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Andreas Dombret’s Opening Keynote at Institute Fund Summit 2015 Europe

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Keynote Speech at Institute Fund Summit 2015 Europe
Hotel Okura, Amsterdam, October 26, 2015
Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank
Source: Deutsche Bundesbank

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1. Introduction

Ladies and gentlemen

Thank you for the invitation to speak at the Sovereign Wealth Fund Institute summit in Amsterdam. It is a pleasure to be here today. Not too long ago, the saying was that when the US sneezes, the world catches a cold. This is certainly still true, as the discussions on the interest rate turnaround in the US show. Nevertheless, the world economy has become so interconnected that nowadays there is more than one chance of catching a cold. No matter where an economic problem occurs, financial markets might have carried it around half the world before policymakers can get their pants on – to paraphrase Winston Churchill.

Let us therefore take a brief trip around the world to see where we currently stand.

2. The world economy – what is it about China?

In its most recent World Economic Outlook, the IMF writes that in the seventh year after the Great Recession “a return to robust and synchronized global expansion remains elusive”. Consequently, the IMF has revised its projections for global growth downwards. It appears that global growth will decelerate somewhat in 2015 – despite lower oil prices and expansionary monetary policy in a number of countries.

This not so favourable outlook for the world economy is surrounded by considerable risks, two of which are of particular concern. First, recent volatility in global financial markets has highlighted the risk of a large and sustained correction in asset prices. Second, there might be a substantial risk of a sharper slowdown in emerging economies.

In this regard, the situation in China is the subject of hot debate. However, the Chinese stock market crash itself is probably mainly a correction of irrational exuberance. Prices had more than doubled within a year, despite declining growth expectations. Moreover, the direct effects of the crash on the domestic economy should remain manageable. In spite of the previous rally, equities constitute only a relatively small share of Chinese household wealth. Moreover, corporate financing is primarily loan-based.

The true issue at stake is the situation of the Chinese real economy. If the slowdown in real growth proves significantly stronger than expected, the consequences could certainly be serious. Commodity exporters and Asian countries would be particularly badly affected, as they form part of the regional supply chain which feeds into the assembly hub China. These countries would most likely face increased pressure from financial markets in the form of capital outflows, currency depreciation and rising credit risk premiums. At the same time, a less favourable outlook for China might undermine investors’ confidence. This in turn could result in a general reassessment of emerging markets as an asset class.

It is undoubtedly true that many emerging economies have increased their resilience to external shocks since the 1990s. Nevertheless, significant risks of further financial tensions remain – particularly for those countries that rely on external financing. Further risks stem from the fact that corporate debt has increased in many emerging economies. According to the IMF, the average debt-to-GDP ratio has grown by 26% over the past decade. The risks are particularly high where that debt is denominated in foreign currency.

On the whole, the general outlook for emerging economies is therefore weakening, and the IMF expects growth to decline for the fifth year in a row. These developments have led to a heightened focus on risk and have increased uncertainty regarding the future. Policy recommendations for emerging markets should focus on the traditional virtues of sound macroeconomic policies and market-oriented reforms – which have both proven successful in the past.

3. The euro area – reforms are still paramount

The same advice applies to the situation in the euro area. Although recovery in the euro area seems to be proceeding broadly in line with expectations, it remains paramount to continue with necessary reforms. At the national level, major progress has indeed been made, as most of the crisis countries havemanaged to improve their public finances and their competitiveness.

Measured in terms of the deflators of total sales, price competitiveness has improved by 8½% in Portugal, just over 11½% in Spain and 16½% in Greece. To some extent, these figures can be attributed to the depreciation of the euro. Nevertheless, the figures for the countries I have just mentioned are also positive when measured in terms of the euro area. As a result, current account deficits have been reduced and the countries I just mentioned are now running a surplus.

At the same time, unemployment seems to have peaked, although it remains exceptionally high in countries such as Greece and Spain. Nevertheless, it is becoming increasingly clear that the reform efforts are bearing fruit, particularly in Spain and Ireland.

This makes it all the more important for the achievements not to be compromised. And this is why it is, in my view, a major success that the Greek government agreed, after a hard struggle with its European partners, to stay on the path of economic reform.

Now it is important that the Greek government is really willing to take ownership of the agreement that was reached in August. The agreed measures have to be implemented. This is not only a prerequisite for further financial assistance but also a precondition for Greece’s economic recovery.

Suffice to say, it is not enough to correct misalignments solely at the national level, either in Greece or elsewhere in the euro area. We also need structural reforms at the European level. And here, a lot has been done since the crisis broke out.

First, the rules of the Stability and Growth Pact have been tightened and a fiscal compact has been adopted to restore confidence in public finances. Second, a procedure for identifying macroeconomic imbalances at an early stage has been established. And third, a crisis mechanism has been set up to serve as a “firewall”, safeguarding the stability of the financial system in the euro area.

In addition to these measures, the euro area took a major step towards deeper financial integration on 4 November 2014, when the first pillar of a European banking union was put in place. On that day, the ECB assumed responsibility for supervising the largest banks in the euro area. As of today, this concerns about 120 banks which together account for more than 85% of the aggregate balance sheet of the euro area’s banking sector, making the ECB one of the biggest banking supervisors in the world.

Taking banking supervision from the national level to the European level has three concrete benefits.

First, European banking supervision allows banks in the entire euro area to be supervised according to the same high standards. These harmonised standards will emerge from the cross-border sharing of experience, noting the best aspects of each national approach to banking supervision and adopting these for use at the European level.

Second, European banking supervision makes it possible to effectively identify and manage cross-border problems. This is essential because large banks are usually active in more than one country. During the crisis, there were some instances where a more pronounced cross-border approach would indeed have been desirable.

Third, taking banking supervision from the national to the European level will add a degree of separation between supervisors and the banks they supervise. This will prevent supervisors from handling their banks with “kid gloves” out of national interest.

As you can see, we have come to expect a lot from European banking supervision, and after one year of experience, I am confident that these expectations will be met. In 2016, European banking supervision will be supplemented by a European resolution mechanism for banks. This will be another major step forward in designing a better framework for the European monetary union.

However, to make monetary union more stable, the general framework needs further reform, too. The primary objective should be to increase the incentives to make sound and responsible decisions within the euro area. To this end, it is important to rebalance liability and control. Either we create a fiscal union by establishing centralised rights to intervene in national fiscal policies or we strengthen the principle of individual national liability.

As I do not see enough support for a fiscal union – either in the political sphere or among electorates – I do not expect it to occur in the foreseeable future. Therefore, the principle of the individual liability of the member states needs to be reinforced. Otherwise, the deficit bias of euro-area member states will be strengthened, causing harm to the stability of the monetary union.

Relying on fiscal rules alone will not suffice to overcome the euro area’s vulnerability to crises once and for all. On the contrary, additional steps are needed to strengthen the disciplining effect of capital markets on fiscal policy. In that sense, the principle of individual national responsibility ultimately means that governments, too, must be allowed to fail financially.

4. Germany – the inevitable challenge

Turning to Germany, the overall picture looks rather benign. The German economy continued its robust upswing in the second quarter of 2015 with GDP growth outpacing potential output growth.

Looking ahead, the conditions are in place for staying on a solid growth path in the second half of 2015. Consumption will benefit from favourable consumer sentiment, fuelled by rising employment, higher wages and low inflation. Business investments are expected to gain momentum, as current production capacities might soon need to be expanded.

External demand currently faces downside risks resulting largely from emerging market economies. And again, China plays a major role in the assessment. If growth in China weakens only moderately, the direct impact on the German economy may be limited. However, a sharp slowdown or even a hard landing in China may have a serious impact on the German economy, given its openness and direct trade links with China – in 2014 about 6½% of all German goods exports went to China.

The outlook for external demand has therefore become more uncertain. This is underscored also by the recent slump in industrial orders from abroad. While orders from the euro area continue to rise, orders from the rest of the world have taken a hit, causing overall orders to fall. Nevertheless, indicators suggest that firms remain modestly upbeat about their export prospects.

All in all, the current situation in Germany continues to looks rather favourable. However, looking to the future we have to face some unpleasant demographic facts. In the coming decades, Germany will experience some significant demographic change. As the baby-boomer generation reaches retirement age, Germans are getting fewer and older.

Back-of-the-envelope calculations tell us that by 2030, there will be roughly three million fewer people in the workforce than today. As a consequence, the relationship between people in paid work and those out of the workforce will worsen considerably. Fewer workers will have to finance more retirees.

These changes will have an impact on public finances and potential output. In the future, there will be fewer people to finance public expenditure, but more people with claims on the government’s budget. This is not exactly beneficial for public finances. The European Commission expects age-related expenditure in Germany to rise by 5 percentage points of GDP by 2060. According to the German Council of Economic Advisors, this means that public debt will rise to almost 250% of GDP over the same timespan if policy remains unchanged.

Unfortunately, we can’t rely on economic growth to bail us out of this uncomfortable demographic situation. In fact, quite the opposite is true: a shrinking workforce will in itself slow potential output.

The conclusion is that Germany has to adjust to demographic change. Here, too, reforms are paramount. In a nutshell, there are at least four measures that have to be taken. First, it has to become easier to combine work and family. Second, the working lifetime has to be gradually increased. Third, there needs to be more investment in education. And fourth, we should consider a systematic approach to attracting skilled workers from abroad.

5. Conclusion

Ladies and gentlemen, my brief survey has taken us around the world – from China to emerging markets, to the euro area and finally to Germany. What have we learnt? The main lesson seems to be that we are always at risk of catching a cold when someone sneezes.

Against this backdrop, every country should improve its immune system. In economic terms, this calls for structural reforms to make economies more resilient. And this doesn’t just apply to those countries that are facing problems at the moment, but also to those that are looking ahead to future challenges.

Thank you very much.

* * *

SWFI First Read, January 18, 2018

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