More work needed to fix global financial system

International regulators making progress but top economies must agree on strong infrastructure, ex-Eurostat chief says


Despite the default risks being raised by the sovereign debt crisis, European unification as a political project will remain intact, and the euro will continue to make sense as a single regional currency in an era when financial markets and global trade are interconnected, a senior European economist said in Tokyo recently.

“If the experience of the last three years teaches us something, it is that Europeans are fully aware of the challenges and want to address them to make sure that the euro area and the euro get out from the crisis stronger and more resilient,” said Herve Carre, former director general of Eurostat, the statistics office of the European Union.

Carre, who was involved in the negotiations for launching the euro in the late 1990s as a member of the Economic and Financial Committee of the European Commission, was speaking on “Prospects for the EU economy and the euro,” a lecture he gave Nov. 15 at the Keizai Koho Center.

Growth in the euro area has begun to rebound and is projected to hit 1.7 percent this year, although the outlooks for inflation and employment remain subdued and bank credit provisions are tight, he said.

Following the massive European bank rescue precipitated by the 2008 financial crisis, new tensions created by the continent’s sovereign debt crisis have been driving market turmoil since last year, Carre said.

“Bank balance sheets must still be cleared in order to restore investor and market confidence; fiscal and budgetary concerns continue to prevail and must still be worked on,” he said.

“In two years, the crisis has wiped out nearly 20 years of work toward achieving budget consolidation in Europe,” Carre observed.

The budget deficits in EU member countries are expected to reach 7.5 percent of GDP on average this year and remain high at 6.9 percent in 2011. Outstanding public debt stands at 79.3 percent this year and is forecast to reach 84 percent in 2011. “Significant budgetary adjustment will be required over the next few years” for the EU to return to its debt-to-GDP threshold of 60 percent by 2020, he said.

In response to the crises, EU leaders have agreed to develop new financial regulation architecture aimed at establishing a more efficient supervisory framework, enhanced capital requirements for financial institutions, improved crisis management, and an extended perimeter for regulation and supervision, he said.

The European Commission has also proposed a package of measures to address its most urgent priorities in economic governance, Carre said.

One of those priorities is simplifying the process for determining how strong and sustainable the underlying fiscal position of an EU member state is, he said.

“Challenges include gauging how far fiscal revenues are temporarily buoyed by asset bubbles . . . As a result of a boom in asset prices, many member states entered the crisis with weak underlying fiscal positions despite years of strong economic growth,” Carre said. The commission “therefore proposes that member states that have not yet reached their budgetary medium-term objective should not increase expenditures faster than a prudent average rate of medium-term economic growth.”

Carre said these EU reforms were not adopted in isolation, but as part of a global response to the wider financial crisis.

International institutions have made substantial progress toward establishing solid financial ground: The G20 took the lead in setting the main pillars for financial reform, the Basel Committee of Banking Supervision took care of the new capital standards, the Financial Stability Board set up in 2009 is working on the mechanisms for crisis prevention and resolution, and the IMF is helping out with financial assistance and peer reviews.

Nevertheless, “a significant amount of work remains . . . to return on a path of increased stability,” Carre said.

Europe’s sovereign debt crisis triggered a fall in the euro, but from a longer-term view, its large fluctuations against the dollar “are to a large extent a dollar story” that reflects “the present disorder in international monetary relations,” Carre told the audience.

This issue is quite topical given that international capital flows have made countries increasingly interconnected and interdependent, Carre said. Noting that most international liquidity is either privately provided or represented by claims on private institutions, he said two “extreme opposite scenarios” could unfold.

“On the one end, capital markets could go through a process of progressive fragmentation . . . New barriers could be erected in the form of soft capital controls or through national regulations. In this scenario, surplus countries would continue to accumulate reserves. Foreign-exchange reserves would keep growing, and international financial instability would continue to dominate,” he said.

On the other hand, “there could be a progressive opening of all capital accounts with some convergence in financial systems and regulations,” he said. “The resulting emergence of a unified world capital market would allow an efficient allocation of savings across countries and a smooth financing of current account imbalances.

“However, an open international financial system is not inherently stable. It needs a strong infrastructure,” including an agreement on the core principles, regulations and elements governing the financial markets and “the availability of a new liquidity instrument equivalent to reserves to be provided through a multilateral mechanism,” Carre said.

Until a proper solution is agreed on by the major economies, he said, “we will have to continue to muddle through between these two scenarios.”