this cycle through decisive actions. Today I will argue that growth is indeed the only way forward.
1. Developments in Europe
Even before the outbreak of the global economic and financial crisis, the euro area’s growth performance was weak compared with other major economies and with the goals of European policymakers. As has been repeatedly stated, the structural reform agenda of the EU failed to deliver on its main objectives for a multitude of reasons. To make matters worse, "…it is likely that the financial crisis has led to a one-off permanent loss in the level of potential output, owing to the economic effects of the downsizing of some sectors…" (ECB, 2011). Thus, expanding the growth capacity of the euro area is even more imperative in the aftermath of the crisis.
Unfortunately, the crisis has had more far-reaching detrimental effects on the functioning of the Economic and Monetary Union (EMU) than its adverse impact on potential output. Apart from the severe synchronised downturn in economic activity at the global level, a distinctive feature of this crisis has been the acute episodes of financial market tensions characterised by loss of confidence across the board. In the euro area, the crisis has been exacerbated by flaws and vulnerabilities inherent in the economic governance and the regulatory and supervisory framework of the EMU, and has fed through into a negative feedback loop between the financial sector and the real economy, and ultimately into a sovereign debt crisis with the vicious cycle between banks and sovereigns being the key characteristic. Eventually, markets questioned not only the sustainability of debt in the most vulnerable euro area countries but also the viability of the euro itself.
Europe and the euro area in particular will only be in a position to raise its long-term productive capacity if it first succeeds in restoring the functioning of its banking and financial system and in overhauling its economic governance framework. To put it another way, restoring and entrenching macroeconomic and financial stability is a necessary condition and first priority for Europe to expand its growth potential and increase the welfare of its people in a sustainable and balanced way.
Admittedly, substantial reforms have been carried out in redesigning the EMU and to that end significant progress has been achieved so far which makes me cautiously optimistic about the future of the euro area. However, as the crisis has demonstrated, Europe’s response has often lagged behind developments, resulting in substantial costs in terms of lost growth, jobs and the welfare of its citizens. Therefore, a faster pace of change is needed, not so much in consolidating public finances at this moment but in achieving a ‘genuine EMU’, with greater economic integration, including a banking union, and more democratic legitimacy and accountability.
Policymakers should focus on reforms which aim to raise Europe’s productive capacity in the long run. In this context, I would like to analyse the following reforms: (i) overhauling the economic governance of the EMU; (ii) restoring the functioning of the banking and financial system and establishing a banking union in the EMU; (iii) fiscal consolidation and growth in the short-run; and (iv) enhancing Europe’s long-term growth potential.
1.1 Overhauling the economic governance of the EMU
The crisis has brought to the fore long-standing weaknesses in the institutional design of the EMU, which unfortunately had not been dealt with in good times. I will briefly review what went wrong in each aspect of economic policy in the euro area, how it contributed to the dynamics of the crisis and then outline the reforms carried out until this moment.
First, the fiscal framework of the EU, i.e. the Stability and Growth Pact (SGP), did not yield the desired fiscal outcomes and most importantly did not assign a counter-cyclical attribute to fiscal policies. Insufficient and often discretionary implementation of the rules of the SGP as well as the lack of incentives for fiscal adjustment gave rise to serious fiscal imbalances in good times. In the context of the crisis, these imbalances have been aggravated, largely due to the fiscal stimulus packages introduced by governments to mitigate the economic downturn and the support provided to the financial sector.
In the field of co-ordination and surveillance of economic policies, it was only after the eruption of the crisis when it became evident that Europe did not have in place a framework to monitor and correct macroeconomic imbalances, analogous to the SGP. This deficiency was added to the already insufficient loose open method of co-ordination of economic policies through the Broad Economic Policy Guidelines (BEPGs) and the Integrated Guidelines. Macroeconomic imbalances that the crisis brought out, such as the erosion of competitiveness in certain member states, low productivity and wage increases that were not in line with productivity growth, as well as unsustainable current account deficits and strong credit expansion, are indicative of poor economic policy co-ordination in the EU.
With regard to the structural reform agenda, delays in implementing the necessary structural changes under the Lisbon strategy deprived EU member states of all the benefits of the single market and resulted in only a modest improvement in the growth potential of the EU in general and the euro area in particular. The main reasons for the unsatisfactory promotion of structural reforms was resistance from well-organised interest groups, inefficiencies in the level of technical and administrative competence, as well as the fact that carrying out desirable or even necessary reforms is not appealing to policymakers (European Commission, 2008).
In the EU’s financial system, significant deficiencies were detected in both micro-prudential and macro-prudential supervision while, overall, fragmented supervision was lagging behind regulation, which in turn was not keeping pace with developments in the financial sector. The latter included, in the context of financial integration in the EMU, the increasing interconnectedness of financial institutions, the repercussions of cross-border activities for financial stability arising both from systemically important and less important financial institutions, the shadow banking sector and financial innovation. As a result, when the crisis came, the euro area was unprepared to adequately address the challenges it presented. National supervisors did not have the tools to resolve cross-border conflicts and arrangements at the EU level were merely of a non-binding advisory nature. Eventually, following the bail-out of systemically important financial institutions, systemic risk was transferred to sovereigns and then sovereign risk was in turn transferred back to financial institutions via their holdings of sovereign debt.
In line with the recommendations put forward in the Van Rompuy Task Force report on economic governance, four out of the six legislative acts adopted by the EU Council in November 2011 (the so-called Six Pack), were aimed at achieving better fiscal coordination and stronger surveillance by reinforcing the preventive and corrective arms of the SGP. The revamped fiscal framework now places more emphasis on fiscal sustainability and on reducing debt levels, thereby making the debt criterion more operational. In addition, the Treaty on Stability, Coordination and Governance in the EMU (the so-called Fiscal Compact), which was signed by all EU member states, with the exception of the United Kingdom and the Czech Republic, in March 2012, requires introducing balanced budget rules in national legislation, preferably at the constitutional level, and provides for an automatic correction mechanism in the case of deviations. The Treaty will enter into force once it has been ratified by at least 12 euro area member states and member states will have a period of one year at most to incorporate the balanced budget rule in their legislation.
As regards the co-ordination and surveillance of economic policies, the main new element in the framework is the introduction of an early warning system, based on a scoreboard of macroeconomic indicators and alert thresholds, covering both the external and the internal sector of the economy. When macroeconomic imbalances or potential risks of macroeconomic imbalances are identified in a member state, the Commission will provide broad-based, in-depth review of economic, financial and public finance developments in the member state concerned, issue recommendations and, where appropriate, propose the initiation of an excessive imbalance procedure, analogous to the excessive deficit procedure under the SGP.
The setting-up of a permanent crisis management mechanism for financial stability in the euro area is in my opinion one of the most important reforms carried out in the institutional design of the EMU since the beginning of the crisis. The European Stability Mechanism (ESM) essentially serves as a financial backstop dealing with the adverse link between sovereigns and banks and, together with the Outright Market Transactions launched by the ECB, addressing challenges from contagion risks. The ESM will succeed the two temporary mechanisms, namely the European Financial Stabilisation Mechanism (EFSM) and the European Financial Stability Facility (EFSF) after a transitional period of nine months during which the ESM will operate alongside the EFSF. The objective of the new permanent mechanism is to provide financial assistance to euro area member states experiencing, or being threatened by, severe financing problems to safeguard financial stability in the euro area as a whole. The initial maximum lending capacity of the ESM is set at €500 billion and assistance will be provided in collaboration with the IMF under strict economic policy conditionality. It should be also noted that as of 1 March 2013 only euro area member states that have ratified the Fiscal Compact will be eligible to apply for ESM assistance.
Furthermore, the Commission proposed two regulations (also known as the Two-Pack) which foresee much closer surveillance for euro area countries receiving financial assistance or in financial distress. Among other things, the Two-Pack provides for the submission of euro area member states’ draft budgetary plans for the year ahead to the Commission and the Eurogroup before 15 October, while in case of non-compliance with budgetary obligations, as set out in the Stability and Growth Pact, it allows the Commission to request a revised draft budgetary plan. The Two-Pack regulations are currently being discussed between the Commission, the Council and the European Parliament.
At this point, I should note that a crucial aspect of the effectiveness of the ESM in breaking the link between banks and sovereigns lies in its capacity to directly recapitalise euro area banks, in line with the conclusions of the euro area summit on 29 June 2012, after a single supervisory mechanism is established for banks in the euro area.
This brings me to the next section of my speech on which I would like to dwell longer, as in my view, this is primarily the area in which the EMU is incomplete and stronger integration is warranted.
1.2 Restoring the functioning of the banking and financial system and establishing a banking union in the EMU
Since the beginning of the financial crisis, concerted efforts at the global level under the aegis of the G20 and the Financial Stability Forum have so far yielded significant progress in repairing the global financial system with the aim of reducing its cyclicality and increasing its resilience so as to avoid similar episodes of excessive risk taking and spill-over effects in the future. At the EU level, on the basis of the de Larosière report (de Larosière, 2009) measures and reforms are primarily aimed at introducing a new regulatory agenda, stronger coordinated supervision and effective crisis management and resolution mechanisms.
More specifically, with reference to the new regulatory framework, an important development relates to the transposition of Basel III into EU law through two European Commission proposals for a directive and a regulation on capital requirements – the new Capital Requirements Directive (CRD IV). These proposals are currently being discussed at the European Parliament and the Council. In its opinion "…the ECB strongly supports the development of a single European rulebook for all financial institutions as it promotes the smooth functioning of the single market within the Union and facilitates greater financial integration in Europe. A single European rulebook ensures that financial institutions providing financial services in the single market comply with one set of prudential rules. This mitigates regulatory arbitrage opportunities and distortions to competition. Furthermore, harmonised rules improve transparency and reduce regulatory and compliance costs" (European Central Bank, 2012). It should be also noted that the ECB proposes in its Opinion the possibility for national authorities to apply more stringent prudential requirements if necessitated by financial stability concerns driven by the domestic structural features of their financial systems.
Another major initiative in the field of regulation relates to the pursuit of a European approach to bank recovery and resolution: during the crisis we have all witnessed the implications of the collapse of cross-border systemically important financial institutions, or ‘too big to fail’ institutions, for taxpayers’ money. In this domain, the objective is to use best practice and superior bank resolution tools to protect taxpayers and to achieve the consistency of national schemes to facilitate home/host resolutions and cross-border crisis management. To that end, the European Commission has presented a proposal for a directive on bank recovery and resolution which is under negotiation between the European Parliament and the Council. The general principles which must be adhered to by the resolution authorities assert that the cost of resolution is borne first and foremost by the private sector, i.e. the shareholders and then the creditors of the financial institution with the ultimate objective of minimising the taxpayers’ exposure to losses.
In addition, significant headway has also been made as far as deposit protection is concerned with the aim of protecting depositors’ wealth and safeguarding financial stability against the risk of panic deposit withdrawals from banks. This includes the harmonisation of national Deposit Guarantee Schemes to a level of €100,000 per depositor, per institution, effective as of 31 December 2010 as well as the Commission proposal to advance with the harmonisation and simplification of protected deposits, faster pay-outs and improved financing, notably through the ex ante funding of deposit guarantee schemes paid for by contributions from banks and a mandatory borrowing facility between national schemes within certain fixed limits.
Financial markets and market infrastructure play a key role in promoting and preserving financial stability: market infrastructures which did not exhibit the expected effectiveness and resilience during the crisis, weaknesses in risk management and opaque counterparty exposures in OTC derivatives markets exacerbated the financial market turmoil and underlined the need for better regulation. Legislative proposals at the EU level which have already been adopted or are being discussed at the Council of the EU and the European Parliament aim at enhancing and widening the scope of regulation in critical fields such as securities settlement and central securities depositories, investment firms and regulated markets, OTC derivatives, central counterparties and trade repositories, credit rating agencies and alternative investments. These legislative efforts are expected to promote the smooth operation of payment systems, foster integration, efficiency and transparency in cross-border arrangements in the EU and restore investors’ confidence in financial markets thereby contributing to financial stability.
Turning to the EU supervisory framework, the establishment of the European Systemic Risk Board (ESRB) and the three European Supervisory Authorities (ESAs), forming together the European System of Financial Supervision (ESFS), is undoubtedly of utmost importance for enhancing supervision and further harmonising it with regulation. The ESRB has been entrusted with the task of macro-prudential supervision in the EU thereby addressing the need to place emphasis on monitoring systemic risk and the stability of the financial system as a whole. Together with the three ESAs, responsible for micro-prudential supervision, that is the supervision of individual institutions, in banking, insurance and pensions, and securities and markets, the ESRB should help to strengthen the oversight, prevention and mitigation of risks, thereby ensuring a sustainable contribution of the financial sector to economic growth.
In the first section of my speech I alluded to the importance of direct bank recapitalisation for the ESM to effectively contribute to the financial stability in the euro area. One of the proposals put forward in the report "Towards a genuine EMU", dated 26 June 2012, prepared by the President of the European Council in close cooperation with the Presidents of the Commission, the Eurogroup and the European Central Bank (ECB) related to the setting-up of an integrated financial framework in the EU with key elements an integrated supervision, including a single supervisory mechanism (SSM) for euro area banks, a European deposit insurance scheme and a European resolution scheme.
Indeed, the proposal for creating a banking union in the EU with a single supervisory mechanism was prompted by the prospect of direct bank recapitalisation by the ESM with the aim of cutting the negative feedback loop between banks and sovereigns. As rightly noted by the Vice-President of the ECB, Vítor Constâncio: "The deeper rationale is however the need to construct a Banking Union for ensuring a successful and well-functioning Monetary Union" (Constâncio, 2012). The interconnectedness of financial institutions means that problems in the banking system at the national level may swiftly affect other euro area countries with devastating consequences for financial stability. Moreover, the fragmentation of financial markets following the sovereign debt crisis resulted in different interest rates in euro area countries reflecting fears of a break-up of the euro area, thereby undermining the monetary policy transmission mechanism. In addition, the bias inherent in national supervision can be identified as one of the causes of severe macroeconomic imbalances. For all these reasons, establishing a banking union should be regarded as an inherent part of a genuine EMU. In that regard, under the Commission’s proposals the ECB will be assigned ultimate responsibility for the supervision of all euro area banks under the SSM, applying the single rulebook applicable across the single market to achieve a strong and consistent supervision across the euro area. Before taking up its new tasks, the ECB will ensure a clear separation between its monetary policy and supervision functions. The legislative framework of the SSM should be completed by 1 January 2013 and work on the operational implementation will take place in the course of 2013.
As regards the other two components of a banking union in the EU, namely a European deposit insurance scheme and a European resolution scheme, the debate here once again relates to the envisaged degree of transfer of national powers to the European level, as has been put forward in the report of the four Presidents. At its meeting on 18-19 October 2012, the European Council noted "…the Commission's intention to propose a single resolution mechanism for Member States participating in the SSM once the proposals for a Recovery and Resolution Directive and for a Deposit Guarantee Scheme Directive have been adopted".
All in all, the legislative proposals aimed at establishing a financial union, one of the building blocks envisaged in the report "Towards a genuine EMU", constitute an important step paving the way for financial stability and growth in a more complete EMU. Pending the conclusion of the discussion of many legislative proposals at the Council, the Commission and the European Parliament, a significant amount of work remains to be carried out and the road towards a fully-fledged banking union is long, particularly when aspects such as burden-sharing rules between governments will determine progress in advancing with European resolution and deposit protection schemes, essential ingredients of a banking union.
2. Revisiting the relationship between banking and growth
The crisis demonstrated the many channels through which a problematic banking system may exert a destabilizing impact on the real economy and adversely affect financial stability. These channels are both direct and indirect, ranging from the capacity of the banking system to finance economic activity, to its prominent role in funds’ flows to and from financial markets, i.e. the money market and the capital market. This is particularly true for the euro area, in which the relative importance of bank-based financial intermediation is higher than in other developed economies such as the USA and Japan. The significant tightening of credit standards and terms and conditions on loans to non-financial corporations and households in euro area countries in financial distress reflects a multitude of factors such as banks’ funding difficulties associated with the malfunctioning of money and capital markets, cost of funds and balance sheet constraints, risk perceptions about the general economic activity and specific sectors of the economy, as well as collateral demanded by banks. Moreover, the vicious link between banks and sovereigns in the euro area was also added to these factors manifesting a plethora of channels through which the financial system impinges on growth and financial stability. Therefore the debate on the establishment of a banking union in the EU should not only take into account and rectify the many shortcomings of the EU regulatory and supervisory framework but should also seek to augment the contribution of the banking and financial system in general to growth and financial stability. Consequently, placing emphasis on the determinants of the relationship between banking and growth would be instrumental in making the best decisions on the design of the new structure.
Empirical research does not enlighten us on causality in the relationship between financial system and growth, i.e. whether a well-developed financial system leads to or follows higher growth. However, it does confirm that finance and growth are positively correlated. That is to say, greater financial development is associated with higher long-run economic growth (Rousseau and Wachtel, 2011).
The literature also suggests that an ailing financial system is linked to poor economic performance. For instance, when bank balance sheets are heavily burdened with non performing loans, banks’ capacity to provide new loans to enterprises, even to those that present positive net present value investment opportunities, may be seriously impaired. This, in turn, reduces investment and economic activity and, ultimately, economic growth. In the extreme, a credit crunch impacts adversely even on trade finance and can grind all economic activity to a halt.
More generally, the consensus now is that a fragile financial system can harm long-run growth. Recent research, for example, demonstrates that lax prudential regulation and supervision in conjunction with inadequate corporate governance practices in banks can have disastrous consequences for the rest of the economy (Andrianova et al., 2012). Another important finding relates to the lethal consequences of the combination of imperfect information with loose supervision and/or regulation and weak corporate governance, which frequently results in bank "looting" (for example through connected lending, dubious or reckless investments and other forms of extraction).
With hindsight, especially in the aftermath of the financial crisis, it is obvious that economic growth is not connected in a simple fashion to the size of the financial system, but more likely to the quality of prudential regulation and supervision. As has been recently shown, a financial system subject to strict supervision can result in up to 2% higher growth rate per year compared with a regime of lax supervision (Demetriades and Rousseau, 2011a). Moreover, it has been discerned that the quality of supervision determines the impact of financial reforms on real economic growth. For example, measures fostering competition in the banking system – which, at first sight, may sound appropriate – can actually lead to a fall in the growth rate of up to 0,4% per year, if accompanied with weak banking supervision (Demetriades and Rousseau, 2011b). This startling outcome has a straightforward explanation: as greater competition pushes up deposit rates, the role of supervision in preventing excessive risk taking by banks becomes more important. When supervision is weak, more competition can result in reckless risk taking (casino banking).
3. Fiscal consolidation and growth in the short-run
In light of the fiscal burden imposed by the banking sectors’ support measures which, in many cases exacerbated already unsound fiscal positions, the need for consolidating public finances is well-understood. Ensuring sustainable fiscal balances in the long-run is conducive to growth via many channels such as interest rates, the market for loanable funds and confidence effects. With regard to the latter, by reinstating confidence in the markets, fiscal consolidation is key to narrowing sovereign spreads and reducing sovereign funding difficulties. In addition, sound fiscal positions are a necessary condition compatible with the long-run smooth functioning of a monetary union.
Nevertheless, fiscal consolidation should not be an end in itself and in any case it should take into account its short-run adverse impact on growth, all the more so at this difficult juncture for the euro area and its citizens.
The experience of euro area member states that have requested EFSF/ESM financial assistance suggests that the short-run multiplier effects have been underestimated, resulting in bigger output and jobs losses in these countries, higher fiscal slippages and, ultimately, more austerity measures. Furthermore, recent empirical evidence ensuing from a relevant IMF study supports the proposition that austerity may not be successful in reducing debt within a reasonable amount of time, while the study finds that the fiscal multiplier has been significantly underestimated, i.e. the impact of fiscal policy on growth is higher than originally estimated. More specifically, the main finding of the study is that the multipliers used in generating growth forecasts, and thus assessing the impact of fiscal consolidation on growth, have been systematically too low since the start of the recession. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. This implies that actual multipliers may be higher, in the range of 0.9 to 1.7 (IMF, 2012). The aforementioned proposition is consistent with other empirical studies suggesting that during the economic downturn fiscal policy is more effective and that the fiscal multiplier may be well above 1, such as in DeLong and Summers (2012).
I would like to recall what standard textbooks in macroeconomics tell us about debt dynamics: that apart from primary deficits, the evolution of debt is determined by real GDP growth and nominal interest rates.
Against this background, fiscal consolidation should be carefully designed, paying due diligence to its implications for growth. This entails drawing up the appropriate composition of measures that will satisfy two objectives: (i) re-orienting public expenditure towards growth enhancing policies and clustering of activities and overall augmenting the quality of the fiscal measures and (ii) preserving social cohesion by shielding the lowest income groups. Achieving the aforementioned objectives contains the risk of self-defeating austerity.
4. Enhancing Europe's long-term growth potential
Both neoclassical(1) and endogenous growth theories(2), pinpoint the importance of the accumulation of capital and labour for economic growth in the long-run and stress the role of technological progress as the factor primarily driving sustained growth in the standard of living, that is per capita GDP. Today, research and development (R&D), human capital, information and communication technologies and patents and other institutional arrangements are different facets of technological progress and manifest the complexity of the production process. Inevitably, policy prescriptions aiming at raising potential growth place great emphasis on promoting structural reforms that augment the contribution of the aforementioned factors to labour productivity and utilisation.
Moreover, investment in public infrastructure, such as roads, railways, water-systems, communication technologies and energy may be viewed as a technology that decreases the costs of intermediate inputs in the production of final goods, thereby promoting specialisation and enhancing productivity. Investment in public infrastructure expands the growth potential both by increasing resources and enhancing the productivity of existing resources(3). It has been also shown that public capital has positive long-run effects on output supply and input demands and that its mean short-run rates of return are fairly low, while the corresponding long-run rates are much higher but declining over time (Demetriades and Mamuneas, 2000). In addition, the benefits ensuing from the role of investment as a final demand component, thereby contributing to growth in the short-run, should not be underestimated. Therefore, in the context of re-orienting public expenditure towards growth enhancing activities, policymakers should seek to reinvest in existing or invest in new public infrastructure.
As I noted in my introduction, policymakers at the EU and the national level should not lose sight of the long-run. Structural reforms in the real economy with the aim of increasing labour productivity and utilisation should be pursued on an ongoing basis. The new framework of co-ordination of economic policies in the EU promotes enforcement and the Strategy "Europe 2020" sets the right priorities engaging the European Council and Parliament more actively in this process. Member states should rigorously carry out the reforms they commit to in their national reform programmes to achieve the "Europe 2020" priorities, namely smart, sustainable and inclusive growth, through more effective investments in education, research and innovation, a decisive move towards a low-carbon economy, with a strong emphasis on job creation and poverty reduction.
5. The road to economic growth in Cyprus
As is the case with the euro area as a whole, in order to raise its long-term growth potential, Cyprus must first ensure conditions of macroeconomic and financial stability. As is well known, the Cyprus Government has applied for an EFSF/ESM/ IMF stabilization programme, mainly driven by the urgent need to recapitalise its banking system in the wake of capital shortfalls resulting mainly from its operations in Greece and the Greek PSI.
Cyprus is now in the process of negotiations with the troika with the aim of putting in place a fully fledged programme of support for the banking system and public finances. The programme is aimed at recapitalizing banks, restructuring the banking system and putting the public finances on a more sustainable footing.
The Central Bank of Cyprus views this programme as paving the way for Cyprus to return to sustainable growth path in the near future. The programme is the key to restoring investors’ confidence to the economy of Cyprus in general and its banking system in particular.
We understand and appreciate that in the short term there will be sacrifices by the people of Cyprus. However, these sacrifices will not be in vain since they will secure greater and more sustainable economic prosperity. The prospects for the economy of Cyprus, once the adjustment has been completed, are indeed very good.
With the public finances on a more sustainable footing, increased labour productivity and a more resilient and more competitive financial system, as well as excellent human capital and a growing natural resource base, due to the discovery of very substantial gas reserves in the Cyprus Exclusive Economic Zone, the prospects for growth will be considerably enhanced.
Conclusions
I would like to briefly recap and conclude. The global economic and financial crisis has aggravated the need for raising the growth potential of the euro area. At the same time it brought to the fore long-standing weaknesses in the institutional design of the EMU which proved to be detrimental to financial stability and growth in the euro area. Dealing first with these challenges is imperative towards reinstating macroeconomic and financial stability which are prerequisites for long-run growth. Concurrently, reforms aiming at promoting long-run growth should not be neglected.
Significant progress has been achieved so far, particularly in the area of fiscal and economic policy co-ordination and enforcement, as well as in the establishment of a permanent crisis management (or stability) mechanism. Moreover, substantial progress has been achieved in repairing the functioning of the financial sector and enhancing regulation and supervision in the EU. The decision to establish a single supervisory mechanism in the EU with ultimate objective an integrated financial framework or a banking union is a great step ahead. But still, the road towards a true banking union in the EU is a long one. The history of the EU reminds us that the process of European integration has been gradual and not effortless.
Thank you.
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ENDNOTES:
(1) See e.g. Solow (1960).
(2) See e.g. Romer (1990).
(3) See e.g. Bougheas et al. (2000) and Munnell (1992).
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