The European System of Central Banks from the experience of the Central Bank of Luxembourg - Yves Mersch

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on the occasion of the Luxembourg Financial Centre Conference

New York, 13 May 1999

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Yur Royal Highness,

It is a particular honour and a privilege for all of us to witness once again your dedication to the economic and social development of the Grand-Duchy as chairman of the Board of Economic Development.

We also feel encouraged by your interest in financial area structural developments and the new bonds they allow to create on the global level.

Be assured of our deep appreciation of your presence today.

Ladies and Gentlemen,

It was often believed that, out of the fifteen European Union countries, Luxembourg was the one for which it was most easy to move towards monetary union, as it was the only Member State which fully respected the convergence criteria of the Maastricht Treaty well before the launch of the single currency.

Well this might be true if you refer to the fiscal criteria, since Luxembourg has always avoided large debts and public deficits. Furthermore, from the inflation point of view, the situation of a small open economy was naturally in line with the inflation level of surrounding countries.

There was however, curiously, another area where Luxembourg struggled more than its neighbours, and that was on the institutional level. According to the Treaty of Maastricht, Luxembourg had to establish a central bank.

In this context, Parliament was faced with the sensitive issues of the independence of the Central Bank together with the elimination of monetary financing of the State. Today, the independence of the Central Bank still seems to be a thorn in the flesh for many politicians. That is why I usually avoid to comment on this subject. I just would like to refer to a story that was told by a fellow central banker from the G-7. He once explained to the public the decision about interest rates of his board like this:

"Government has over the last time consistently exerted public pressure on the central bank to lower the interest rates, but you know we are entrusted with statutory independence. Trade unions and employers, they also have called upon us to lower interest rates, but you know we enjoy functional independence. Even academics seemed to have united to insist on the lowering of interest, but again you know, we are committed to personal independence. That is why, Ladies and Gentlemen, we have decided today, in all independence, to lower the interest rates."

Anyway, I would recommend to all of you to read the excellent booklet on the matter of central bank independence published by Alan Blinder, who is certainly a household name in this room.

For my part, I will share with you some personal thoughts about the first four months of the emerging new currency in Europe with a particular view from the Luxembourg side.

Royal Highness, Ladies and Gentlemen,

Rome, as everyone knows, was not build in one day. Yet this seems to be exactly what is expected by many academics from the euro construction.

Many criticised the excessively long period between the conclusion of the Maastricht Treaty and the implementation of the euro system. It was very often the same who criticised the insufficient democratic legitimacy of the currency. The fact is, that no other currency has been created by a democratic process in eleven member countries, voted by eleven Parliaments backed up by referenda in several countries.

Many disbelieved the capacity of Europe to rein fiscal profligacy.

The fact is that the fiscal adjustment that Europe had to undergo, was necessarily an evolutionary process if it was to be done by Governments, which had to be democratically elected every now and then in eleven different countries. Yet deficits were cut, privatisation was widespread, debts turned around. Far not enough, yet more than critics anticipated.

Many also point to institutional flaws in the European System of Central Banks. They bemoan an insufficient degree of concentration as if Europe was a centrally governed unitary State, without understanding that the monetary side is the first area where political integration in Europe has reached areas of policy making comparable to a Federal Government decision-making, while all other areas of policy-making remain subject to eleven distinct decision-makings, with at most prior co-ordination or exchange of views at European level.

Coming from the smallest European country, it is of course particularly interesting to see that the "one man, one vote principle" that underlies decision-making at European monetary level, is considered as undermining the efficiency of decision-making.

Interestingly, these statements are never ever accompanied by any examplative fact; a seventeen members Council, must be more unruly than a Milosevic's style system . I agree that the latter in terms of time saving decision-making is probably swifter. But in view of merging eleven different financial structures and cultures, a centralised system could only have led to its own down fall.

We therefore deliberately opted for a decentralised system, allowing each financial institution direct access to central bank money rather than acting through a few centralised large money market banks with a quasi monopolistic situation. The best way to respect the existing financial landscape, was to act through the established channels which were those existing at national level.

What counts however in terms of monetary policy is that the attribution of liquidity through the weekly tenders, or fortnightly tenders are not taken by the seventeen members of the Governing Council but are considered to be management's decision by the Executive Board.

Liquidity distribution decisions are highly centralised in the Eurosystem, even if implementation is decentralised through national collection of demand as well as distribution of supply.

But even implementation obeys common rules. Eligible assets as eligible counterparties are subject to a common set of quality standards, which are the same throughout the euro zone.

The repetition of facts to the contrary even in serious publications is evidence to the fact that this new currency needs more explanation. I would not exclude that some misperception about alleged disfunctionings of the euro and the comparison with different cultural environments might have contributed to the recent exchange rate evolution.

My guess is still that we achieve a smoother and faster acceptance of the euro than was needed in case of the dollar of the Federal United States.

It is, however, also undeniable that with the advent of the euro we will undergo changes of a structural nature in the European financial markets, and that all the consequences of the single currency have not yet fully materialised on the road towards a single European financial market.

Let me state some areas of change inducing uneasiness.

The largest uncertainties are probably stemming from the change from eleven different statistical environments to one single statistical environment, which brings about a problem of continuity of series. In the most important of all statistics in monetary policy making, namely, the establishing of a harmonised consumer price index in the euro zone, we have made considerable progress, even if the question of overestimation of inflation is a common concern of all inflation measuring indexes.
The first data for the euro zone on monetary aggregates also have to be considered as influenced by the change in behaviour of economic agents with the introduction of the euro and we estimate that it will take some more months before we get a sufficiently satisfactory feeling about the different monetary aggregates.
A third area, were we are still in the process of improving our statistical instrument, is the area of balance of payments, where the aggregate national balances certainly overstate the existing surplus in Europe, and where first European wide figures only become available in the future.

But it is not only in the area of statistics where we experience the need for the dust to settle. The financial markets themselves also have to gain experience with a new environment and adjust to it.

Let's visit these markets in turn :

Immediately after the launch of the euro, it gained broad financial bases, not least because all public debt in the euro area was redenominated in euro during the weekend of the transition from the old monetary regime to the new currency, creating a domestic market which is around the same dimensions as are the fixed term securities in the United States. Four months after the start of EMU, the money market is already well integrated. This was one of the main sources of concern for the Eurosystem at the start of the year, as we were aware that creating an efficient single money market also depends upon the creation of a tight network of contractual agreements between market players across the euro area. The data on the money market transactions of the fifty-seven largest commercial banks in the euro area, which are processed daily for the computation of the overnight rates across the euro area are homogeneous with differences of only few bases points, mainly justified by the different liquidity needs of the credits institutions. The turnover of the open-night transactions in the euro money market of these fifty-seven banks, is in the range between 30 and 60 billion per day. Another indicator of the smooth functioning of the money market is a reduced use , which is now made of the two standing facilities offered by the Eurosystem to all our counterparts to deposit access liquidity or finance debit positions overnight. When the euro was launched, many banks were forced to have very extensive recourse to these facilities as they were not able to find counterparts in the broader market.
The integration of the money market across the area is supported by TARGET, the real-time gross settlement system of the euro area which processed in terms of value, a daily average of close to 1 trillion euro in March, nearly half of it represented by cross border transactions. Other wholesale payment systems operating across the euro area processed on average a total of 422 billion per day in March. With the removal of currency risk and its low interest rates the euro resulted to a source of dynamism in Europe's financial markets. This is particularly evident in bond markets worldwide where 44 % of all new bond securities in the world where issued in euro in the first quarter of 1999. A substantial improvement compared with the combined percentage of the former national currencies. It is true that the integration of the European capital markets has already started before the launch of the euro. The interest rate spreads of public debt have diminished and stabilised, thus reflecting the move towards the fiscal soundness by Governments within the framework of the Stability and Growth Pact. The spreads of Government debt do not reflect exchange rate movements between national currencies anymore. The differences are primarily related to differences in the debt structures, the liquidity of markets and other issues as the maturity profile. The evolution and the regular stability of the euro yield curve is also a signal of sound developments in these markets. This evolution shows the degree of liquidity and the quality of arbitrage allowing to attain the level of the American bond markets.
If we look at equity markets, a notable evolution is the creation of aggregate indices at the euro level, which allows investors to cover positions on the European zone rather than national markets. The euro was also the driving force behind recent alliances between exchange or derivative markets and the numerous mergers and acquisitions in the banking and the financial industry. As of today, we have another example to this effect in the area of securities settlement with the announced merger of an international clearing and settlement depository, namely, Luxembourg based CEDEL with the largest national CSD, Deutsche Börse Clearing, as well as the announcement by a French clearing house SICOVAM to join this new alliance.
So far the Eurosystem has no policy to "sell its own currency" to foreign monetary authorities. In addition it does not express views or recommendations to other monetary authorities on their foreign exchange rate orientations neither concerning their choices for the investment of reserves.

In fact we take the view that the euro will gain ground in the international financial markets on the basis of its own intrinsic merits :

a high degree of anti-inflationary credibility,

the effective persistence of its internal stability,

the setting up of broad an deep financial markets,

the strengths of its economy and the position of Europe as the world's leading trade partner.

The countries of the euro area today share a culture of monetary stability, fiscal soundnessand the respect of common rules of market oriented governance of the economy. For these reasons they enjoy a high degree of credibility.

The euro area or euroland is an area of almost 300 million people producing 15 % of world GDP, against 20 % for the United States and 8 % for Japan. It counts for 16 % of world exports and is thus the largest trading partner in the world economy.

In comparison the largest Member State of the euro area counts for only 4 % of world GDP and I am aware that Luxembourg counts for less than 0.1 %. In terms of monetary policy operations, the financial centre of Luxembourg represents between 4 % and 6 % of the euro zone.

From its introduction, the euro has become the second most important international currency behind the US dollar but far ahead of the Japanese yen. This is mainly attributable to the fact that the former currencies of the euro area played a more important role than the yen with respect to the different functions of international money.

How much the euro will gain as a medium of exchange, (vehicle and intervention currency), as a store of value (investment and reserve currency) or as a unit of account for quotation and pegging currency remains to be seen.

The pace of internationalisation of the euro is likely to be very depending on the above mentioned functions both in the private and official sector.

In principle two basic factors will play a role enforced with the international use of the euro: size and risk.

With regards to the size factor, increasingly integrated broad and liquid financial markets in the euro area may lead to lower transaction costs and thereby to widen products of the euro by investors, issuers and foreign traders.
Economic agents may use the euro to hedge their risk with portfolio diversification. If market participants and investors consider the euro as a stable currency and the euro area as a strong economy, they will hold euro assets to minimise risks in their international diversified portfolios.

As regards a future use of the euro official reserves, it may be expected that non euro area central banks will reassess their reserve management strategy in the light of improved global diversification opportunities offered by the new currency.

Luxembourg as a financial centre is not only accompanying the establishment and consolidation of the euro and its outside role, but participates in the structural evolution of European financial markets. The internationally oriented centre clearly views the euro as an opportunity to enhance the services needed for participating in the new institutional shoreline in Europe.

It sees its role in the creation of a European wide infrastructure as for example for clearing and settlement, or fund management in improving distribution networks, as well as in a front role in defining new products for the European and global investor, compared to the national products which have dominated and segmented our continent so far.

You shall hear more about it in the conference this afternoon.

Let me conclude with exposing my appreciation to the organisers of this venue!