Remarks by Dr Sinikka Salo, Member of the Board, Bank of Finland at the luncheon on 23rd January 2009, Embassy of Finland, Bratislava
Your Excellency, Dear Friends, Ladies and Gentlemen
I am pleased and honoured to have been invited to present my views about the past years of Finland’s membership in the EU and EMU before such a distinguished audience, and I would like to thank the Ambassador for giving me this opportunity.
I accepted the invitation believing that the story of Finland's entry to the EMU can be interesting for Slovakians today, but I promise I will try not to make the silly mistake of trying to give any general advice. I will merely try to offer just one perspective on the life with the common currency.
Finland joined the EU, together with Austria and Sweden, from the beginning of 1995. In its accession negotiations, Finland did not seek any opt-out from the third stage of the EMU, and the government, which was formed after the general elections of March 1995, proclaimed in its programme that its goal was to prepare Finland to join the EMU in the first group of countries to do so.
Actually the EMU membership had important effects already before it materialized. I think this is a phenomenon seen in all countries with the prospect of joining the EMU. In the case of Finland, expectations of joining in the common currency were fairly firmly established in 1995 already, and it was very soon clear that these expectations influenced monetary policy and private behaviour already long before membership in the monetary union became a reality.
In the light of now 14 years of Finland’s EU membership and 10 years of euro there are already some grounds to review and assess the hopes and expectations as well as risks which were originally held about the membership in the EU, and in particular about the membership in the EMU. In my remarks my focus, indeed, is on the impact of monetary union.
When looking at the past years, it should be kept in mind that many factors other than monetary union have influenced the Finnish economy, and it is very difficult to disentangle the effects of giving up national monetary policy and joining the EMU from these other factors. This is true, in particular, because when Finland joined the EU and committed to join the EMU, the country was just recovering from a severe economic and financial crisis which in itself had changed the structure of the economy in several ways.
According to the widely shared view at the time of joining the union, three major effects of EMU were considered relevant for Finland, and I shall discuss each of them briefly. In the end I shall provide a brief overview of the current economic situation in Finland.
The first and most important effect of the EMU membership was expected to be the benefit of improved credibility of monetary policy. This was considered very important, as Finnish monetary policy traditionally had suffered from lack of credibility, which caused recurrent balance of payment problems and large risk premiums in market interest rates. It was hoped that (the expected) high credibility of euro area monetary policy would bring about lower and more stable interest rates.
It was also predicted that monetary union would be conducive to wage moderation, because better credibility would lower inflation expectations and therefore imply smaller inflation premiums in wage contracts. In the monetary union, so it was hoped, wage inflation would not take off as easily as it had before, as the monetary policy could no more bail out export industries in the event of problems − like in the old days which in Finland were characterized by "inflation-devaluation cycles".
Both these hopes have become materialised. Finland has indeed been able to enjoy historically low interest rates, not only in absolute terms, but also relative to other countries. One may argue that the significant improvement in the general government financial position which took place since 1994 could have worked to the same direction, but we should keep in mind that the real interest rates were high in Finland also in the 1980s, when our government debt was quite small and our budget was in surplus. This supports the conclusion that credibility of monetary policy, achieved through the membership in the monetary union, was a crucial ingredient in the improvement.
Wage moderation has also been good after the membership, relative to the productivity improvements and in terms of the external competitiveness of our economy – at least until last year when, as a result of overheating of the labour markets, wage costs increased sharply at the same time when the traditionally dominant centralized wage bargaining system was discontinued.
In conclusion: Finland in the days before EU was suffering from persistent inflation and, as a result, from higher interest rates and chronically eroding competitiveness. With the euro both of these problems have vanished.
The second expected effect, which was a source of some concern, was the problem of asymmetric shocks after giving up independent national monetary policy.
Asymmetric here means country-specific: if the member countries do not fulfil the criteria for an optimum currency area – which Finland and the rest of EU countries obviously do not quite do – common monetary policy cannot react to the asymmetric shocks the countries face as effectively as national monetary policies could.
To the extent that national monetary policies or exchange rate movements do in fact facilitate adjustment to asymmetric shocks, a country may have to face more severe economic fluctuations as a result of forsaking its national currency. This question was discussed extensively in Finland and was considered as the main risk for Finland in the EMU, although it was noted that a separate exchange policy is also a source of speculative disturbances – several times experienced in Finland – and that this source of shocks would be eliminated in EMU.
Experiences so far are rather positive in this regard and common monetary policy has been reasonably appropriate for the Finnish economy. So far, the problem of asymmetric shocks has not at all been at the forefront in Finnish economic policy during our EMU membership. It also seems that the business cycle in Finland has become more synchronized with the other euro area countries, although the amplitude of the cycle in Finland may still be larger than in the euro area on average. This is true, in particular, for industrial production.
The third expected category of effects − and a source of hoped-for benefits − were the structural effects of joining the single currency. Adopting the euro was predicted to reduce transaction costs, increase competition, and facilitate the internationalization of firms, and thus make Finland in every way a more productive economy and better integrated to the European single market.
These hopes have been fulfilled, I think, beyond expectation. Finnish firms have indeed become much more international than before, in terms of ownership and operations. Competition has increased in many sectors, especially trade, telecommunications and financial services, and this has led to lower consumer prices for instance of foodstuffs, clothes, home electronics, phone calls etc. In this respect, an important role has been played by many foreign firms establishing in Finland and thereby intensifying competition which was arguably too weak in our small domestic markets before joining the EU.
Finland's EMU membership may also have made Finland a more attractive destination for investors outside the euro area. A large part of the foreign ownership of Finnish shares is by investors who are not euro area residents; also foreign direct investments are to a large extent to non-EMU countries.
One outstanding feature has been the large share of Sweden as well in inflows as in outflows of equity capital and direct investment.
During the EMU membership, Finnish securities markets have changed from being mostly national to more European − and Scandinavian − in terms of infrastructure. This has been very important from the point of view of big investors and borrowers. For example, large Finnish pension funds have been able to diversify their assets outside Finnish markets in an unprecedented fashion. Actually, this is the way the bulk of the large current account surplus, which we have had in the last years, is invested.
Finally, as regards real integration, it was expected when Finland joined the EU and the EMU that our foreign trade would be somewhat more directed to the euro area and EU countries, but this has not actually happened. On the contrary, the share of EU countries in Finnish exports and imports has decreased over the recent years. This development may be due to the relatively sluggish growth in many euro area countries during this time. At the background are also the important structural changes of global trade patterns which have redirected Finnish foreign trade during the past 10-15 years: the rise of ICT sector, globalisation and the increased weight of Asia − and Russia − in the world economy.
During the past ten years there have been several occasions which could have caused turbulences in the global financial markets, with negative consequences (including competitive devaluations) in Europe, had there not been EMU. Therefore, we can say that the EMU membership has been protecting the EMU countries during many international crises, like the September 11 terrorist attacks, Iraq wars etc. The current global financial crisis, the worst since the 1930s, which started in the US, and spread particularly to the most developed financial systems, and is causing the worst slowdown in the world economy since the Second World War, is naturally a most demanding test for the EMU.
In my view we can already draw a positive conclusion of the success of the euro also during this crisis. In societies we cannot make controlled experiments, but we can, based on past experiences, imagine the counterfactual scenario in which the euro area had not been created. It is most likely that we would have seen exchange rate turbulences, competing devaluations etc as reactions to the present crisis. Instead, now the Eurosystem has been able to act promptly, in unity and in cooperation with other major central banks of the world, most notably with the US Fed, to provide liquidity and take other measures to mitigate uncertainty in the global money markets.
Although we are not yet in the “normal” situation, we have good reasons to believe that credibility in the financial system is better, thanks to the international central bank cooperation which was facilitated by the monetary union, and also because of wider multilateral cooperation. As regards the latter, we should mention the recent efforts of G20, IMF and Financial Stability Forum, where common guidelines for rescue operations, necessary to solve the crisis, are being drafted and agreed. It should be emphasized that it is in the particular interest of smaller EU and euro area members to find out and support common positions for the whole EU to be presented in these global forums.
When Finland joined the EMU, financial stability issues were somewhat overshadowed by macroeconomic and structural efficiency considerations. But now, of course, the policy agenda would seem otherwise, and we need to consider the EMU from the perspective of financial stability and financial regulation.
Financial market integration is an area where EMU is not yet ready. In general, the European integration of financial markets has been slower than anticipated 10 years ago, and the prediction that the EMU would give firms, households, and governments access to deeper and more efficient financial markets, is not yet completely fulfilled. This is one major reason that we still have not been able to reap to the maximum benefits of EU’s common markets.
The current global financial crisis is also a test for the structure of financial regulation in the EU, and of the governments' will to work together in crisis management for a common goal of financial stability. The crisis has revealed in Europe the need for EU-wide supervision and rules to cover cross-border provision of financial services and in this way to strengthen EU’s internal market.
From the perspective of the Finnish financial system, a key question is how the reform of the financial regulation will impact cooperation and the allocation of rights and responsibilities between the authorities of the home and host countries of international banking organizations. This is important for us, because of large banks operating in Finland, Nordea Bank Finland and Sampo Bank are currently subsidiaries of foreign banking groups. Together, they cover slightly over half of the banking market. Both of these banks are intended to be eventually changed into branches, but the projects have been postponed until further notice.
The European Commission recently (in October 2008) put forward a proposal for a revision of the Capital Requirements Directives. Among other things, this would bring about a number of changes to the supervision of banks with cross-border operations. The directive proposal would help improve supervision of internationally operating banking groups by increasing cooperation between supervisors. The proposal includes an establishment of a college of supervisors for each cross-border banking group or bank. The colleges could include supervisors of subsidiaries and systematically relevant branches, but ultimately the consolidating supervisor (meaning the supervisor of the parent bank’s home country) will determine on supervisors entitled to take part in the meetings or other activities of the colleges.
This is all very welcome but, nevertheless, we see from the Finnish perspective that the specification of the directive would be crucial so as to provide supervisors of branches and subsidiaries systematically relevant in the host country with an assured right to participate in the activities of the colleges of supervisors. I believe that this point is also of interest in Slovakia, because also in your country banks are largely owned by banks domiciled in other EU-countries.
All in all, the current crisis has indeed increased the pressure for these reforms. Whether the proposed reforms of financial supervision in the EU would be sufficient is debatable. Increasingly, there are voices for a single EU-level supervisor (system of supervisors). Indeed, the Commission has nominated a small high-level group, chaired by Mr. de Larosiere to look into this matter. As I already said, I personally regard a European supervisor for the largest cross-border financial institutions necessary, and would welcome the work to explore the initiative. The European structure could comprise national supervisors and a central body with sufficient powers to ensure that large multinational financial groups are adequately supervised.
The EMU membership has, indeed, been protecting the Finnish economy (like other euro area economies – and also worldwide) during the international financial crisis. The euro has fulfilled its task: it has provided monetary stability to citizens and firms in the euro area, and also, more broadly, by significantly contributing to the stability of the global financial system. We can conclude that euro has confirmed its reputation as a successful currency. It is a boon to be a member.
However, it should be reminded that the euro can only provide stability in monetary and financial sphere of the economy. This is obvious when considering the current economic situation, when slowdown of demand is taking place everywhere. Although the origin and timing of the recession in the euro area is the same for all, and in that sense we are in the euro area experiencing a common shock, the ECB cannot make the crisis go away. Most of real economic problems cannot be solved by monetary policy, even very good monetary policy.
Euro and the EMU provide an important element for stability, but the member countries still need to use other policies to meet the real economic challenges, and to counter country-specific problems. The impact of the slowdown of the world economy on any single euro area country depends on the structure and trade of that member's economy. There the flexibility of markets and the possibility to apply fiscal policy play a role. During exceptional periods like the current crisis, also the Stability and Growth Pact, which is essential part of the EMU, shows its justification.
EMU has not posed any particular challenges for Finnish fiscal policy. The consolidation of the public finances after our economic crisis in the beginning of the 1990s has been successful, and currently Finnish public finances are among the strongest in the euro area. The economic motives for fiscal discipline (especially preparing for the ageing of the population, and the fear of erosion of the tax base) have been so compelling that the policy has been voluntarily satisfying the formal criteria of the Stability and Growth Pact, and by a clear "safety margin" at that.
Generally I believe, a solid fiscal position is desirable in the EMU in order to generate some leeway for fiscal policy which can be used to "buy time" in the event of an unexpected recession - such as the one we face right now. In this respect, the highly debated Stability and Growth Pact, has probably done some good in reminding the governments of the EMU countries about the importance of fiscal discipline. Maybe, without the SGP, the fiscal leeway in many countries would be even less than currently.
To summarise, the Finnish EU and EMU membership seems to have fulfilled most of its promises, and most of the fears have not materialized. There is a very broad consensus among Finnish economists and policymakers that the underlying stability of the economy is now much better than it used to be in the past, and that the policy trade-offs are much more favourable than they used to be. It is, of course, difficult to say, what exactly is due to the EU or EMU membership and what is due to other factors. The past fourteen years have been good times for Finland. The economic development has been strong and also relatively stable despite the large swings in the global economy. In this sense EMU has improved the resilience of the Finnish economy. I dare say that the overall outcome of the whole EU-membership has been very positive for Finland.
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Let me conclude with just a couple of words about the current economic situation in Finland, even though any assessment or outlook is filled with uncertainties.
The direct impact of the financial crisis on Finnish banks was rather limited. Among other things counterparty risk has increased. As the economic situation has weakened, credit risk has increased at the same time as income has decreased. So far the credit losses have been minor. According to the analysis of the Finnish Financial Supervisory Authority (FIN- FSA), the Finnish banking sector remains solid but its profitability has declined.
Banking sector faces some challenges, however. Banks should be able to compensate the financial gap following drying of other sources of finance, in particular for firms. Many companies, in particular larger ones, used to raise finance directly from the commercial paper market, which now is not functioning well. Consequently, these big companies now turn to banks for their needs, which phenomenon causes an increased demand for bank loans, and may begin to crowd out lending to small and medium sized companies. Therefore, we hope that banks make use of the available means (state guarantees, capital loans), offered them by the government, to strengthen their lending abilities.
Albeit the financial crisis has not had a major impact on the Finnish banks directly, the Finnish economy is of course not immune to its indirect effects, on the contrary. The global recession is having a big impact on the open Finnish economy – the share of exports in our GDP is about 46 per cent. In addition, because the share of investment goods is relatively high in our exports, and because investments are the expenditure category most severely hit by the recession, the Finnish exports are affected, as is the domestic construction investment.
The forecast of the Bank of Finland from last November sees a slowdown of the GDP from the growth of 2.1 per cent last year to -0.5 per cent this year. With regard to growth, households and their consumption behaviour is now in a key role. According to our projections, in a couple of years the savings ratio of households, currently negative, turns positive as employment starts to decline. However, households' real income will increase quite favourably because of generous and long wage agreements combined with declining inflation. Thus, those households who can rely on their jobs, do not need to change their consumption or investment behaviour.
In my view, it is important to avoid encouraging excessive pessimism, although the macroeconomic projections will most likely get somewhat grimmer yet. With regard to Finland, we still have in our memories the severe crisis of the beginning of 1990s, when our GDP declined by more than 10 per cent in just two years and the unemployment rate rose to about 17 per cent. It is important to point out that nobody in Finland is foreseeing a repetition of that. Without underestimating the obvious seriousness of the current recession, I also believe that the cycle ahead of us is still a cyclical one, by its nature, at least if the international policy response to it is adequate and cooperative so that the rise of "economic nationalism" and global protectionism are avoided.
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