Unfreezing the financing pipeline

Andres Lipstok
Governor of Eesti Pank and member of the Governing Council of the ECB

According to Andres Lipstok, Governor of Eesti Pank and member of the ECB's Governing Council, euro area central banks have issued extraordinarily large-scale long-term credit in support of the financial system, but they nevertheless manage to keep inflation in check.

The financial system can be compared to a city waterworks, since their functions are similar. The task of the water system is to ensure unobstructed water flow to companies and households. In normal circumstances it functions well and people do not usually give a lot of thought to the water pipeline. However, the situation changes radically when the winter is colder than usual and pipes will start freezing. A cold winter highlights construction problems in waterworks and frozen pipes make water unavailable to many. Moreover, such pipes may also explode, causing extensive damage that is very costly to repair. The situation is pretty similar in the financial system, the "pipes" of which circulate money between banks, companies and households. The global financial environment has cooled more than usual in the crisis and earlier hidden weaknesses have come to the surface. Money circulation between banks, companies and households is no longer smooth. Should the circulation pipeline freeze up inside very heavily, its consequences to companies and jobs will be very sorely felt by us all.

The goal of central banks is to deliver price stability and the main tool in their hands to do that is interest rates. When price growth is neither too rapid nor too slow, it will be easier for companies and households to grasp the value of money and to decide whether to spend or to save. Price stability is the central bank's contribution to long-term economic growth. To alleviate the financial crisis, central banks across the world have reduced interest rates, with many of them having reached the historical low. The last time the ECB decreased the key interest rate was in December and it is now also at a record low level. This facilitates investment and supports economic resurgence. Under normal circumstances, varying interest rates by the central bank would suffice to alleviate the situation. However, the severity and large scale of the financial crisis has seriously curbed the ability and willingness of banks to issue credit to companies and households. As a result, the central banks of the euro area have had to step in and take several non-standard measures.

We have been offering unlimited liquidity to euro area commercial banks for over three years. In addition to short-term liquidity, we have also provided longer-term loans on very favourable conditions. The list of collaterals eligible for securing monetary policy loans has also been expanded. Last year, we lowered the reserve requirement from two per cent to one per cent. We have supported the functioning of the bond market, when there has existed the threat that the financial system would be unable to fully pass through the changes made by the central bank to the price of money to companies and households.

With two longer-term refinancing operations (in December 2011 and in February 2012) we have issued loans to commercial banks worth a total of about a trillion euros. This is nearly a third of the euro area central banks' consolidated balance sheet and some five per cent of the euro area commercial banks' loan portfolio. The loans with three-year maturity issued by the ECB are of the most extensive volume of all the non-standard measures taken so far.

All of the non-standard measures have a specific goal and they come at a price. The latter entails heightened risks for central banks. The level of assets and liabilities of euro area central banks has increased by one and a half times over the past year. Here it is important that central banks' capital buffers conform to the changed situation. As member of the ECB's Governing Council, I can assure that the risks we have taken are well-considered, all alternatives have been discussed and we have taken these risks to prevent the financial system from freezing, since it would have a very adverse effect on both companies and households. Although I am convinced that our risk management is among the best in the world, tax payers need to be aware of the objectives and price of crisis control. This is why the non-standard measures are of limited volume and temporary in nature.

Returning to the large-scale liquidity assistance, it is probable that its impact has not yet fully manifested itself, since relending to companies and households takes time. The most important thing to pay attention to is the extent to which the measures affect price stability. Based on forecasts by investors and international institutions, euro area central banks will succeed in ensuring price stability also after the implementation of the non-standard measures, even though this year's inflation is very likely to exceed the target of slightly below 2%. Inflation is set to increase due to high energy prices as well as because of tax increases implemented in several euro-area countries to balance the state budget. On the other hand, inflationary pressures are eased by sluggish economic activity.

After unfreezing the financial intermediation "pipeline" in the euro area, it is very important to focus on economic policy cooperation targeted at the implementation of measures of longer-term effect. The measures aim at taking the finances of the euro area to a more sustainable ground.

Countries' efforts in setting their finances straight are of vital importance here. Budget balancing normally puts short-term brakes on economic activity. However, from the viewpoint of restoring long-term growth it is very important that all euro area countries adhere to their commitments of achieving sustainable public finances. The continuously high global uncertainty will result in a more modest growth in the euro area than last year. The ECB's forecast expects growth in 2012 to remain in the range of -0.5-0.3%. Nevertheless, the factors curbing growth are expected to become exhausted relatively soon and economic expansion in 2013 is expected to be between 0 and 2.2%.

Crisis management will require tighter cooperation between euro area Member States. Any entanglements in solving the crisis could bring along higher costs to euro area citizens. The clarity of decision makers' mandate is a precondition for efficient cooperation. Lawmaking should lay down rapid and legally consistent decision-making processes in a crisis situation. In this respect, the compliance of the European Stability Mechanism (ESM) with the Estonian Constitution should receive a fast and finite assessment. Here it is important to realise the principle that assistance is provided not to help out single countries but to solve crises that are systemic and endanger the economy of the entire Europe, including Estonia. It is beneficial for Estonia to fully implement the EU's strong financial stability framework.

Global uncertainty is still high, although the start of this year has shown first signs of stabilisation. The restoration of confidence in the financial system and in economic policy requires considerably more time than was spent losing it. It is vital for the system participants to stick to their promises. If euro area Member States are able to meet their commitments and improve cooperation between them, a spring will follow the harsh and long-lasting winter in the financial system. Close cooperation in complying with fiscal policy rules and improving the crisis management framework will ensure better preparedness for a next harsh winter.

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