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The Brussels Economic Forum What kind of policies should the new Member States apply to optimise their speed of convergence? Banco de Portugal VÍTOR CONSTÂNCIO Brussels, 23d of April 24

I. INTRODUCTION SUMMARY 1. Benefits and conditions of successful integration 2. Situation of acceding countries. Problems and risks II ERM participation 1. The role of ERM and the portuguese experience 2. Interventions, interest rates and realignments 3. Credibility and fiscal policy III. Monetary Union: risks and policy responses 1. Experience of overheating in Euro Area countries. An unavoidable adjustment to a new intertemporal equilibrium. 2. Inflation differentials in the Euro Area 3. Competitiveness and wage policy 4. Market driven demand booms and the external balance: the Portuguese case. 5. The role of fiscal policy and market based adjustments 6. Financial stability risks 7. Structural reforms and potential growth

8.% GDP per capita (PPS in % of EU-15 average) 75.% 7.% 65.% 6.% Portugal 55.% 5.% 45.% EU entry EMS entry Euro entry 81 83 85 87 89 91 93 95 97 99 21 23 Source: Eurostat

Benefits and conditions of successful integration Conditions of successful integration: High degree of trade integration Synchronization of economic cycles (similarity of economic structures, institutions ) Good alternative mechanisms of adjustment: flexible markets with flexible setting of wages and prices anti-cyclical use of national fiscal policy developed financial sector well integrated with the monetary area people mobility fiscal federalism

Cyprus Czech Rep. Estonia Hungary Latvia Lithuania Malta Poland Slovakia Slovenia Cyprus Czech Rep. Estonia Hungary Latvia Lithuania Malta Poland Slovakia Slovenia Ireland 78 Spain 88 Portugal 91 Greece 97 Ireland 78 Spain 88 Portugal 91 Greece 97 MAASTRICHT CRITERIA INFLATION: DIFFERENCES TO THE REFERENCE VALUES MAASTRICHT CRITERIA BUDGET DEFICITS: DIFFERENCES TO THE REFERENCE VALUES 8 6 4 2-2 -4-6 6 5 4 3 2 1-1 -2-3 -4

PRICE LEVELS AND INFLATION EU-15 average Portugal 1991 Price levels ( 21) 1. 73.9 Inflation differentials with EU15 if price levels converge to Portugal s in (1) 5 years 1 years Czech Rep. 46.9 9.5 4.6 Estonia 51.2 7.6 3.7 Hungary 48.7 8.7 4.3 Latvia 47.9 9.1 4.4 Lithuania 52.1 7.2 3.6 Poland 6.9 3.9 1.9 Slovakia 42.1 11.9 5.8 Slovenia 66.6 2.1 1.1 (1) Source: OECD and De Nederlandsche Bank

Total revenue 5 Total revenue % GDP 45 4 35 Greece Hungary Portugal Poland Czech Rep Lithuania Slovakia Slovenia Spain Italy Euro 3 5 1 15 2 25 GDP per capita 1 euros Source: AMECO Autumn 23, BP calculations Regression line based on OLS estimate over the 15 EU countries For euro area countries average 1995-23, for CEC's 23 estimates

Primary expenditure 5 Czech Rep Primary Expenditure % GDP 45 4 35 Latvia Hungary Malta Poland Portugal Lithuania Slovakia Slovenia Greece Spain Euro Italy 3 5 1 15 2 25 GDP per capita 1 euros Source: AMECO Autumn 23 Regression line based on OLS estimate over the 15 EU countries For euro area countries average 1995-23, for CEC's 23 estimates

Potential problems and risks Main risks: o o o o Pressures for higher inflation. Strong Balassa-Samuelson effect. High growth dynamics and catching-up of price levels. Real appreciation above the equilibrium exchange rate. Possible real interest rate misalignment and consequent credit boom. Large capital inflows Boom and bust cycle with recession and hysteresis Overheating in asset markets (housing and stock exchange) Loss of competitiveness and current account unbalance Financial stability risks These risks may occur before and after the euro adoption. To optimize the speed of convergence countries must make proper use of ERM II participation, avoid the worse consequences of overheating and continue reforms to improve their growth potential and increase total factor productivity.

2.% INFLATION 15.% 1.% Portugal 5.% EU.% 86 88 9 92 EMS entry 94 96 98

Escudo Exchange Rate v. the Deutsche Mark, Interventions and the Overnight rate 14 14 12 1 12 8 1 6 4 2 8 6 4-2 -4 Jan-9 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Dez-98 2-6 Overnight rate Intervention Index PTE/DEM Central rate Band Band Source: Adão A. and J. Pina (23) Boletim Económico do BP, June

Budget Deficits in % of GDP 6 4 2-2 -4-6 -8-1 EMS entry Primary deficit Overall deficit 1989 1991 1993 1995 1997 1999 21 23

Successful and flexible use of ERM Determined and simultaneous use of interventions and interest rates with a sense of the primacy of the exchange rate objective During the period there were 2,4% of days with active intervention with 91,5% of success. Flexible use of realignments that offset initial real appreciation and did not affected the disinflation process. Central rate was not seen as future conversion rate. The escudo stayed a long period in ERM gaining stability as policies gradually made the target of adopting the euro more credible. There was a disciplinary effect. The initial success with disinflation was helped by very high real interest rates and by the the european recession of the early 9 s. During the first years of ERM participation there was no demand or credit boom 14 12 1 8 6 4 2-2 -4-6 Escudo Exchange Rate v. the Deutsche Mark, Interventions and the Overnight rate Jan-9 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Dez-98 Overnight rate Intervention Index PTE/DEM Central rate Band Band Source: Adão A. and J. Pina (23) Boletim Económico B.P, June. 14 12 1 8 6 4 2

II. 1. Experience of overheating in Euro Area countries. An unavoidable adjustment to a new intertemporal equilibrium. The change of regime with the adoption of the euro: Increased substitutability of financial assets Consolidated reduction of the cost of capital Increase in wealth and reduced liquidity constraints Different meaning of the current account and primacy of credit risk. These features create the conditions for demand/credit booms and possible overheating. The drop in interest rates increases wealth, reduces liquidity constraints and favours consumption intertemporal smoothing. The reduction of the cost of capital and the prospects of higher growth as a result of goods markets integration, lead to investment growth The counterbalancing policies are: Anti-cyclical use of Fiscal Policy; Realistic wage policy; Good Prudential Supervision; Flexible and competitive price setting mechanisms

Greece EU 12 EU 12 Spain Spain Greece Portugal Ireland Portugal Ireland etherlands 6 5 4 3 2 1 6 5 4 3 2 1 Netherlands Experience of overheating in Euro Area countries. Inflation (21) Output gap (21)

Experience of overheating in Euro Area countries. Real long term interest rate - change from 1996 to 21-1 -2-3 -4-5 -6 Spain 25 Portugal Greece Ireland Netherlands EU 12 Credit to residents (excluding General Government) Average rate of growth 1998-21 2 15 1 5 Ireland Portugal Greece Spain Netherlands EU 12

Experience of overheating in Euro Area countries. 14 12 1 Housing prices percentage change from 1995 to 21 8 6 4 2 Ireland Netherlands Portugal Spain Other EU12 Stock Exchange índices in Portugal 4 35 3 25 2 15 1 5 Dez-94 Dez-95 PTE PSI2 FT EU1 Dez-96 Dez-97 Dez-98 Dez-99 Dez- Dez-1 S&P 5 Dez-2

Inflation dispersion in the Euro Area and the USA Source: ECB

Unit Labour Costs developments and incomes policy Trends for higher inflation should not be aggravated by wage developments that could lead to a loss of competitiveness. In a monetary union the adjustment variable would be unemployment. Necessary to apply adequate guidelines for wage negotiations: a) wage growth differentials with the euro area should not deviate much from the differential in real productivity growth. b) wage negotiations valid for two years (stability of contracts) 14 12 1 8 6 4 2 Nominal Unit Labour Costs (increase in % since 1995) EU15 Portugal AC 1 Hungary Poland Slovenia Estonia Czech Rep Slovakia Latvia Lithuania Malta Cyprus Source: European Commission, Economic Forecasts, Spring 24 4 3 2 1-1 -2-3 Euro area Portugal Source: IMF, IFS Real Effective exchange rate (increase in % since 1995) Czech R. Poland Hungary Malta Slovakia Cyprus

Portugal:Short and Medium term real interest rates 1 8 6 4 A credit boom developed after the drop in real interest rates became significant and was seen as permanent as participation in Monetary Union grew more certain. 2-2 92 3% 25% 2% 15% 1% 5% % 93 94 95 96 97 98 99 2 21 Portugal: Credit to the Private Sector (Annual growth rates) 22 23 92 93 94 95 96 97 98 99 2 21 22 23

Household debt, interest charges and total financial charges in % of Disposable Income 12 1 8 6 4 2 1995 1997 1999 21 23(e) Debt Interest Total service Debt of Firms and interest charges (% of GDP) 1 8 6 4 2 1995 1996 1997 1998 1999 2 21 22 23 Debt Interest charges

Portugal: Investment and Savings Rate (% of GDP) 3 35 25 2 15 1 5 Investment Savings 3 25 2 15-5 -1 86 87 88 89 9 91 92 93 94 95 96 97 98 99 External deficit 2 21 22 23 1 5

Net lending (+) or Net Borrowing(-) by the Public, Private and External sectors 1 8 External 6 Private sector 4 2-2 -4 Public Sector -6-8 9 91 92 93 94 95 96 97 98 99 2 21 22 23 External = - (Current Account +Capital Account)

2 21 22 23 2 21 22 23 1999 1998 1999 28 26 24 22 2 18 GREECE 1996 1997 1998 SPAIN 1995 1996 1997 1995 26 24 22 2 18 16 199 1991 1992 1993 1994 199 1991 1992 1993 1994 Adjustment to a new economic regime. Investment and Savings (% of GDP). Source: AMECO

GDP and Domestic Demand growth. Current Account in % of GDP 16 11 Domestic demand External demand 6 1 GDP -4-9 External deficit -14 89 91 93 95 97 99 21 23 25

6 3 Primary deficit Budget Deficits in % of GDP -3-6 -9 EMS entry Overall deficit 1989 1991 1993 1995 1997 1999 21 23 45.% Current Primary Expenditures (% of GDP and real growth rates) 3.% 15.%.% 199 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 21 22 23

Fiscal Revenue and Expenditure Multipliers Austria Belgium Finland France Germany Greece Ireland Spain Portugal QUEST Revenue Expenditure.1.5.1.5.3.4.1.5.2.4.1.5.1.4..7.1.5 Source: P. Hoeller et al (22) Overheating in small euro area economies: should fiscal policy react? OCDE WP nº 323, Feb 22

«Simulations suggest that market based adjustments is fairly rapid in the small ecoconomies in returning demand shocks to baseline. In this respect, deeper integration (stronger trade linkages, greater migration and an anchoring of expectations in area wide inflation) would help to smooth adjustment.... Concerning fiscal policy, the automatic stabilisers help to smooth the impact of a demand shock, but only to a limited extent and the fiscal multipliers are fairly small in open economies. With low fiscal multipliers, big swings in expenditure or revenues would be needed to damp the cycle. Such volatility would undermine the effectiveness of fiscal policy and the credibility of a rules-based fiscal policy. (P. Hoeller et al. (22) Overheating in small euro area economies: should fiscal policy react? OCDE WP nº 323, Feb 22)

Simulation of a reduction of the Budget Deficit in 2 p. p. in 21 by reducing expenditure from 1998 onwards Difference from base scenario Annual Growth rates Primary expenditure -2.8 p.p. Real GDP Inflation -.8 p.p. -.6 p.p. Deficit value in 21 Current Account -2 % of GDP (from 8 to 6 %)

DEMAND BOOMS AND THE ROLE OF FISCAL POLICY 2. Fiscal policy, in spite of its limitations, is essential to counter the more negative effects of a demand/credit boom and partially smooth the cycle. In particular, the Portuguese experience shows that the following points are important: a) Maintain at all times an anti-cyclical fiscal policy. A prudent approach requires that real budget consolidation with a deficit well bellow 3% should be achieved before adopting the euro. b) The structural deficit should not exceed the level compatible with the full play of the automatic stabilizers without breaching the 3% limit. c) Introduce structural reforms early on to contain future budget pressures. Adopt efficient institutional procedures for the preparation and implementation of the budget. For instance, obtain multi-year expenditure commitments from Government and Parliament; or in view of the need to invest in infrastructure and the limitations of the Stability Pact that does not allow the use of debt over the cycle to finance those expenditures, prepare rules for PPP initiatives and project finance that ensure real transfer of risk, transparent accounting of multi-year commitments and limits to future expenditures.

DEMAND BOOMS, RISKS FOR INFLATION AND THE THE CURRENT ACCOUNT 1. The problem is not the current account unbalance as such if it is the result of one-time rational adjustment to a new intertemporal equilibrium. Unbalances that stem from a rational adjustment by private agents to a new steady state, have market driven selfcorrecting mechanisms that operate through change of competitiveness and the consequences of budget constraints monitored by the financial sector. 2. Serious problems may, nevertheless, arise if the macroeconomic unbalances become sizable enough to create the following effects: a boom/bust economic cycle with significant recession and hysteresis; overheating in asset markets; loss of competitiveness resulting from excessive inflation and ULC misalignment; financial stability risks.

I. INTRODUCTION SUMMARY 1. Benefits and conditions of successful integration 2. Situation of acceding countries. Problems and risks II ERM participation 1. The role of ERM and the portuguese experience 2. Interventions, interest rates and realignments 3. Credibility and fiscal policy III. Monetary Union: risks and policy responses 1. Experience of overheating in Euro Area countries. An unavoidable adjustment to a new intertemporal equilibrium. 2. Inflation differentials in the Euro Area 3. Competitiveness and wage policy 4. Market driven demand booms and the external balance: the Portuguese case. 5. The role of fiscal policy and self-correcting mechanisms 6. Financial stability risks 7. Structural reforms and potential growth

15 Financial Account Percentage of GDP 1 5-5 -1-15 (+) Net inflows (-) Net outflows Monetary Financial Institutions Monetary Authorities Public Administrations Non-monetary Financial Institutions + households Total -2 1996 1997 1998 1999 2 21 22

Portuguese consolidated Banking System «Portuguese banks are well managed, have strong internal management systems and good credit risk management, and resemble their European counterparts in terms of product range, innovation, and sophistication.... Portuguese banks have maintained sound and fairly consistent profitability throughout the economic cycle.» (Standard & Poor s, April 24, - Banking Risk Analysis: Portugal) ) Total Assets in % of GDP Transformation ratio (Credit /Deposits) Cost/Income ratio Non Performing Loans (% of total credit) Provisions in % of Non Performing Loans Exposure to Emerging Countries (% of Assets) Net Interest Income (% of Assets) Return on Assets (ROA) Return on Equity (ROE) Solvency Ratio 23 229 % 129 % 5.4 % 2.41% 17 % 1.7 % 2.1%.81% 15.8% 1.1 %

I. INTRODUCTION SUMMARY 1. Benefits and conditions of successful integration 2. Situation of acceding countries. Problems and risks II ERM participation 1. The role of ERM and the portuguese experience 2. Interventions, interest rates and realignments 3. Credibility and fiscal policy III. Monetary Union: risks and policy responses 1. Experience of overheating in Euro Area countries. An unavoidable adjustment to a new intertemporal equilibrium. 2. Inflation differentials in the Euro Area 3. Competitiveness and wage policy 4. Market driven demand booms and the external balance: the Portuguese case. 5. The role of fiscal policy and self-correcting mechanisms 6. Financial stability risks 7. Structural reforms and potential growth

CONCLUSIONS 1. Adequate use of ERM II with a sense of the primacy of the exchange rate objective. Monetary policy cannot be conducted as a pure inflation targeting regime and that should be clear to the markets. The initial central rate should not be seen as the future conversion rate into the euro 2. Permanent anti-cyclical use of Fiscal Policy, building-up a very solid and cautious position before joining the euro. 3. Realistic wage policy to avoid excessive real appreciation in terms of relative Unit Labour Costs. 4. Strong prudential supervision of the banking sector, taking seriously financial stability risks 5. Implement structural and institutional reforms to ensure flexible and competitive markets. 6. Continue to improve Institutions necessary to increase the rate of growth of potential GDP