European Primary Dealers Association Second Annual European Government Bond Summit



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Bruxelles, 25 October 2007

Ladies and gentlemen,

It is my great pleasure to join you this morning.

I would like to begin by thanking Mark Austen and the EDPA for inviting me to address the European Government Bond Summit for the second year running.

These are certainly interesting times to be discussing financial market related issues. Let's have a look at the situation.

The financial turmoil of the last months is not yet behind us and we are still assessing the impact on the real economy.

This turbulence is also providing us with important indications of how financial markets work and where more action is needed.

Even if government bond markets have been less affected, they have not escaped the turmoil altogether and it is worth drawing some lessons from this experience.

Therefore this morning I also want to touch on some of the remaining weaknesses in government bond market functioning.

Economic situation

First, let me give you some quick comments about the current economic situation.

Over the last two years, Europe has been enjoying a period of stronger growth and impressive job creation. Around 3.5 million additional jobs were created in 2006 alone.

Unemployment has fallen to the lowest level in 15 years. Both employment and real GDP growth in the EU has outpaced that of the US in four successive quarters.

There is no doubt that the economy has been heading in the right direction.

But since last August we face a rather more uncertain economic future.

In our September forecast for 2007, we revised our growth projections downwards, to 2.8% of GDP in the EU and 2.5% in the euro area.

These results are quite similar to the previous ones.

But our fully-fledged autumn forecast, which will be released on 9 November, will give us a clearer picture of the impact of the turmoil. Already it is apparent that the economic outlook for the next two years will be somewhat less favourable than we expected before the summer.

The EU growth rate is likely to be influenced by the tightening of financing conditions worldwide, as well as by high oil prices, rising commodity prices and weakness in the US household sector.

Downside risks to the growth outlook have now obviously increased due to the events in the financial markets, a fact that was underlined by last week's G7 and IMF meetings.

Nevertheless, I continue to see relatively strong economic fundamentals both in the euro area and in the EU, which should help cushion the impact of the current uncertainties.

Among the supportive factors are improved productivity growth, well-behaved wage inflation and solid corporate balance sheets. These factors should give some support to corporate investment. At the same time, very rapid employment growth should – under normal circumstances - translate into stronger consumption growth.

Fortunately, in spite of the US slowdown, the global environment remains relatively favourable. The IMF forecast for the world's GDP growth is 5.2% this year and 4.8% for 2008. If these figures are confirmed, we will be in our fifth consecutive year with global growth at or above 4.8%.

Our estimates suggest that EU exports are more affected by global trade developments than by movements in the exchange rate. It bodes well, therefore, that the outlook for global trade is for continued robust growth thanks mainly to the booming emerging market economies.

For instance, according to the IMF estimates, China will contribute next year more than the euro area or the US to global growth, in market prices terms.

Financial market situation

Nevertheless, the present turbulence has spread a lack of confidence in the financial markets and beyond in a manner and intensity that was not foreseeable.

To restore confidence, policy input needs to be provided to financial markets in order to establish a common framework that will help prevent a repeat of the current episode.

With this aim, and following what we have learnt from the current turmoil, the Ecofin council decided this month on which areas policy action must be focused:

The first set of issues to be addressed relates to transparency. Financial innovation has contributed to the efficiency of financial markets by facilitating the spreading of risk. However, it has created challenges for market participants and public authorities alike in identifying risk exposures within financial institutions and across the financial system. In this context, an important feature of the recent turbulence has been a lack of comprehensive information on exposures to the markets for complex financial products.
A second set of issues relates to valuation and the accounting treatment of assets. The main responsibility in this area certainly lies with the institutions holding the assets. However, more work is needed on standards to ensure reliable valuation of assets, particularly of those where markets are potentially illiquid in times of stress.
A third set of issues relates to strengthening the prudential framework, risk management and supervision in the financial sector. It is essential that arrangements for safeguarding financial stability are kept up to date. EU Finance Ministers have agreed on common principles to enhance the ability of authorities to respond jointly in serious disturbances in EU financial markets. Before the end of the year, the Ministers will also address outstanding issues in the framework for cross-border prudential supervision, when the so-called Lamfalussy framework is reviewed.
A final set of issues relates to improvements in financial-market functioning. The objective here is to obtain a better insight into the incentive structures of the various actors in financial markets. In this context, the role of credit rating agencies in the area of structured finance will come under particular scrutiny.
Work on all of these issues is to be completed by the end of 2008, at the very latest. These issues are wide-ranging and affect banks, investors and regulators alike and consequently have to be dealt with in a comprehensive and coherent manner. Notably, given their global nature, these issues will also be dealt in key international fora, such as the Financial Stability Forum.

The discussion at the Washington meetings last week showed convergence with the analysis developed in the ECOFIN Council, also in terms of policy prescriptions.

Strengthening the role of financial markets

Let me turn now to consider the issue of government bond markets which will no doubt be of particular interest to you.

Perhaps one of the most striking lessons from the current turmoil is that liquidity is strongly linked to the confidence of market participants. Should it 'dry up,' disruption is spread throughout the financial system.

Ensuring that markets are efficient and liquid should be high on our priorities as it guarantees stability and brings important benefits to the wider euro area economy. This is no less the case for government bond markets:

Firstly, government bond markets are a necessary condition for a modern and developed financial system in the euro area. Bond markets represent an important, quasi risk-free asset class, which serves as a necessary benchmark for pricing other higher risk assets. Their efficient functioning provides the basis for a diversified financial structure, thereby helping the financial system to better perform the essential functions of allocating resources by intermediating savings to investment and managing risks.
Secondly, efficient and liquid government bond markets make the euro area an attractive location for investment. This is all the more important at a time of global liquidity and increasing reserves.
And thirdly, they support the role of the euro as an international currency thereby contributing to a balanced functioning of the international financial system.
Successes of the euro-area government bond market

In light of these benefits, the impressive progress of euro-area government bond markets since the introduction of the euro is highly welcome. Indeed, we consider it one of the best examples of Europe's financial integration and development.

The euro area bond market has experienced a massive expansion over the past ten years, and now rivals the markets for US Treasuries and Japanese government bonds. Today it plays a major role in attracting an increasingly international investor base.

Using both economic and market-based measures, the euro-area government bond market can be classified as significantly integrated. The different national bond issues have become close substitutes and their price has converged substantially. Holdings of different national issues now seem well diversified across euro-area investors. Moreover this large euro-area investor base allows national issues to be bought and sold without significantly distorting prices.

Various factors explain this rapid progress:

For one, the stability oriented framework of EMU has ensured a remarkable performance in terms of inflation and fiscal discipline over the last 10 years. This has made bonds issued by euro area Member States a very safe investment.
Second, harmonising the basic characteristics of issuance - such as interest-rate calculations and quotation basis, has helped drive integration. Euro area debt managers can take considerable credit for this achievement.
The availability of large and integrated cash market for government bonds in the euro area has also had many positive spill-over effects. For example, it has spurred the development of markets for related derivative instruments, facilitating risk management among investors and government debt managers alike.

The benefits of an integrated government bond market have not been confined to the euro area. Government debt issuers from outside the euro area have also benefited. In particular, the recently acceded Member States have been able to exploit a broader investor base and comparably low financing costs by complementing their domestic issuance with issuance denominated in euro.

Remaining weaknesses in the euro-area government bond market

The achievements of the euro-area government bond market are clear. But while the foundations for delivering greater efficiency and liquidity have been put in place, there is evidence that we can improve further the functioning of this market.

Let me give you an example from the recent financial turmoil: The effects of the turbulence have not been uniform across the euro-area government bond market and this has been reflected not only in increased volatility in yields, but also in increased spreads between bonds according to their issuer. Spreads to the bund have recently increased in some euro area countries.

These changes have been the result of flight–to-quality effects - even between relatively risk-free assets. It is not entirely unexpected, but it confirms that government bonds within the euro area are not perfect substitutes, even if they share the same or similar credit ratings. The liquidity of different national issues clearly remains an important factor for investors.

There are clear opportunity costs of having fragmented supply side in the euro area government bond market. While the euro-area market well exceeds the US Treasuries market in terms of outstanding stock, these two markets are not seen as equals by international investors.

Evidence suggests that investors distinguish between the two markets in terms of overall liquidity, contrasting the rate of turnover in the US Treasury cash market with a much lower rate in the euro-area market.

This reduced liquidity in certain segments of the euro area government bond market can especially penalise small issuers.

Concern about such asymmetry in liquidity has led the market to settle for a very specific trading model for the euro-area government bond market. This trading model - based on market-making agreements - ensures that there are sufficient buyers and sellers of all euro-area government bonds irrespective of their size of issuance.

This model has served the euro area well since 1999. In particular, it has helped to preserve the liquidity of smaller issuers and so guaranteed the smooth transition to the single-currency environment. There have been some drawbacks, however.

In addition, the trading model has come under the spotlight because of the competition concerns raised by having one dominant trading platform. It will also need to be reassessed in light of the Mifid framework. Mifid, which will be fully operational next week, will promote competition between trading platforms in all financial instruments, including government bonds.

Towards improving the functioning of the euro-area government bond market

From what I have just said, it seems increasingly clear that however successful the euro-area government bond market has been in terms of integration, it may be under-performing relative to its potential. This should concern us all. The functioning of this market has a specific importance to you as managers, traders and investors, but it also has a broader economic significance to which I have to pay attention.

This is why we must pursue all efforts to promote progress towards deeper integration within this market but also within the financial sector as a whole.

The forthcoming review of Lamfalussy which the Commission will launch in November will be an important step to this end. It will take stock of the functioning of the Lamfalussy framework and present further ideas for improving it, including on supervisory convergence. This will provide the basis for a political debate at the December ECOFIN with a view to formulating concrete recommendations in 2008.

From a macroeconomic perspective, the experience we have garnered of the functioning of EMU has shown how important financial markets are for adjustment within the euro area.

Therefore financial markets will form a major focus of an ongoing review of the functioning of EMU, the results of which I will present next May.

Notably, the review will assess how financial market integration can contribute to a smoother and more efficient economic and monetary union. In this context, in depth analysis of the euro-area government bond market may lead us to identify possible recommendations for improvements.

Conclusion

Ladies and Gentlemen, let me conclude.

We have managed to weather the recent financial turbulence without suffering major damage. Sustaining confidence is vital to ensure that sound fundamentals in Europe translate into solid growth over the coming years.

Financial markets have been at the origin of this turbulence which is impacting on the real economy. But taking the decisive steps identified by the ECOFIN council will help safeguard against similar risks in the future. Better transparency and liquidity management will also contribute to strengthen the functioning of financial markets and inevitably also the government bond market.

The euro area government bond market will continue to be a cornerstone of our process towards an integrated financial system for Europe. As for the rest of the financial sector, we should continue to explore how the remaining weaknesses in the government bond market can be resolved.

Thank you for your attention and I wish you a successful conference.


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