ANNUAL REPORT 2004 - ecb.europa.eu · 3 ECB Annual Report 2004 CONTENTS FOREWORD 10 CHAPTER 1 ECONOMIC DEVELOPMENTS AND MONETARY ... 2.3 Accounting 116 3 FINANCIAL INTEGRATION 117

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ANNUAL REPORT2004

2004 20042004200420042004200420042004200420042004

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The cut-off date for the data includedin this report was 25 February 2005.

ISSN 1561-4573 (print)ISSN 1725-2865 (online)

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CONTENTSFOREWORD 10

CHAPTER 1ECONOMIC DEVELOPMENTS AND MONETARYPOLICY

1 MONETARY POLICY DECISIONS 16

2 MONETARY, FINANCIAL AND ECONOMICDEVELOPMENTS 192.1 The global macroeconomic

environment 192.2 Monetary and financial

developments 222.3 Price developments 432.4 Output, demand and labour market

developments 502.5 Fiscal developments 592.6 Exchange rates and balance of

payments developments 66

3 ECONOMIC AND MONETARYDEVELOPMENTS IN NON-EURO AREAEU MEMBER STATES 71

CHAPTER 2CENTRAL BANK OPERATIONS ANDACTIVITIES

1 MONETARY POLICY OPERATIONS,FOREIGN EXCHANGE OPERATIONSAND INVESTMENT ACTIVITIES 821.1 Monetary policy operations 821.2 Foreign exchange operations 871.3 Investment activities 88

2 PAYMENT AND SECURITIES SETTLEMENTSYSTEMS 892.1 The TARGET system 892.2 TARGET2 912.3 Cross-border use of collateral 92

3 BANKNOTES AND COINS 943.1 The circulation of banknotes and

coins 94

3.2 Banknote counterfeiting andcounterfeit deterrence 95

3.3 Banknote issuance and production 96

4 STATISTICS 994.1 Further improvements in the

statistical framework for theeuro area 99

4.2 New or enhanced statistics 1004.3 Government finance statistics 100

5 ECONOMIC RESEARCH 1025.1 Research agenda 1025.2 Research networks 1035.3 Macroeconometric modelling

of the euro area 104

6 OTHER TASKS AND ACTIVITIES 1066.1 Compliance with the prohibitions

of monetary financing andprivileged access 106

6.2 Advisory functions 1066.3 Administration of the borrowing

and lending operations of theEuropean Community 107

CHAPTER 3FINANCIAL STABILITY AND INTEGRATION

1 FINANCIAL STABILITY 1121.1 Financial stability monitoring 1121.2 Cooperation in crisis situations 114

2 FINANCIAL REGULATION ANDSUPERVISION 1152.1 Banking 1152.2 Securities 1152.3 Accounting 116

3 FINANCIAL INTEGRATION 117

4 OVERSIGHT OF MARKETINFRASTRUCTURES 1224.1 Oversight of large-value euro

payment systems andinfrastructures 122

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4.2 Retail payment services 1234.3 Securities clearing and settlement

systems 124

CHAPTER 4EUROPEAN AND INTERNATIONALRELATIONS

1 EUROPEAN ISSUES 1321.1 Policy issues 1321.2 Institutional issues 133

2 INTERNATIONAL ISSUES 1362.1 Key developments in the

international monetary andfinancial system 136

2.2 Cooperation with countries outsidethe EU 138

CHAPTER 5ACCOUNTABILITY

1 ACCOUNTABILITY VIS-À-VIS THEGENERAL PUBLIC AND THE EUROPEANPARLIAMENT 142

2 VIEWS OF THE ECB ON SELECTEDTOPICS RAISED AT MEETINGS WITHTHE EUROPEAN PARLIAMENT 143

CHAPTER 6EXTERNAL COMMUNICATION

1 COMMUNICATION POLICY 148

2 COMMUNICATION ACTIVITIES 149

CHAPTER 7ENLARGEMENT OF THE EUROPEAN UNION

1 SUCCESSFUL ACCESSION OF TEN NEWMEMBER STATES 154

2 RELATIONS WITH EU CANDIDATECOUNTRIES 158

CHAPTER 8INSTITUTIONAL FRAMEWORK,ORGANISATION AND ANNUAL ACCOUNTS

1 DECISION-MAKING BODIES ANDCORPORATE GOVERNANCE OF THE ECB 1621.1 The Eurosystem and the European

System of Central Banks 1621.2 The Governing Council 1641.3 The Executive Board 1661.4 The General Council 1681.5 Eurosystem/ESCB committees

and the Budget Committee 1691.6 Corporate governance 169

2 ORGANISATIONAL DEVELOPMENTS 1722.1 Human resources 1722.2 New ECB premises 173

3 ESCB SOCIAL DIALOGUE 175

4 ANNUAL ACCOUNTS OF THE ECB 177Management report 178Balance Sheet as at31 December 2004 180Profit and Loss Account for theyear ending 31 December 2004 182Accounting policies 183Notes on the Balance Sheet 187Notes on the Profit andLoss Account 195Note on the Allocation of Losses 198Auditor’s report 199

5 CONSOLIDATED BALANCE SHEETOF THE EUROSYSTEMAS AT 31 DECEMBER 2004 200

ANNEXES

LEGAL INSTRUMENTS ADOPTEDBY THE ECB 204

OPINIONS ADOPTED BY THE ECB 207

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DOCUMENTS PUBLISHED BY THE EUROPEANCENTRAL BANK SINCE JANUARY 2004 211

CHRONOLOGY OF MONETARY POLICYMEASURES OF THE EUROSYSTEM 217

GLOSSARY 219

LIST OF BOXES1 Trends in the financial investment of the

euro area non-financial sector in 2004 25Table: Financial investment of the

euro area non-financial sector 252 What could happen with the excess

liquidity in the euro area? 28Chart: Schematic presentation of how

excess liquidity may be used 283 Common trends in implied financial

market volatility 33Chart A: Implied financial market

volatility in the euro area 33Chart B: Implied bond and stock market

volatility in the euro area andthe United States 34

4 Were small and medium-sizedenterprises subject to less favourablefinancing conditions than largeenterprises in the euro area in 2004? 39Chart A: Changes in the credit standards

applied to the approval of loansor credit lines to non-financialcorporations 40

Chart B: MFI interest rate spreadsbetween small-sized loansand large-sized loans tonon-financial corporations 41

5 Oil prices and the euro area economy 45Chart A: Brent crude oil prices 45Table: Increases in Brent crude oil

prices over specific periods 46Chart B: Oil prices and the contribution

of energy components toHICP inflation 46

Chart C: Oil prices and the contributionof transport components toHICP inflation 46

6 Progress with structural reformsin EU labour and product markets 52

7 Potential effects of demographic changein the euro area 56Chart: Main demographic

developments in the euro area 568 Developments in general government

debt securities in the euro area 60Chart A: Euro area outstanding

government debt securitiesby issuing country in 2004 61

Table: Structure of amountsoutstanding of debt securitiesissued by euro areagovernments 61

Chart B: Long-term government bondyield spreads against Germany 62

Chart C: Changes in relative debt-to-GDP ratios against Germanyand changes in yield spreadsbetween 2001 and 2004 63

9 Fiscal policy and macroeconomicstability 64

10 Main elements of the exchange ratemechanism II 76

11 Eurosystem reserve managementservices 108

12 Research network on capital marketsand financial integration in Europe 118

13 Financial integration in the euro areacredit market 121

14 Standards for securities clearing andsettlement in the European Union 125

15 The Eurosystem mission statement 163

LIST OF TABLES1 Price developments 432 Labour cost indicators 493 Composition of real GDP growth 504 Labour market developments 545 Fiscal positions in the euro area 596 Real GDP growth in the non-euro area

EU Member States and the euro area 717 HICP inflation in the non-euro area

EU Member States and the euro area 728 Fiscal positions in the non-euro area

EU Member States and the euro area 749 Balance of payments of the non-euro

area EU Member States and theeuro area 75


10 Developments in ERM II 7711 Official monetary policy strategies of

the non-euro area EU Member States 7812 Payment traffic in TARGET 9013 Overall availability of TARGET 9014 Distribution of counterfeits by

denomination 9515 Allocation of euro banknote production

in 2004 9716 Key characteristics of the EU economy

including and excluding the newMember States 155

LIST OF CHARTS1 ECB interest rates and money market

rates 162 Main developments in major

industrialised economies 193 Main developments in commodity

markets 224 M3 and M3 corrected for the estimated

impact of portfolio shifts 235 Contributions to annual M3 growth 236 Short-term MFI interest rates on

deposits 247 Movements in M3 and its counterparts 268 Estimates of the money gap 279 Short-term interest rates and the slope

of the money market yield curve 3010 Three-month EURIBOR futures rates

and implied volatility derived fromoptions on three-month EURIBORfutures 30

11 Long-term government bond yields 3112 Long-term real bond yields and

break-even inflation rates in theeuro area 32

13 Major stock market indices 3614 Growth in actual and expected

corporate earnings 3615 Housing market dynamics and loans in

euro area countries 3716 MFI interest rates for lending to

households and non-financialcorporations 37

17 Debt-to-GDP ratio and growth in loansof households 38

18 Indicators of market-based financingcosts of non-financial corporations 39

19 Contribution to the annual rate ofgrowth of debt of non-financialcorporations 42

20 Balance sheet indicators fornon-financial corporations 42

21 Breakdown of HICP inflation: mainsub-components 44

22 Contributions to HICP inflation fromsub-components 44

23 Residential property price developmentsin the euro area 49

24 Breakdown of industrial producerprices 49

25 Sectoral compensation per employee 5026 Contributions to quarterly real GDP

growth 5127 Labour productivity 5528 Unemployment 5529 Nominal and real effective euro

exchange rates 6830 Current account balance and its

components 6831 Financial account balance and its

components 6932 Exchange rate changes of the euro

against EU currencies outside ERM II 7733 Bid and allotment amounts in weekly

MROs in 2004 8334 Liquidity factors and the development

of banknotes in the euro area in 2004 8435 Eligible marketable collateral 8536 Use of marketable collateral 8537 Total value of banknotes in circulation

between 2000 and 2004 9438 Total number of euro banknotes in

circulation between 2002 and 2004 9439 Number of euro banknotes in circulation

between 2002 and 2004 9540 Number of counterfeit euro banknotes

recovered from circulation between2002 and 2004 96

41 ECB Working Paper series: Journal ofEconomic Literature classification 102

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ABBREVIATIONSCOUNTRIES

BE BelgiumCZ Czech RepublicDK DenmarkDE GermanyEE EstoniaGR GreeceES SpainFR FranceIE IrelandIT ItalyCY CyprusLV LatviaLT LithuaniaLU LuxembourgHU HungaryMT MaltaNL NetherlandsAT AustriaPL PolandPT PortugalSI SloveniaSK SlovakiaFI FinlandSE SwedenUK United KingdomJP JapanUS United States

OTHERS

BIS Bank for International SettlementsBPM5 IMF Balance of Payments

Manual (5th edition)c.i.f. cost, insurance and freight at

the importer’s borderCPI Consumer Price IndexECB European Central BankECU European Currency UnitEEA European Economic AreaEER effective exchange rateEMI European Monetary InstituteEMU Economic and Monetary UnionESA 95 European System of Accounts 1995ESCB European System of Central BanksEU European UnionEUR eurof.o.b. free on board at the exporter’s borderGDP gross domestic productHICP Harmonised Index of Consumer PricesILO International Labour OrganizationIMF International Monetary FundMFIs monetary financial institutionsNCBs national central banksPPI Producer Price IndexULCM Unit Labour Costs in Manufacturing

In accordance with Community practice, the EUMember States and the accession countries are listedin this report using the alphabetical order of thecountry names in the national languages.

Since 1998 the ECB has organised a series of exhibitions entitled “Contemporary art from theMember States of the European Union”. Each exhibition aims to give ECB staff and visitors aninsight into the art of a particular EU country. Contemporary art has been chosen since itreflects the period in which Monetary Union has become reality.

Some of the artworks are purchased for the ECB’s art collection, which is to be expanded. Theeight pages which separate the chapters of this Annual Report show a selection of works fromthis collection.

Artist: Stephan JungTitle: P.WP1, 2002Material: Oil on canvas, Format: 230 × 265 cm 14

Artist: Isa DahlTitle: “eben still”, 2004Material: Oil on canvas, Format: ø 190 cm 80

Artist: Jacob DahlgrenTitle: Krakow, 2002Material: Yoghurt pots mounted on aluminium, Format: 184 × 148 × 10 cm 110

Artist: Ana Luísa RibeiroTitle: Untitled, 2002Material: Oil on canvas, Format: 150 × 230 cm 130

Artist: Xenia HausnerTitle: Traumspiel, 2004Material: Chromolithograph on handmade paper (ed. 16/25), Format: 96 × 129 cm 140

Artist: Philippe CognéeTitle: Foule, Place St Pierre de Rome, Pâques,1999Material: Encaustic on canvas, Format: 154 × 153 cm 146

Artist: Jan FabreTitle: Untitled, 1987Material: Ballpoint ink on paper, Format: 200 × 158 cm 152

Artist: Reinhold A. GoellesTitle: UntitledMaterial: Acrylic on canvas, Format: 152 × 100 cm 160

FOREWORD


When looking back at the events of last year,the enlargement of the EU which took place on1 May 2004 stands out as a major historicalachievement. We had prepared for thisenlargement well in advance in our areas ofcompetence, in particular by involving ourfellow governors of the central banks of the tennew Member States as early as possible, asobservers in the General Council meetings; thesuccess of this enlargement also resulted fromthe intense preparatory work carried out by theECB and its staff. In addition, we opened up thecommittees of the European System of CentralBanks (ESCB) to experts from those centralbanks, who also participated as observers. Thethorough and friendly nature of this preparationpermitted the smooth entry of these countriesand central banks into the EU and the ESCB.The first General Council meeting held after

enlargement was a moving occasion for all ofus, while the first teleconference of the GeneralCouncil also marked a significant milestone:we were able to assure ourselves of the perfectfunctioning of our new, secure communicationnetwork and to demonstrate our capacity toengage in effective discussion throughteleconferencing right across Europe.

The ten new Member States have joined the EUwithout an “opt-out” clause. They have thusmade a commitment to ultimately join the euroarea. We are all in agreement that, in fullconformity with the Treaty requirements, thebest possible preparation for adopting the euro,namely a high level of sustainable convergencein accordance with the Maastricht criteria, is ofthe essence.

During 2004 three more currencies, those ofEstonia, Lithuania and Slovenia, entered theexchange rate mechanism II (ERM II), whichwas previously composed of its anchor, theeuro, and the Danish krone. The three newentrants are committed to participating inERM II in such a way as to ensure both thesmooth functioning of the system and the bestpossible contribution to the achievement ofsustainable convergence.

***

The members of the EU are on their way toratifying the newly signed Treaty establishinga Constitution for Europe. The Constitution is apowerful illustration of the will of Europe toproceed with the historical deepening of theUnion alongside its enlargement. TheEurosystem, which has as its primary objectivethe responsibility to deliver price stability, isfully conscious of its role, confirmed by theConstitution, in the deepening of the EU. TheConstitution also confirms all the essentialelements of the policy framework for EMU,

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Annual Report2004

under both the monetary pillar and theeconomic and fiscal pillar. The ECB looksforward to the ratification of the Constitution.

***

2004 was a year of moderate growth in the euroarea, with real GDP growth for the year as awhole standing at 1.8% compared with 0.5% in2003. The growth profile of the year wasmarked by a relatively dynamic first halffollowed by slow growth in the third and fourthquarters. Overall, the diagnosis of a gradualrecovery taking place in the context of anumber of domestic and internationaluncertainties has been confirmed.

The Governing Council of the ECB maintainedthe main refinancing rate at the exceptionallylow level of 2% throughout 2004. It pursueda monetary policy which aimed to preserveprice stability in a complex internationalenvironment marked, in particular, bycommodity and oil price increases, episodesof volatility in the exchange markets, thepersistence of significant global imbalancesand the significant contribution to globalgrowth arising from the very rapiddevelopment of a number of emergingeconomies. Throughout the year one of theGoverning Council’s main messages was ofvigilance in respect of the inflationary risksassociated with the possible “second-roundeffects” of wage and price increases followingthe headline inflation humps which resulted, inparticular, from the commodity and oil priceshocks. Not least because economic agents andsocial partners have understood our messageclearly, second-round effects remain subdued.

During the first half of 2004 we observed someupward tendency in the medium and long-termestimates of inflation expectations extractedfrom various surveys and from indexed bonds.

This adverse trend stopped around the middleof 2004 and started to reverse during the secondhalf of the year. The Governing Council’s firmexpression of its vigilance during this periodcertainly contributed to preserving the overallanchoring of inflation expectations at a level inline with our definition of price stability: below2% and close to 2%.

This anchoring of medium and long-terminflation expectations in the euro area, whichreflects the credibility of the GoverningCouncil of the ECB, is essential. It is thiscredibility which allows the ECB to deliverprice stability, in line with the mandateassigned to it by the Treaty, even whencircumstances are difficult, by providingeconomic agents with a clear reference in theprice and wage-setting process. It also allowsthe euro area to benefit from a financialenvironment that is favourable to growth andjob creation, through historically low mediumand long-term market interest rates, whichincorporate inflation expectations in line withour definition of price stability.

***

A good monetary policy is a necessarycondition for sustainable growth and jobcreation. However, it is not sufficient on itsown. It must be accompanied by a sound fiscalpolicy and an appropriate set of structuralreforms.

This is why the Eurosystem has always arguedso firmly in favour of the correctimplementation of the Stability and GrowthPact, and has consistently emphasised the needto fully preserve the integrity of the correctivearm of the Pact, in particular the nominalanchor of 3% of GDP as the limit for fiscaldeficits, as well as of the excessive deficitprocedure itself.


It is also the reason why the Eurosystem hascalled so strongly for the euro area to embarkresolutely on implementing structural reformsin labour markets, in education and training, inresearch and development, in goods andservices markets as well as in the managementof social security spending. These reforms areof the utmost importance in order to raisethe growth potential of the European economy,to foster job creation and to reduceunemployment significantly. Throughout 2004the ECB supported the initiatives of theEuropean Commission and the EU Councilaimed at reviving and speeding up theimplementation of the structural reformsembodied by the Lisbon agenda. We alsowelcomed the proposals included in the reportby the high-level group chaired by Wim Kok,published at the end of 2004, to focus theLisbon agenda on a limited number of priorityareas that support higher growth andemployment.

***

Turning to the organisation and functioning ofthe ECB, 2004 was a challenging year forthe institution. The ECB made a net loss of€1,636 million, compared with a net loss of€477 million in 2003. This net loss was againdue to the development of exchange rateswhich affected the value, in euro terms, of theECB’s holdings denominated in foreigncurrency. Our accounting principles are basedon maximum prudence. For this reason, theseunrealised exchange rate losses are treated asrealised and taken to the profit and loss accountat the year-end: in 2004 the appreciation of theeuro resulted in net exchange rate revaluationlosses of almost €2.1 billion. By contrast,unrealised gains from exchange rate andmarket price revaluations are not recognised asprofit, but transferred directly to revaluationaccounts.

The ECB’s regular income is derived primarilyfrom investment earnings on its holdings offoreign reserve assets and its paid-up capital of€4.1 billion and from interest income on its 8%share of the euro banknotes in circulation.Interest income in 2004 was again low, due inparticular to the exceptionally low level ofinterest rates, the main refinancing rate havingbeen maintained at 2% throughout 2004.The ECB earned total net interest income of€690 million, compared with €715 millionin 2003. The ECB’s administrative expenseson salaries and related costs, rental ofpremises, and goods and services amounted to€340 million. At the end of 2004 the ECBemployed 1,314 members of staff, comparedwith 1,217 one year earlier.

Last year saw the completion of the ECB inMotion project, which aimed to improve theeffectiveness and efficiency of the ECB, toenhance the management of human resourcesand to reinforce central banking values amongall staff. Most of the measures contained in theprogramme and approved by the ExecutiveBoard have already been completed and a feware still being implemented. ECB in Motion hasbeen a remarkable programme which hashelped to improve our working culture and toconsolidate team spirit within the Bank. TheExecutive Board is fully committed to theimplementation of the programme and to thepreservation of the spirit of ECB in Motion.

2004 was marked by two other importantdevelopments. First, the adoption of the ECBcore values: competence, effectiveness andefficiency, integrity, team spirit, transparencyand accountability, and working for Europe.The second major development was thedecision to embark on a zero-based budgetingexercise. From its creation on 1 June 1998, theECB has grown quickly in order to successfullymeet the historical challenges it was faced

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Frankfurt am Main, March 2005

Jean-Claude Trichet

with; having proved its effectiveness, theECB felt that it was time to thoroughlyreview the efficiency of its functioning.The Executive Board thus launched in 2004a zero-based budgeting exercise aimed atexamining all the tasks of the institution andthe related allocation of staff. The project is inprogress and will be completed by mid-2005.

***

The Executive Board, the Governing Counciland the General Council of the ECB areinspired by an exceptional team spirit. In theeuro area, the ECB and the 12 national centralbanks make up a single team, the Eurosystem.2004 saw the creation of the “EurosystemMission Statement” (included in Box 15 ofthis Annual Report), a single statement for13 institutions and their staff throughout theeuro area. This statement offers a strikingillustration of our collective will to reinforcefurther our Eurosystem team in the service ofEurope and of its single currency. The ECB isproud to be at the forefront of this unique team.

ArtistStephan JungTitleP.WP1, 2002MaterialOil on canvasFormat230 × 265 cm© VG Bild-Kunst, Bonn 2005

CHAPTER 1

ECONOMICDEVELOPMENTS AND

MONETARY POLICY


The recovery in economic activity in the euroarea, which started in the second half of 2003,continued in 2004. The euro area economystrengthened in the first half of the year,benefiting from strong global economicgrowth. In the second half of 2004 economicactivity in the euro area weakened somewhat,partly on account of rising oil prices. Overall,real GDP grew – on a working day-adjustedbasis – by 1.8% in 2004, up from 0.5% in 2003and 0.9% in 2002.

Against this background of gradual economicrecovery, underlying domestic inflationarypressures remained contained, benefitingsignificantly from subdued increases inlabour compensation. The slight appreciationof the euro in nominal effective terms alsocontributed to somewhat lower inflationarypressures. Headline inflation rates in 2004were, however, significantly affected byincreases in administered prices and indirecttaxes, and, particularly in the second half of theyear, by rises in oil prices. Overall, therefore,

I MONETARY POLICY DECISIONSannual HICP inflation in 2004 was 2.1% –unchanged from the previous year.

In this environment of subdued domestic pricepressure and a positive outlook for pricestability over the medium term, the GoverningCouncil of the ECB kept the key ECB interestrates unchanged throughout 2004, at historicallylow levels. The minimum bid rate on the ECB’smain refinancing operations was kept at 2%,while the rates on the deposit facility and themarginal lending facility were maintained at 1%and 3% respectively (see Chart 1).

Looking at monetary policy decisions in moredetail, data in the first months of 2004confirmed a continuation of the gradualeconomic recovery that had started in thesecond half of 2003. On the external side,export growth was buoyant, aided by the strongdynamics of the world economy. In addition,the very favourable financing conditionswithin the euro area and the improved outlookfor corporate earnings, reflecting balance

Chart 1 ECB interest rates and money market rates

(percentages per annum; daily data)

Source: ECB.Note: The rate for main ref inancing operations is the rate applicable to fixed rate tenders for operations settled before 28 June 2000.Thereafter, the rate reflects the minimum bid rate applicable to variable rate tenders.

1999 2000 2001 2002 2003 20040.0

1.0

2.0

3.0

4.0

5.0

6.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

marginal lending ratedeposit rateminimum bid rate in main refinancing operationsthree-month EURIBOR

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Annual Report2004

sheet adjustments, provided a positive picturefor investment. With regard to privateconsumption, a gradual recovery was expectedon the basis of an anticipated increase in realdisposable income and a gradual improvementin labour market conditions. Regarding prices,HICP inflation declined to below 2% in early2004, largely owing to easing inflationarypressures resulting from the appreciation of theeuro in the last few months of 2003 and fromthe base effects stemming from the strongincreases in energy prices in early 2003.

Annual M3 growth in the first quarter of 2004continued the downward trend that began in thesummer of 2003. This mainly reflected theunwinding of earlier portfolio movements, asinvestors gradually shifted the structure of theirportfolios towards longer-term and riskierfinancial assets outside M3, following a periodof exceptional preference for liquidityassociated with the heightened economic andfinancial uncertainty observed between 2001and mid-2003. Notwithstanding the normalisationobserved in M3 growth, significantly moreliquidity remained in the euro area than wasneeded to finance non-inflationary economicgrowth. While this implied that upside risks toprice stability had to be carefully monitored, onbalance, the Governing Council assessed theoutlook for price stability as being favourable inthe first quarter of 2004.

Economic developments in the second quarterof 2004 suggested two possible opposingscenarios. On the one hand, the data availablepointed to continued robust growth in the globaleconomy and a very favourable picture foreuro area exports. On the other hand, oil pricesstarted to increase markedly after March 2004,gradually posing stronger downside risks to theongoing recovery. Overall, as the second quarterproceeded, the former scenario prevailed andeconomic indicators increasingly confirmed thatthe recovery was gaining momentum. Indeed, bythe end of the second quarter, data releasesindicated that the economic recovery seen in theeuro area in the first half of 2004 had been morepronounced than previously expected, thus

nurturing optimism about the outlook foreconomic growth. Real GDP grew, on average,by 0.6% quarter on quarter in the first half of theyear, the highest rate recorded in the euro areasince the first half of 2000. The momentum of therecovery mainly reflected stronger exports and,following a long period of stagnation, an initialstrengthening of private consumption. Againstthis background, the June 2004 Eurosystem staffprojections saw euro area real GDP growthincreasing to between 1.4% and 2.0% on averagein 2004 and rising to between 1.7% and 2.7% in2005. Forecasts by international and privateorganisations were also in line with expectationsof a strengthening economic upswing in thesecond half of 2004.

The surge in oil prices exerted considerableshort-term upward pressures on consumer pricesand had a sizeable effect on inflation. AnnualHICP inflation rates rose again in the secondquarter of 2004, partly as a result of risesin administered prices and indirect taxes.However, when assessing price trends over themedium term, the Governing Council took theview that inflationary pressures were likely toremain contained, particularly given thesubdued labour market conditions and theexpectation that wage increases would remainmoderate in the context of only graduallyimproving labour markets and the gradual paceof the economic recovery. These views were inline with the June 2004 Eurosystem staffprojections, which put average annual HICPinflation at between 1.9% and 2.3% in 2004 andbetween 1.1% and 2.3% in 2005, and consistentwith forecasts by international and privateorganisations. However, some upside risks tothese projections, stemming from oil pricedevelopments, uncertainty surrounding changesin indirect taxes and administered prices, andpotential second-round effects via wage andprice-setting behaviour, were identified. Inaddition, medium to longer-term inflationexpectations in financial markets increasedsomewhat in this period.

The annual growth rate of M3 broadlycontinued its downward trend in the second


quarter of 2004, reflecting a furthernormalisation of the portfolio behaviourof holders of money. Nonetheless, thisnormalisation process proceeded ratherslowly and M3 growth remained relativelyhigh, due also to the stimulative effect oflow interest rates on demand for liquid assets.The Governing Council therefore remainedconcerned about the persistently high excessliquidity in the euro area, which, in aneconomic upswing, could lead to inflationarypressures over the medium term.

While the main scenario of an ongoingrecovery did not fundamentally change overthe second half of 2004, it became increasinglyapparent that the recovery in euro area activitywould proceed at a somewhat more moderatepace than anticipated. This developmentstemmed mainly from a temporary decelerationin world economic growth, a further substantialincrease in oil prices in the third quarter and amarked appreciation of the euro in the fourthquarter. Indeed, in the course of the second halfof the year, data confirmed that the impact ofhigher oil prices had continued to unfold,dampening the growth in demand both insideand outside the euro area. Real GDP growth inthe euro area was only 0.2% quarter on quarterin the third and fourth quarters of 2004.The Eurosystem staff projections published inDecember 2004 pointed to real GDP growth ofbetween 1.4% and 2.4% in 2005 and between1.7% and 2.7% in 2006. In addition, theGoverning Council stressed that there weredownside risks to these projections, linked topotential unfavourable developments in the oilmarket.

With respect to price developments, over thesecond half of 2004 annual HICP inflation ratescontinued to hover somewhat above 2%,mainly as a result of rising oil prices. However,there were no indications of stronger domesticinflationary pressures building up. Wageincreases had remained subdued since the lastquarter of 2003, a trend that was expected tocontinue in the context of ongoing moderategrowth and continued labour market weakness.

Against this background, the Eurosystem staffprojections published in December 2004 put theannual HICP increase at between 1.5% and2.5% in 2005 and between 1.0% and 2.2% in2006. However, the balance of risks to theseprojections remained tilted to the upside. Risksrelated mainly to developments in oil prices,uncertainty about further increases in indirecttaxes and administered prices, and potentialsecond-round effects in wage and price-settingbehaviour.

Such risks were also increasingly signalled bythe ECB’s monetary analysis. In the secondhalf of 2004 the upward impact on M3 growth– particularly its more liquid components –from continued low interest rates came topredominate over the gradual downwardimpact stemming from the normalisation ofportfolio behaviour. Low interest rates alsofurther fuelled private sector demand forcredit. In particular, demand for loans for housepurchase increased from already robust levels,contributing to the strong house price dynamicsin several euro area countries. In this context,the Governing Council noted that persistentlyhigh excess liquidity and strong credit growthwere regarded not only as upside risks toprice stability but also as a possible sourceof unsustainable asset price increases,particularly in property markets. In early 2005this picture did not fundamentally change. Thestrong monetary growth seen since mid-2004continued and significantly more liquidityremained in the euro area than was needed tofinance non-inflationary growth.

Overall, in the second half of 2004 and early2005, the Governing Council expressedincreasing concern about adverse short-terminflation developments. At the same time, itnoted that there were no indications thatdomestic inflationary pressures were buildingup. Against this background, the key ECBinterest rates were kept unchanged throughoutthis period. However, the Governing Councilstressed that a number of upside risks to pricestability over the medium term requiredcontinued vigilance.

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2.1 THE GLOBAL MACROECONOMICENVIRONMENT

WORLD ECONOMY REGISTERED STRONGESTGROWTH IN OVER TWO DECADESIn 2004 the global economy expanded at itsfastest rate since 1976, with growth beingrelatively broad-based across the variousregions (see Chart 2). Growth in the Asian regionwas particularly robust, with the Chineseeconomy showing signs of overheating. Strongglobal economic growth was supported byfavourable financing conditions and stimulativemacroeconomic policies in many countries. Itwas accompanied by a robust expansion of worldtrade, which, in 2004, reached its highest levelsince 2000.

The expansion of the global economy wasespecially strong in the early months of theyear, decelerating thereafter in most countries.This slowdown partly reflected a normalisationof the strong dynamics observed in thepreceding quarters, and the beginning of agradual withdrawal of policy stimuli. Thesignificant increase in oil prices, whichreached a peak in October 2004, exerted anadditional dampening influence. The rise in oilprices contributed to a moderate increase ininflation rates in many countries, largely as aresult of developments in energy-relatedprice components. Underlying inflation trendsremained relatively stable, however, suggestingthat second-round effects were fairly well-contained (see Chart 2).

Continued robust growth in the United States(compared with some of its trading partners)contributed to a further widening of the UScurrent account deficit. This, together with theuncertainties surrounding the country’s fiscalpolicy outlook, rekindled market concernsabout the sustainability of global imbalances.Partly reflecting these concerns, the USdollar experienced a relatively broad-baseddepreciation in the last months of the year.

In the United States, economic growthcontinued at a generally brisk pace in 2004,

2 MONETARY, FINANCIAL AND ECONOMICDEVELOPMENTS

with real GDP increasing by 4.4% for theyear as a whole (according to preliminaryestimates). This expansion also broadenedfurther to encompass the long-awaitedimprovement in the labour market. Growth inreal GDP was supported by continued strengthin household consumption and businessinvestment (particularly on equipment andsoftware), while net trade made a negativecontribution to growth.

Char t 2 Ma in deve lopments in ma jorindus t r i a l i s ed economies

Sources: National data, BIS, Eurostat and ECB calculations.1) Eurostat data are used for the euro area; for the UnitedStates and Japan national data are used. For all countries,GDP f igures have been seasonally adjusted.

Inflation rates(annual percentage changes; monthly data)

euro areaUnited StatesJapan

Output growth 1)

(annual percentage changes; quarterly data)

1999 2000 2001 2002 2003 2004-4

-2

0

2

4

6

-4

-2

0

2

4

6

1999 2000 2001 2002 2003 2004-2

-1

0

1

2

3

4

-2

-1

0

1

2

3

4


Private consumption growth remained solid formost of the year, reflecting the continuedeffects of accommodative macroeconomicpolicies, a strong rise in residential houseprices and a significant improvement in payrollemployment. Although employment growthpicked up after several years of weakness,upward pressures on wages remained generallycontained owing mostly to remaining slack inthe labour market. Subdued growth in labourcosts, combined with high oil prices,contributed to restraining underlying growth inreal disposable income in the second half of2004. In the absence of a one-off boost toincome coming from an extraordinary largedividend payment in December, this wouldhave pushed down the personal saving rate stillfurther. At the same time, household debt roseto a historically high level as a proportion ofdisposable income in 2004.

Business investment grew vigorously in 2004,led by increased investment in equipment andsoftware, in an environment of favourablefinancing conditions, temporary fiscalincentives and low levels of inventoriesaccompanied by strong demand. Althoughhigher oil prices contributed to an increasein the cost of raw materials, corporateprofitability remained strong. Partly reflectingthe improvement in the labour market,productivity growth declined during 2004,although it still remained relatively strong forthe year as a whole.

The external balance of the United Statescontinued to deteriorate in 2004, with the UStrade and current account deficit rising tohistorically high levels as a proportion of GDP.In real terms, growth in imports continued tooutpace that of exports despite the cumulativedepreciation of the US dollar since early2002, as strong domestic demand in the UnitedStates significantly outpaced that of majortrading partners. The related domestic saving/investment imbalance reflected continuedpublic sector dissaving and a historically lowpersonal saving rate.

Consumer price inflation rebounded in 2004,largely in response to higher energy prices,with annual CPI growth standing at 3.3% at theend of the year. Inflation excluding food andenergy also reversed its downward trend ofthe last few years, rising to 2.2%. Upwardprice pressures, however, remained relativelymoderate owing to a gradual absorption oflabour market slack, continued strongproductivity growth and only a limited pass-through of the depreciation of the US dollarinto consumer prices. Accordingly, survey-based and market measures of longer-terminflation expectations remained contained,despite a moderate rise in the latter.

Following a period of historically low interestrates, the Federal Open Market Committee(FOMC) of the Federal Reserve Systemincreased the federal funds rate target by125 basis points in 2004. This increase wascarried out in five successive 25 basis pointsteps beginning in June 2004, which broughtthe target for the federal funds rate to 2.25% bythe end of the year (in early February 2005 itreached 2.5%). While the FOMC noted thatpolicy accommodation could be removed at apace that was likely to be measured, itunderlined that it would respond to changes ineconomic prospects as and when needed inorder to fulfil its obligation to maintain pricestability. With respect to fiscal policy, thefederal government budget deficit worsened to3.6% of GDP in the fiscal year 2004, despite thepick-up in economic activity.

In Japan, the economic recovery lostmomentum in the course of 2004. Following astrong expansion in the first quarter of the year,economic activity significantly deceleratedthroughout the rest of 2004. This decelerationin economic activity particularly reflectedlower public spending and weakening privatedomestic demand, as well as a moderation inthe dynamics of exports. Nevertheless, as aresult of base effects and the strong firstquarter, in 2004 annual real GDP growth roseto its highest rate since 1996 (2.6%). Somegradual improvements were observed in labour

21ECB

Annual Report2004

market conditions. Meanwhile, the restructuringof corporate balance sheets, together with cost-cutting efforts, contributed to a strong reboundin corporate profit growth, while the bankingsector reduced the level of outstanding non-performing loans.

Concerns about deflation eased somewhatduring the year, but did not fully dissipate.Corporate goods prices increased, mainlyreflecting increases in raw material prices, whilefinal goods prices continued to declinemoderately. The annual rate of change inconsumer prices for the year as a whole stood at0%, compared with -0.3% in 2003. In Octobersigns of abating deflationary pressures led someBank of Japan Policy Board members to predicta slight increase in the CPI excluding fresh foodin the fiscal year 2005. However, deflationarypressures re-emerged towards the end of 2004 asa result of the decline in prices of liberalisedutility services. The Bank of Japan raised thetarget range for the outstanding balance oncurrent accounts held with it to JPY 30-35trillion in January 2004. The monetary policystance remained unchanged during theremainder of the year.

Sustaining strong momentum from the previousyear, the non-Japan Asian economies registeredanother very robust year of growth in 2004,benefiting particularly from strong externaldemand, reviving domestic demand and China’sinvestment boom. Regional integration in Asiastrengthened, as indicated by the rapid growthin intra-regional trade and investment flows.Nevertheless, the growth momentum easedtowards the end of 2004 amid moderatingexternal demand and high oil prices. At thecountry level, the Chinese economy continuedto grow strongly, with some signs of overheatingin the first half of the year. Policy measuresslowed investment momentum in the second halfof the year, but did not dampen overall economicactivity. In the year as a whole, Chinese GDPgrew by 9.5%.

In Latin America, the economic situationshowed a considerable improvement, supported

by both export activity and domestic demand.Growth in Brazil and Mexico gainedmomentum over the course of the year,mainly sustained by robust exports and thestrengthening of investment activity. InArgentina, the recovery of economic activityremained strong, although it moderatedsomewhat in the course of the year.

COMMODITY PRICES ROSE STRONGLY IN 2004Oil prices increased throughout most of theyear amid considerable volatility. The priceof Brent crude oil reached a peak ofUSD 51 at the end of October, compared withUSD 30 at the beginning of the year (seeChart 3). For the whole of 2004, the averageprice of Brent crude oil was USD 38, 33%above the average of 2003. If measured in termsof euro, the price of Brent crude oil increasedby 20% over the same period. The main factorsbehind the surge in oil prices in 2004 were thestrength of global demand for oil, securityconcerns about oil supplies and a supply anddemand mismatch for different qualities of oil.

Demand for oil soared, particularly in Asia andNorth America, and continued to exceedexpectations throughout 2004 in a context ofrobust global economic growth. According tothe International Energy Agency, the globaldemand for oil increased by 3.4% in 2004,its highest rate of growth in almost threedecades.

Turning to supply conditions, in early 2004market participants expected – in response tostatements by the Organisation of PetroleumExporting Countries (OPEC) – that cuts inOPEC production were imminent, even thoughthey did not subsequently materialise. Instead,both OPEC and non-OPEC producers increasedcrude oil production significantly in 2004. Asthe global supply of oil increased, spareproduction and refining capacity shrankconsiderably, leaving only a very limitedmargin for unexpected oil supply disruptions.As a result, oil prices in 2004 became verysensitive to unanticipated changes in thesupply/demand balance, to market perceptions


about the security of crude oil supplies and toconcerns over the adequacy of oil inventories.In addition, rapidly rising demand for final oilproducts and growing supplies of crude oilled to a quality mismatch, resulting in recordhigh premiums for high-quality crudes such asBrent.

The prices of non-energy commodities, whichhad been buoyant since the second half of 2003,peaked in the first half of 2004 (see Chart 3)owing to the strong global economic recovery.Overall non-energy commodity prices easedsomewhat in the second half of 2004, as theprices of both food and agricultural rawmaterials fell from the peaks reached earlier inthe year. The prices of metals, however,continued to rise. In US dollar terms, overallnon-energy commodity prices were, onaverage, 22% higher in 2004 than a year earlier.

2.2 MONETARY AND FINANCIALDEVELOPMENTS

M3 GROWTH INFLUENCED BY TWO OPPOSINGFORCESAgainst the background of the monetary policystance and capital market developments,monetary dynamics in 2004 were influenced bytwo opposing forces: on the one hand, the lowlevel of interest rates and, on the other hand, thenormalisation of portfolio allocation behaviourof euro area residents following their strongpreference for liquidity between 2001 andmid-2003. In the first half of 2004 themoderating impact on M3 growth of thenormalisation of portfolio allocation behaviourdominated and the annual growth rate of M3continued the slowdown that had started in thesummer of 2003, declining to 5.3% in June 2004.The annual growth rate of M3 strengthenedagain in the second half of 2004, standing at6.4% at the end of the year, as the stimulativeimpact of the low level of interest rates and theresulting low opportunity costs of holdingmoney came to the fore, reinforced by arenewed decline in long-term interest rates. Atthe same time, monetary dynamics in 2004 alsoreflected the fact that output growth wasstronger than in the previous year.

The normalisation of portfolio allocationbehaviour seen in 2004 proceeded only slowly.Although the exceptional economic andfinancial market uncertainty of previousyears diminished, the risk aversion of, interalia, euro area households appeared to remainpronounced after a prolonged period of capitallosses in stock markets between 2000 andmid-2003. This may explain the liquiditypreference among investors, which was greaterthan would be considered normal for this stageof the economic cycle. Moreover, thestimulative impact of the low level of interestrates on money holdings may be particularlystrong when interest rates are very low. Thiscould be due to the existence of transactioncosts that are associated with shifts out ofliquid assets and would further lower theopportunity costs of holding such assets.

Char t 3 Ma in deve lopments incommod i ty market s

Sources: Bloomberg and HWWA.

Q1 Q2 Q3 Q4 Q12004 2005

27

31

35

39

43

47

51

55

100

110

120

130

140

150

Brent crude oil (USD/barrel; left-hand scale)non-energy commodities (USD; index: 2000 = 100; right-hand scale)

23ECB

Annual Report2004

The increasing dominance of the low level ofinterest rates in driving M3 dynamics can beillustrated with the help of a measure of M3which is corrected for the estimated impact ofportfolio shifts into M31 during the periodof exceptional financial market uncertaintybetween 2001 and mid-2003. By construction,this measure is also unaffected by thesubsequent normalisation of portfolio allocationbehaviour and should thus provide clearerindications of the effect of interest rates thanthe official M3 series. It should be stressed thatthe estimate of M3 corrected for the impact ofportfolio shifts is surrounded by a considerabledegree of uncertainty and should therefore beinterpreted with caution. Over the last threequarters of 2004 the official M3 growth ratewas below the annual growth rate of thecorrected M3 series, suggesting that thenormalisation of portfolio allocation behaviourhad a moderating impact. However, the factthat both the growth rate of the official M3series and that of the corrected M3 seriesstrengthened in the second half of 2004 may

Char t 5 Contr ibut ions to annua l M3growth

(in percentage points; M3 growth in percentages; adjusted forseasonal and calendar effects)

Source: ECB.

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1999 2000 2001 2002 2003 2004-2.0

0.0

2.0

4.0

6.0

8.0

10.0

marketable instrumentsother short-term depositsM1M3

Char t 4 M3 and M3 cor rec ted fo r thees t imated impact o f por t fo l i o sh i f t s

(annual percentage changes; adjusted for seasonal andcalendar effects)

Source: ECB.1) Estimates of the magnitude of portfolio shifts into M3 areconstructed using the approach discussed in Section 4 of thearticle entitled “Monetary analysis in real time” in the October2004 issue of the ECB’s Monthly Bulletin.

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1999 2000 2001 2002 2003 20042.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

official M3M3 corrected for the estimated impact of portfolio shifts 1)

reference value (41/2%)

indicate that the stimulative impact associatedwith the low level of interest rates, rather thanthe normalisation of portfolio allocationbehaviour, was the main driving force behindM3 dynamics (see Chart 4).

As had been the case in 2003, the maincontribution to annual M3 growth in 2004 camefrom the most liquid components, i.e. thosecontained in the narrow monetary aggregateM1 (see Chart 5). That contribution was a resultof substantial increases in the holdings of bothcurrency in circulation and overnight deposits.The growth of currency in circulation reflectedthe continued strong demand for eurobanknotes both inside and outside the euro area(see also Section 3 of Chapter 2 on banknotesand coins).

1 For further details, see Section 4 of the article entitled“Monetary analysis in real time” in the October 2004 issue ofthe ECB’s Monthly Bulletin.


The growth rate of overnight deposits remainedrather high in 2004, supported by the very lowopportunity costs of holding these deposits.The average interest rates on overnightdeposits of households and non-financialcorporations remained broadly unchangedcompared with end-2003, at levels of 0.73%and 0.90% respectively at the end of 2004(see Chart 6). This mirrored developmentsin money market rates in 2004.

The contribution to annual M3 growth of short-term deposits other than overnight deposits wasaround 1.1 percentage points in 2004,considerably lower than in 2003. This lowercontribution mainly reflected developments inshort-term time deposits (i.e. deposits with anagreed maturity of up to and including twoyears), the annual growth rate of which wasnegative, while short-term savings deposits(i.e. deposits redeemable at notice of up to andincluding three months) grew strongly. Thedifferent developments in these two sub-components may reflect the fact that the typicalremuneration advantage of time deposits up toone year over savings deposits did not exist in2004 (see Chart 6). In such a situation, short-term savings deposits are relatively attractive,as they possess a higher degree of liquidity.

Finally, the contribution of marketableinstruments to the annual growth rate of M3diminished to 0.4 percentage point in 2004,from 1.2 percentage points in the previous year.This reflected in particular a strong decline inthe annual growth rate of money market fundshares/units. These assets are often held byhouseholds and firms as a safe savings vehiclein times of economic and financial uncertainty,

Char t 6 Shor t - te rm MF I i n te re s t ra te son depos i t s

(percentages per annum; rates on new business;weight-adjusted 1))

Source: ECB.1) For the period from December 2003 onwards, the weight-adjusted MFI interest rates are calculated using countryweights constructed from a 12-month moving average of newbusiness volumes. For the preceding period, from January toNovember 2003, the weight-adjusted MFI interest rates arecalculated using country weights constructed from the averageof new business volumes in 2003. For further information, seethe box entitled “Analysing MFI interest rates at the euro arealevel” in the August 2004 issue of the ECB’s Monthly Bulletin.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q42003 2004

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0

overnight deposits from householdsdeposits from households redeemable at notice of up to three monthsdeposits from households with an agreed maturity of up to one yearovernight deposits from non-financial corporations

and the fact that their growth slowed reflectsthe normalisation of the portfolio allocationbehaviour of euro area residents in 2004 (seealso Box 1 entitled “Trends in the financialinvestment of the euro area non-financialsector in 2004”).

25ECB

Annual Report2004

Box 1

TRENDS IN THE FINANCIAL INVESTMENT OF THE EURO AREA NON-FINANCIAL SECTOR IN 2004

The annual growth rate of the financial investment of the non-financial sector in the first threequarters of 2004 was broadly unchanged compared with the average rate of growth in 2003 (seetable). This stability masked somewhat heterogeneous developments in the various categoriesof financial investment. While there was a pick-up between 2003 and 2004 in the rate of growthof investment in long-term debt securities and quoted shares, the growth rate of investment inmoney market fund shares/units declined significantly. Moreover, while investment in equityand equity-linked funds grew at a faster rate in 2004 than in previous years, purchases ofbonds and bond-linked funds slowed somewhat. Overall, these developments provide furtherconfirmation of a gradual normalisation of the portfolio allocation behaviour of euro arearesidents as agents’ propensity to invest in riskier and longer-term assets recovered.

Households continued to invest a large percentage of their financial savings in insurancereserves, albeit at a slightly slower pace than in 2003. The high degree of interest in theseproducts has been sustained over several years. It probably reflects precautionary savings forretirement in an ageing society and possibly also agents’ concerns regarding public pensionschemes.

Outstanding amount Annual growth rates

as a percentage 1999 2000 2001 2002 2003 2004 2004 2004 2004of financial assets 1) Q1 Q2 Q3 Q4

Financial investment 100 5.6 6.5 4.6 3.8 4.4 4.3 4.6 4.5 .Currency and deposits 37.8 3.0 3.3 4.6 4.9 5.5 5.3 5.3 5.6 .Securities other than shares 12.2 8.0 9.0 8.1 0.7 -2.4 -0.6 3.7 3.2 .

of which: short-term 1.2 2.8 29.8 4.9 -13.8 -16.1 -4.7 15.4 11.9 .of which: long-term 11.0 4.4 6.4 8.6 2.7 -0.7 -0.2 2.6 2.4 .

Mutual fund shares 11.9 2.3 6.3 6.0 4.6 6.9 4.6 2.3 1.3 .of which: mutual fund shares,excluding money market fund shares 9.2 4.7 7.1 4.1 3.4 6.5 5.2 2.4 1.6 .of which: money market fund shares 2.6 13.1 0.1 21.4 12.0 8.5 2.8 1.7 0.5 .

Quoted shares 13.0 14.4 8.5 -0.9 -0.1 1.1 1.3 3.3 2.6 .Insurance technical reserves 25.2 2.7 8.5 7.2 6.2 6.6 6.3 5.9 5.8 .

M3 2) 5.6 4.1 8.0 7.0 7.1 6.2 5.3 6.0 6.4

Annual gains and losses on the holdingsof securities by the non-financialsector (as a percentage of GDP) 10.7 -2.4 -9.1 -14.1 4.1 7.9 3.8 3.6 .

Source: ECB.Notes: See also Section 3.1 in the “Euro area statistics” section of the ECB’s Monthly Bulletin. Annual data as at the end of the period.1) As at the end of the third quarter of 2004. Figures may not add up due to rounding.2) As at the end of the period. The monetary aggregate M3 includes monetary instruments held by euro area non-MFIs (i.e. the non-f inancial sector and non-monetary financial institutions) with euro area MFIs and central government.

F inanc i a l i nves tment o f the euro a rea non- f i nanc i a l s e c tor


MORE BROADLY BASED GROWTH OF MFI CREDITTO THE PRIVATE SECTORDevelopments in the counterparts of M3confirmed the influence of the two opposingforces on monetary dynamics mentionedpreviously. On the one hand, stronger growth inMFI longer-term financial liabilities and, in thefirst half of the year, lower increases in netexternal assets reflected the unwinding of pastportfolio shifts into M3. On the other hand,stronger growth in MFI loans to the privatesector reflected the prevailing low level ofinterest rates.

In the first half of 2004 capital outflows fromthe euro area remained robust, whereas weakercapital inflows led to a decline in the annualflow of the net external assets of the euro areaMFI sector (see Chart 7). Such capital outflowswere the result of euro area residentspurchasing assets from non-euro area residents– one aspect of the normalisation of portfolioallocation behaviour by euro area residents. Tothe extent that such transactions are settledthrough the euro area MFI sector, the netexternal assets of the MFI sector and thedeposits of euro area residents decrease. Thefirst half of 2004 also saw a sustainedexpansion in MFI longer-term financialliabilities (excluding capital and reserves),which was consistent with the ongoingnormalisation of portfolio allocationbehaviour, as funds were shifted from liquidmonetary assets into longer maturityinstruments. These developments in netexternal assets and longer-term financialliabilities were essentially a continuation oftrends observed in the second half of 2003.However, already in the first half of 2004 thedampening effect of these factors on M3growth was partly offset by the robust growthin MFI credit to euro area residents inan environment characterised by low levelsof interest rates and improved economicconditions.

In the second half of 2004 the continuedstrengthening of growth in MFI credit to theprivate sector made that counterpart the

dominant factor driving M3 dynamics.Moreover, the dynamism of MFI loans to theprivate sector became more broadly basedacross the main non-financial sectors. Upwardpressure on M3 dynamics was also associatedwith the reversal of the previous downwardtrend in the annual flow of net external assets, areversal which resulted from capital inflowscaused by a renewed interest in euro area equityand bonds on the part of non-euro area residentsas well as expectations of a further appreciationof the euro exchange rate. The averagecontribution of net external assets to annual M3growth increased from 1.1 percentage points inthe second quarter of 2004 to 2.2 percentagepoints in the fourth quarter. At the same time,the growth in MFI longer-term financialliabilities (excluding capital and reserves)strengthened further, pointing to an ongoingnormalisation of portfolio allocation behaviourby euro area residents in favour of non-monetary assets.

Char t 7 Movements in M3 and i t scounte rpa r t s

(annual flows; end of period; EUR billions; adjusted forseasonal and calendar effects)

Source: ECB.M3 = 1 + 2 + 3 - 4 + 5

-200

-100

0

100

200

300

400

500

600

M3 Credit tothe privatesector (1)

Credit togeneral

government(2)

Net external assets (3)

Longer-termfinancialliabilities

(excludingcapital and

reserves) (4)

Othercounterparts(includingcapital and

reserves) (5)

-200

-100

0

100

200

300

400

500

600

H2 2004H1 2004H2 2003H1 2003H2 2002

27ECB

Annual Report2004

LIQUIDITY REMAINED AMPLEThe strength of M3 dynamics over the course of2004 implied a further increase in availablemeasures of excess liquidity, which denotes theliquidity available in the euro area that exceedsthe amount needed to finance non-inflationarygrowth (see Chart 8). The first of thesemeasures is the nominal money gap, which isdefined as the difference between the actuallevel of M3 and the level of M3 that would haveresulted from constant M3 growth at itsreference value of 4½% taking December 1998as the base period; the second is the real moneygap, which corrects the nominal money gap forthe excess liquidity that has been absorbed by

past price developments (i.e. the cumulateddeviation of inflation rates from the ECB’sdefinition of price stability); and the third is analternative measure of the real money gapwhich is constructed using an estimate of M3corrected for portfolio shifts.

When assessing these measures of excessliquidity, it should be recognised that thechoice of December 1998 as the base period isarbitrary. The levels of the measures musttherefore be interpreted with caution.Moreover, as noted previously, the estimate ofM3 corrected for portfolio shifts is surroundedby a considerable degree of uncertainty.2

Bearing these caveats in mind, all estimates ofthe money gap rose further in the second half of2004, having shown signs of levelling off in thefirst half of the year. The large differencebetween the real money gap measure based onthe official M3 series and that based on M3corrected for the estimated impact of portfolioshifts indicates that much of the stock of excessliquidity reflected previous portfolio shiftsinto M3. However, Chart 8 also shows that thecorrected measure has risen significantly sincemid-2003, indicating that excess liquidity inthe euro area has increasingly ceased to be areflection only of portfolio shifts.

These levels of excess liquidity signal risks tomedium-term price stability. If a significantpart of this excess liquidity were to betransformed into transaction balances,particularly at a time when confidence andeconomic activity strengthened, this couldcontribute to the emergence of inflationarypressures (see Box 2 entitled “What couldhappen with the excess liquidity in the euroarea?”). In addition, ample liquidity and strongcredit growth could become a source of strongasset price increases, particularly in housingmarkets.

Char t 8 E s t imates o f the money gap1)

(as a percentage of the relevant measure of the stock of M3;adjusted for seasonal and calendar effects; December 1998 = 0)

Source: ECB.1) The nominal money gap is def ined as the difference betweenthe actual level of M3 and the level of M3 that would haveresulted from constant M3 growth at its reference value of4½% taking December 1998 as the base period. The real moneygap is def ined as the difference between the actual level of M3deflated by the HICP and the deflated level of M3 that wouldhave resulted from constant nominal M3 growth at its referencevalue of 4½% and HICP inflation in line with the ECB’sdef inition of price stability, taking December 1998 as the baseperiod.2) Estimates of the magnitude of portfolio shifts into M3 areconstructed using the approach discussed in Section 4 of thearticle entitled “Monetary analysis in real time” in the October2004 issue of the ECB’s Monthly Bulletin.

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1999 2000 2001 2002 2003 2004-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

nominal money gap based on official M3real money gap based on official M3real money gap based on M3 corrected for theestimated impact of portfolio shifts 2)

2 For further details, see Section 4 of the article entitled“Monetary analysis in real time” in the October 2004 issue ofthe ECB’s Monthly Bulletin.


Box 2

WHAT COULD HAPPEN WITH THE EXCESS LIQUIDITY IN THE EURO AREA?

The strong growth in M3 since mid-2001 has led to a sustained increase in measures of excessliquidity in the euro area, which have reached historical highs. This implies that there wassubstantially more liquidity in the euro area in 2004 than needed to finance non-inflationaryeconomic growth. However, the levels of these measures should be interpreted with caution.

When assessing what could happen with the excess liquidity, the factors responsible for itsbuild-up should be borne in mind. Two broad factors can be identified. First, the protractedperiod of economic, financial and geopolitical uncertainty between mid-2001 and mid-2003led to a significantly increased preference during this period for safe and liquid instrumentsincluded in M3. Second, the low level of interest rates across the maturity spectrum and theassociated low opportunity costs of holding liquid assets have added to the demand for money,particularly over the most recent period. On the basis of these factors, the strong demand forshort-term instruments included in M3 may reflect a mixture of mainly speculative andprecautionary, rather than transaction, motives. Each of these motives may, in turn, implydifferent ways in which excess liquidity can be used in the future and, accordingly, differentdegrees of risk to price stability (see the chart).

One possibility for the use of excess liquidity is for economic agents to invest their liquidholdings in longer-term assets, in equity or debt securities, or in real estate, either directly orindirectly via investment funds. In order to achieve an aggregate reduction of excess liquidity,it is necessary for either the resident MFI sector or agents outside the euro area to act ascounterparties in these transactions. This use of excess liquidity would have no direct impacton HICP inflation, but the readjustment of portfolios may, under certain circumstances, havean impact on asset prices which, in turn, could have indirect effects on inflation at a later pointin time via wealth effects.

Schemat i c p re sentat ion o f how exces s l i qu id i ty may be used

no significant directimpact on HICP inflation,

but risk of asset priceinflation

short-term instruments includedin M3

structural break inmoney demand

speculative motive

no direct impact onHICP inflation and

no asset priceinflation

positive direct impacton HICP inflation, butlittle direct impact onasset price inflation

precautionary motive transaction motive

aggregate spendinglonger-term assets

29ECB

Annual Report2004

A second possibility is that the excess liquidity will at some point translate into transactionbalances. This is most likely to be the case at a time when economic confidence isstrengthening. To the extent that these balances are used to increase the demand for domesticgoods and services, this could progressively reabsorb the current margins of idle capacity.Should strong consumption growth continue for a sufficiently long time, a tightening ofproduction capacities could eventually cause risks to price stability.

Finally, it cannot be entirely ruled out that the current situation of excess liquidity to someextent reflects a permanent change in the money demand behaviour of economic agents, i.e. astructurally higher liquidity preference and, hence, an increase in the desired level of moneyholdings. Such a permanent change could, for example, be due to structurally higher riskaversion on the part of households as regards financial investments following the significantlosses they incurred on the stock markets between 2000 and 2003. To the extent that such afactor plays a role, excess liquidity in the euro area would be lower than indicated by thecurrent measures and would not have an inflationary impact.

In reality, the situation is probably a combination of these three possibilities. At the currentjuncture, it is difficult to determine whether or not there has been a permanent rise in liquiditypreferences over recent years. At the same time, a continued strong preference for real estatepurchases could be associated with strong rises in real estate prices. Furthermore, there is someevidence that economic agents have readjusted their portfolio behaviour by investing more inlonger-term financial assets. Looking ahead, it cannot be ruled out that some of the excessliquidity will be used for higher nominal transactions, particularly at a time of strongereconomic confidence, and then be associated with higher inflation.

Overall, therefore, even if some of the excess liquidity reflects a higher liquidity preference onthe part of households and companies in the euro area, the high levels reached in 2004 remain aconcern for the ECB and call for vigilance. In order to capture the relative empiricalimportance of the possible scenarios for the use of excess liquidity and, thereby, the risks tomedium-term price stability, the ECB will continue to monitor closely developments on allfronts, in particular: a) evidence of portfolio reversals and the risk of emerging asset pricebubbles, b) evidence of stronger than usual consumption and c) evidence of any structuralchange in money demand.

MONEY MARKET RATES REMAINED BROADLYSTABLEIn 2004 the Governing Council of the ECBdecided to keep its key interest ratesunchanged. As a consequence, money marketrates at the very short end of the yield curveremained broadly stable throughout the year.

Money market interest rates at longer maturitiesdeclined significantly in the first quarter of2004, continuing the downward trend observedfrom mid-December 2003 (see Chart 9).Towards the end of March 2004, in a contextwhere key ECB interest rates were expected to

decline further, the money market yieldcurve became negatively sloped. In fact, theslope of this curve, as measured by thedifference between the twelve-month and theone-month EURIBOR, reached its lowest pointon 26 March 2004, at -7 basis points.

However, between April and June 2004 anormalisation of the slope of the yield curvewas observed, with significant increases ininterest rates at longer maturities, whileinterest rates remained broadly stable at thevery short end of the curve. Thereafter, longer-term money market interest rates remained


Char t 9 Shor t - te rm in te re s t ra te s andthe s l ope o f the money market y i e ldcu rve(percentages per annum; percentage points; daily data)

Source: Reuters.

Q3 Q4 Q1 Q2 Q3 Q4 Q12003 2004

-0.2

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1.8

2.1

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2.7

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one-month EURIBOR (left-hand scale)twelve-month EURIBOR (left-hand scale)spread between twelve-month and one-month EURIBOR (right-hand scale)

Chart 10 Three-month EURIBOR futuresrates and impl ied vo lat i l i ty der ived f romopt ions on three-month EURIBOR futures(percentages per annum; basis points; daily data)

Sources: Bloomberg, Reuters and ECB calculations.

Q3 Q4 Q1 Q2 Q3 Q4 Q12003 2004

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three-month EURIBOR futures maturing in December 2004 (left-hand scale)three-month EURIBOR futures maturing in March 2005 (left-hand scale)implied volatility with constant six months to maturity (right-hand scale)

broadly stable, fluctuating in a very narrowrange of around 10 basis points. At the end ofthe year the one-month and twelve-monthEURIBOR stood at 2.12% and 2.35%respectively, close to the levels reached at theend of 2003.

In the first two months of 2005 EURIBORinterest rates at longer maturities remainedbroadly stable, as market participants expectedshort-term interest rates to remain stable overmost of 2005, and term premia remainedsubdued. On 24 February 2005 the one-monthand the twelve-month EURIBOR stood at2.10% and 2.34% respectively.

The changes in short-term money marketinterest rates in the course of 2004 weregenerally mirrored in the evolution of theimplied three-month EURIBOR futures rate.The implied volatility derived from options onthree-month EURIBOR futures contractsdeclined substantially throughout the year,

indicating that market participants saw verylittle uncertainty in the expected future path ofshort-term interest rates (see Chart 10).

LONG-TERM GOVERNMENT BOND YIELDSDECLINED SIGNIFICANTLY IN 2004Long-term government bond yields in the euroarea ended 2004 at very low levels by historicalstandards. While in the first half of the yeareuro area ten-year government bond yieldsfluctuated somewhat but did not change muchoverall, in the second half of 2004 theyexhibited a protracted downward trend and, byyear-end, had reached 3.7%, significantlybelow the levels prevailing at the end of 2003(see Chart 11).

Overall, these movements in euro area long-term bond yields mainly reflected the changingperceptions of market participants with regardto inflationary pressures and the outlook forthe euro area economy, perceptions which werein turn closely related to changes in global

31ECB

Annual Report2004

Char t 11 Long - te rm government bondy ie lds 1 )

(percentages per annum; daily data)

Sources: Reuters, Bloomberg and Thomson FinancialDatastream.1) Ten-year bonds or the closest available bond maturity.2) From 1 January 2001, data include Greece.

3.0

4.0

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7.0

1999 2000 2001 2002 2003 20043.0

4.0

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euro area 2)

United States

concerns about the sustainability of theeconomic recovery in the United States.

The decline in euro area long-term bond yieldsin the first three months of the year was quicklyreversed from early April onwards. Thesubsequent rise in long-term bond yieldsappeared to be influenced by two main factors.First, there was increasing confidence amongmarket participants regarding the ongoingrecovery in the euro area, by then alsosupported by better prospects for the worldeconomy. Second, market participants becameincreasingly concerned about the potentialinflationary impact of the surge in oil pricesagainst the background of the ongoing globaleconomic recovery. Indeed, in the spring long-term bond yields and break-even inflation ratesedged up amid renewed inflationary concernson the part of investors (see Chart 12).However, such concerns were much lesspronounced in the euro area than in the UnitedStates, where bond yields and break-eveninflation rates rose more sharply.

Between April and June 2004 marketparticipants’ inflation expectations in theeuro area appeared to increase most overshorter horizons, while longer-term inflationexpectations, as measured by implied forwardbreak-even inflation rates, appeared to besomewhat more stable, although theseremained at relatively high levels.3 It is likelythat the increase in euro area break-eveninflation rates reflected to some extent a higherinflation risk premium required by investorsin the light of the uncertainty surroundingthe impact of the oil price developments.Additional information from survey measuresof euro area inflation expectations, which didnot show an increase in the point estimatesfor long-term inflation expectations, wasconsistent with this interpretation.

macroeconomic prospects throughout the year.Market participants’ expectations regardingthe impact of the upsurge in oil prices over theyear strongly influenced perceptions regardingboth inflationary pressures and economicactivity. These expectations, however, seemedto vary over time in line with the flow ofmacroeconomic data releases. Indeed,although in the spring market participantsappeared to be mainly concerned about theinflationary effects of the sharp rise in oilprices, later in the year concerns appeared toshift towards the impact of the high level of oilprices on economic activity.

In the first quarter of the year long-term bondyields in the euro area declined, mirroringmovements in the US market, amid growingconcerns about the strength of the economicrecovery in the United States. Despite thegradual strengthening in euro area economicactivity, long-term index-linked bond yields inthe euro area also declined in the first quarter ofthe year in line with comparable US yields,reflecting the fact that market participants’expectations regarding future global economicactivity appeared to be influenced largely by

3 Chart 12 shows that, in spring 2004, the rise in the 2012 spotbreak-even inflation rate, which reflects, among other things,average inflation expectations between 2004 and 2012, wasstronger than that in the long-term implied forward break-eveninflation rate, which reflects average inflation expectationsbetween 2008 and 2014. This suggests a stronger increase ininflation expectations at shorter horizons.


Developments in oil prices continued to exert asubstantial influence on bond yields over thesecond half of the year. However, markets alsoappeared in this period to be increasinglyconcerned about the impact of oil prices oneconomic activity in the euro area and theglobal economy. This was reflected in thegradual decline, observed from mid-Juneonwards, in long-term nominal and index-linked bond yields, suggesting that the marketsexpected the pace of economic growth in theeuro area to decline somewhat. A furtherdepreciation of the US dollar vis-à-vis the euro,in particular over the last quarter of 2004, alsoseemed to contribute to the moderation inmarket participants’ perceptions of the near-term growth prospects of the euro area. Thedecline in long-term nominal and index-linked

bond yields in the euro area also mirroreddownward revisions to market expectationsregarding the pace of monetary policytightening over the near to medium term.

As a result of these developments, nominallong-term bond yields in the euro area fellsignificantly over 2004, declining by around60 basis points to end the year at 3.7%, close totheir historical lows. The interest ratedifferential vis-à-vis the United Statesremained broadly stable for most of the year,reflecting more or less synchronous changes inthe macroeconomic prospects in the twoeconomies. However, some decoupling oflong-term bond yield movements occurredtowards the end of 2004, when the interest ratedifferential between US and euro area ten-yeargovernment bond yields widened somewhat,reaching a level of almost 60 basis points.

Break-even inflation rates also moderatedslightly in the second half of 2004.Nevertheless, long-term break-even inflationrates in the euro area remained at the end of theyear above their average values since late 2001,when inflation-linked bonds indexed to theeuro area HICP excluding tobacco were firstissued. The ten-year break-even inflation rateended the year at around 2.2%, an increase ofmore than 10 basis points compared withDecember 2003.

A further decline in implied volatility in thebond market – a measure which providesevidence of market views about the rangeswithin which bond yields are expected to movein the near term – was also a noticeable featureof 2004. Indeed, subsequent movements inrealised volatility confirmed those marketexpectations of lower bond market volatility(see Box 3 entitled “Common trends in impliedfinancial market volatility”).

Char t 12 Long - te rm rea l bond y i e ld s andbreak -even in f l a t i on ra te s i n the euroarea(percentages per annum; daily data)

Sources: Reuters, French Treasury and ECB calculations.1) Derived from French Treasury bonds indexed to the euroarea HICP excluding tobacco which mature in 2012.2) For details of calculation, see Box 2 in the February 2002issue of the ECB’s Monthly Bulletin.3) Calculated from index-linked bonds in the euro area,maturing in 2008 and 2014, since the issuance of the latter.

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2002 2003 20040.5

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2012 index-linked bond yield 1)

ten-year break-even inflation rate 2)

long-term implied forward break-even inflation rate 3)

33ECB

Annual Report2004

Box 3

COMMON TRENDS IN IMPLIED FINANCIAL MARKET VOLATILITY

The year 2004 brought a marked overall decline in implied volatility across several financialmarket segments in the euro area and in other advanced economies. Implied volatility – whichis derived from option prices – is usually interpreted as a measure of market participants’uncertainty regarding near-term developments in different financial markets. In 2004 therewas some concern that the relatively low levels of implied volatility might not be fully justifiedinsofar as they may have been driven down by factors other than market participants’expectations of future realised volatility. Such a potential “mis-pricing” of volatility couldconstitute, among other things, a risk to financial stability. If financial institutions, forexample, respond to lower volatility by increasing their risk exposure accordingly, they mightincur heavy losses if an upward correction of volatility were to take place. According toempirical evidence, no such mis-pricing was detected and the decline in implied volatility invarious financial markets was correctly followed by lower realised volatility.1 Lower realisedvolatility, in turn, can be explained, for instance, by an ongoing process of normalisation,especially in the global stock markets, after several years of exceptionally turbulentdevelopments.

Char t A Imp l i ed f i nanc i a l market vo l a t i l i t y i n the euro a rea

(percentages per annum; monthly data)

Sources: Bloomberg and ECB calculations.1) Volatility index for the German DAX index, measuring implied volatility for the next 45 calendar days.2) Implied volatility for options on Bund futures contracts with 22 trading days to maturity.3) Implied volatility for option contracts on the USD/EUR exchange rate with around one month to maturity.

0

10

20

30

40

50

60

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 20040

4

8

12

16

20

stock market (left-hand scale) 1)

bond market (right-hand scale) 2)

foreign exchange market (right-hand scale) 3)

LTCMepisode

terroristattacks of11 September 2001

WorldComepisode

1 See the boxes entitled “Recent trends in implied stock market volatility” and “Recent trends in implied bond market volatility” inthe November and December 2004 issues of the ECB’s Monthly Bulletin respectively.


Char t B Imp l i ed bond and s tock market vo l a t i l i t y i n the euro a rea and the Un i tedS ta te s(percentages per annum; monthly data)

Sources: Bloomberg and ECB calculations.1) Volatility index for the German DAX index, measuring implied volatility for the next 45 calendar days.2) Volatility index for the S&P 500 index, measuring implied volatility for the next 30 calendar days.3) Implied volatility for options on US Treasury futures contracts with 22 trading days to maturity.4) Implied volatility for options on Bund futures contracts with 22 trading days to maturity.

0

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1995 1996 1997 1998 1999 2000 2001 2002 2003 20042

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euro area stock market (left-hand scale) 1)

US stock market (left-hand scale) 2)

US bond market (right-hand scale) 3)

euro area bond market (right-hand scale) 4)

terroristattacks inMadrid

Chart A shows the implied volatility of (i) the German DAX index, as measured by the VDAXvolatility index, (ii) long-term government bonds, as extracted from options on Bund futureswith 22 trading days to maturity, and (iii) the euro exchange rate vis-à-vis the US dollar, asderived from currency options with around one month to maturity. Since all the optionsconcerned are from the same day and have roughly the same remaining time to maturity, theimplied volatility series shown in the chart measure market participants’ uncertainty in allthree market segments over a similar short-term horizon.

In the past, there seemed to be a rather low degree of co-movement in near-term expectedvolatility in the different market segments, except in occasional periods of cross-marketturmoil that were probably triggered by common rather than market-specific shocks. Morerecently, the decline in volatility over the first three quarters of 2004 was quite similar acrossmarkets. In the absence of evidence of mis-priced volatility, this would suggest widespreadand gradually increasing confidence among financial market participants regarding moretranquil market conditions in the near term. Over the last few months of 2004, however, thestrong decline in implied volatility in the USD/EUR exchange rate came to a halt amid arenewed acceleration of US dollar weakness.

Today’s capital markets are highly integrated and one may suspect that the internationalvolatility linkages within each market segment are significant. Chart B below shows theimplied volatility in stock markets in both the United States and the euro area, as measured bythe VIX and the VDAX indices respectively, as well as implied volatility in the corresponding

35ECB

Annual Report2004

long-term bond markets, as derived from options on US Treasury and Bund futuresrespectively.

It is clear from the chart that there is a high degree of co-movement in implied volatility withinboth asset classes in the United States and in the euro area. Moreover, the internationallinkages seem to be somewhat stronger for the equity markets than for the long-termgovernment bond markets. Still, country and market-specific factors can play a dominant role.The terrorist attacks of 11 March 2004 in Madrid, for instance, had a larger, albeit temporary,impact on expected stock market volatility in the euro area than in the United States. The chartalso provides further evidence that the overall decline in implied volatility over the past fewyears has not been restricted to the euro area.

All in all, the linkages within certain financial asset classes across geographic areas are quitestrong, particularly for the equity markets. While there is no general tendency for impliedvolatility to move in parallel across market segments in normal circumstances, there seems tobe a stronger connection in times of turbulence. The recent alignment of implied volatilityacross the three asset classes is noteworthy since it is not related to any financial turmoil and,therefore, lends support to the widespread anticipation among market participants of calmerfinancial market conditions in the near future than was the case at the beginning of 2004.

In early 2005, long-term bond yields in globalmarkets at first continued to decline beforethey sharply rebounded around mid-February2005. As a result, on 24 February ten-yeargovernment bond yields, both in the euro areaand the United States, stood at levels close tothose prevailing at the end of 2004.

EURO AREA STOCK MARKETS CONTINUED TOSHOW STRONG GAINS IN 2004In 2004 euro area stock prices continued theupward trend observed from early 2003 (seeChart 13). The Dow Jones EURO STOXXindex ended the year with a gain of around 10%compared with the end of the previous year, aslightly higher increase than the Standard &Poor’s 500 and the Nikkei 225.

These overall stock price increases in the euroarea appeared to reflect several factors, inparticular declines in long-term interest ratesand strong growth in actual earnings anddividend payouts (see Chart 14).

A substantial decline in stock market volatility,which suggested reduced uncertainty among

market participants regarding the stock marketoutlook, also seemed to contribute positively tothe stock price gains over the year (see alsoBox 3). Potentially negative factors, such asthe somewhat less optimistic outlook forglobal growth as a result of oil price risesand – particularly towards the end of 2004 –exchange rate developments, seemed to haveonly an attenuating effect on stock prices.

As regards the sectoral breakdown, theincrease in euro area stock prices in 2004 wasbroadly based, with only one sector(technology) out of the ten economic sectors ofthe Dow Jones EURO STOXX index recordinglower stock prices at end-2004 than a yearearlier. The strongest gains were recorded inthe healthcare and utility sectors, while thetelecommunication sector recovered in 2004 aswell. The energy sector also outperformed theoverall index, supported by the fact that itsrevenues are positively linked to oil pricedevelopments. This factor also contributed tothe performance of the utility sector, as demandshifts towards alternative energy sources suchas natural gas are common in periods of high oil


Char t 13 Ma jo r s tock market ind i ce s 1 )

(index: 1 January 1999 = 100; daily data)

Sources: Reuters, Thomson Financial Datastream and ECBcalculations.1) The Dow Jones EURO STOXX broad index for the euro area,the Standard & Poor’s 500 for the United States and the Nikkei225 for Japan. From January 2001 onwards, euro area data alsoinclude Greece.

40.0

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euro areaUnited StatesJapan

Char t 14 Growth in ac tua l and expectedcorporate ea rn ings

(annual percentage changes; monthly data)

Source: Thomson Financial Datastream (analysts’ earningsestimates from Institutional Brokers Estimate System, IBES).

-30

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2001 2002 2003 2004-30

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actual earnings per sharelong-term expected earnings per shareexpected earnings per share (12 months ahead)

prices. By contrast, the consumer sector wasweaker than the overall index in 2004, both forcyclical and non-cyclical goods and services.This may reflect investors’ concerns about thestrength of domestic demand, and privateconsumption in particular, in the euro area.

The upward trend in global stock pricedevelopments continued in the first two monthsof 2005. The Dow Jones EURO STOXX indexgained more than 3% between the end of 2004and 24 February, while the Standard & Poor’s500 and the Nikkei 225 also rose slightly in thesame period. These price increases seemed tobe mainly supported by further strongimprovements in corporate profitability.

STRONG DEMAND FOR HOUSEHOLD FINANCEDemand for financing on the part of thehousehold sector was strong in 2004, asreflected by the fact that the annual averagerate of growth of MFI loans to households roseto 7.8%. Household loan dynamics in 2004continued the upward trend observed from thefirst quarter of 2002 and were primarily relatedto robust growth in long-term loans. Over the

first three quarters of 2004 the annual growthrate of total loans to households was higherthan that of loans by MFIs, pointing to acontinued high rate of growth of loans by otherfinancial institutions (OFIs) in the context ofthe securitisation of residential mortgages in anumber of countries.

Long-term MFI loans to households weremostly composed of loans for house purchase.The strong dynamics of this componentwere supported by buoyant house pricedevelopments in several euro area countriesand continued growth in house prices at anannual rate of more than 7% for the euro area asa whole in the first half of 2004. Available datasuggest that growth in household borrowingfor house purchase remained sluggish inmost countries with subdued house pricedevelopments, while it was strong in countrieswhere house prices were rising rapidly (seeChart 15). In a number of euro area countries,developments in house prices and housefinancing may also have contributed tosupporting consumption. The increase in houseprices created greater financing requirements

37ECB

Annual Report2004

but may also have enhanced the access ofhouseholds to credit by increasing the amountof collateral available to them. At the sametime, the strong growth in loans for housepurchase may itself have become a source ofincreases in house prices.

A factor underpinning the strong growth inloans for house purchase was the low cost offinancing for housing loans, which declinedfurther in 2004 from the already low levelprevailing in previous years. This increased theaffordability of house purchases. MFI interestrates on new loans for house purchase with overfive and under ten years’ initial rate fixationdeclined by 52 basis points over the course ofthe year and stood at 4.49% in December 2004(see Chart 16), mirroring developments incomparable market interest rates for medium-term government bonds. It also appears that theoverall availability of financing for householdsimproved in 2004. Indeed, the results of theEurosystem’s bank lending survey suggest thatthere was some easing of credit standardsapplied by banks to the approval of loans forhouse purchase in the last three quarters of2004.

The annual growth rate of consumer credit alsostrengthened in 2004, although from a moresubdued level and with a lag compared with thedevelopments in lending for house purchase.

Char t 15 Hous ing market dynamic s andloans in euro a rea count r i e s

(average annual growth between 1998 and 2003; percentages)

Source: ECB calculations based on MFI data for loans andlatest available national data on house prices.

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y-axis: house pricesx-axis: loans for house purchase

DE AT

IT

ES IENL

FI

PTBE

LU GRFR

Char t 16 MF I i n te re s t ra te s fo r l end ingto househo lds and non- f i nanc i a lco rpora t i on s(percentages per annum; rates on new business; excludingbank overdrafts; weight-adjusted 1))

Source: ECB.1) For the period from December 2003 onwards, the weight-adjusted MFI interest rates are calculated using countryweights constructed from a 12-month moving average of newbusiness volumes. For the preceding period, from January toNovember 2003, the weight-adjusted MFI interest rates arecalculated using country weights constructed from the averageof new business volumes in 2003. For further information, seethe box entitled “Analysing MFI interest rates at the euro arealevel” in the August 2004 issue of the ECB’s Monthly Bulletin.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2003 2004

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loans to households for consumption with a floating rate and up to one year initial rate fixationloans to households for house purchase with over five and up to ten years’ initial rate fixationloans to non-financial corporations over €1 million with a floating rate and up to one year initial rate fixationloans to non-financial corporations over €1 million with over one and up to five years’ initial rate fixation

This strengthening might reflect the gradualimprovement in the European Commission’sindicator of consumer confidence in anenvironment of relatively low interest rates onloans to households for consumption. Theresults of the Eurosystem’s bank lendingsurvey also indicate that the availability of bothcredit for consumption and other lendingimproved as lending conditions eased over thecourse of 2004.


RISING HOUSEHOLD DEBTThe increased borrowing of householdsresulted in a further edging-up of the ratio ofhousehold debt to GDP (see Chart 17). The risein the debt-to-GDP ratio is partly a reflection ofthe move towards an environment of pricestability and lower interest rates in several euroarea countries after the adoption of the euro.Indeed, the debt service burden (i.e. the ratio ofinterest payments and principal repaymentsto disposable income) remained fairly low as aresult of the low level of interest rates. Thedebt-to-GDP ratio of euro area households alsoremained low for example relative to theUnited Kingdom and the United States.Nonetheless, this rise in debt is not withoutrisk, as it increased households’ exposure tochanges in interest rates, income and assetprices. The risk of higher sensitivity applies,for instance, to households that, under thehistorically low interest rate conditions,financed mortgages at variable rates with lowinitial interest payments. Estimates of thissensitivity are surrounded by considerable

uncertainty because, for instance, the share ofexisting mortgage debt exposed to changes inprevailing interest rate conditions depends onthe features of the underlying mortgagecontracts. These features are linked to thenational mortgage market structure, culturalhabits and historical factors, as well asregulatory and fiscal issues, all of which varysubstantially across the euro area.4

LOW COST OF EXTERNAL FINANCING FORNON-FINANCIAL CORPORATIONSDebt financing conditions for non-financialcorporations in the euro area remained veryfavourable throughout 2004, as was reflected incorporate bond market rates and bank interestrates. Firms enjoyed low debt financing costsand generally unconstrained access to sourcesof finance.

As regards financing in the form of securities,the yields on bonds issued by non-financialcorporations stood at historically low levelsboth in nominal and in real terms (seeChart 18). At the same time, real dividendyields (which can be seen as an indicator for thereal cost of equity financing), while remainingat a somewhat higher level than their averagesince the mid-1990s, declined from the peakobserved in 2003.

The low cost of bond financing is to a largeextent a consequence of the historically lowlevels of interest rates across the maturityspectrum, as well as a reflection of investors’perceptions of a positive outlook for corporatecredit risk in the euro area. Spreads betweencorporate bonds and government bonds,particularly for AA and BBB-rated bonds,declined further in 2004 from already lowlevels. The decline in spreads may be explainedby fundamental factors such as the pronounceddecline in volatility in financial markets (seeBox 3 entitled “Common trends in impliedfinancial market volatility”) and improvementsin corporate profitability. At the same time, in

4 For further details, see the box entitled “Features of mortgagecontracts in the euro area” in the November 2004 issue of theECB’s Monthly Bulletin.

Chart 17 Debt-to-GDP ratio and growth inloans of households

(debt-to-GDP ratio and annual growth in percentages;contribution to annual growth rate in percentage points)

Source: ECB.Note: The ratio of debt to GDP is somewhat lower on the basisof the quarterly f inancial accounts than on the basis of theannual f inancial accounts mainly because loans by non-f inancial sectors and banks outside the euro area are notincluded.

45

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0

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15

annual growth rate of loans (right-hand scale)contribution of lending for house purchase (right-hand scale)contribution of consumer credit (right-hand scale)contribution of other lending (right-hand scale)debt-to-GDP ratio (left-hand scale)

1999 2000 2001 2002 2003 2004

39ECB

Annual Report2004

the context of low interest rates, the possibilitycannot be ruled out that an extensive search foryield by investors continued to play a role in thefall in corporate yields.

Turning to the financing costs associated withMFI loans, which are the main form of debtfinancing for non-financial corporations, MFIinterest rates remained broadly stable in 2004(see Chart 16), after the declines whichoccurred in 2002 and 2003, and were very lowoverall.

Firms may have also had easier access to bankcredit in 2004. The results of the bank lendingsurvey conducted by the Eurosystem indicate agradual decrease in the net tightening of creditstandards applied to loans to enterprises duringthe first half of 2004, which became a neteasing in the second half of the year. At thesame time, there were some differencesbetween large enterprises and small andmedium-sized enterprises in terms of financingcosts (see Box 4 entitled “Were small andmedium-sized enterprises subject to lessfavourable financing conditions than largeenterprises in the euro area in 2004?”).

Box 4

WERE SMALL AND MEDIUM-SIZED ENTERPRISES SUBJECT TO LESS FAVOURABLE FINANCINGCONDITIONS THAN LARGE ENTERPRISES IN THE EURO AREA IN 2004?

Small and medium-sized enterprises (SMEs) may, in general, be subject to greater constraintsthan large companies in terms of costs of financing and access to external finance. In contrast tolarger firms, SMEs are typically not able to raise financing in the capital markets and,therefore, have to rely predominantly on bank credit or more expensive types of externalfinance (e.g. trade credit, leasing and factoring, etc.). In addition, smaller firms would beexpected, on average, to suffer more from problems relating to potential creditors’ lack ofinformation when trying to obtain funding as they are often younger and face less rigorousreporting requirements (i.e. they provide less detailed accounting statements, etc.). Moreover,SMEs tend to have less collateral (e.g. fixed assets) to offer, which could mitigate the problemsof inadequate information, than more established larger firms. As a consequence, banks mayoften apply tighter credit standards to loans to smaller and younger firms as they tend to haveless information about these firms.

Chart 18 Ind i ca tor s o f market -basedf inanc ing cos t s o f non- f i nanc i a lco rpora t i on s(percentages per annum)

Sources: ECB, Thomson Financial Datastream, Merrill Lynchand Consensus Economics Forecasts.1) Bond yields of non-f inancial corporations are based on anindex compiled by Merrill Lynch referring to investment-grade non-f inancial corporations as well as on a high-yieldindex. Prior to April 1998, only national data are available(Belgium, France, Germany, Italy, the Netherlands and Spain).Yields are aggregated using GDP weights corresponding to thepurchasing power parity in 2001. Nominal yields are deflatedby average inflation expectations (published by ConsensusEconomics Forecasts) over a period equal to the averageduration of the corporate bonds.2) Dividend yields are def ined as the annual dividendsanticipated by market participants, expressed as a percentageof the share price. Nominal yields are deflated by the HICP.

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-2.0

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real corporate bond yields (left-hand scale) 1)

real dividend yields (right-hand scale) 2)


Chart A Changes in the cred i t standardsappl ied to the approva l o f loans orcred i t l ines to non- f inanc ia l corporat ions(net percentages)

Source: ECB.Note: The net percentages refer to the difference between the sumof the percentages for “tightened considerably” and “tightenedsomewhat” and the sum of the percentages for “eased somewhat”and “eased considerably”.

-20

0

20

40

60

80

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4-20

0

20

40

60

80

SMEslarge enterprises

2002 2003 2004

Furthermore, SMEs often face higher financing costs (e.g. in terms of bank interest rates) thanlarger enterprises. The relatively higher interest rates on small-sized loans may be explainedby a number of factors. For example, there may be fixed costs of lending that are notproportional to the size of the loan. Small corporations may also be riskier than larger and moreestablished ones (although the diversification effects for banks may even be greater withrespect to loans to SMEs). In addition, there may be a lack of competition among lenders toSMEs, which may thus be better able to “lock in” their small-sized borrowers, therebyincreasing these borrowers’ bank switching costs. Moreover, owing to their relativelyconstrained access to, and higher costs of, external financing, SMEs traditionally rely more oninternal financing by holding, on average, more liquid assets in their balance sheets. Sinceholding liquid assets is costly, this may represent an additional burden for small enterprises.1

Against this background, increasing attention has recently been paid to SMEs’ financingconditions in the euro area. The bank lending survey (BLS), which is conducted by theEurosystem four times a year, provides qualitative information on the financing conditions ofSMEs and large enterprises. In particular, the BLS reports the changes in credit standards forloans granted to large enterprises and SMEs (see Chart A). Since the fourth quarter of 2002,banks’ credit standards for loans to SMEs and large companies have followed a broadly similarpattern of a gradual decrease in the nettightening of credit standards. The creditstandards applied to loans to large enterpriseshave tended, on average, to be marginally lesstight, and were even eased (in net terms) fromthe second quarter of 2004 onwards. In thefourth quarter of 2004 the net tightening ofcredit standards on loans to SMEs declinedrelatively more and eased for the first timesince the start of the BLS.

The introduction of the new MFI interest ratestatistics (from January 2003 onwards) allowsrates on loans of different sizes (below andabove €1 million) to be compared.2 Assumingthat loans of more than €1 million are grantedmore often to large enterprises, a comparisonof interest rates charged on loans of differentsizes may provide some information onSMEs’ costs of financing compared withthose of large enterprises. Naturally, this canonly be a rough distinction. Throughout theperiod from January 2003 to December 2004,the level of interest rates on small-sized MFIloans (as measured by MFI interest rates on

1 For a more detailed discussion of the f inancing of SMEs in Europe, see “Europe’s changing f inancial landscape: The f inancing ofsmall and medium-sized enterprises”, EIB Papers, vol. 8, No 2, 2003, and the European Commission’s “SMEs and access tof inance”, Observatory of European SMEs, 2003, No 2.

2 See also Box 13 entitled “Financial integration in the euro area credit market” later in this report.

41ECB

Annual Report2004

Chart B MFI interest rate spreads betweensmal l -s ized loans and large-s ized loans tonon-f inancia l corporations 1), 2)

(percentage points; new business loans)

Source: ECB.1) For the period from December 2003 onwards, the weight-adjusted MFI interest rates are calculated using countryweights constructed from a 12-month moving average of newbusiness volumes. For the preceding period, from January toNovember 2003, the weight-adjusted MFI interest rates arecalculated using country weights constructed from the averageof new business volumes in 2003. For further information, seethe box entitled “Analysing MFI interest rates at the euro arealevel” in the August 2004 issue of the ECB’s Monthly Bulletin.2) Small-sized loans are loans up to €1 million and large-sizedloans are loans over €1 million.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2003 20040.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

over one and up to five years’ initial rate fixationover five years’ initial rate fixationfloating rate and up to one year initial rate fixation

loans of up to €1 million to non-financialcorporations) was between 0.4 and 1.8percentage points higher than the level ofinterest rates on larger MFI loans (asmeasured by MFI interest rates on loans ofmore than €1 million to non-financialcorporations) (see Chart B). Overall in theperiod since January 2003, the spreadsbetween small-sized loans and large-sizedloans changed only slightly. Looking at recentdevelopments in more detail, in 2004, thespread of interest rates on small-sized loansover both those on large-sized loans with overone year’s and up to five years’ initial ratefixation and those on such loans with over fiveyears’ initial rate fixation decreased slightly(by 10 and 15 basis points respectively),while it remained broadly unchanged over theinterest rates on loans with floating rates andup to one year’s initial rate fixation.

It is difficult to draw firm conclusions on thebasis of the evidence available. While the costof financing of SMEs remained relativelyhigh compared with large companies, thedevelopments in 2004 were broadly similarfor small and large companies. At the sametime, some evidence suggests that SMEs’access to finance improved significantly inthe same period.

LIMITED RECOURSE TO EXTERNAL FINANCINGDURING 2004Despite financing conditions remainingfavourable, non-financial corporations hadonly limited recourse to external financing in2004. The annual rate of growth of debtfinancing stood at 4.8% at the end of 2004,slightly higher than the 4.5% at the end of 2003.In the second half of 2004, it picked upsomewhat mainly as a result of an increase inloan financing (see Chart 19). Indeed, theannual growth rate of MFI loans to non-financial corporations rose to 5.4% at the endof 2004, from 3.5% at the end of 2003. At thesame time, the growth rate of the net debt

securities issuance activity of non-financialcorporations was considerably lower in 2004than in the previous year, declining from 10.5%at the end of 2003 to 2.4% at the end of 2004.

The fact that, overall, debt financing flowsremained relatively subdued may be relatedto several factors. First, improvements incorporate profitability, at least for majorcompanies in the Dow Jones EURO STOXXindex (see Chart 14), by boosting internalsavings, may have increased the incentive offirms to reduce their total debt. Second, therelatively slow growth of debt financing mightalso reflect the gradual nature of the current


economic recovery. In this respect, companiesappeared to adopt a cautious wait-and-seeapproach with regard to the financing ofadditional large capital investments.

In 2004 there was also a slowdown in indirectfinancing of non-financial corporationsthrough companies in the non-monetaryfinancial corporations sector. This sectorincludes financial subsidiaries of non-financialcorporations, special-purpose vehicles andother corporations which raise funds on behalfof banks.

The annual growth rate of net issuance ofdebt securities by non-monetary financialcorporations declined from 22.3% at the end of2003 to 13.2% at the end of 2004. Nevertheless,it remained strong compared with the issuanceactivity of the other sectors.

The annual growth rate of quoted shareissuance by non-financial corporations in theeuro area was 0.9% at the end of 2004, broadlyunchanged from the very low level observedover the previous two years. The low recourseto equity financing is a consequence both ofrelatively low demand for external financingand of the very low cost of other sources offinance. The low net issuance of quoted sharesis also, to some extent, a reflection of a numberof more structural developments, such as thedelisting of stocks and buyback operations,which are principally carried out by companiesthat have generated enough cash to bothreinvest in their businesses and buy back theirstocks.

The favourable financing conditions led tosome improvement in the balance sheetpositions of firms in 2004 (see Chart 20). Froma historical perspective, corporate debt ratiosremained at a rather high level. However, as a

Chart 19 Contr ibut ion to the annua lra te o f g rowth o f debt o f non- f i nanc i a lco rpora t i on s(percentage points)

Source: ECB.

debt securitiesMFI loans

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

1999 2000 2001 2002 2003 2004

Char t 20 Ba l ance sheet i nd i ca tor s f o rnon- f i nanc i a l corporat ions

(percentages)

Sources: ECB and Eurostat.Note: The figures for the fourth quarter of 2004 have beenestimated on the basis of transactions reported in the moneyand banking statistics and in securities issues statistics. Thedebt ratios are somewhat lower on the basis of the quarterlyf inancial accounts than on the basis of the annual f inancialaccounts mainly because loans by non-f inancial sectors andbanks outside the euro area are not included.

debt-to-gross operating surplus ratio (left-hand scale) debt-to-GDP ratio (right-hand scale)

130

135

140

145

150

155

160

165

170

1999 2000 2001 2002 2003 200450

55

60

65

43ECB

Annual Report2004

result of the general decline in MFI interestrates, these have not resulted in markedlyhigher debt servicing costs for non-financialcorporations over recent years.

2.3 PRICE DEVELOPMENTS

Overall HICP inflation in the euro area stood atan average of 2.1% in 2004, unchanged fromthe previous year (see Table 1). Higher oilprices and further increases in indirect taxesand administered prices were the main factorsexerting upward pressure on prices. Thesewere offset by a further strengthening of theeuro, subdued demand conditions and thesubstantial decline in the annual growth rateof unprocessed food prices. Yet, despitethe sizeable upward impact of oil pricedevelopments on euro area consumer prices,there was little evidence of stronger underlyinginflationary pressures building up in the euroarea economy. Producer prices grew at anaverage annual rate of 2.3% in 2004, comparedwith 1.4% in 2003, largely on account ofincreases in energy and intermediate goodsprices. However, there were only limited signsof significant pass-through to prices at a laterstage of the production chain. Similarly, wageincreases remained contained in 2004, in the

context of ongoing moderate growth and labourmarket developments.

In January 2005 overall HICP inflation fellto 1.9%, a decline of 0.5 percentage pointcompared with December 2004. This declinewas broadly based across components of HICPinflation and partly driven by base effects. Italso reflected additional favourable influencesfrom the decline in the annual growth rate ofenergy prices, the fall in unprocessed foodprices and deeper seasonal sales discounts insome euro area countries.

HEADLINE INFLATION AFFECTED BY VOLATILECOMPONENTSThe volatile components of the HICP, inparticular energy and to a lesser extentunprocessed food prices, largely explain thepattern of headline inflation in 2004 (seeChart 21).

Oil prices were higher than expected in 2004.In December, the average euro price of a barrelof Brent crude oil stood 25% above its averagein December 2003 (see Box 5 for more detailson the impact of oil prices on the euro areaeconomy). This put significant direct upwardpressure on consumer energy prices in the euroarea, which rose by an average of 4.5% in 2004

2002 2003 2004 2003 2004 2004 2004 2004 2004 2005Q4 Q1 Q2 Q3 Q4 Dec. Jan.

HICP and its componentsOverall index 2.3 2.1 2.1 2.0 1.7 2.3 2.2 2.3 2.4 1.9

Energy -0.6 3.0 4.5 1.6 -1.5 4.8 6.3 8.5 6.9 6.2Processed food 3.1 3.3 3.4 3.8 3.5 3.9 3.6 2.8 3.2 2.8Unprocessed food 3.1 2.1 0.6 3.6 2.2 1.5 -0.3 -0.7 0.0 -0.6Non-energy industrial goods 1.5 0.8 0.8 0.8 0.7 0.9 0.8 0.8 0.8 0.5Services 3.1 2.5 2.6 2.4 2.6 2.6 2.6 2.7 2.7 2.4

Other price and cost indicatorsIndustrial producer prices 1) -0.1 1.4 2.3 1.0 0.2 2.0 3.1 3.8 3.5 .Oil prices (EUR per barrel) 2) 26.5 25.1 30.5 24.5 25.0 29.3 33.3 34.5 30.0 33.6Commodity prices 3) -0.9 -4.5 10.8 -1.2 9.8 20.9 11.9 1.3 -0.2 -1.9

Table 1 Price developments

(annual percentage changes, unless otherwise indicated)

Sources: Eurostat, Thomson Financial Datastream and Hamburg Institute of International Economics.1) Excluding construction.2) Brent Blend (for one-month forward delivery).3) Excluding energy; in EUR.


Chart 22 Contributions to HICP inf lat ionfrom sub-components

(annual percentage point contributions; monthly data)

Source: Eurostat.Note: Due to rounding, the contributions do not add up exactlyto the overall index.

Q1 Q2 Q3 Q42003 2004

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

servicesnon-energy industrial goodsprocessed foodunprocessed foodenergyoverall index

Chart 21 Breakdown of HICP inf lat ion: mainsub-components


Source: Eurostat.

1999 2000 2001 2002 2003 2004-2

0

2

4

6

-6

-3

0

3

6

9

12

15

18

total HICP (left-hand scale)unprocessed food (right-hand scale)energy (right-hand scale)

1999 2000 2001 2002 2003 2004-2

0

2

4

6

-2

0

2

4

6

total HICP excl. energy and unprocessed foodprocessed foodnon-energy industrial goodsservices

after 3.0% in 2003. Their contribution of 0.4percentage point to the average annualinflation rate in 2004 was the highest in fouryears (see Chart 22).

Driven by strong base effects in the energycomponent of the HICP, headline inflationdeclined to around 1.7% year on year in the firstquarter of 2004. It then started to rise in line withunexpected energy price increases and peaked at2.5% in May. This upward pressure largely offsetthe moderating impact of unprocessed foodprices, for which the annual growth rate declinedfrom 2.1% on average in 2003 to 0.6% in 2004.Over the summer and autumn, unprocessed foodprices, dampened by favourable weather

conditions, had a moderating influence onoverall HICP developments. However, HICPinflation remained slightly above 2% until theend of the year.

Other sources of external inflationarypressures were also at work in 2004. Inparticular, non-oil commodity prices increasedstrongly in the first half of the year, beforemoderating. However, the significantappreciation of the euro partly offset theinflationary impact of both oil and non-oilcommodity prices.

The remaining, less volatile components of theHICP contributed to some persistence in

45ECB

Annual Report2004

headline inflation in 2004, notably due todevelopments in indirect taxes andadministered prices. As in 2003, furtherincreases in tobacco taxes were introduced inseveral euro area countries, contributing tosignificant upward pressure on processed foodprices. Consequently, processed food pricesgrew at an average of 3.4% in 2004, comparedwith 3.3% in 2003. The annual rate of changeof non-energy industrial goods prices stoodat 0.8% in 2004, unchanged from 2003. Adecline in this component was prevented byincreases in administered prices, in particular

for healthcare goods and pharmaceuticalproducts. Similarly, government measurestargeting administered prices for health caretriggered substantial increases in medical,dental and hospital services prices. Theseexplained the increase in overall servicesprice growth, from 2.5% in 2003 to 2.6% in2004. The upward impact of energy priceson transport costs also contributed, albeit to alesser extent, to the increase in services pricesas a whole. Box 5 details the impact of oil pricedevelopments on the euro area economy.

Box 5

OIL PRICES AND THE EURO AREA ECONOMY

This box describes oil price developments in 2004 and their effect on the euro area economy.First of all, it puts the oil price increase of 2004 into a historical perspective. It then goes on todescribe the channels through which oil prices affect euro area inflation and output growth.Finally, it gives a tentative quantification of the impact of the oil price increase, but stressesthat some effects cannot be captured by models.

Developments in oil prices from a longer-term perspective

Oil prices in US dollars rose to record levels in nominal terms during 2004. There are, however,key differences between this increase and previous oil price shocks. First, the increase in 2004

Chart A Brent crude oi l pr ices

(per barrel)

Sources: IMF and ECB calculations.Note: Real oil prices allow a comparison of the impact of oil price developments on purchasing power over time. They are computed bydeflating nominal oil prices with the euro area HICP with December 2004 as a base. Price data before 1990 refer to national CPI data.

0

10

20

30

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50

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70

80

0

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30

40

50

60

70

80

nominal in EURreal in EURnominal in USD

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


Chart B Oi l pr ices and the contribution ofenergy components to HICP inf lat ion

(percentage point contribution, unless otherwise indicated)

Chart C Oi l pr ices and the contribution oftransport components to HICP inf lat ion

(percentage point contribution, unless otherwise indicated)

Sources: Eurostat, Thomson Financial Datastream and ECB calculations.

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

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-20

0

20

40

60

80

100

liquid fuels (left-hand scale)heat energy (left-hand scale)lubricants (left-hand scale)oil price in EUR (annual rate of change, right-hand scale)

1997 1998 1999 2000 2001 2002 2003 20040.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

-40

-20

0

20

40

60

80

100

combined passenger transport (left-hand scale)passenger transport by air (left-hand scale)passenger transport by road (left-hand scale)oil price in EUR (annual rate of change, right-hand scale)

1997 1998 1999 2000 2001 2002 2003 2004

1973-1974 1978-1979 1999-2000 2003-2004

in USD 204 125 60 33in EUR 210 110 84 20

Increases in Brent crude oi l pr ices overspeci f ic periods(percentage change of the annual average)

Sources: IMF and ECB calculations.

was considerably smaller than those observedduring other major oil price shocks (seetable). On average, the price of Brent crudeoil in 2004 was 33% higher than in 2003.Nonetheless, as a result of the overallappreciation of the euro against the US dollar,oil prices in euro terms went up by 20% in2004. Second, after taking account of inflation, i.e. in real terms, oil prices were significantlylower in 2004 than they were during earlier periods of high prices (see Chart A). Third, thefactors driving the price increase in 2004 also differed from earlier oil price shocks. In contrastto the oil price increases of 1973, 1979, 1990 and 1999, which were mainly caused by sizeabledisruptions to the supply of oil, a variety of factors had an impact on oil prices in 2004. Thesefactors include buoyant demand for oil that surpassed expectations, the dwindling global sparecapacity and concerns over the security of supplies from several oil-producing countries.

Transmission of oil price changes to euro area inflation

Turning to the impact of the oil price increase on euro area prices, it is helpful to distinguishbetween direct, indirect and second-round effects.1 First, direct effects refer to the impact of anoil price change on the overall HICP through its immediate effect on consumer prices ofenergy. The energy component constitutes 8% of the overall HICP and is strongly correlatedwith oil prices in euro terms. Chart B shows the contribution of the most important oil-relateditems of the energy component to the annual overall HICP inflation rate along with oil pricedevelopments. This chart shows that the direct effect materialises within a year of the oil priceincrease.

1 See also the article entitled “Oil prices and the euro area economy” in the November 2004 issue of the ECB’s Monthly Bulletin andthe box entitled “Recent oil price developments and their impact on euro area prices” in the July 2004 issue of the same publication.

47ECB

Annual Report2004

2 For further information, see also the article referred to in footnote 1.

Second, indirect effects refer to the possibility that, in addition to direct effects, an oil priceshock, by increasing energy input costs, may have an impact on the prices of other goods andservices. This may result in a more general rise in prices, although it also depends on the extentto which profit margins can absorb rising costs. As an example, Chart C illustrates the indirecteffect through transport-related service components of the HICP. The contribution of thesecomponents to overall HICP inflation tends to increase with some lag after oil price increases.It should, however, be noted that other factors also have an impact on these components, whileother components of the HICP are also indirectly affected by oil price changes.

Finally, second-round effects refer to the possibility that, in addition to the direct and indirecteffects mentioned above, an oil price shock may have a further impact on inflation because itmight result in higher wage claims to compensate for the decline in real income. Such second-round effects tend to occur with a lag. Typically, besides the expectations concerning thepersistence of the shock, the occurrence of second-round effects depends on whether theeconomic context, in particular the labour market situation, encourages higher wage claims. In2004, second-round effects related to the oil price shock remained contained owing to thecyclical position of the euro area economy and labour market conditions. Less wage indexationthan in the 1970s and 1980s may have also contributed to reducing the role played by inflationin the wage formation process.

Transmission of oil price changes to euro area output growth

There are primarily two channels through which oil price shocks affect the real economy. First,there is the supply-side channel, because oil is an important input factor in the productionprocess. A rise in the price of oil entails, particularly in the short term, an increase inproduction costs, as the options for substituting other energy sources for oil are limited. Thelevel of output may fall as a result of the oil price increase, which may also imply lower demandfor other production factors such as labour. Second, on the demand side, an increase in oilprices entails a deterioration in the terms of trade of net oil-importing economies like the euroarea. The resulting decline in real income translates into lower domestic demand insofar as it isnot compensated for by reduced saving or increased borrowing. A number of other channels,which are more difficult to measure, transmit the effects of an oil price shock via confidence orstock markets for example.

Model-based quantification of the impact of the oil price increase

The impact of the oil price increase observed over the last year on euro area inflation and realGDP growth can be approximated using different models. Such estimations generally suggestthat a 20% increase in oil prices raises euro area inflation by about 0.2 percentage point in thefirst year, with a further impact of around 0.1 percentage point expected for the following twoyears. As regards real GDP growth, the estimated impact would amount to around -0.1 to -0.3percentage point in the first year, with only a minor effect in the second and third years.2


The simulation results should, however, not be taken at face value. On the one hand, severalcaveats should be clearly borne in mind, such as the possible existence of non-linearities andasymmetries, and the fact that models do not include all possible transmission channels. On theother hand, it should also be noted that, from a structural perspective, several factors suggestthat the euro area economy has become more resilient to oil price shocks in recent years, withthe result that model simulations could overestimate the impact. First of all, compared with the1970s, the oil intensity of production and the share of oil consumption in total energyconsumption have fallen significantly in the euro area. Moreover, labour and product marketsappear to have become somewhat more flexible, allowing for a smoother and fasterreallocation of resources, which should reduce the impact of an oil price shock on the economy.Furthermore, the credibility and the reaction of monetary policy play an important role indetermining the impact of oil price increases on the euro area economy, renderingquantification of the effect uncertain.

However, further structural reforms are clearly needed to increase the ability of the euro areaeconomy to adjust more smoothly and quickly to future shocks. In particular, increasing thedegree of effective competition in the euro area energy sector would be highly beneficial as itwould allow higher oil prices to be absorbed without significant distortions. To this end,compensating for oil price increases with fiscal measures, such as tax cuts, is not advisablebecause this would increase existing distortions in the allocation of resources and thus preventeconomic agents from adjusting to such an external shock.

DYNAMIC RESIDENTIAL PROPERTY PRICESEuro area residential property prices, which arenot included in the measurement of the HICP,continued to rise strongly in 2004, increasingby 6.9% in the first half of 2004 comparedwith the first half of 2003. This figure concealscontrasting developments across euro areacountries, with double-digit increases in Spain,Ireland, France and Italy, and a small decline inGermany. Available data for the second half of2004 suggest that strong price increasescontinued, which would make 2004 thefourth consecutive year in which residentialproperty prices increased by around 6-7% (seeChart 23). However, this period of sustainedand robust increases followed a period ofrelatively modest increases (of less than 3%)during the mid-1990s.

INCREASING PRODUCER PRICES AT EARLY STAGESOF THE PRODUCTION CHAINThe overall annual rate of growth of industrialproducer prices in the euro area (excludingconstruction) rose steadily in the course of2004 (see Chart 24). The increase gathered

momentum in the second quarter and wasprimarily driven by energy and intermediategoods prices. This is in line with rising oil andnon-oil commodity prices, which put pressureon input prices at early stages of the productionchain. On average, intermediate goods pricesrose by 3.5% in 2004, compared with 0.8% in2003.

There was, however, little sign of significantprice pressures building up at later stages of theproduction chain. On average, consumer goodsproducer prices grew by 1.3%, still below theirhistorical average but above the averageincrease of 1.1% in 2003. A significant part ofthe increase in consumer goods producer pricesbetween 2003 and 2004 resulted from tobaccotax increases. More generally, as it takes timefor upward pressure from input prices to feedthrough the production chain, the lagged effectof commodity price increases, alreadyobserved at earlier stages of production, onconsumer goods producer prices may have onlystarted to gather momentum in early 2005.However, subdued demand conditions may

49ECB

Annual Report2004

Chart 23 Residential property pricedevelopments in the euro area

(annual percentage changes; annual data)

Source: ECB calculations, based on non-harmonised nationaldata.Note: Data for 2004 refer to the f irst half of the year.

1992 1994 1996 1998 2000 2002 20040

2

4

6

8

10

0

2

4

6

8

10

in nominal terms

Chart 24 Breakdown of industr ia l producerprices


Source: Eurostat.

1999 2000 2001 2002 2003 2004-12

-8

-4

0

4

8

12

16

20

24

-6

-4

-2

0

2

4

6

8

10

12

energy (left-hand scale)industry excl. construction (right-hand scale)intermediate goods (right-hand scale)capital goods (right-hand scale)consumer goods (right-hand scale)

prevent firms from passing on increases inenergy and intermediate goods prices.

MODERATE DEVELOPMENTS IN LABOUR COSTS IN2004Labour cost indicators in the euro areacontinued to ease in 2004 compared with recentyears (see Table 2). Growth in compensationper employee showed a decline in the first halfof 2004, with an average annual growth rate of2.2% compared with 2.4% in 2003. This

decline was broadly based across the mainsectors of the economy (see Chart 25), althoughit was somewhat stronger in market-relatedservices. Available data on compensation peremployee in the second half of 2004 point to afurther moderation of wage growth. This is alsosuggested by other labour cost indicators. Theannual growth rate of negotiated wages stoodat 2.2% in 2004, compared with 2.4% in 2003.Anecdotal evidence from wage bargainingagreements signed in the period up to late 2004

2002 2003 2004 2003 2004 2004 2004 2004Q4 Q1 Q2 Q3 Q4

Negotiated wages 2.7 2.4 2.2 2.2 2.3 2.3 2.0 2.2Total hourly labour costs 3.7 2.8 . 2.3 2.8 2.2 1.9 .Gross monthly earnings 3.0 2.6 . 2.5 2.6 2.5 2.3 .Compensation per employee 2.5 2.3 . 2.2 2.2 2.1 1.4 .Labour productivity 0.3 0.3 . 0.6 1.2 1.7 1.3 .Unit labour costs 2.2 2.0 . 1.5 1.0 0.4 0.1 .

Table 2 Labour cost indicators

(annual percentage changes, unless otherwise indicated)

Sources: Eurostat, national data and ECB calculations.


Chart 25 Sectoral compensation peremployee

(annual percentage changes; quarterly data)

Sources: Eurostat and ECB calculations.

1999 2000 2001 2002 2003 20040.0

1.0

2.0

3.0

4.0

5.0

0.0

1.0

2.0

3.0

4.0

5.0

industry excl. constructionconstructionservices

in several euro area countries did not suggestthe emergence of second-round effects ofhigher oil prices. The annual growth rate of

hourly labour costs also declined graduallythroughout 2004, to reach an averagesignificantly lower than in 2003. With ongoingmoderate real GDP growth and limitedpressure in euro area labour markets, wagedevelopments remained subdued in 2004.

The moderate growth in wages combined with arebound in productivity growth rates to anaverage of 1.4% in the first three quarters of2004 resulted in a significant decline in unitlabour cost growth. Unit labour costs grew byan average of 0.5% in the first three quartersof 2004, compared with 2.0% in 2003.

2.4 OUTPUT, DEMAND AND LABOUR MARKETDEVELOPMENTS

ECONOMIC RECOVERY CONTINUED IN 2004The recovery of economic activity in the euroarea, which started in the second half of 2003,continued in 2004. At 1.8%, the highest raterecorded since 2000, overall GDP growth in

Annual rates 1) Quarterly rates 2)

2002 2003 2004 2003 2004 2004 2004 2004 2003 2004 2004 2004 2004Q4 Q1 Q2 Q3 Q4 Q4 Q1 Q2 Q3 Q4

Real gross domestic product 0.9 0.5 1.8 0.8 1.6 2.2 1.9 1.6 0.4 0.7 0.5 0.2 0.2of which:Domestic demand 0.4 1.2 1.9 1.5 1.2 1.7 2.6 1.9 1.0 0.3 0.3 0.9 0.3

Private consumption 0.7 1.0 1.1 0.6 1.2 1.2 0.9 1.3 0.0 0.8 0.0 0.1 0.5Government consumption 3.1 1.6 1.6 1.4 1.9 1.8 1.5 1.2 0.5 0.2 0.4 0.4 0.2Gross fixed capital formation -2.5 -0.6 1.7 0.2 1.2 1.9 2.1 1.6 1.1 -0.1 0.5 0.6 0.6Changes in inventories 3), 4) -0.1 0.4 0.5 0.8 -0.1 0.2 1.3 0.5 0.7 -0.1 0.1 0.7 -0.1

Net exports 3) 0.5 -0.6 0.0 -0.6 0.4 0.6 -0.6 -0.3 -0.6 0.4 0.2 -0.7 -0.2Exports 5) 1.9 0.2 5.6 0.2 3.6 7.2 5.6 6.0 0.1 1.4 2.7 1.3 0.5Imports 5) 0.5 2.0 5.9 2.0 2.8 6.0 7.8 7.1 1.7 0.4 2.4 3.1 1.0

Real gross value addedof which:

Industry excl. construction 0.4 0.2 2.2 0.9 1.3 3.6 2.6 1.2 0.8 0.8 1.1 -0.1 -0.6Construction -0.2 -1.5 0.8 -1.0 0.8 1.1 0.6 0.8 0.1 0.6 0.5 -0.7 0.3Purely market-related services 6) 1.0 0.9 1.9 0.9 1.5 2.4 1.8 2.0 0.1 0.8 0.8 0.2 0.3

Table 3 Composit ion of real GDP growth

(percentage changes, unless otherwise indicated; seasonally adjusted)

Sources: Eurostat and ECB calculations.1) Percentage change compared with the same period a year earlier.2) Percentage change compared with the previous quarter.3) As a contribution to real GDP growth; in percentage points.4) Including acquisitions less disposals of valuables.5) Exports and imports cover goods and services and include internal cross-border trade in the euro area. Since intra-euro area tradeis not cancelled out in import and export f igures used in national accounts, these data are not fully comparable with balance ofpayments data.6) Includes trade, transport, repairs, hotels and restaurants, communication, f inance, business services, real estate and renting services.

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2004 was broadly in line with expectationstowards the end of 2003. The recovery was ledby the strength of exports, which were 5.6%higher in 2004 than in 2003. Domestic demand,especially investment, was also higher.However, various developments which had notbeen fully anticipated prevented the recoveryfrom strengthening over the course of 2004. Inparticular, growth on a quarter-on-quarterbasis was higher in the first half of the year thanin the second. Oil price and exchange ratedevelopments weighed on growth, and onlygradually improving labour market conditionsand low consumer confidence contributed tothe weakness in private consumption.

From mid-2003 to mid-2004 the recoverywas largely driven by export growth, whilethe contribution of final domestic demand(i.e. excluding changes in inventories) wasrelatively modest (see Chart 26). The moderationof quarter-on-quarter growth in the second halfof 2004 largely resulted from a marked decline inthe contribution from the external sector, whichwas only partially compensated for by graduallyincreasing final domestic demand growth. Thecontribution from inventories was relativelysignificant in some quarters during the recoverybut was also volatile. With the exception ofchanges in inventories, these developments arebroadly consistent with the characteristics ofrecoveries observed in the past few decades in theeuro area.

As regards the domestic side, quarter-on-quarter growth in private consumption was onaverage relatively weak during 2004, reflectingnot only subdued labour market developmentsbut also continuing uncertainty regarding theimplementation of necessary structural reforms(see Box 6 for more details on the progresswith structural reforms). This is likely to haveweighed on consumer confidence. Gross fixedcapital formation rose significantly during2004, despite the negative impact of significantdeclines in German construction investmentgrowth in the first half of the year and of falls ingeneral government investment in the secondhalf.

The pattern of economic growth in 2004 wasalso influenced by specific external factors,including oil price and exchange ratedevelopments. Euro area growth was affectednot only by the direct impact of oil priceincreases, in the form of increased productioncosts and reduced purchasing power ofconsumers’ income, but also indirectly via theimpact on the international environment. Thestrong expansion of global economic activityobserved at the beginning of 2004 wasdampened in the second half of the year. It wasaffected by, among other factors, oil priceincreases recorded from mid-2004 onwards,which thus contributed to reducing the growthof foreign demand for euro area exports duringthe second half of the year. Similarly, thesignificant appreciation of the euro exchangerate observed during most of 2003, despitehaving reduced the cost of oil for euro areaimporters, also had a lagged negative effect onthe competitiveness of the euro area as a whole.

Chart 26 Contributions to quarterly realGDP growth

(quarterly percentage point contributions; seasonally adjusted)

Sources: Eurostat and ECB calculations.1) Percentage change compared with the previous quarter.

real GDP 1)

final domestic demandexports

2001 2002 2003 2004-1.0

-0.5

0.0

0.5

1.0

1.5

-1.0

-0.5

0.0

0.5

1.0

1.5


Box 6

PROGRESS WITH STRUCTURAL REFORMS IN EU LABOUR AND PRODUCT MARKETS

Structural reforms in product and labour markets are essential to enhance Europe’s economicgrowth potential, facilitate adjustment and increase resilience to shocks. Measures to raise thepotential rate of economic growth are all the more important in view of the downward impactthat population ageing is likely to have on future labour supply. In March 2000 the LisbonEuropean Council introduced an ambitious reform agenda aimed at making the EU the mostcompetitive and dynamic knowledge-based economy in the world by 2010. The November2004 report by the high-level group chaired by Wim Kok1 formed the starting point for the mid-term review of this strategy. In February 2005 the European Commission’s Spring Report tothe European Council called for increased national ownership of the Lisbon strategy, itssimplification and streamlining and an increased focus on growth and employment. The mid-term review of the strategy was concluded by the European Council in March 2005. This boxbriefly reviews the progress made in implementing the EU’s reform agenda over recent yearsand particularly in 2004.

The EU defines overarching priorities for various fields of economic policy in the BroadEconomic Policy Guidelines (BEPGs). These priorities then form the basis of policyrecommendations which are made for each EU Member State. In the field of labour markets,the BEPGs for the period 2003-05, together with the update of the BEPGs carried out in 2004 toincorporate the new Member States, stress the need to: (i) improve the combined incentiveeffects of taxes and benefits in order to make work pay, (ii) ensure efficient, active labourmarket policies targeted towards the most disadvantaged groups, (iii) promote a more flexibleorganisation of work and review employment contract regulations, (iv) facilitate geographicaland occupational mobility, and (v) ensure that wage bargaining systems allow wages to reflectproductivity.

Over recent years a number of countries have implemented reforms in their tax and benefitsystems in order to reduce non-wage labour costs and encourage labour supply. Income taxrates have decreased in the bottom and middle income brackets and employees’ and employers’social security contributions have been reduced, particularly for the low-paid. Moreover,progress has been made in increasing the employment rate among people on the margins of thelabour market. Some Member States have strengthened the role of temporary work agenciesand relaxed employment protection legislation on temporary contracts. There have also beenchanges to working time regulations to allow for a more flexible calculation of maximumallowable working hours across the EU, and the right to work part-time has been extended insome countries. There is some evidence that firms have acquired greater flexibility in their useof labour resources as a result of reforms implemented in the past. For example, recentevidence suggests that the adjustment of working hours played a more important role in theeuro area in the 2001-03 slowdown than in earlier cycles.2

1 For more details, see Section 1.1 of Chapter 4.2 For more details, see the box entitled “Developments in total hours worked in the euro area” in the October 2004 issue of the ECB’s

Monthly Bulletin.

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Most EU Member States introduced further labour market reforms in 2004, including thecontinued reform of income tax systems, the restructuring of social security and benefitsystems, and policies to increase the average retirement age. However, reforms seem to lagbehind what is implied in government announcements. Limited progress has been made inattracting more people into the labour market, investing in human capital accumulation andincreasing the adaptability of both workers and enterprises to changing macroeconomicconditions. Measures that aim to reduce long-term unemployment through retraining and seekto increase labour productivity through vocational and professional development and lifelonglearning continue to be priority areas for reform. Moreover, further reforms are needed toencourage labour mobility by improving the transferability of pensions and healthcare rightsand by allowing wage differentiation according to local, regional and sectoral differences inproductivity.

The structural reform agenda for product markets covers a wide range of areas. Among otherthings, the BEPGs urge Member States to foster competition in goods and services markets by:(i) transposing internal market directives more quickly into national legislation, (ii) furtheropening up public procurement, (iii) giving adequate powers and resources to competitionand regulatory authorities and ensuring their independence, (iv) reducing state aid and(v) encouraging market entry and effective competition in network industries.

The percentage of EU internal market legislation which Member States had not yet transposedinto national law (known as the “transposition deficit”) increased further. The EuropeanCommission has taken several steps to improve the functioning of the internal market, inparticular in the service sector, where some significant barriers to its functioning remain. Manyof these barriers appear to be due to national regulations, for example administrative burdensand procedures for setting up subsidiaries in other EU countries. At the beginning of 2004 theIrish, Dutch, Luxembourg and British presidencies agreed upon a joint initiative to prioritiseregulatory reforms over the course of 2004 and 2005 and step up efforts to reduce theadministrative burden. Many countries have taken steps to improve the efficiency andtransparency of public procurement procedures. In addition, some countries have increased thepowers and independence of their competition and regulatory authorities. Moreover, the trendtowards reducing and redirecting state aid towards horizontal objectives seems to havecontinued over recent years, although state aid still plays an important role in some sectors,such as transport. Member States have continued to implement regulatory reforms in networkindustries, although the regulatory reform agenda in this area has not yet been completed.De facto competition in previously sheltered sectors, such as electricity and gas, should beincreased further.

To sum up, further progress with structural reform was made in 2004, especially in labourmarkets, but overall the pace of reform remained disappointing. As a result, the EU will mostlikely not be able to achieve the Lisbon targets unless Member States vigorously step up theirefforts to implement reform. Renewed momentum in the process of structural reform will notonly increase overall economic efficiency and enhance longer-term growth prospects, but willalso strengthen the basis for a sustained economic upswing.


From a sectoral perspective, value addedgrowth tended to track overall real outputdevelopments over the cycle. In particular,value added growth in both manufacturing andpurely market-related services was sustainedduring the first half of 2004 but moderated inthe second half. The cyclical movement of theeconomy in the past year seems therefore tohave been driven mainly by aggregate, ratherthan sector-specific, disturbances.

Various dispersion measures indicate that thedivergence of real GDP growth rates amongeuro area countries declined in 2004.Reflecting in part the global economicupswing, average annual real GDP growthincreased in all euro area countries in 2004compared with the year before, except inGreece, where it nonetheless remainedrelatively strong.

IMPROVEMENT IN LABOUR MARKET ANDPRODUCTIVITY GROWTH IN 2004Labour market conditions did not changesignificantly in the euro area in 2004, althoughsigns of a gradual improvement can bedetected. After remaining broadly unchangedin 2003, employment rose throughout 2004 (seeTable 4). The overall increase was moderate,

however. This was partly in line with thelagged response of employment to economicactivity but also reflected the unusualresilience of employment (measured in termsof persons employed) during the economicslowdown in 2001-03, which lessened the needto hire labour at this stage of the upturn. Whiledevelopments in the number of personsemployed were relatively stable during therecent cyclical phases, available evidenceindicates that employment in terms of hoursworked was more responsive to the businesscycle. This suggests that during the recentslowdown and subsequent recovery employersmay have decided to adjust employment morein terms of hours than in terms of personsemployed.

Employment continued to decline in industry(excluding construction) in the course of 2004,although to a decreasing extent over successivequarters, while it rose continuously in theservices sector. Labour productivity continuedto recover significantly during 2004(especially in the industrial sector) (seeChart 27). Labour productivity growth hadbeen increasing since mid-2003, reflectingusual cyclical developments in activity andemployment.

2002 2003 2004 2002 2002 2003 2003 2003 2003 2004 2004 2004 2004Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Labour force 1.0 0.7 . 0.1 0.1 0.2 0.2 0.1 0.1 0.2 0.1 0.2 .

Employment 0.6 0.2 . -0.0 0.0 0.0 0.1 0.0 -0.0 0.1 0.2 0.2 .Agriculture 1) -2.1 -2.5 . -0.8 -0.7 -0.9 -0.6 -0.1 -0.1 -0.4 0.1 -0.1 .Industry 2) -1.2 -1.5 . -0.4 -0.5 -0.3 -0.3 -0.5 -0.5 -0.5 0.3 -0.2 .– excl. construction -1.3 -2.0 . -0.4 -0.6 -0.5 -0.5 -0.5 -0.7 -0.6 -0.0 -0.2 .– construction -0.7 -0.2 . -0.3 -0.1 0.1 0.4 -0.4 -0.0 -0.2 1.2 -0.1 .Services 3) 1.4 1.0 . 0.2 0.3 0.2 0.3 0.2 0.1 0.4 0.2 0.3 .

Rates of unemployment 4)

Total 8.2 8.7 8.8 8.3 8.4 8.6 8.7 8.7 8.8 8.9 8.8 8.8 8.8Under 25 years 16.8 17.6 17.8 16.9 16.8 17.2 17.5 17.6 18.0 18.0 18.0 17.8 17.625 years and over 7.0 7.4 7.6 7.1 7.2 7.4 7.4 7.5 7.5 7.6 7.6 7.6 7.6

Table 4 Labour market developments

(percentage changes compared with the previous period; percentages)

Sources: Eurostat and ECB calculations.1) Includes f ishing, hunting and forestry.2) Includes manufacturing, construction, mining and quarrying, electricity, gas and water supply.3) Excludes extra-territorial bodies and organisations.4) Percentage of the labour force according to ILO recommendations.

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Chart 27 Labour productivity

(annual percentage changes)

Source: Eurostat.

1996 1998 2000 2002 2004-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

whole economyindustry excl. construction

Chart 28 Unemployment

(monthly data; seasonally adjusted)

Source: Eurostat.Note: Data refer to the Euro 12 (including periods prior to 2001).1) Annual changes are not seasonally adjusted.

annual change in millions (left-hand scale) 1)

percentage of the labour force (right-hand scale)

1994 1996 1998 2000 2002 2004-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

The unemployment rate in the euro arearemained broadly stable at 8.8% in 2004 (seeChart 28). There was also no significant changerecorded in the unemployment rates by agegroup and by gender. However, the number ofunemployed decreased by about 50,000persons overall in 2004, after having increasedmarkedly in 2003. These signs of improvement,albeit modest, were in line with otherindications of a turning-point in the labourmarket. These include developments in thenumber of vacancies, which increased in thesecond half of 2004 after having fallencontinuously since 2001.

The unemployment rate in most euro areacountries was broadly unchanged on averagebetween 2003 and 2004, although theunemployment figures recorded in somecountries were affected to some extent bystatistical changes. All in all, the degree of

dispersion of unemployment rates among euroarea countries declined slightly in 2004.


Main demographic developments in the euro area

-14.0

-10.0

-6.0

-2.0

2.0

6.0

10.0

1990-1995

1995-2000

2000-2005

2005-2010

2010-2015

2015-2020

2020-2025

2025-2030

2030-2035

2035-2040

2040-2045

2045-2050

62.0

66.0

70.0

74.0

78.0

82.0

86.0

population growth rate (percentage change; left-hand scale)total fertility rate (left-hand scale)life expectancy (years; right-hand scale)

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 20500.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

% of population aged 15-64 (left-hand scale)% of population aged 65 and above (left-hand scale)old age dependency ratio (right-hand scale)

Sources: United Nations 2002 World Population Prospects (medium fertility variant) and ECB calculations.1 The f igures in this paragraph and the charts refer to the “medium variant” assumptions regarding fertility, which can be seen as the

most likely. For more information, see “World Population Prospects: The 2002 Revision”, United Nations.

Box 7

POTENTIAL EFFECTS OF DEMOGRAPHIC CHANGE IN THE EURO AREA

Recent and projected demographic dynamics in the euro area, as in many other industrialisedcountries, are characterised by decreasing population growth and a gradual ageing of thepopulation. These developments are the result of low fertility rates in most euro area countriesand increasing life expectancy. Although considerable uncertainty surrounds all demographicprojections, these patterns seem to be common to most, including those by Eurostat and theUnited Nations. This box discusses some of the main implications.

Demographic changes

According to the most recent projections available for euro area countries (the United Nations2002 World Population Prospects1), total fertility rates in the euro area are expected to remainbelow the population replacement level of about two children per woman in the period to 2050. Atthe same time, average life expectancy is expected to increase by five years between 2005 and2050 (see left-hand panel of the chart below). The combination of these two effects implies aslowdown in the euro area’s population growth rate and, from around 2015, a decline in its totalpopulation. Furthermore, the proportion of older people (aged 65 and over) in the population isprojected to increase and the proportion of people of working age (aged 15 to 64) to decrease (seeright-hand panel of the chart below), gradually at first and then at a faster rate from around 2015.This would imply an increase in the euro area’s old age dependency ratio (i.e. the ratio of thepopulation aged 65 and above to the population aged 15 to 64) from about 26% in 2005 to about30% in 2015 and to more than 52% in 2050, a total increase of about 26 percentage points over theperiod 2005 to 2050.

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Annual Report2004

Economic implications

Such a demographic shift will have a profound effect on euro area economies. For example, thecomposition of the labour supply will change as the proportion of older workers increases, andthe labour supply may even fall if workers continue to retire early and too few new workersenter the labour market to replace those leaving it. The projected decrease in the working agepopulation will exert downward pressure on the growth rate of potential output of the euro area,unless it can be compensated for by increased contributions from other growth factors, such asincreases in labour market participation, labour productivity and/or the productive use of otherresources such as capital. There has been some discussion of the extent to which immigrationmay help to increase labour supply. Most studies suggest that the role of migration inaddressing Europe’s demographic challenge is likely to be small and temporary, being limitedby the number of potential migrants relative to the size of the problem and by practical andpolitical constraints.

The financing of social security systems, and in particular public pension systems based on thepay-as-you-go principle, will also come under pressure as the ratio of the number of pensioners tothe number of contributors to pension and health systems rises. Public expenditure on health andlong-term care is expected to increase as progress in medical technologies continues to be madeand the demand for these services grows with the number of elderly people. The size of thesepotential effects could be substantial. Estimates by the European Commission’s Economic PolicyCommittee’s Working Group on Ageing Population suggest additional pension expenditure ofbetween 3% and 6% of GDP by 2050 in most euro area countries. A further increase in expenditureof 2% to 4% of GDP could result from rising health and long-term care costs.

Population ageing is also likely to induce changes in the structure of financial markets and thepricing of financial assets. Households of different generations typically hold differentamounts of financial assets and choose assets with different risk profiles for their investmentportfolios. Given that long-run demand for housing depends, inter alia, on the number ofhouseholds in an economy, demographic changes may also affect real estate prices.Furthermore, pension reforms, in particular a move towards more private funding, are likely tohave a significant effect on financial markets as the role of institutional investors, such aspension funds and insurance corporations, increases. The limited availability of long timeseries of financial prices, measurement problems and the fact that typically only a smallfraction of the population hold equities limit the extent to which possible effects ofdemographic change on financial markets can be quantified. However, simulations carried outusing models based on the “life-cycle” theory generally find that an ageing population impliesa decrease in financial asset prices (both equities and bonds) and an increase in the requiredequity premium when the currently active population retires.

The need for comprehensive reforms

To cope with such effects of demographic change, governments need to undertakecomprehensive reforms. Such reforms should aim to address specific problems in pension andhealthcare systems, reduce overall public debt and strengthen the forces driving economicgrowth. Within the EU, governments have agreed on a three-pronged strategy. This strategywas first set out in the 2001 BEPGs and comprises three broad objectives: to raise employment


rates, reduce government debt and reform pension systems, including moves towards greaterreliance on funding.

In euro area countries there is an urgent need to increase labour market participation andemployment for all groups within the working age population and particularly some, such asover 55-year-olds, among whom the participation rate is especially low. A first important stepis to further reduce the disincentives to work currently persisting within a number of euro arealabour markets due to the interplay of taxes and benefits and the provision of early retirementschemes. Such systems create disincentives particularly for second earners, low-paid workers,the youngest and oldest workers, and women. Policies to increase female labour marketparticipation must make it easier for women to combine family and work by increasing theflexibility of working hours and improving services for childcare and care of the elderly.Furthermore, in some cases it might be useful to improve incentives to continue working laterin life, for example through gradual exit-from-work policies and increased provision of part-time or temporary positions for older workers. However, there must also be sufficientincentives for employers to hire and/or retain older workers. Moreover, many countries willneed to embark on a sustained process of investment in human capital and research anddevelopment in order to offset the possible effects of population ageing on labour and totalfactor productivity.

Reducing public debt would contribute to improving fiscal sustainability and thus make publicfinances less vulnerable to the impact of demographic changes. In particular, lower debt levelswould provide governments with additional leeway in times of increased ageing-related fiscalburdens. Likewise, lower interest payments on public debt would free up fiscal resources andgive governments more flexibility to cope with any unforeseen developments. In this regard,the provisions of the Stability and Growth Pact, in particular the requirement that publicfinances remain close to balance or in surplus, establish incentives in the right direction forgovernments to prepare for ageing-related fiscal burdens.

The scale of the projected pressure on pension systems suggests that two sets of strategies needto be pursued in the area of pension reform. First, further adjustments to the structure ofbenefits and contributions within existing pay-as-you-go arrangements are needed (parametricreforms). These include revisions of benefit formulas and adjustments to the indexation ofpension benefits. As a complement, it will be necessary for most countries to move towardsgreater funding of benefits and the diversification of financing arrangements (systemicreforms). Instead of through current transfers from labour income, pensions would be financedfrom previously accumulated capital via pension funds. Thus, policies should be put in place tofacilitate the development of an infrastructure that would enable these funds to efficientlyallocate retirement savings and manage the related risks, and to safeguard the non-speculativecharacter of retirement savings.

In conclusion, population projections suggest that demographic change in the euro area will bemost apparent from around 2015, although developments in individual countries are proceeding atdifferent rates and in a number of euro area countries the total population has already begun todecline. Although many countries are starting to improve the incentive compatibility of their taxand benefit systems and the sustainability of public finances, further wide-ranging reforms arenecessary in the near future. The timely implementation of comprehensive and incentive-compatible reforms is needed in order to prepare for demographic change.

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2.5 FISCAL DEVELOPMENTS

BUDGET BALANCE BROADLY STABLE IN 2004Fiscal developments in the euro area wereunsatisfactory in 2004. According to the latestdata available from Eurostat, the euro areadeficit remained broadly stable at 2.7% ofGDP (see Table 5). The budgetary outcomein 2004 reflected a slight fiscal loosening,while the impact of the economic cycle wasminor. Most euro area countries failed to meetthe targets set out in the updated stabilityprogrammes of end-2003 and early 2004.Targets were missed on average by 0.3percentage point of GDP, mainly becauseof a failure to meet ambitious structuralconsolidation plans on the part of countrieswith substantial imbalances.

A number of countries recorded deficit ratios ator above the 3% of GDP reference value andfour countries (Germany, Greece, France andthe Netherlands) were in an excessive deficitsituation. For the third year in a row, deficitsexceeded 3% of GDP by a significant margin inGermany and France. Following significantstatistical revisions, it became clear thataccording to the ESA 95 methodology Greecehad recorded deficits above the reference valuesince 1997; its deficit for 2004 was 6.1% ofGDP. Italy posted a deficit of 3.0% ofGDP and Portugal recorded a deficit of justbelow 3% of GDP, despite the continued(though declining) implementation of sizeabletemporary policy measures.

General government surplus (+) / deficit (-)

2001 2002 2003 2004

Euro area -1.8 -2.5 -2.8 -2.7Belgium 0.4 0.1 0.4 0.1Germany -2.8 -3.7 -3.8 -3.7Greece -4.1 -4.1 -5.2 -6.1Spain -0.5 -0.3 0.3 -0.3France -1.6 -3.2 -4.2 -3.7Ireland 0.9 -0.5 0.2 1.3Italy -3.0 -2.6 -2.9 -3.0Luxembourg 6.2 2.3 0.5 -1.1Netherlands -0.1 -1.9 -3.2 -2.5Austria 0.3 -0.2 -1.1 -1.3Portugal -4.4 -2.7 -2.9 -2.9Finland 5.2 4.3 2.5 2.1

General government gross debt

2001 2002 2003 2004

Euro area 69.6 69.5 70.8 71.3Belgium 108.0 105.4 100.0 95.6Germany 59.4 60.9 64.2 66.0Greece 114.8 112.2 109.3 110.5Spain 57.8 55.0 51.4 48.9France 57.0 59.0 63.9 65.6Ireland 35.8 32.6 32.0 29.9Italy 110.7 108.0 106.3 105.8Luxembourg 7.2 7.5 7.1 7.5Netherlands 52.9 52.6 54.3 55.7Austria 67.1 66.7 65.4 65.2Portugal 55.9 58.5 60.1 61.9Finland 43.8 42.5 45.3 45.1

Table 5 Fiscal posit ions in the euro area

(as a percentage of GDP)

Sources: Eurostat and ECB calculations.Note: Data are based on the excessive deficit procedure definitions. Budget balances exclude proceeds from the sale of UMTS licences.


When measured by the change in the cyclicallyadjusted primary balance according toEuropean Commission estimates, the budgetaryoutcome for the euro area as a whole reflecteda slightly expansionary fiscal stance. Withinterest expenditure virtually unchanged, thedeterioration of the primary balance was themain factor behind this outcome. GDP growthis estimated to have increased broadly in linewith potential growth, and the economicenvironment is therefore estimated to have hadvery little effect on the change in the cyclicalcomponent of the budget on average. Structuralconsolidation was implemented in only a fewcases. All three very highly indebted countries(Belgium, Greece and Italy) continued tobenefit from interest expenditure savings, witha favourable effect on overall budgetarypositions. This partly compensated for theworsening of the primary balances in thesecountries.

Fiscal developments reflect the fact that, onaverage in the euro area, tax cuts and the gradualphasing-out of temporary adjustment measureswere insufficiently financed by savings inprimary expenditure. Revenue-reducing factorsincluded cuts in direct taxes and social securitycontributions as well as a fall in capitalrevenue due to the gradual disappearanceof temporary measures. These were partlycompensated for by increases in indirect taxes.On the expenditure side, there is evidence of

some restraint (mainly via public consumptionand social benefits) despite the partialdisappearance of temporary measures. Whilethis reflects a reversal of more lax expenditurepolicies in recent years, it was not sufficient tofully offset the revenue decline.

The euro area debt-to-GDP ratio increased, forthe second year in a row, to 71.3% in 2004.This worsening mainly reflects the low (andfalling) primary surplus ratio, the fact thateconomic growth was lower than the implicitaverage interest rate on public debt, and insome cases sizeable discrepancies betweendeficit and debt developments – known asdeficit-debt adjustments. Among the sevencountries posting debt ratios higher than 60%of GDP, only Belgium recorded a significantdecline in its debt ratio, to below 100% of GDP,reflecting budget outcomes that remained closeto balance. Greece and Italy continued toexhibit debt ratios above 100% of GDP, withlittle change since 2001. Germany, France,Austria and Portugal posted debt ratiosmoderately above the reference value of 60% ofGDP, and in all of these countries exceptAustria the ratio increased by comparison with2003. The continued deterioration of budgetbalances and the rising debt-to-GDP ratio isalso reflected in the amount of outstandinggovernment debt securities (see Box 8).

Box 8

DEVELOPMENTS IN GENERAL GOVERNMENT DEBT SECURITIES IN THE EURO AREA

Against a background of rising general government deficits in the euro area, the level ofoutstanding general government debt securities has increased in recent years. Thisdevelopment is reflected both in the increase in the debt-to-GDP ratios and in the higher annualgrowth rates of debt securities issued by general government in the euro area – 5.0%, 5.5% and5.4% at the end of 2002, 2003 and 2004 respectively (against 3.3% at the end of 2001).1

1 Growth rates are based on f inancial transactions and are corrected for reclassif ications, revaluations, exchange rate variations andother changes that do not arise from transactions. For details, see the Technical note for Sections 4.3 and 4.4 of the “Euro areastatistics” section in the ECB’s Monthly Bulletin.

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Annual Report2004

Chart A Euro area outstanding governmentdebt securit ies by issuing country in 2004

(percentages; end of period)

IT27.4

DE23.2

FR20.4

ES7.8

LU0.0

GR3.6

PT1.7AT

3.0

FI1.4 IE

0.7

NL4.9

BE5.9

Source: ECB.

Looking at the total amount of generalgovernment debt securities outstanding at theend of 2004, the main players in this segmentof the euro area capital markets are Italy,Germany and France, with shares rangingbetween approximately 20% and 30% of thetotal market (see Chart A).

The evolution of the structure of outstandinggeneral government debt securities in the euroarea has three key features. First, governmentdebt is issued predominantly by centralgovernment, which accounted for 94.3% ofoutstanding debt securities in 2004, withother general government responsible forthe remaining 5.7% (see the table below).Nevertheless, the other general governmentsector has become more active. The share ofdebt securities issued by central governmenthas been steadily declining since 1998, while the share of debt securities issued by othergeneral government almost doubled between 1998 and 2004.

Second, regarding the breakdown of government debt securities by maturity, long-term debtaccounted for around 91.6% of outstanding debt securities at the end of 2004. The table belowshows that the share of short-term debt declined between 1998 and 2000 but subsequently roseagain.

Third, the table also indicates that the vast majority of long-term general government debtsecurities are issued at a fixed rate. Over time, the relative importance of floating-rate issueshas decreased substantially, from 12.3% of the total in 1998 to 7.6% in 2004. Underlying thisdevelopment is the gradual decline towards the end of the 1990s in the term premium paid bysome governments on fixed-rate long-term securities in an environment of price stability. Italy,

Structure of amounts outstanding of debt securit ies issued by euro area governments

(as a percentage of total debt securities issued by general government; end of period)

1998 1999 2000 2001 2002 2003 2004

Central government 96.9 96.9 96.7 96.3 95.4 94.7 94.3Long-term securities 87.5 89.3 89.9 89.0 87.2 85.8 36.0Short-term securities 9.4 7.6 6.9 7.2 8.2 8.9 8.3

Other general government 3.1 3.1 3.3 3.7 4.6 5.3 5.7Long-term securities 3.0 3.0 3.2 3.6 4.5 5.2 5.6Short-term securities 0.1 0.2 0.1 0.1 0.1 0.1 0.1

Total general governmentLong-term securities 90.5 92.3 93.0 92.6 91.7 91.1 91.6

fixed-rate 75.4 79.3 81.2 82.5 82.1 82.2 82.9floating-rate 12.3 10.5 10.0 8.7 8.0 7.5 7.6

Short-term securities 9.5 7.7 7.0 7.4 8.3 8.9 8.4Total general government in EUR billions 3,304.9 3,450.5 3,546.4 3,764.6 3,939.3 4,141.2 4,362.5

Source: ECB.


Chart B Long-term government bond yield spreads against Germany 1)

(basis points; monthly data)

Sources: BIS and ECB calculations.1) Long-term government bond yields refer to ten-year bonds or to the closest available bond maturity.

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where the share of floating-rate debt securities is 20.7%, is the only country significantly abovethe euro area average.

The decline in risk premia has been reflected in more favourable costs of debt financing inrecent years. For example, the euro area average ten-year government bond yield declined froman average of 7% in the period 1994-98 to an average of 4.7% in the period 1999-2004. Asshown in Chart B, however, there are differences between government bond yields across euroarea countries, which could reflect differences in liquidity and credit risk.

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Chart C Changes in relat ive debt-to-GDPratios against Germany1) and changes inyie ld spreads2) between 2001 and 2004(x-axis: in percentage points; y-axis: in basis points)

Sources: Eurostat and ECB.1) X-axis: decrease in the relative debt-to GDP ratio againstGermany, i.e. in the difference between the debt-to-GDP ratioof Germany and that of other euro area countries, between2001 and 2004.2) Y-axis: decrease in yield spreads against German ten-yeargovernment bonds between January 2001 and December2004.Note: The chart should be read as follows, using Belgium as anexample. The debt-to-GDP ratio in Belgium was 108.0% in2001 and 95.6% in 2004, while in Germany it was 59.4% in2001 and 66.0% in 2004. Thus, the difference between thedebt-to-GDP ratio of Germany and that of Belgium – a relativedebt-to-GDP ratio of Belgium against Germany – was48.6% in 2001 and 29.6% in 2004. This difference decreasedbetween 2001 and 2004 by 19.0 percentage points – animprovement in the relative debt-to-GDP ratio againstGermany – as shown on the x-axis. Over the same period, thespread between Belgian and German government bond yieldsdecreased by 28 basis points, as shown on the y-axis. Thestraight solid line represents the fitted regression line.

0-2 0 2 4 6 8 10 12 14 16 18 20

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40Greece

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German long-term bond yields have been thelowest in the euro area primarily becauseGerman government bonds are relativelyliquid. The financing advantage of theGerman government over all other euro areagovernments in terms of basis points was inthe double-digit range until early 2001. Fromthat time the spreads between ten-yeargovernment bond yields of other euro areacountries and comparable German bondyields declined constantly, reaching a low atthe end of 2003. The most significantdecreases in yield spreads have beenexperienced in Belgium, Greece, Italy,Portugal and Spain. One of the factorsunderlying this convergence may have beenthe fiscal developments in Germany, where,between 2001 and 2004, the debt-to-GDPratio worsened relative to that of all other euroarea countries except France.

Available data suggests that those countriesthat experienced an improvement in theirdebt-to-GDP ratio relative to Germanybetween 2001 and 2004 also experienced adecrease in long-term yield spreads vis-à-visGerman government bonds, as depicted by thepositive relationship in Chart C. Althoughother factors, mainly related to the liquidity ofthe bonds, may also be of importance, this may be regarded as a first indication that investors tosome extent take into account the fiscal positions of euro area governments when pricingbonds.

Overall, recent trends in the structure of government financing reflect the significantmacroeconomic advantage which has arisen in conjunction with the move to more stability-oriented policies over the last decade. The most visible benefit for the public is thesignificantly lower proportion of government budgets spent on interest payments.

FISCAL PLANS FOR 2005The latest update of the stability programmessuggests that, despite some progress, too littleis planned to address the problem of budgetdeficits and that comprehensive structuralreform agendas are still lacking. For 2005 theaverage deficit for the euro area as a whole isexpected to decline by about half a percentagepoint of GDP. Both a marginal decline in

interest expenditure and a moderateimprovement of the primary balance shouldcontribute to this development. Economicgrowth is expected to stay near potential.However, about half the euro area countries,i.e. Germany, Greece, France, Italy, theNetherlands and Portugal, are projected tocontinue to report deficits close to or at 3%of GDP. Only a few are projected to be in a


close-to-balance or in-surplus position. Thedebt-to-GDP ratio is expected to decline byabout half a percentage point of GDP.

CONSOLIDATION IN LINE WITH PRIORCOMMITMENTS NEEDEDPublic finances face three major challengesin the euro area. First, there is a needfor substantial fiscal consolidation:macroeconomic stability hinges significantlyon the sustainability of public finances, whichis the ability of a government to meetits outstanding obligations (see Box 9).Compliance with the EU fiscal framework andthe strict application of the rules are criticalbecause this contributes to the sustainabilityof public finances in EMU. In particular,the deficit limit of 3% of GDP – if crediblyimplemented – provides an anchor forexpectations of fiscal discipline and future debtdevelopments. It is therefore an importantsignal of fiscal soundness for financial marketsand the public.

The fact that the euro area average deficit isnear the 3% reference value and that a numberof countries have deficits close to or abovethis value underlines the urgent need tostrengthen the position of public finances. Theimproved economic environment offers a goodopportunity to accelerate the process of fiscalconsolidation. Growth dividends in the formof higher than expected tax revenues shouldbe assigned to reducing budget imbalances.Countries with excessive deficits shouldcorrect this situation as soon as possible andfulfil their commitments. Moreover, therecurrence of excessive deficits needs to beavoided. It is also desirable that those euro areacountries which do not have a budgetaryposition close to balance or in surplus, but arenot in an excessive deficit situation either,progress with budgetary consolidation in linewith the Eurogroup agreement of October2002, according to which underlying deficitratios should be cut by at least 0.5 percentagepoint of GDP per year.

Box 9

FISCAL POLICY AND MACROECONOMIC STABILITY

This box discusses the main influences of fiscal policy on macroeconomic stability and pricedevelopments, as well as the way in which the EU fiscal framework reflects these influences.

Fiscal policies can have an impact on the short-run macroeconomic environment viadiscretionary measures and automatic stabilisers. Discretionary measures, i.e. active changesto government revenue or expenditure, can affect economic growth and prices, via their effecton both aggregate demand and aggregate supply. Experience over the last few decades hasshown, however, that discretionary fiscal fine-tuning, aimed at stabilising the economy, oftenproves to be pro-cyclical. Moreover, the asymmetrical use of fine-tuning measures (mainlyduring downturns and to a much lesser extent during upswings) has led to higher fiscal deficitsover time. The free operation of automatic stabilisers, on the other hand, can help to smootheconomic fluctuations, via the stabilising impact of taxes and unemployment benefits on thedisposable income of households. Their automatic nature makes them timely and morepredictable, while their symmetrical operation leaves the government debt level unaffectedover a business cycle.

As regards medium-term fiscal effects, the setting of fiscal policies is particularly importantfor the sustainability of public finances and potential economic growth. Fiscal sustainabilitycan be described as the ability of a government to meet its outstanding obligations. The ratio of

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government debt to GDP gives an indication of this, although other elements, such ascontingent and implicit government liabilities, also need to be taken into consideration.Sustainabilty of public finances has a positive impact on the macroeconomic environment, asconsumers and households do not expect major tax increases or difficulties experienced bygovernments in servicing their obligations. Economic confidence is thus enhanced, long-termdecision-making (e.g. for private investment) is facilitated and financial conditions are morefavourable. As regards potential economic growth, fiscal measures that improve the “quality”of public finances can have a beneficial effect on the economic growth rate compatible withprice stability. For example, government expenditure on physical and human capital mayimprove the quality of production factors. Furthermore, tax rates have an impact on incentivesto work, save, invest and innovate. Higher growth, in turn, supports sustainability, as existingdebt is serviced by a larger economic base.

Setting fiscal policy in accordance with rules is generally preferable to an ad hoc approach.Rules can discourage an undue focus on short-term gains and a disregard for longer-term costs.Furthermore, rules can anchor expectations, thereby giving economic agents guidance onfuture fiscal policy in the event of shocks and thus facilitating longer-term planning in theprivate sector. Of course, the rules must be observed in order for these benefits to materialise.The advantages of following rules are even greater in a monetary union such as EMU, wheredistortions in fiscal incentives can be exacerbated. For instance, a larger deficit bias may ariseas, with a single currency and more integrated financial markets, the impact of a country’shigher debt level on interest rates is smaller than before. Fiscal rules in a monetary union needto be applicable in a straightforward manner, given that they need to apply to all membercountries in a uniform way in order to ensure equal treatment. A transparent fiscal frameworkalso raises awareness in the financial markets and the public at large, and can help to enforcecompliance with the rules.

The medium-term, rule-based framework adopted in EMU takes into account both short-termstabilisation and long-term sustainability considerations. The reference values for the budgetdeficit and government debt are ways of promoting responsible fiscal behaviour. A medium-term budgetary position close to balance or in surplus contributes to short-term economicstabilisation via the free operation of automatic stabilisers, while preventing excessive deficitsin the future and ensuring improvements in the sustainability of public finances by inducinglower government debt ratios.

From the perspective of a central bank whose primary objective is to maintain price stability,the focus of fiscal policy analysis is on the impact of fiscal policies on inflation andmacroeconomic stability because these policies form part of the environment in whichmonetary policy has to operate. Sound fiscal policies facilitate monetary policy by creating anenvironment of stable economic conditions, in both the short and long term.


STRUCTURAL REFORMS REMAIN VITALA second challenge for public finances in theeuro area is to integrate fiscal consolidationplans into a structural reform agenda that favoursgrowth, competitiveness and employment. Thiswould also help to put budgetary developmentson a more sustainable footing, particularlyagainst the background of the increasingfiscal burden related to ageing populations.Expenditure reforms are crucial in thisregard, although there might also be some roomfor efficiency gains on the revenue side.Expenditure reforms allow fiscal consolidation,pave the way for further tax cuts and may alsorender tax/benefit systems more growth-friendly. Within given expenditure budgets,productive investments in infrastructure andhuman capital should be prioritised.

RELIABLE STATISTICS UNDERPIN THECREDIBILITY OF THE FISCAL FRAMEWORKThird, the integrity of government financestatistics is a precondition for the credibility ofthe EU fiscal framework. Large revisions ofpast deficit figures – as witnessed, for example,in the case of Greece in 2004 – are clearlydamaging to public confidence and thecredibility of the entire framework. Theyundermine the accurate and timelyidentification of imbalances and adjustmentneeds, which can cause serious delays in theimplementation of policy measures. By addinguncertainty to fiscal monitoring, they reducethe value of multilateral surveillanceprocedures and, thus, weaken the effectivenessof peer pressure. It is therefore of vitalimportance that action be taken to ensure thereliable compilation and timely reporting ofgovernment finance statistics. All MemberStates should respect the European accountingrules when reporting expenditure and revenues.As stated by the ECOFIN Council on 2 June2004, budgetary statistics must not bevulnerable to political and electoral cycles.

2.6 EXCHANGE RATES AND BALANCE OFPAYMENTS DEVELOPMENTS

EURO CONTINUED TO STRENGTHEN AMID BROAD-BASED WEAKENING OF THE US DOLLARIn the foreign exchange markets, movements inthe main bilateral euro exchange rates wererelatively moderate in the first nine months of2004, particularly if compared with the markedappreciation of the euro in the precedingtwo years. Thereafter, the euro appreciatedstrongly, particularly against the US dollar. Atthe end of 2004 the euro stood in effectiveterms moderately above its level at thebeginning of the year, reflecting a significantappreciation against the US dollar, the Asiancurrencies pegged to the US currency and, to asmaller extent, the Japanese yen. This waspartially counterbalanced by the depreciationof the euro against the currencies of somesmaller trading partners of the euro area (theSwiss franc, the Norwegian krone and theKorean won) as well as the currencies ofseveral of the new EU Member States.

In more detail, after the appreciation of the eurolevelled off in January and February 2004, theeuro reversed some of its earlier gains amid animprovement in the global economic outlookand shifting market perceptions about thefundamental forces affecting exchange rates.At that time, there were increasing signs thatthe recovery was taking hold in the UnitedStates and Japan, while the outlook for the euroarea continued to be more subdued. This servedto switch the market’s attention from the largeand persistent US current account deficittowards expectations of higher returns in theUnited States, thereby providing support to theUS currency. Between May and mid-October2004 the euro strengthened slightly, amid agradually improving outlook for the euro areaeconomy as tentative signs emerged ofeconomic expansion spreading from the exportsector to domestic demand. At the same time,market concerns about the outlook for globalgrowth – fuelled mainly by geopoliticaluncertainty and soaring oil prices – appearedto be putting some renewed downward pressure

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on the US dollar and the Japanese yen.Decisions by the FOMC to raise interest rateshad already been priced in by the financialmarkets and did not affect exchange ratedevelopments. As of mid-October, however,the euro strengthened significantly against theUS currency, as well as against several Asiancurrencies, given their formal or informal pegto the dollar. This occurred in the context of abroad-based weakening of the US currency inthe last quarter of 2004. During this quarter theUS dollar reached multi-year lows against theeuro, the pound sterling and the Japanese yen.

At the end of 2004 the euro stood in nominaleffective terms – as measured against thecurrencies of 23 important trading partnersof the euro area – 2.3% above the levelobserved at the beginning of the year. Thisoverall appreciation in 2004 concealscounterbalancing movements of the euroagainst a number of partner currencies includedin the effective exchange rate index. Morespecifically, the euro appreciated markedlyagainst the US dollar, as well as against theChinese renminbi and the Hong Kong dollar,which are both linked to the US currency. On31 December 2004 the euro stood at USD 1.36,roughly 8.2% stronger than at the beginning ofthe year. During the same period the euro alsostrengthened against the Japanese yen (by3.7%) and was quoted by the end of the yearat JPY 139.7, implying an appreciation ofthe Japanese yen against the US dollar bymore than 4%. Against the pound sterling,the euro was at GBP 0.71 at the end of theyear, unchanged compared with its level on2 January 2004.

At the same time, the euro moderatelydepreciated against the Swiss franc, theNorwegian krone and, to a larger extent, theKorean won (by 6.3%). It also depreciatedagainst the currencies of several of the newEU Member States: the Czech koruna, theHungarian forint, the Polish zloty and theSlovak koruna (see also Section 3). The Cypruspound also appreciated slightly, while theLatvian lats, which was partially linked to the

US dollar, depreciated vis-à-vis the euro. Witheffect from 1 January 2005, however, theLatvian lats has been pegged to the euro atLVL 0.702804, and has since traded close tothe peg rate. The Maltese lira remainedrelatively stable against the euro in 2004,reflecting the dominant weight of the euro inthe currency basket underlying its peg.

In ERM II the Danish krone traded close to itscentral parity, while the currencies that enteredERM II on 28 June 2004 (the Estonian kroon,the Lithuanian litas and the Slovenian tolar)either moved in a very narrow range or wereunchanged relative to their central parityagainst the euro.

In the first two months of 2005 the euroretreated against most major currencies,notably against the US dollar. Thedevelopments in euro exchange rates over thisperiod were affected by signs of robusteconomic activity in the United States, whilemarket concerns about the US current accountdeficit seem to have subsided somewhat. On24 February 2005 the euro stood in nominaleffective terms about 1.4% below its level atthe beginning of the year. The depreciationreflected a weakening against the US dollar,


the Chinese renminbi and, to a lesser extent,against the pound sterling, which all have arelatively large weight in the trade-weightedeuro exchange rate index.

The real effective exchange rate of the euro –based on cost and price indices – also continuedto rise in 2004, in line with the increase in thenominal effective exchange rate (see Chart 29).In the fourth quarter of 2004 the real effectiveexchange rate indices of the euro stoodwell above their level in the first quarter of1999, and the measures based on consumerand producer price developments were alsofairly close to the peak levels observed overthe past ten years.

CURRENT ACCOUNT SURPLUS INCREASEDSLIGHTLY IN 2004The euro area current account surplusincreased to €40.2 billion in 2004 (i.e. around0.5% of GDP), from €22.2 billion in 2003(0.3% of GDP). This increase was largely theresult of a decline in the income and

Chart 29 Nominal and real ef fect ive euroexchange rates 1)

(monthly/quarterly data; index: 1999 Q1 = 100)

Source: ECB.1) An upward movement of the EER indices represents anappreciation of the euro. The latest observations for monthlydata are for December 2004. In the case of the ULCM-basedreal EER, the latest observation is for the third quarter of 2004and is partly based on estimates.

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Chart 30 Current account balance and itscomponents

(EUR billions; seasonally-adjusted data)

Source: ECB.

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200420032002

current transfers deficits combined with amarginal increase in the services surplus (seeChart 30). The goods surplus remained broadlyunchanged, as exports and imports of goodsincreased in value terms by a similar amount.

In the course of 2004, however, the 12-monthcumulated seasonally adjusted goods surplusexperienced two significant movements. Inthe first half of the year it increased (from€106 billion in December 2003 to more than€125 billion in June 2004), owing particularlyto strong exports in this period. Subsequently,though, it decreased to a level close to that seenat the end of 2003, as a result of the strongimports registered in the second and thirdquarters of 2004 and the deceleration of exportsthat took place in the second half of the year.Turning to the fall in the income deficit, thisreflected mostly a significant increase inincome receipts, which rose much faster thanincome payments. The rise in income receiptsseems for the most part to have been drivenby favourable developments in returns on

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Chart 31 Financial account balance and itscomponents

(EUR billions)

Source: ECB.

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200420032002

investment reflecting the strong growth ofthe global economy, which more than offsetthe negative impact of the higher euro (asan appreciation of the euro reduces the eurovalue of income credits received in foreigncurrencies).

Developments in exports and imports of goodscan be better understood by breaking down thevalues into prices and volumes on the basis ofEurostat’s external trade statistics (theavailable statistics cover the period up toOctober 2004). Such a breakdown shows thatthe strong rise in export values that took placein the first half of the year was mostlyaccounted for by robust growth in exportvolumes, while export prices remainedsubdued. It seems, therefore, that the negativeeffect of the appreciation of the euro on euroarea export volumes was more thancompensated for by the strong growth offoreign demand during the first half of 2004. Interms of geographical destination, the volumeof exports to Asia and the new EU MemberStates grew particularly rapidly over thisperiod. Although export prices experiencedsome upward pressure from rising costs owingto higher oil prices, this may have been partlycounterbalanced by some reductions in profitmargins as exporters attempted to partly offsetthe loss in price competitiveness resulting fromthe appreciation of the euro. The decelerationof euro area exports in the second half of theyear seems to stem mostly from weaker exportsto Asia and the new EU Member States,although exports to the United States alsoslowed substantially. As regards the increase inthe value of imports of goods that took place inthe second and third quarters of 2004, thisreflected rises in both prices and volumes.Most of the rise in import prices was a resultof the higher price of oil. Part of the increasein import volumes can be attributed to therecovery in euro area domestic demand,particularly the high import-intensity categoriesof expenditure.

NET INFLOWS IN COMBINED DIRECT ANDPORTFOLIO INVESTMENT IN 2004In the financial account, combined direct andportfolio investment experienced net inflowsof €18.3 billion in 2004, compared with netinflows of €38.3 billion in 2003. This lowerlevel of net financial flows into the euro areawas mainly a result of increased net outflows indirect investment (see Chart 31).

Developments in direct investment can beprimarily accounted for by the gradual declinein foreign direct investment inflows into theeuro area, basically due to direct investment ineuro area equity capital by non-residents beingone-third of that recorded a year earlier. Thisdecline was larger than the decline in euro areadirect investment abroad in the form of equitycapital and may partly reflect a stronger growthoutlook for the global economy in 2004 relativeto the euro area.

The rise in net inflows in portfolio investmentemanated mainly from an increase in netpurchases of euro area equity securities by non-residents. Market survey data indicated a


renewed interest in euro area equity securitiesamong foreign investors. The fact that euroarea equities were seen, in relative terms,as being attractively priced, together withexpectations of an appreciation of the euro inthe course of 2004, also contributed to thisdevelopment.

Turning to debt instruments, cross-borderflows were of a similar magnitude in 2003 and2004, amounting to roughly €200 billion onboth the asset and the liability sides. On theliability side, the low level of euro area short-term interest rates did not encourage foreigninvestment in euro area money marketinstruments, with non-residents investingalmost exclusively in euro area bonds and notesin 2004. On the asset side, euro area investorsallocated about 75% of their internationalportfolio of debt instruments to bonds andnotes and 25% to money market instruments.Compared with 2003, this allocation amountedto a smaller weight being given by euroarea residents to international bonds and notesin 2004. This may have been linked toanticipation of possible capital losses as aresult of expected higher long-term interestrates in the United States. Indeed, euro area

debt flows to the United States declined from€75 billion in 2003 to €29 billion in the firstthree quarters of 2004.

Based on cumulated flows over the first threequarters of 2004, the euro area recorded netoutflows in foreign direct investment vis-à-vismost of its main partner countries, apart fromthe United States and Switzerland. The UnitedKingdom and the United States were both themain recipients of euro area direct investmentand the main investors in the euro area.

The geographical breakdown of portfolioinvestment shows that euro area portfolioinvestment abroad in the first three quarters of2004 was directed primarily towards the UnitedKingdom and the United States, which aretraditionally the main recipients of thatcategory of investment. Euro area investorswere also large net purchasers of Japaneseequity securities. The improvement of theeconomic outlook in Japan, particularly at thebeginning of 2004, appears to have influencedthe portfolio investment decisions of euro areainvestors.

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ECONOMIC ACTIVITYReal GDP growth in the non-euro area EUMember States was relatively strong in 2004and generally exceeded the euro area average(see Table 6). Output growth was highest in theBaltic States and Poland, the countries with thelowest level of GDP per capita in the EU. At theother end of the scale, it was lowest in Denmarkand Malta, although real GDP growth started torecover in these countries from the subduedrates that prevailed in 2003.

Domestic demand was the main contributor toreal GDP growth in 2004 in many non-euro areaEU Member States. In particular, gross fixedcapital formation was the key driver of outputgrowth. Growing industrial confidence, a highdegree of capital utilisation and an improveddemand outlook contributed to the recovery ininvestment in many of the new Member States,Denmark and Sweden. In many of the newMember States, particularly in the BalticStates, the robustness of domestic demand alsoreflected the significant growth in privateconsumption, which was supported by gainsin real disposable income associated withvigorous wage increases and improvements inthe labour market. In the United Kingdom,

3 ECONOMIC AND MONETARY DEVELOPMENTS INNON-EURO AREA EU MEMBER STATES

private consumption growth was sustained bythe strong performance of the labour marketand growth in housing wealth. In a number ofnon-euro area EU Member States, especially inthe Baltic States and Hungary, householdspending was also backed by high and, insome cases, increasing credit growth to theprivate sector. In addition, in most of thenew Member States, price rise expectationsstemming from changes in taxation andregulated prices related to EU accessionstimulated consumption spending in the firsthalf of 2004. Finally, in some countries, thefiscal stance remained relatively loose.

Turning to external demand, the contribution ofnet exports to real GDP growth variedsignificantly across the non-euro area EUMember States. While external demandsignificantly supported output growth inPoland and Sweden, it acted as a drag ongrowth in most of the new Member States andthe United Kingdom. Despite this, it isimportant to note that export and import growthremained relatively strong in 2004, especiallyin the new Member States. In particular, goodsand services trade volumes were spurred by theremoval of barriers to trade on EU accession,

2000 2001 2002 2003 2004 2004 2004 2004 2004Q1 Q2 Q3 Q4

Czech Republic 3.9 2.6 1.5 3.7 4.0 3.8 3.9 4.2 4.2Denmark 2.8 1.6 1.0 0.4 2.0 1.7 2.5 1.8 2.2Estonia 7.8 6.4 7.2 5.1 . 6.8 5.9 6.1 .Cyprus 5.0 4.1 2.1 2.0 3.7 3.7 4.1 4.0 3.1Latvia 6.9 8.0 6.4 7.5 8.5 8.7 7.7 9.1 8.6Lithuania 3.9 6.4 6.8 9.7 6.7 7.1 7.3 5.8 6.7Hungary 5.2 3.8 3.5 3.0 4.0 4.3 4.2 3.7 3.8Malta 6.4 -1.7 2.2 -1.8 1.5 2.3 -0.5 1.9 2.3Poland 4.0 1.0 1.4 3.8 5.3 6.9 6.1 4.8 3.9Slovenia 3.9 2.7 3.3 2.5 4.6 4.1 4.9 5.0 4.3Slovakia 2.0 3.8 4.6 4.5 5.5 5.4 5.5 5.3 5.8Sweden 4.3 1.0 2.0 1.5 3.5 3.4 4.0 3.7 2.8United Kingdom 3.9 2.3 1.8 2.2 3.1 2.8 3.5 3.1 2.9EU10 1) 4.2 2.7 2.6 3.9 4.8 5.4 5.1 4.6 4.3EU13 2) 3.9 2.2 1.9 2.3 3.3 3.2 3.7 3.3 3.0Euro area 3.5 1.6 0.9 0.5 2.0 2.0 2.5 1.7 1.8

Table 6 Real GDP growth in the non-euro area EU Member States and the euro area


Source: Eurostat.Note: Quarterly figures are seasonally adjusted for the Czech Republic and seasonally and working day-adjusted for the United Kingdom.1) The EU10 aggregate comprises the 10 new EU Member States.2) The EU13 aggregate comprises the 13 non-euro area EU Member States.


2000 2001 2002 2003 2004 2004 2004 2004 2004Q1 Q2 Q3 Q4

Czech Republic 3.9 4.5 1.4 -0.1 2.6 2.0 2.5 3.0 2.7Denmark 2.7 2.3 2.4 2.0 0.9 0.7 0.8 1.0 1.2Estonia 3.9 5.6 3.6 1.4 3.0 0.6 3.2 3.9 4.4Cyprus 4.9 2.0 2.8 4.0 1.9 1.0 1.2 2.5 2.8Latvia 2.6 2.5 2.0 2.9 6.2 4.3 5.8 7.4 7.2Lithuania 0.9 1.3 0.4 -1.1 1.1 -1.1 0.5 2.3 3.0Hungary 10.0 9.1 5.2 4.7 6.8 6.8 7.4 7.0 5.9Malta 3.0 2.5 2.6 1.9 2.7 2.5 3.3 3.0 2.2Poland 10.1 5.3 1.9 0.7 3.6 1.8 3.4 4.7 4.5Slovenia 8.9 8.6 7.5 5.7 3.6 3.7 3.8 3.6 3.5Slovakia 12.2 7.2 3.5 8.5 7.4 8.2 8.0 7.2 6.0Sweden 1.3 2.7 2.0 2.3 1.0 0.6 1.2 1.2 1.1United Kingdom 0.8 1.2 1.3 1.4 1.3 1.3 1.4 1.2 1.4EU10 1) 8.4 5.7 2.6 1.9 4.0 2.9 4.0 4.8 4.4EU13 2) 3.2 2.7 1.8 1.6 2.1 1.7 2.2 2.3 2.3Euro area 2.1 2.4 2.3 2.1 2.1 1.7 2.3 2.3 2.3

Table 7 HICP inf lat ion in the non-euro area EU Member States and the euro area


Source: Eurostat.1) The EU10 aggregate comprises the 10 new EU Member States.2) The EU13 aggregate comprises the 13 non-euro area EU Member States.

by higher demand in trading partner countriesand by further gains in productivity.

As a result of the recovery in economicactivity, sizeable foreign direct investmentinflows received in the last few years andongoing structural reform, the labour marketsituation gradually improved in most non-euroarea EU Member States throughout 2004,particularly in the Baltic States. Employmentgrowth, however, tended to be rather subduedin most of the new Member States, due toearlier increases in wage costs in somecountries and a structural skill mismatchbetween labour supply and demand. In severalcountries, especially Poland and Slovakia,unemployment rates remained very high. In theUnited Kingdom the labour market was tighter.

PRICE DEVELOPMENTSPrice dynamics in the non-euro area EUMember States were very mixed acrosscountries in 2004. Denmark, Lithuania,Sweden and the United Kingdom recorded thelowest annual HICP inflation rates at around1%, thus well below the euro area average. Inmost of the new Member States, inflation wasabove the euro area average. In Latvia,

Hungary and Slovakia, annual HICP inflationrates were almost three times higher than theeuro area average.

Most of the new Member States recordedhigher HICP inflation rates in 2004 comparedwith 2003 (see Table 7). The strongest increasein inflation was observed in the CzechRepublic, Latvia, Lithuania, Hungary andPoland. In some non-euro area EU MemberStates, however, average inflation ratesdeclined in 2004. The strongest declines wererecorded in Cyprus and Slovenia. Moreover,the inflation pattern during 2004 varied acrosscountries. In a number of countries, inflationpicked up considerably in the first half of 2004before either stabilising at a higher level orgradually declining in the second half of theyear. In a few other Member States, however,HICP inflation rates remained broadly stablefor the whole year.

Inflation developments in the non-euro area EUMember States were partly driven by somecommon factors, in particular the strongincrease in oil prices in 2004. However, theprecise impact of this factor on inflation variedacross countries, largely reflecting differences

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in consumption patterns, market structures andenergy intensity of production. Moreover, insome countries the pass-through of higher oilprices into inflation might not have fullymaterialised yet in 2004. Some inflationarypressures also emerged from strong real GDPgrowth in most countries. Consequently, wagepressures have also started to rise in a numberof countries.

In the new Member States, EU accession alsocaused some inflationary pressures. Foodprices increased in most new Member States inthe first half of the year as these countrieswere integrated into the Common AgriculturalPolicy and as remaining sectoral trade barrierswere removed. Given the relatively large shareof food prices in their HICP consumer baskets,this had a noticeable impact on HICP inflationin most of the new Member States. Moreover,indirect taxes and excise duties were increasedin a number of the new Member States to bringthem more into line with those prevailing inthe EU. The prospect of tax-induced priceincreases following EU accession led to higherdemand in early 2004, thereby also causinghigher inflation. In the second half of 2004,however, the impact gradually started toreverse in a number of countries. Furthermore,in some new Member States, administeredprices have been substantially raised with aview to completing the adjustment of somestate-owned enterprises to producing at cost-recovery levels.

Nominal effective exchange rate developmentsand their lagged pass-through to import pricesalso influenced inflation developments in2004. In a number of countries, in particular theCzech Republic, Hungary and Slovakia,effective exchange rate developments had adampening impact on inflation, while in others,such as Latvia, the impact contributed toinflation pressures. In Poland the laggedimpact of exchange rate developmentscontributed in the first half of 2004 to anincrease in HICP inflation, but their impactreversed in the second half of the year.

FISCAL POLICIESThree non-euro area EU Member States(Estonia, Denmark and Sweden) recorded afiscal surplus and ten countries recorded fiscaldeficits in 2004. As set out in ECOFIN Councildecisions on 5 July 2004, six countries (theCzech Republic, Cyprus, Hungary, Malta,Poland and Slovakia) were found to be in anexcessive deficit situation. In all cases butCyprus, the Council decisions allow for thecorrection of these excessive deficits in amedium-term framework given the existence ofspecial circumstances, because (i) the generalgovernment deficit upon EU accession wassignificantly above the reference value and(ii) for the Czech Republic, Hungary, Polandand Slovakia, the structural shift to amodern service-oriented market economyaccompanying the process of real convergencewas still ongoing. The United Kingdom,recorded a deficit ratio above the 3% referencevalue in both 2003 and 2004. The large numberof countries still in an excessive deficitsituation points to a continued need for astronger political commitment to carrying outstructural reforms and fiscal consolidation.

General government budget balances improvedin ten of the 13 non-euro area EU MemberStates in 2004, while they deteriorated in theremaining three countries (see Table 8). The


improvement can be explained mainly bytemporary factors, as well as by the positiveeffect of the economic cycle. In the CzechRepublic and Malta, the countries recordingthe largest improvement in their fiscal balance,temporary factors had sizeable deficit-increasing effects in 2003.

In 2004 the debt ratios in most non-euro areaEU Member States remained well below theaverage ratio in the euro area. The ratiosdeclined in six of the 13 non-euro area MemberStates in line with their improved governmentbudget balances. In the other countries, theincrease in the debt ratios reflected mainly thelow primary surplus ratios and debt-increasingdeficit-debt adjustments, i.e. variations inpublic debt that cannot be explained by thedeficit/surplus. Only Cyprus and Maltacontinued to record debt ratios above the 60%of GDP reference value.

In most countries, budgetary outcomes in 2004were either broadly in line with or better thanthe targets of the convergence programmessubmitted in May 2004. In several countriesrevenue collection was more favourable than

anticipated. Expenditure execution wasgenerally close to the pre-set spendingpaths. Hungary showed signs of significantslippage relative to the May 2004 convergenceprogramme targets. Furthermore, somegovernments (for example, in Estonia andLithuania) utilised part of their excessrevenues in 2004 to finance additionalexpenditure rather than improve their budgetbalances.

BALANCE OF PAYMENTS DEVELOPMENTSAs regards external balances, Sweden andDenmark continued to report sizeable surpluseson current account in 2004, while the UnitedKingdom and most new Member States recordedcurrent account deficits, which in somecountries were large (see Table 9). The onlyexception was Slovenia, which has a history ofbroadly balanced current account positions.Particularly large current account deficits –close to or above 10% of GDP – were observed inthe Baltic States and Hungary, while Slovakiaand Poland showed more moderate currentaccount deficits, which contracted in the pasttwo years compared with the previous twoyears.

General government surplus (+) / deficit (-) General government gross debt2001 2002 2003 2004 2001 2002 2003 2004

Czech Republic -6.2 -6.8 -11.7 -3.0 27.2 30.7 38.3 37.4Denmark 2.9 1.7 1.2 2.8 47.8 47.2 44.7 42.7Estonia 0.3 1.4 2.9 1.8 4.4 5.3 5.3 4.9Cyprus -2.3 -4.5 -6.3 -4.5 61.9 65.2 69.8 71.9Latvia -2.1 -2.9 -1.5 -0.8 14.9 14.1 14.4 14.4Lithuania -2.0 -1.5 -1.9 -2.5 22.9 22.4 21.4 19.7Hungary -3.7 -8.5 -6.2 -4.7 52.2 55.5 56.9 57.6Malta -6.4 -5.9 -10.5 -5.2 62.4 62.7 71.8 75.0Poland -3.9 -3.6 -4.5 -4.8 36.7 41.2 45.4 43.6Slovenia -3.3 -2.4 -2.0 -1.9 28.1 29.5 29.4 29.4Slovakia -6.0 -6.0 -3.7 -3.3 48.7 43.3 42.6 43.6Sweden 2.5 -0.3 0.2 1.4 54.3 52.4 52.0 51.2United Kingdom 1) 0.7 -1.7 -3.4 -3.2 38.8 38.3 39.7 41.6EU10 2) -4.2 -4.9 -5.7 -3.9 37.3 40.1 43.5 42.7EU13 3) 0.2 -1.9 -3.1 -2.4 40.9 40.9 42.1 42.9Euro area -1.8 -2.5 -2.8 -2.7 69.6 69.5 70.8 71.3

Table 8 Fiscal posit ions in the non-euro area EU Member States and the euro area

(as a percentage of GDP)

Sources: Eurostat and ECB calculations.Note: Data are based on the excessive deficit procedure definitions. Budget balances exclude proceeds from the sale of UMTS licences.1) Calendar year estimates.2) The EU10 aggregate comprises the 10 new EU Member States.3) The EU13 aggregate comprises the 13 non-euro area EU Member States.

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In many of the new Member States the rise inthe current account deficit in 2004 wasassociated with strong import growth owing torobust domestic demand and high oil prices.Other structural and temporary factors havealso affected the current account position. Onthe structural side, current account deficitsare a normal characteristic of catching-upeconomies such as the new Member States.Whereas these deficits could signal problemsregarding the sustainability of externalpositions, the current account deficits in manynew Member States were to some extent linkedto a rise in the income deficit reflectingearnings related to past foreign directinvestment inflows. As a transitory factor,current account balances may have beenaffected by the EU accession process itself as,for instance, companies increased their stocksin anticipation of higher tariffs.

Looking at the financing side of the balanceof payments, net foreign direct investmentinflows recovered somewhat in most new EUMember States in 2004, having slowed the yearbefore (see Table 9). Among these countries,only Slovenia recorded moderate outflows innet foreign direct investment in 2004. As to theother non-euro area EU Member States,Denmark and Sweden witnessed net outflows

of foreign direct investment in the same period,while in the United Kingdom, net foreign directinvestment turned positive after registeringmodest outflows in previous years. Overall, netforeign direct investment inflows constitutedan important source of financing in recent yearsfor a number of the non-euro area MemberStates, although in most cases these inflowswere not sufficient to cover the current accountdeficit. Net inflows in portfolio investment andin “other investment” provided additionalfinancing. As a result the external indebtednessof some countries also rose.

ERM II AND EXCHANGE RATE-RELATED ISSUESOn 28 June 2004 Estonia, Lithuania andSlovenia joined Denmark as participants inERM II. They entered the mechanism with astandard fluctuation band of ±15% around theircentral rates against the euro, while Estoniaand Lithuania kept their currency boards as aunilateral commitment. To ensure their smoothparticipation in ERM II, the countries havefirmly committed to taking the necessarymeasures to preserve macroeconomic andexchange rate stability. Box 10 provides anoverview of the characteristics of ERM II.

Participation in ERM II has not been associatedwith tensions in the foreign exchange markets

Table 9 Balance of payments of the non-euro area EU Member States and the euro area

(as a percentage of GDP)Current account plus capital account balance Net foreign direct investment flows2001 2002 2003 2004 1) 2001 2002 2003 2004 1)

Czech Republic -5.4 -5.7 -6.2 -6.1 9.0 11.2 2.6 2.4Denmark 3.1 2.1 3.3 2.8 -1.9 1.0 0.1 -0.6Estonia -5.6 -9.9 -12.7 -13.3 5.7 2.2 8.3 4.5Cyprus -3.3 -4.5 -3.3 -4.8 7.3 5.7 3.7 4.6Latvia -7.2 -6.5 -7.6 -11.0 1.4 2.7 2.4 3.5Lithuania -4.7 -4.8 -6.5 -8.7 3.6 5.0 0.8 3.2Hungary -5.6 -6.9 -9.0 -8.8 6.9 4.2 0.8 3.3Malta -4.2 0.5 -5.6 -6.6 6.2 -10.3 5.7 7.3Poland -2.8 -2.6 -2.2 -1.6 3.1 2.0 1.9 1.4Slovenia 0.2 0.7 -1.0 -0.9 1.1 6.8 -0.5 -0.4Slovakia -8.0 -7.6 -0.5 -2.6 7.4 16.5 2.2 3.3Sweden 4.3 5.3 6.4 7.8 2.5 0.4 -4.7 -1.7United Kingdom -2.2 -1.7 -1.6 -2.0 -0.3 -0.5 -2.5 0.4Euro area -0.1 1.0 0.5 0.8 -1.7 0.0 0.0 -0.5

Source: ECB.1) Figures for 2004 are a four-quarter moving average for the period from the fourth quarter of 2003 to the third quarter of 2004, exceptfor Cyprus, for which the average is for the period from the third quarter of 2003 to the second quarter of 2004.


Box 10

MAIN ELEMENTS OF THE EXCHANGE RATE MECHANISM II

With the introduction of the euro on 1 January 1999, the exchange rate mechanism II (ERM II)replaced the European Monetary System (and its exchange rate mechanism component) whichhad been in operation since 1979. ERM II is a multilateral arrangement of fixed but adjustableexchange rates, with bilateral central rates between the euro and participating currencies, and astandard fluctuation band of ±15% around those central rates.

Participation in ERM II for at least two years without severe tensions prior to the examinationof economic convergence is a requirement for fulfilling the exchange rate criterion of theMaastricht convergence criteria that must be met in order to adopt the euro. The economicrationale behind this requirement is that it helps Member States outside the euro area to orienttheir policies towards stability and enhances the prospects of achieving a lasting convergenceof economic fundamentals.

This reflects the notion that economic conditions and policies of participating Member Statesshould be consistent with the preservation of the central rates set. The overall goal of thisprocess is to foster macroeconomic stability in the new EU Member States, thereby providingthe best possible contribution to sustainable growth and real convergence. Moreover, soundmacroeconomic policies and stable exchange rates are supportive of a smooth functioning ofthe internal market.

According to the Governing Council, the mechanism, as well as the policy orientation requiredfor participation, is designed to help Member States outside the euro area in their efforts toadopt the euro, while dealing with the complex relationship between economic fundamentalsand exchange rate stability.1

The mechanism foresees a range of policy instruments that may be combined to addressmarket pressures: interest rate measures, flexibility of the exchange rate within the band,interventions, and possible realignments of the central rate.

From an operational perspective, decisions concerning central rates and the standardfluctuation band are taken by mutual agreement of the ministers of the individual euro areacountries, the ECB and the ministers and central bank governors of the non-euro area EUMember States participating in the mechanism. The General Council is responsible formonitoring the functioning of ERM II and serves as the forum for monetary and exchange ratecooperation. It closely monitors, on a permanent basis, the sustainability of the bilateralexchange rate between each participating currency and the euro.

1 See also “Policy position of the Governing Council of the European Central Bank on exchange rate issues relating to the accedingcountries”, 18 December 2003.

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of any of the participating countries. The fourcurrencies in ERM II have traded continuouslyat or close to their central rates, while short-term interest rate differentials vis-à-vis theeuro area have been small in most countries(see Table 10). In the context of ERM II entry,Banka Slovenije smoothly discontinued thegradual trend depreciation of the Sloveniantolar against the euro.

Most of the currencies of the non-euro area EUMember States experienced a strengtheningagainst the euro in 2004 and also a markedappreciation on a trade-weighted basis. Theweakening of the euro was particularlypronounced against the currencies of several ofthe larger new EU Member States, amid arelatively favourable growth outlook for thesecountries (see Chart 32). The Polish zloty

experienced the largest appreciation against theeuro in 2004, followed by the Czech koruna, theSlovak koruna and the Hungarian forint. Bycontrast, the Latvian lats, which in 2004 waspartially linked through its exchange rate regimeto the US dollar, depreciated against the euro.Since the beginning of 2005 Latvia has changedthe peg of the lats from the special drawingright (SDR) currency basket to the euro, atLVL 0.702804 per euro. Since the re-pegging,the lats has fluctuated within a narrow bandaround its peg rate. The Swedish krona, theMaltese lira and the Cyprus pound wererelatively stable against the euro. The poundsterling appreciated somewhat against the euroin early 2004 amid a favourable outlook for theUK economy and rising interest rates. In thesecond half of the year, however, it depreciatedvis-à-vis the euro.

MONETARY POLICYThe primary objective for monetary policy inall non-euro area EU Member States is pricestability. Monetary policy strategies differ to agreat extent from country to country, reflectingthe heterogeneity among them in nominal, realand structural terms (see Table 11). During2004 the monetary policy and exchange rateregimes in the non-euro area EU MemberStates remained largely unchanged, althoughsome refinements were made to the monetarypolicy frameworks of several countries with aview to gearing monetary policy more towardsfuture monetary integration. In particular,Estonia, Lithuania and Slovenia joined ERM IIon 28 June 2004. Moreover, in Latvia, Latvijas

Chart 32 Exchange rate changes of the euroagainst EU currencies outside ERM II

(in percentages)

Source: ECB.Note: A positive (negative) value represents an appreciation(depreciation) of the euro. Changes refer to the period from2 January 2004 to 24 February 2005.

5

0

-5

-10

-15

-20

5

0

-5

-10

-15

-20

0.3

-1.6

-16.2

-0.5

-7.8

3.7

-7.6

0.1

-8.0

CZK CYP LVL HUF MTL PLN SKK SEK GBP

DKK EEK LTL SIT

Maximum deviation from ERM II central rate 1)

(ten-day moving average of daily data at business frequency)Upward +0.5 0.0 0.0 0.0Downward 0.0 0.0 0.0 -0.2Short-term interest rate differential(monthly data, average)Fourth quarter of 2004 0.0 0.3 0.5 1.9

Table 10 Developments in ERM II

(in percentage points)

1) For Estonia, Lithuania and Slovenia the reference period is from 28 June 2004 to 24 February 2005. For Denmark the referenceperiod is from 1 November 2002 to 24 February 2005.


Banka re-pegged the lats from the SDR to theeuro on 1 January 2005.

Regarding monetary policy decisions in 2004in countries with an exchange rate objective,

the Central Bank of Cyprus increased its policyinterest rate by 100 basis points to 5.5%, thussending a signal of support for the Cypruspound against the background of rumours ofdevaluation. Moreover, a minimum reserve

Monetary policy strategy Currency Features

Czech Republic Inflation target Czech koruna Inflation target: 2-4% by end-2005, thereafter3% ±1 percentage point (p.p). Exchange ratestrategy: (managed) float.

Denmark Exchange rate target Danish krone Participates in ERM II with a ±2.25% fluctuation bandaround central rate of DKK 7.46038 per euro.

Estonia Exchange rate target Estonian kroon Participates in ERM II with a ±15% fluctuation bandaround central rate of EEK 15.6466 per euro. Estoniacontinues with its currency board arrangement as aunilateral commitment.

Cyprus Exchange rate target Cyprus pound Peg to the euro at CYP 0.5853 per euro, with ±15%fluctuation bands. The Cyprus pound has de factofluctuated within a narrow range.

Latvia Exchange rate target Latvian lats From February 1994 peg to the SDR (euro weight36.4%) with a ±1% fluctuation band. Since 1 January2005 peg to the euro at LVL 0.702804 per euro with a±1% fluctuation band.

Lithuania Exchange rate target Lithuanian litas Participates in ERM II with a ±15% fluctuation bandaround central rate of LTL 3.4528 per euro. Lithuaniacontinues with its currency board arrangement as aunilateral commitment.

Hungary Inflation target with an Hungarian forint Exchange rate target: peg to the euro at HUF 282.36 perexchange rate constraint euro, with ±15% fluctuation band. Inflation target:

3.5% (±1 p.p.) by end-2004, 4% (±1 p.p.) by end-2005and 3.5% (±1 p.p.) by end-2006.

Malta Exchange rate target Maltese lira Peg to a currency basket comprising the euro (70%),pound sterling (20%) and US dollar (10%). Nofluctuation margin but a trading margin of ±0.25% forforeign exchange market operations.

Poland Inflation target Polish zloty Inflation target: 2.5% ±1 p.p. (year-on-year change inCPI) as from 2004. Free floating exchange rate.

Slovenia Two-pillar strategy Slovenian tolar Participates in ERM II with a ±15% fluctuation bandmonitoring monetary, around central rate of SIT 239.640 per euro.real, external and financialindicators of macroeconomicconditions

Slovakia Combined inflation Slovak koruna Inflation objective: short-term inflation target set attargeting and managed 3.5% (±0.5 p.p.) at end-2005. The inflation target forfloat 1) the period 2006-2008 is set below 2.5% for end-2006

and below 2% at end-2007 and thereafter. Exchangerate strategy: managed float.

Sweden Inflation target Swedish krona Inflation target: 2% increase in the CPI with a tolerancemargin of ±1 p.p. Free floating exchange rate.

United Kingdom Inflation target Pound sterling Inflation target: 2% as measured by the 12-monthincrease in the CPI 2). In the event of a deviation ofmore than 1 p.p., the Governor of the Bank of Englandis expected to write an open letter to the Chancellor ofthe Exchequer. Free floating exchange rate.

Table 11 Off ic ia l monetary pol icy strategies of the non-euro area EU Member States

Source: ESCB.1) Národná banka Slovenska’s official wording is “inflation targeting in the conditions of ERM II”.2) The CPI is identical to the HICP.

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requirement of 2% for deposits in foreigncurrency was introduced. In Latvia the centralbank increased its key policy rate by 100 basispoints to 4%. To contain risks stemming fromhigh economic growth, strong credit growthand a widening current account deficit, italso decided to increase minimum reserverequirements from 3% to 4% and to expand thebase for minimum reserves by including bankliabilities to foreign banks and foreign centralbanks with an agreed maturity or redeemable ata period of notice of up to two years. In Maltathe official interest rate remained unchanged at3% throughout 2004.

Turning to the non-euro area EU MemberStates with an inflation targeting framework inplace, the Czech Republic and Polandincreased interest rates in 2004 with a view tocontaining inflationary pressures and limitingpossible second-round effects of higherinflation rates. In the Czech Republic the keypolicy rate was increased by 50 basis points to2.5% – although it was lowered to 2.25% inJanuary 2005 – and in Poland the key rate wasraised by 125 basis points to 6.5%. In theUnited Kingdom, the repo rate was raised by100 basis points to 4.75%, mainly due to aworsened outlook for CPI inflation. In contrast,Hungary, which follows an inflation targetcombined with an exchange rate constraint,reduced interest rates by a total of 300 basispoints to 9.5% in 2004, and further to 8.25% inFebruary 2005. The gradual interest rate cutsthroughout 2004 reversed the one-off 300 basispoint increase that had taken place inNovember 2003 after a sudden deterioration ofinvestor confidence. The reversal was madepossible by the easing of short-term riskperceptions, an improvement in the inflationoutlook and relatively subdued developmentsin private sector wage growth. In Slovakiaappreciation pressures on the koruna were themain motivation for a reduction in the keyinterest rate by a total of 200 basis points to4%. In Sweden limited inflationary pressuresupported the reduction of interest rates by75 basis points to 2%.

FINANCIAL DEVELOPMENTSIn 2004 long-term bond yield developmentswere mixed in non-euro area EU MemberStates. Long-term interest rates, as measuredby the ten-year benchmark government bondyield, increased in Cyprus, the Czech Republicand Poland, but towards the end of 2004 startedto decline again. As a result, bond yield spreadsvis-à-vis the euro area increased in thesecountries. In Hungary long-term bond yieldswere relatively volatile, with a downward trendin the second half of 2004, while in Latvia,Lithuania, Slovenia and Slovakia, long-terminterest rates continued to decline in the courseof 2004, narrowing the spread vis-à-vis theeuro area, in particular in the countriesparticipating in ERM II. In Malta long-terminterest rates were stable, while in Denmark,Sweden and the United Kingdom they moved inparallel with the rates in the euro area asindicated by stable bond yield spreads.5

Stock markets in the non-euro area EU MemberStates continued to perform favourably in2004, with some of the stock market indices,especially those of most of the new MemberStates, reaching all-time highs and recordingannual increases in a range between 20% and80%. Stock markets in all the new MemberStates, with the exception of Cyprus,significantly outperformed euro area stockprices, as measured by the Dow Jones EUROSTOXX index. Stock markets in Denmark,Sweden and the United Kingdom continued tofollow broadly the development of the DowJones EURO STOXX index, with the first twocountries slightly outperforming and the lastone slightly underperforming the euro areabenchmark.

5 Estonia does not have a developed market for long-term bondsdenominated in domestic currency. A proxy indicator for long-term interest rates in Estonia, developed jointly by the EuropeanCommission, the ECB and Eesti Pank and based on a weightedaverage of interest rates for new business loans denominated indomestic currency with maturities of over f ive years, shows adownward trend during 2004.

ArtistIsa DahlTitle“eben still”, 2004MaterialOil on canvasFormatø 190 cm© VG Bild-Kunst, Bonn 2005

CHAP T E R 2

CENTRAL BANKOPERATIONS

AND ACTIVITIES


1 MONETARY POLICY OPERATIONS, FOREIGNEXCHANGE OPERATIONS AND INVESTMENTACTIVITIES

1.1 MONETARY POLICY OPERATIONS

The key operational task of the Eurosystem isthe implementation of monetary policy. Theoperational framework which the Eurosystemhas set up for this purpose consists of threecategories of instruments: open marketoperations, standing facilities and theminimum reserve system. All credit operationscarried out by the Eurosystem have to becovered by adequate collateral provided bycounterparties.1 The Eurosystem took majorsteps in 2004 towards the establishment of asingle list of collateral.

INITIAL EXPERIENCE WITH THE NEWFRAMEWORK FOR MONETARY POLICYIMPLEMENTATIONThe operational framework continued to workwell in 2004, delivering stable short-termmoney market rates and clearly signalling themonetary policy stance. In order to furtherimprove the implementation of monetarypolicy, two important changes to theframework were introduced on 9 March 2004.

– The timing of the reserve maintenanceperiods was adjusted so that these periodsalways start on the settlement day ofthe main refinancing operation (MRO)following the Governing Council meeting atwhich the monthly decision on the monetarypolicy stance is scheduled. Previously,reserve maintenance periods started onthe 24th calendar day of one month andended on the 23rd calendar day of thesubsequent month, irrespective of theGoverning Council’s meeting schedule. Asa complement, changes in the standingfacility rates are now implemented, as a rule,on the first day of the new maintenanceperiod. Previously, these changes tookeffect on the day after the GoverningCouncil’s meeting.

– The maturity of the MROs was shortenedfrom two weeks to one week. Together withthe above-mentioned changes, this meansthat MROs settled in one reserve

maintenance period no longer extend intothe subsequent reserve maintenance period.

These changes were designed to align thereserve maintenance period with the cyclefor interest rate decision-making, ensuringthat, as a rule, changes in key ECB interestrates only take effect at the beginning of thesubsequent reserve maintenance period. TheECB thereby aims to eliminate expectationsof changes in the key ECB interest rateswithin a maintenance period and thus stabilisemarket participants’ bidding behaviour inthe MRO. Previously, such expectationshave occasionally destabilised counterparties’bidding in the MROs. In particular, whenthere were expectations of imminent interestrate reductions, counterparties bid for lessliquidity than the ECB intended to allot.This phenomenon, known as underbidding,reflected counterparties’ attempts to fulfiltheir reserve requirements at the lowestpossible cost, i.e. after a potential interest ratereduction.

Moreover, communication to counterpartieswas enhanced. On MRO announcement days,the ECB continues to publish the forecast of theautonomous liquidity factors which are notunder the direct control of the ECB’s liquiditymanagement, such as banknotes in circulation,government deposits and net foreign assets. Inaddition, the ECB has started to publish anupdated forecast on the allotment day. TheECB now also communicates the benchmarkamount on both the announcement and theallotment day. The benchmark amount is theallotment amount that allows the euro areabanking system as a whole to smoothly fulfil itsreserve requirements, given the Eurosystem’scomplete liquidity forecast, i.e. includingautonomous factors and excess reserves. Thisimproved communication makes explicitlyclear to the market whether the ECB’s

1 A detailed description of the operational framework can befound in the ECB publication entitled “The implementation ofmonetary policy in the euro area: General documentation onEurosystem monetary policy instruments and procedures”,February 2005.

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allotment decisions in MROs aim to balanceliquidity conditions or not.

The implementation of the changes to theframework was smooth. The shortening of theMRO maturity from two weeks to one week andthe elimination of the overlap betweenoperations led to an immediate doubling in sizeof each MRO. Counterparties’ biddingbehaviour adapted quickly to the strongincrease in the average allotment amount,although in the third MRO with a maturity ofone week, the total amount of bids fell short ofthe benchmark amount by €5 billion. The totalMRO bid amount quickly increased thereafterto levels steadily above the allotment amount,standing in November 2004 at an all-time highof around €384 billion (see Chart 33). Overall,the bid-cover ratio, which is the ratio ofsubmitted bids to satisfied bids, has beensound, ranging almost consistently between1.20 and 1.50 since March 2004. The smoothadaptation of market participants’ bid volumesalso indicates that the larger turnover ofcollateral implied by the shortening of theMRO maturity was managed well by creditinstitutions.

Since the changes to the framework came intoeffect, the short-term fluctuations in theallotment amount have decreased. From June2000 to March 2004 the average weekly changein the allotment amounted to €33 billion, whilethis figure fell to €7 billion in the periodbetween the implementation of the changes andDecember 2004. This reduction can beattributed to the fact that the MRO maturity isnow always aligned with the time horizon ofthe liquidity targeted by the ECB in itsallotment. As a further consequence, thereduction in the short-term fluctuation of theallotment amount has contributed to astabilisation of credit institutions’ bidding inthe MROs.

Approximately 2,100 credit institutions in theeuro area are eligible to participate in theMROs. The average number of bidders inMROs increased from 266 in 2003 to 339 in

2004, thus reversing the declining trendobserved since 1999. In the period from Marchto December 2004, i.e. after the changes to theframework were implemented, the averagenumber of bidders reached 351. This increase isprobably primarily the consequence of thereduction in the maturity of the MROs from twoweeks to one week, which implies that banksnow need to submit a bid each week instead ofevery second week in order to satisfy theirliquidity needs. However, it is possible that theincreased transparency and simplicity of thenew framework have made it easier forcounterparties to prepare their bids and havetherefore also facilitated increasedparticipation in tenders.

Overall, the volatility of the EONIA declinedin 2004. The standard deviation of the spreadbetween the EONIA and the minimum bid rateof the MRO was 9 basis points in 2004, against16 basis points in 2003 and 13 basis points in2002. However, significant volatility has beenobserved in the spread after the settlement ofthe last MRO of some maintenance periods.This is a result of the fact that the allotment ofthe last MRO now usually takes place eightdays before the end of the reserve maintenanceperiod, while previously the timing of the lastallotment varied from month to month betweeneight and two days before the end of the reservemaintenance period. The closer the underlying

Char t 33 B id and a l l o tment amounts inweek ly MROs in 2004

(EUR billions)

Source: ECB.

50

100

150

200

250

300

350

400

50

100

150

200

250

300

350

400

allotmentbid

05Jan.

04Feb.

05Mar.

04Apr.

05May

03June

03July

02Aug.

01Sep.

01Oct.

31Oct.

30Nov.

30Dec.


forecast is to the end of the reservemaintenance period, the more accurate it is.Therefore, the changes to the framework lead toan increased likelihood of substantial liquidityimbalances accumulating after the allotment ofthe last MRO of a reserve maintenance periodand, thus, of the overnight rate deviating fromthe minimum bid rate earlier and moresubstantially than in the past.

The ECB’s enhanced communication policyhelps to mitigate this risk to some extent as itmakes it somewhat easier for marketparticipants to detect a given liquidityimbalance since the last MRO allotment of themaintenance period. However, some evidenceemerged in particular during the autumn of2004 that excessive volatility in the overnightrate at the end of the maintenance period canhave a somewhat disruptive effect on thesmooth functioning of the money market. Asthe ECB aims to establish neutral liquidityconditions in the overnight market, itresponded to these developments, carrying outfine-tuning operations on the last day of fivemaintenance periods with a view to offsettingexpected undesirable liquidity imbalanceswhich mainly resulted from changes in theEurosystem’s forecast of autonomous factors.Two operations were liquidity-absorbing(11 May and 7 December 2004) and threewere liquidity-providing (8 November 2004,18 January and 7 February 2005). Theseoperations were successful in restoring neutralliquidity conditions at the end of the respectivemaintenance periods.

The changes to the operational framework alsohad implications for the conduct of longer-termrefinancing operations (LTROs). In order tominimise disruption to the timetable of LTROs,the technical link between the maintenanceperiods and the allotment days of LTROs hasbeen discontinued. As of 26 February 2004LTROs are normally allotted on the lastWednesday of the month (instead of the firstWednesday of the maintenance period). Incontrast to the MROs, LTROs – which have amonthly frequency and a maturity of normally

Char t 34 L iqu id i ty f a c tor s and thedeve lopment o f banknotes i n the euroarea in 2004(EUR billions)

Source: ECB.

Jan. Feb. Mar. Apr. May June July Aug.Sep. Oct. Nov.Dec.

liquidity deficitautonomous factorscurrent accountsrequired reserves

Liquidity factors

400

420

440

460

480

500

520

Jan. Feb. Mar. Apr. MayJune July Aug.Sep. Oct. Nov.Dec.400

420

440

460

480

500

520

Banknotes

100

150

200

250

300

350

100

150

200

250

300

350

400 400

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Annual Report2004

three months – are not used for signalling theGoverning Council’s monetary policy stanceand are conducted as pure variable rate tenderswith a pre-announced allotment volume. Onaverage, LTROs accounted for around 23% ofthe total net liquidity provided through openmarket operations in 2004. In view of thehigher liquidity needs anticipated for the euroarea banking system, the LTRO allotmentvolume was increased from €20 to €25 billionin January 2004 and from €25 to €30 billion inJanuary 2005.

DEVELOPMENT OF LIQUIDITY NEEDSIn order to prepare its weekly tenders, the ECBmonitors on a daily basis the liquidity needs ofthe euro area banking system, which aredefined as the sum of reserve requirementsimposed on banks, excess reserves (funds heldby credit institutions in excess of the reserverequirements) and net autonomous factors. Thedaily average liquidity needs of the euro areabanking system amounted to €311.8 billionin 2004, representing a 30% increase bycomparison with 2003, when they stood at€241.5 billion (see upper part of Chart 34).

During 2004 net autonomous factors continuedto grow strongly, averaging €174.2 billion ascompared with €109.3 billion in 2003. Thissteep rise was almost exclusively due to thecontinued strong growth in banknotes, whichincreased at an annual rate of almost 15% in2004, reaching an all-time high of €505 billionon 24 December 2004 (see lower part ofChart 34).

The minimum reserves that euro area creditinstitutions must hold with the Eurosystem arecalculated by applying the 2% reserve ratio tothe credit institutions’ reserve base. In 2004reserve requirements represented 44% of thetotal liquidity needs of the euro area bankingsystem. The average level of aggregaterequired reserves held by credit institutionsin the euro area increased from €130.9 billionin 2003 to €136.5 billion in 2004 in linewith the expansion of the reserve base. Creditinstitutions’ average current account holdingsin excess of their average reserve requirementsstood at €0.6 billion in 2004, compared with€0.7 billion in 2003.

Source: ECB.1) Separate data for asset-backed securities are only availablefrom 2004; they were previously reported under corporations.2) This category includes covered and uncovered bonds issuedby credit institutions.

Char t 35 E l i g ib l e marketab l e co l l a te ra l

(nominal amount outstanding; EUR billions)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1999 2000 2001 2002 2003 2004

governmentuncovered bank bondscovered bank bondscorporations

ABS 1)

othercredit institutions 2)

Source: ECB.1) Separate data for asset-backed securities are only availablefrom 2004; they were previously reported under corporations.

Chart 36 Use o f marketab l e co l l a te ra l

(nominal amount outstanding; EUR billions)

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

1999 2000 2001 2002 2003 2004

governmentuncovered bank bondscovered bank bonds

corporationsABS 1)

other


ELIGIBLE ASSETS FOR MONETARY POLICYOPERATIONSWith the aim of protecting the Eurosystem fromincurring losses, all Eurosystem creditoperations are required to be based on adequatecollateral. The range of assets accepted ascollateral is broad. The bulk consists ofmarketable debt instruments which fulfil euroarea-wide eligibility criteria and are referred toas “tier one” assets. “Tier two” consists ofadditional assets, marketable and non-marketable, which have been of particularimportance to national financial markets andbanking systems.

The average value of marketable collateraleligible for Eurosystem credit operationsstood at €7.7 trillion in 2004, compared with€7.1 trillion in 2003 (see Chart 35). Themajority of marketable assets took the formof government securities (54%) or covered(i.e. Pfandbrief-style securities) and uncoveredbonds issued by credit institutions (28%). Inaddition, strong growth has been observed inasset-backed securities, which represented 5%of outstanding marketable collateral at the endof 2004. The average value of marketableassets used by counterparties as collateralagainst Eurosystem credit operations stoodat €787 billion in 2004, compared with€704 billion in 2003 (see Chart 36). Relativeto the overall eligible amount, governmentissues and corporate securities were under-proportionally used as collateral in creditoperations with the Eurosystem. Conversely,credit institution issues and asset-backedsecurities were over-proportionally used. Forinformation on the use of eligible assets acrossnational borders, see Section 2 of this chapter.

TOWARDS A SINGLE LIST OF COLLATERALThe Eurosystem’s present two-tier collateralsystem has contributed to a smooth functioningof the operational framework of theEurosystem in the first years of its existence.However, against the background of increasingfinancial market integration in the euro area,the heterogeneity of the assets included in thetier two lists of different euro area NCBs may

undermine the level playing-field forcounterparties and reduce the transparency ofthe collateral framework. Moreover, demandfor collateral is on an upward trend, not least onaccount of the fact that the liquidity deficit ofthe banking sector increased in the course of2004. The trend in private interbank marketstowards secured lending has also augmentedcounterparties’ needs for collateral.

To address these issues, the Eurosystemdecided to establish over time a single list ofcollateral eligible for all Eurosystem creditoperations, taking into account the results of apublic consultation. This single list will beintroduced gradually and will eventuallyreplace the current two-tier system. The firststep towards establishing the single list willcome into force on 30 May 2005. It consists ofthree elements:

– The inclusion in tier one of new instrumentsthat are currently ineligible, namely euro-denominated debt instruments issued byentities established in those G10 countriesthat are not part of the EEA (United States,Canada, Japan and Switzerland).

– Debt instruments which are only listed orquoted on non-regulated markets willbecome or remain eligible if the respectivenon-regulated market has been positivelyassessed by the Eurosystem against the threestandards of safety, transparency andaccessibility. These standards have beenintroduced to broaden the number ofacceptable markets while at the same timeensuring the smooth and efficientassessment of Eurosystem collateral.

– A very limited number of marketable debtsecurities will lose their eligibility statusand will be phased out over time. Inaddition, equities have been withdrawn fromthe list of tier two assets.

As a second step towards a single list ofcollateral, the Governing Council has approvedin principle the inclusion in the single list of

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bank loans from all euro area countries, as wellas non-marketable retail mortgage-backed debtinstruments, which currently only include Irishmortgage-backed promissory notes. The mainreason for accepting bank loans is that, despitethe increasing role of capital markets, thefinancial system of the euro area still relies to alarge extent on bank intermediation, with bankloans remaining the most important asset classon banks’ balance sheets. By accepting bankloans as collateral, the Eurosystem reaffirms itspreference for ensuring broad access forcounterparties to monetary policy and intradaycredit operations.

RISK MANAGEMENT ISSUESRisk management in the context of theEurosystem’s policy operations (i.e. monetarypolicy or payment systems credit operations)focuses mainly on the credit risk theEurosystem incurs when providing centralbank funds to a counterparty, although othertypes of risk are also taken into account.

Extensive analysis was carried out in 2004 onthe inclusion of bank loans in the single list ofcollateral. Since corporate loan issuers areoften unrated, alternative credit qualityassessment sources for bank loans will need tobe used. While those NCBs that already acceptbank loans as tier two collateral haveestablished in-house credit assessmentsystems, additional sources of credit

assessment for bank loans will need to beestablished once bank loans are included inthe single list for the whole Eurosystem.The development and implementation of aconsistent and efficient Eurosystem creditassessment framework for marketable and, inparticular, non-marketable assets is expectedto represent a major challenge over the comingyears.

1.2 FOREIGN EXCHANGE OPERATIONS

In 2004 the ECB did not undertake anyinterventions in the foreign exchange marketfor policy reasons. Its foreign exchangetransactions were exclusively related toinvestment activity. Furthermore, the ECB didnot undertake any foreign exchange operationsin the non-euro area currencies that participatein ERM II.

The standing agreement between the ECB andthe IMF to facilitate the initiation of specialdrawing rights (SDR) transactions by the IMFon behalf of the ECB with other SDR holderswas activated on four occasions in 2004.


1.3 INVESTMENT ACTIVITIES

FOREIGN RESERVE MANAGEMENTThe ECB’s foreign reserve portfolio iscomposed of foreign reserve contributionsfrom the euro area NCBs. Its purpose is to fundthe ECB’s operations in the foreign exchangemarket. In particular, the ECB holds the part ofthe Eurosystem’s reserves that can be useddirectly and without delay to fund foreignexchange interventions, and it can make furthercalls on the NCBs’ foreign reserves in case itneeds to replenish its depleted holdings.

The ECB’s foreign reserve portfolio mainlyconsists of US dollars, but also includesJapanese yen, gold and SDRs. In line with theCentral Bank Gold Agreement of 26 September1999, renewed on 8 March 2004, gold holdingswere not actively managed in 2004. The valueof the ECB’s net foreign reserve assetsdeclined from €38.3 billion to €36.3 billionduring 2004, mainly due to the depreciation ofthe US dollar against the euro.

Each euro area NCB currently manages aportion of both the ECB’s US dollar and yenportfolios. The Eurosystem reviewed thisstructure in 2004 with the objective ofmaintaining its effectiveness, particularly inview of the future enlargement of the euro area.The new system, currently being finalised, willbe implemented in 2006 and will entailspecialisation among Eurosystem members interms of the currency denomination of themanaged portfolios, with due respect to theprinciple of decentralisation.

During 2004 work began on expanding theinvestment universe to include interest rateswaps, currency-hedged instruments and USSTRIPs2. In addition, quantitative forecastingmodels for government bond yields increasedthe sophistication of the analysis of marketdevelopments. Finally, a pilot exercise, due tostart in 2005, was devised for an automaticsecurities lending programme in the US dollarportfolio.

2 STRIP stands for Separate Trading of Registered Interest andPrincipal, which is a security created by separating the bondprincipal from the interest payments in a US government bond.

OWN FUNDS MANAGEMENTThe ECB’s own funds portfolio consists of thepaid-up share of the subscribed capital and thegeneral reserve fund. The purpose of thisportfolio is to provide the ECB with a reserve tomeet possible losses. The objective of itsmanagement is to generate returns over thelong term in excess of the average mainrefinancing rate of the ECB. In 2004 theinvestment options of the own funds portfoliowere expanded by adding euro-denominatedfixed-income securities issued by some newMember States, some euro area regionalgovernment bonds and more covered bonds.

In 2004 the ECB’s own funds portfolio grew by€0.3 billion to €6.2 billion. In particular, thepaid-up capital portion increased by €63.5million due to EU enlargement and changes inthe ECB’s capital key.

RISK MANAGEMENT ISSUESWhen managing its investment portfolios(foreign reserves and own funds), the ECB isexposed to financial risks. In order to managethese risks, the ECB defines a framework thatreflects its preferences regarding credit,liquidity and market risk. This framework isimplemented, inter alia, via a detailed limitssystem, whereby compliance is monitored andverified on a daily basis. With a view to thefuture enlargement of the euro area, work wasconducted in 2004 with the aim of simplifyingthe credit and market risk framework.

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2 PAYMENT AND SECURITIES SETTLEMENTSYSTEMS

The Eurosystem has the statutory task ofpromoting the smooth operation of paymentsystems. Its main instrument for carrying outthis task – besides the oversight function – isthe provision of payment and securitiessettlement facilities. To this end, theEurosystem has created the Trans-EuropeanAutomated Real-time Gross settlementExpress Transfer system, known as TARGET,for large-value payments in euro. It has beensubject to enhancements over the past fewyears, and work is under way to develop asecond-generation system, TARGET2. On thesecurities settlement side, the Eurosystem andthe market offer a number of channels tofacilitate the use of collateral across nationalborders.

2.1 THE TARGET SYSTEM

The present TARGET system is a “system ofsystems” made up of the national paymentsystems of the 15 countries that were membersof the EU at TARGET’s launch, the ECBpayment mechanism (EPM) and an interlinkingmechanism that enables the processing ofpayments between the linked systems. In 2004TARGET contributed further to the integrationof the euro money market and, because theEurosystem’s credit operations are processedvia this system, continued to play an importantrole in the smooth implementation of the singlemonetary policy. On account of its real-timesettlement service in central bank money andits broad market coverage, the TARGETsystem also attracts a variety of otherpayments.

TARGET functioned smoothly and successfullyin 2004 and continued its trend of settlingan increasing number of large-value europayments. This is in line with the Eurosystem’spolicy objective of promoting settlement incentral bank money as a uniquely safe meansof payment. In 2004 88% of the total turnoverof large-value payments in euro was executedvia TARGET. TARGET is available for allcredit transfers in euro between banks located

in any of the Member States whose NCBs arelinked, directly or indirectly, to TARGET.Such transfers may be made both betweenbanks in the same Member State (intra-MemberState traffic) and between those in differentMember States (inter-Member State traffic).The latest survey in 2004 revealed thatthere were 10,483 participants in TARGET.This is about three times higher than thefigure for 2002 and mainly reflects theintroduction of a new methodology fordefining TARGET participants. Overall, around48,500 institutions, in particular branchesof participants, can be addressed throughTARGET using a Bank Identifier Code.

TARGET OPERATIONSIn 2004 TARGET processed a daily average of267,234 payments with a total value of €1,714billion a day. Compared with 2003, this is anincrease of 2% in volume and 4% in value.

Of the total TARGET traffic in 2004, inter-Member State traffic represented 33% in termsof value and 24% in terms of volume, comparedwith 33% and 23% respectively in 2003. Ofthat inter-Member State traffic, 95% in termsof value and 49% in terms of volume wereinterbank payments, the remainder beingcustomer payments. The average value of aninter-Member State interbank payment was€17 million, and the average value of aninter-Member State customer payment was€0.8 million. Further information on paymenttraffic is provided in Table 12.

In 2004 the overall availability of TARGET,i.e. the extent to which participants were ableto use TARGET during its business hourswithout incident, reached 99.81%. On average,95.87% of inter-Member State payments wereprocessed within five minutes. Furtherinformation is provided in Table 13.

Throughout 2004 the mandatory changesnecessary for the migration to the newmessaging system, SWIFTNet FIN, continued,and all components of TARGET migratedsuccessfully.


PROVISIONS FOR SYSTEMICALLY IMPORTANTPAYMENTS IN TARGETOwing to the TARGET system’s pivotal role inthe market and its broad market coverage,suitable protection against a wide range ofthreats is essential for the reliable andsmooth functioning of the system. It is ofthe utmost importance that systemicallyimportant payments – i.e. those that couldcause a systemic risk if not processed whendue – be carried out without delay, even inabnormal circumstances. The Eurosystem hasestablished contingency measures to ensurethat such payments are processed in an orderlymanner, even in the event of TARGETmalfunctioning. In 2004 a number of trialswere carried out by central banks (ofteninvolving commercial banks), and these provedthe effectiveness of the TARGET contingencymeasures. They confirmed that the Eurosystemis in a good position to ensure that paymentsystems and financial markets can continue tofunction smoothly in a crisis situation.

TARGET CONNECTION FOR THE NEW EU MEMBERSTATESIn October 2002 the Governing Councildecided that, following EU enlargement, theEurosystem would connect the real-time grosssettlement (RTGS) systems of the NCBs of thenew Member States to TARGET at theirrequest. Given the limited remaining lifetimeof the current TARGET system and in order tosave costs, the Eurosystem developedalternatives to full integration which allowthe new Member States’ RTGS systems tobe connected to the current TARGET system.For instance, the solution envisaged forSORBNET-EURO, Narodowy Bank Polski’seuro RTGS system, is a connection via acurrent euro area NCB. The connection will beprovided in 2005 through the Banca d’Italia.

RELATIONS WITH TARGET USERS AND REAL-TIMEGROSS SETTLEMENT OPERATORS OF OTHERCURRENCY AREASThe ESCB maintains close relations withTARGET users in order to ensure that theirneeds are given due consideration and receive

Volume (number Changeof transactions) 2003 2004 (%)

OverallTotal 66,608,000 69,213,486 4Daily average 261,208 267,234 2Intra-Member StateTotal 51,354,924 52,368,115 2Daily average 201,392 202,193 0Inter-Member StateTotal 15,253,076 16,845,371 10Daily average 59,816 65,040 9

Value Change(EUR billions) 2003 2004 (%)

OverallTotal 420,749 443,992 6Daily average 1,650 1,714 4Intra-Member StateTotal 283,871 297,856 5Daily average 1,113 1,150 3Inter-Member StateTotal 136,878 146,137 7Daily average 537 564 5

Tab le 12 Payment t ra f f i c i n TARGET 1 )

Source: ECB.1) 255 operating days in 2003 and 259 operating days in 2004.

RTGS system 2004

EPM (ECB) 99.48

ELLIPS (BE) 99.88

KRONOS (DK) 99.85

RTGSplus (DE) 99.37

HERMES euro (GR) 99.80

SLBE (ES) 99.89

TBF (FR) 99.94

IRIS (IE) 99.59

BI-REL (IT) 99.91

LIPS-Gross (LU) 99.97

TOP (NL) 99.98

ARTIS (AT) 99.87

SPGT (PT) 99.86

BOF-RTGS (FI) 99.85

E-RIX (SE) 99.74

CHAPS Euro (UK) 99.95

Overall system availability 99.81

Tab le 13 Overa l l ava i l ab i l i t y o f TARGET

(percentages)

Source: ECB.

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Annual Report2004

an appropriate response. In 2004, as inprevious years, regular meetings were heldbetween the 15 NCBs linked to TARGET andthe national TARGET user groups. In addition,joint meetings of the TARGET ManagementWorking Group of the ESCB and the TARGETWorking Group of the European bankingindustry were held to discuss TARGEToperational issues. Strategic issues wereaddressed in the Contact Group on EuroPayments Strategy, a forum in which the seniormanagement of commercial and central banksis represented.

The Eurosystem, as operator of one of thelargest RTGS systems in the world, maintainsclose contacts with the RTGS operators ofother currency areas. Increasing interrelations,such as those stemming from ContinuousLinked Settlement operations, have created theneed for joint discussions on operationalissues.

2.2 TARGET2

In December 2004 the Governing Councilaccepted the joint offer made by the Bancad’Italia, the Deutsche Bundesbank and theBanque de France to build the single sharedplatform for TARGET2 and to develop andoperate it on behalf of the Eurosystem. Thisdecision will result in a fundamental redesignof the architecture of TARGET, which, atpresent, consists of multiple interlinked RTGSsystems which are maintained by the NCBs andthe ECB. TARGET2 will offer TARGET usersa higher level of service and will alloweconomies of scale to be made.

The main preparatory work undertaken in 2004for TARGET2 involved developing thefunctional specifications. This work wasundertaken in close cooperation with TARGETusers. The General Functional Specifications(GFS) for TARGET2, which were approved bythe Governing Council in July 2004, describeon a general level the features and functions ofthe system as well as its IT architecture.

TARGET2 will offer comprehensive liquiditymanagement functions that allow creditinstitutions to better control their euroliquidity. For example, a participant that usesseveral payment and securities settlementsystems settling in central bank money willhave the possibility of settling all suchpositions from a single RTGS account inTARGET2. Furthermore, for RTGS accountsof euro area credit institutions held with euroarea central banks, TARGET2 will offer anintraday liquidity pooling feature. It willenable euro area TARGET2 participants togroup individual RTGS accounts held withdifferent euro area central banks and to poolthe available intraday liquidity for the benefitof all members of the group of accounts.The Eurosystem is working towards theestablishment of a robust legal framework forthis purpose, which is a precondition foroffering this function. TARGET2 will be basedon a state-of-the-art business continuityconcept that will enable it to cope with wide-scale regional disaster situations.

On the basis of the GFS, the Eurosystem ispreparing the User Detailed FunctionalSpecifications (UDFS), which describe thefeatures and functions of TARGET2 at thelevel of detail required for the start of thetechnical development and implementationwork. As was the case for the GFS, the UDFShave been intensively discussed with TARGET


users. The UDFS are expected to be finalised inApril 2005.

The Eurosystem is also developing a pricingscheme for the TARGET2 core service whichwill eliminate the current differences in pricingbetween domestic and cross-bordertransactions. It includes an option to be decidedon by the Governing Council which wouldallow participants to choose between paying atransaction fee only or a lower transaction feeplus a periodical fee. Further details of theTARGET2 pricing scheme will be defined in2005.

Another major area of work in 2004 was thedevelopment of the governance structure forTARGET2 and, on the basis of this, aneffective project organisation for the nextproject phases (development, testing andmigration). The Governing Council approvedinternal rules concerning the commongovernance of TARGET2. These define theroles and responsibilities in the TARGET2project of, respectively, the GoverningCouncil, the full group of euro area centralbanks and the three NCBs building andoperating the system. The chosen governancestructure and project organisation will ensureboth the effective organisation of thedevelopment work in the project phase and anappropriate level of continued involvement andcontrol by all euro area central banks after thelaunch of TARGET2.

The development of software and theestablishment of the IT infrastructure forTARGET2 will be carried out in 2005. Firsttesting activities with the central banks areplanned to start in early 2006. TARGET userswill migrate to TARGET2 in different wavesand on different predefined dates. Each wavewill consist of a group of national bankingcommunities and the migration process will bespread over several months, during whichcurrent TARGET components and the newsystem will coexist. The phased migration willbe organised in a way which minimises projectrisk. Other important considerations when

deciding on the concrete migration process willbe to minimise potential transition problemsand costs for central banks and TARGET users.It is planned that the first group of countrieswill migrate to TARGET2 on 2 January 2007.The Eurosystem will continue its closecooperation with the TARGET user communityduring all phases of the project and will reportregularly on the progress made.

2.3 CROSS-BORDER USE OF COLLATERAL

Eligible assets may be used across nationalborders to collateralise all types of Eurosystemcredit operation by means of the correspondentcentral banking model (CCBM) or througheligible links between EU securities settlementsystems (SSSs). The CCBM is provided by theEurosystem, while eligible links are a market-led solution.

The amount of cross-border collateral held bythe Eurosystem increased from €305 billion inDecember 2003 to €370 billion in December2004. Overall, at the end of 2004 cross-bordercollateral represented 43.89% of the totalcollateral provided to the Eurosystem. Thesefigures confirm the trend observed in previousyears of increasing integration of financialmarkets in the euro area and the growingwillingness of counterparties to hold in theirportfolios assets issued in another euro areacountry.

THE CORRESPONDENT CENTRAL BANKING MODELThe CCBM has remained the main channelfor transferring cross-border collateral. Itaccounted for 35.37% of the total collateralprovided to the Eurosystem in 2004. Assetsheld in custody through the CCBM increasedfrom €259 billion at the end of 2003 to €298billion at the end of 2004.

By the beginning of 2004 NCBs had, as aresult of enhancements made in 2003,already achieved the objective of performinginternal CCBM procedures within an hour,provided that counterparties (and their

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custodians) submitted their instructionscorrectly. The Eurosystem is investigatingfurther improvements and alternatives forthe efficient and safe use of cross-bordercollateral.

Custodian banks often play an important role inthe CCBM processing chain by deliveringcollateral on behalf of counterparties. InJanuary 2004 “best practices” for custodianbanks involved in CCBM transactions,established by the major European credit sectorassociations, were implemented. They aim tooptimise the efficiency of the CCBM. Marketparticipants’ efforts in implementing these bestpractices also helped NCBs to perform internalCCBM procedures within an hour. However,deviation from this one-hour benchmark mayoccur in certain circumstances, for instance inthe case of peak traffic.

ELIGIBLE LINKS BETWEEN SECURITIESSETTLEMENT SYSTEMSSSSs can be linked by means of contractual andoperational arrangements to allow the cross-border transfer of eligible securities betweensystems. Once eligible securities have beentransferred via such links to another SSS, theycan be used through local procedures in thesame way as any domestic collateral. There arecurrently 59 links available to counterparties,of which only a limited number are activelyused in transfers related to Eurosystem creditoperations. Furthermore, these links onlycover part of the euro area. Links becomeeligible for Eurosystem credit operationsif they fulfil the Eurosystem’s nine userstandards3 which focus on the requirements ofcentral banks when settling their operations inSSSs. The Eurosystem assesses any new linksor enhancements of eligible links against thesestandards. In 2004 three existing eligible linkswere enhanced and positively assessed.

3 “Standards for the use of EU securities settlement systems inESCB credit operations”, January 1998.

Collateral held through links increased from€46 billion in December 2003 to €72 billion inDecember 2004, but represented only 8.5% ofthe total collateral, cross-border and domestic,held by the Eurosystem.


3 BANKNOTES AND COINS3.1 THE CIRCULATION OF BANKNOTES AND

COINS

DEMAND FOR EURO BANKNOTES AND COINSFollowing an annual growth rate of 22% in2003, the value of euro banknotes in circulationincreased by 15.0% in 2004, from €436.1 to€501.3 billion. The number of euro banknotesin circulation increased by 6.8% (comparedwith 10.1% in 2003), from 9.0 to 9.7 billion.Chart 37 shows the development of nationalbanknotes and euro banknotes in circulationin terms of value between 2000 and 2004.Chart 38 illustrates the development of thenumber of euro banknotes in circulation sincetheir introduction.

The value of banknotes in circulation has risenmore steeply than the number ever sincethe cash changeover, which reflects theparticularly strong increase in the number ofhigh-denomination banknotes in circulation.Chart 39 shows the development of eurobanknotes in circulation by denominationbetween 2002 and 2004. The strongest increasein demand in 2004 was for the €500 banknote,at 28.4%. Demand was also very strong forthe €50 and €100 banknotes, which sawcirculation growth rates of 12.4% and 13.5%respectively.

Overall growth in the number of €5, €10, €20and €200 banknotes in circulation has beenvery moderate since the introduction of thebanknotes in 2002, although developmentsmay vary between countries. Only duringseasonal peaks has a strong rise in demandbeen witnessed for the €10 and €20 banknotes,i.e. those denominations which are mainly usedfor daily cash transactions. In the case of the€50 banknote, both fairly high growth andseasonal fluctuations have been recorded. Bycontrast, the circulation of the €5 and €100banknotes has shown only moderate seasonalvariation, while that of the €200 and €500banknotes has followed no seasonal pattern atall. It is clear that demand for transactionpurposes within the euro area alone does notexplain the lasting upward trend in demand forthese denominations, but that other factorsmust also play a role. One such factor seemsto be the growing international demand foreuro banknotes. Recent analyses suggestthat around 10% to 15% of the banknotesin circulation are held outside the euro area.Another factor is hoarding by the public,partially influenced by the low level of interestrates.

During 2004 the value of euro coins incirculation (i.e. the net circulation excludingstocks held by NCBs) increased by 9.1%, from€14.1 billion to €15.3 billion. The total number

Char t 37 Tota l va lue o f banknotes inc i r cu l a t ion between 2000 and 2004

(EUR billions)

Source: ECB.

national banknoteseuro banknotes

0

100

200

300

400

500

0

100

200

300

400

500

2000 2001 2002 2003 2004

Char t 38 Tota l number o f eurobanknotes in c i r cu l a t ion between 2002and 2004(billions)

Source: ECB.

6

7

8

9

10

6

7

8

9

10

2002 2003 2004

95ECB

Annual Report2004

of euro coins in circulation grew by 14.8% tostand at 56.2 billion. There has been a steadygrowth in the number of euro coins incirculation since the beginning of 2003, whenthe volume returned to the initial level of40.4 billion coins issued at the time of thechangeover.

BANKNOTE HANDLING BY THE EUROSYSTEMDeposits and withdrawals of euro banknoteshave been quite stable for all euro area NCBssince the second quarter of 2002. Fluctuationsin the monthly deposits and withdrawalsmainly reflect the usual seasonal variations inbanknote demand.

A total of 29.4 billion euro banknotes wereprocessed by euro area NCBs in 2004, whichwas similar to the figure for 2003. BetweenJanuary and December 2004 a total of 30.4billion banknotes were issued and 29.7 billionwere returned to the NCBs. The returnfrequency of banknotes, measured as the ratioof banknotes deposited at NCBs to the numberof banknotes in circulation, has remainedrelatively stable since 2002 and in 2004 stoodat around 3.4 times a year. 3.8 billion unfitbanknotes were destroyed in 2004.

3.2 BANKNOTE COUNTERFEITING ANDCOUNTERFEIT DETERRENCE

COUNTERFEIT EURO BANKNOTESHaving risen steadily in 2002 and much of2003, the rate of euro banknote counterfeitingis now relatively stable. From the last quarterof 2003 to the end of 2004, an average ofaround 50,000 counterfeits were recoveredfrom circulation each month, with seasonalfluctuations coinciding with those of genuinebanknotes, for example during holiday periods.The total number of counterfeits received byNational Analysis Centres (NACs)4 in 2004was 594,000. This represents an increase of7.8% compared with 2003, which issubstantially lower than the growth rateobserved one year earlier. Chart 40 shows thetrend in counterfeits recovered from

€5 €10 €20 €50

Percentage 1 5 24 48

€100 €200 €500 Total

Percentage 17 4 1 100

Tab le 14 D i s t r ibut ion o f counter f e i t s bydenominat ion

Source: Eurosystem.

4 Centres established in each EU Member State for the initialanalysis of counterfeit euro banknotes at the national level.

Char t 39 Number o f euro banknotes i n c i r cu l a t ion between 2002 and 2004

(millions)

Source: ECB.

EUR 500EUR 200EUR 100

0100200300400500600700800900

1,000

01002003004005006007008009001,000

2002 2003 2004 2002 2003 20040

500

1,000

1,500

2,000

2,500

3,000

3,500

0

500

1,000

1,500

2,000

2,500

3,000

3,500

EUR 50EUR 20EUR 10EUR 5


circulation, with figures taken at half-yearlyintervals since the banknotes were launched.

Table 14 shows that the €50 banknote remainsthe counterfeiters’ biggest target, althoughsome evidence emerged during the year thatorganised crime is increasingly targeting the€100, €200 and €500 banknotes. A smallquantity of better than average counterfeitshave been produced in these denominations.

Overall, it is evident that the number ofcounterfeits (594,000 in 2004) is a tiny fractionof the average number of genuine banknotes incirculation (8.9 billion in 2004). The publiccan continue to have confidence in the securityof the euro: it remains a well protectedcurrency, in terms of both the sophisticationof its security features and the effectivenessof European and national law enforcementauthorities. However, the public shouldcontinue to be watchful. The “feel-look-tilt”test remains sufficient to detect counterfeits inalmost all cases.

COUNTERFEIT DETERRENCEIn addition to cooperating with the NCBs,Europol and the European Commission (inparticular the European Anti-Fraud Office,OLAF), the ECB concluded an agreementwith Interpol in 2004 on the protection of theeuro and the fight against counterfeiting.Further cooperation agreements were establishedwith the central banks of two of the EU’s

neighbouring countries (Ukraine andBulgaria), and similar agreements with othercountries are envisaged for the future. TheEurosystem was active in training cash-handlingprofessionals, both in the EU and beyond, inrecognising and handling counterfeit banknotes.The Counterfeit Analysis Centre at the ECB andthe NACs collaborated with the police in the fightagainst counterfeiting, and technicians from theNACs provided, upon request, legal authoritieswith expert advice and technical reports.

The International Counterfeit DeterrenceCentre, hosted by the ECB, continued toevaluate new reproduction equipment andcounterfeit deterrence systems and to supportthe Central Bank Counterfeit DeterrenceGroup, a joint initiative of 27 central banksworldwide.

3.3 BANKNOTE ISSUANCE AND PRODUCTION

THE EUROSYSTEM’S ROLE IN THE CASH CYCLEIn December 2004 the Governing Councilagreed on common principles and objectives inrespect of the Eurosystem’s role andresponsibilities in the cash cycle. The

Char t 40 Number o f counter f e i t eurobanknotes recovered f rom c i r cu l a t ionbetween 2002 and 2004(thousands)

Source: ECB.

0

50

100

150

200

250

300

350

0

50

100

150

200

250

300

350

2002/1 2002/2 2003/1 2003/2 2004/1 2004/2

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Annual Report2004

definition of its role and responsibilitieswill contribute to the establishment of theSingle Euro Payments Area (see Section 3of Chapter 3). It also provides a reliableframework for the Eurosystem’s partners in thecash cycle (i.e. the banking industry and cash-in-transit companies). In line with the principleof decentralisation, the Governing Councildid not establish a fully harmonised systemfor euro area cash services. While someharmonisation and standardisation underthe guidance of the ECB is necessary, the NCBsare responsible for the implementation atthe national level, taking into account therespective national economic environment andbanking structures, the existing NCB branchnetwork and the relative share of cashpayments and/or long-term agreements.

ECB FRAMEWORK FOR THE DETECTION OFCOUNTERFEITS AND FITNESS SORTINGFollowing consultations with the banking andcash-in-transit industries, in December 2004the ECB adopted a framework for the detectionof counterfeits and the sorting of banknotes byquality (known as “fitness sorting”) by creditinstitutions and other professional cash-handlers. The principal objectives of thisframework are to implement a common policyfor banknote handling and processing by creditinstitutions and other professional cash-handlers as well as to provide them withassistance in fulfilling their obligationsaccording to Article 6 of Council Regulation(EC) No 1338/2001 regarding the detection andwithdrawal of counterfeit euro banknotes.NCBs will implement this framework withintheir jurisdiction by the end of 2006 at thelatest. There will be a two-year transitionperiod, ending no later than the end of 2007,for the adaptation of procedures and existingmachines in operation by credit institutions andother professional cash-handlers.

PRODUCTION ARRANGEMENTSA total of 1.6 billion banknotes were producedin 2004, compared with 3.1 billion in 2003.This significant reduction in the 2004production requirement was primarily due to a

lower actual replacement need than expected in2003.

Since 2002 the production of euro banknoteshas been allocated to the NCBs in accordancewith a decentralised production scenario withpooling. Under this arrangement, each euroarea NCB is responsible for the procurement ofan allocated share of the total requirement forcertain denominations. Table 15 summarisesthe 2004 production allocation.

The arrangements for future banknoteprocurement are laid down in Guideline ECB/2004/18, adopted by the Governing Council inSeptember 2004. The Guideline establishes asingle Eurosystem tender procedure for theproduction of euro banknotes, which will beimplemented by 1 January 2012 at the latest.The implementation of this procedure will bepreceded by a transitional period, thus allowingNCBs and the printing works ample timeto prepare for the new procedure. Thistransitional period will start no earlier than1 January 2008, but the precise starting date –which will be decided by the GoverningCouncil – is dependent on the achievement of acritical mass in terms of both the number ofNCBs agreeing to participate in the singleEurosystem tender procedure and the totalvolume of banknotes to be tendered.

The Guideline has been developed inaccordance with the principle of an openmarket economy with free competition,favouring an efficient allocation of resources,

Denomination Quantity (millions NCB commissioningof banknotes) production

€5 - -€10 378 DE, FR, GR, IE, AT€20 290 FR, PT€50 683 BE, DE, ES, IT, NL€100 124 IT, FI€200 - -€500 124 DE, LUTotal 1,599

Tab le 15 A l l o ca t ion o f euro banknoteproduct ion in 2004

Source: ECB.


and in line with EU competition law. Inparticular, the objectives of the procedure areto ensure equal treatment of all printing workswishing to participate in the single Eurosystemtender procedure, as well as to guaranteetransparency and the continued secureproduction of euro banknotes. The tender ruleslaid down in the Guideline will apply to theEurosystem’s entire banknote requirement.Those NCBs with in-house printing works orthose using public printing works may decidenot to participate in the single Eurosystemtender procedure and will then continue toproduce the euro banknotes allocated to them inthose printing works.

VERY LOW-DENOMINATION BANKNOTESIn response to suggestions from varioussources, the Eurosystem examined thepotential positive and negative aspects ofintroducing very low-denomination banknotes,i.e. €1 and/or €2. After careful consideration,the Governing Council decided in November2004 not to revise the decision it had taken in1998 on the denominations of euro banknotesand, consequently, not to issue €1 or €2banknotes. Having assessed all the argumentsput forward in the debate, the GoverningCouncil concluded that, on balance, thenegative aspects of introducing very low-denomination banknotes outweighed thepositive aspects. The insufficient demand forvery low-denomination banknotes by themajority of euro area citizens, the increasedinefficiency which their introduction wouldimply for most of the affected third parties – forinstance, the retail sector and the vendingmachine industry – and the high costs ofprinting and processing contributed inparticular to this decision.

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Annual Report2004

The ECB, assisted by the NCBs, collects a widerange of statistics which enable the ESCBto fulfil its tasks. The necessary statisticalinformation is collected either from thecompetent national authorities or directly fromeconomic agents. In 2004, as in previous years,the provision of statistics proceeded smoothly,while work continued on further improvingthe statistical framework and new statisticsbecame available in accordance with the ECB’smedium-term strategy for statistics. The ECBalso held its second conference on statistics,this time focusing on their use for monetary andeconomic policy-making.

Some outstanding issues, mainly concerningthe reliability of data, remain in the field ofgovernment finance statistics, which areessential for the implementation of theStability and Growth Pact and the credibilityof budgetary surveillance. The EuropeanCommission (Eurostat), assisted by nationalstatistical institutes (NSIs) and NCBs, whereapplicable, is responsible for the provision ofthese statistics. The ECB makes intensive useof general economic statistics, most of whichare collected and compiled by Eurostat. Theprovision of these statistics for the euro areahas further improved in some fields, forexample as regards the timeliness of quarterlyGDP data, the quality of the HICP flashestimate and the availability of short-termbusiness indicators. Taking into accountthe developments in recent years, the ECBpublished its review of the requirements inthe field of general economic statistics inDecember 2004.

4.1 FURTHER IMPROVEMENTS IN THESTATISTICAL FRAMEWORK FOR THE EUROAREA

Notwithstanding significant achievementswith regard to the statistical framework thus farand the good quality of euro area statistics ingeneral, further improvements to the overallstatistical framework for the euro area remainnecessary. Ongoing economic transformation

4 STATISTICS

has to be accommodated in a forward-lookingmanner and some remaining statistical gapsidentified by users inside and outside the ECBhave to be filled where feasible. During 2004the ECB started work on further improving theoverall framework. Owing to the long leadtimes involved in statistical projects, resultsshould be expected in the medium term.

An important element of the statisticalframework for the euro area is the design andcompilation of a system of quarterly nationalaccounts by institutional sector, which theEurosystem is preparing together with Eurostatand the NSIs. The sectors covered by thissystem of accounts are households, non-financial corporations, financial corporations,government and the rest of the world. Thesestatistics will reveal the interrelationshipsamong these different sectors and between thefinancial and non-financial transactions in theeconomy. A sufficiently long time series ofsuch sector accounts, published soon after thereference period, makes it possible to tracemonetary policy impulses from the financialsector to the non-financial sectors of the euroarea and, additionally, to better analyse theimpact of economic shocks on the euro area.Such a time series will also enable a widerrange of other analyses to be carried out.Various key indicators which are essential forbusiness cycle analysis and for forecasting arealso embedded in the quarterly nationalaccounts by institutional sector.


The incorporation of International AccountingStandard 39 (IAS 39) on financial instrumentsinto EU law, which requires its use by all listedcompanies as of 1 January 2005, has made itnecessary to amend the Regulation concerningthe consolidated balance sheet of the MFIsector (ECB/2001/13) in order to preserve theconceptual basis of the monetary statistics. Theamending Regulation (ECB/2004/21), whichentered into force on 1 January 2005, ensuresthat, irrespective of the specific form in whichIAS 39 is finally adopted, MFIs will continue toreport their stocks of loans and deposits atnominal value, regardless of changes that maybe made to the EU legal accounting frameworkafter that date.

4.2 NEW OR ENHANCED STATISTICS

During 2004 the ECB started publishing somenew statistics that are relevant for monetarypolicy and other ESCB tasks, for economicpolicy in general, for market participants andfor the public at large.

In spring 2004 the ECB, together with theEuropean Commission, for the first timereleased monthly statistics on long-terminterest rates for the ten new EU MemberStates, which are necessary to assesstheir achievement of the high degree ofconvergence required for entry into EMU.Since June 2004 the ECB has also publishedthe monetary presentation of the euro areabalance of payments on a monthly basis. Inaddition, the ECB and Eurostat published areport on foreign direct investment, whichproposes improved methods for compiling suchstatistics. Quarterly current account data ofthe euro area balance of payments are nowavailable from 1980 onwards. With regard toeuro effective exchange rates, the trade weightsused for the computation of the indices havebeen updated, the geographical coverage hasbeen enhanced and new series have beenpublished since September 2004. Statistics onflows and stocks of euro area quoted shares are

now released on a monthly basis. The newstatistics include gross issues, redemptionsand outstanding amounts of all quoted sharesissued by euro area residents.

In the framework of the ECOFIN Council’sAction Plan on EMU Statistical Requirements,the ECB made available in 2004 acomprehensive set of quarterly non-financialand financial accounts for the governmentsector. Work has already started on integratingthese statistics into the quarterly nationalaccounts by institutional sector.

In 2004 the ECB also improved its legalframework to enable the publication of newstatistics in the future. The ECB Guideline andRecommendation on the statistical reportingrequirements in the field of balance ofpayments and international investmentposition statistics and the internationalreserves template were revised. The ECBstarted publishing enhanced statistics in thisfield, including a geographical breakdown,in January 2005. Furthermore, the ECBpublished guidance notes on MFI balance sheetstatistics relating to EU enlargement. Theseguidance notes aim to promote a clear andconsistent understanding of the requirementsand standards of Regulation ECB/2003/10.

In 2004 efforts were made to improve thedissemination and accessibility of statistics.Both the ECB’s redesigned Monthly Bulletin,published for the first time in January 2004, andthe new version of the ECB’s website, whichwent live in June 2004, incorporate improvedstatistical sections.

4.3 GOVERNMENT FINANCE STATISTICS

During 2004 serious concerns arose about thereliability of the statistics for budgetarysurveillance under the Treaty and the Stabilityand Growth Pact. The ECB fully supported thestatement on good standards in statistics madeafter the informal ECOFIN Council meeting in

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Scheveningen on 11 September 2004. Thesestandards should reinforce the independence,integrity and accountability of the NSIs. TheECB is working closely with the EuropeanCommission on this issue, in particular viathe Committee on Monetary, Financialand Balance of Payments Statistics, whichcomprises senior statisticians from Eurostat,the NSIs, the NCBs and the ECB. Theimplementation of the ECB Guideline ongovernment finance statistics, adopted by theGoverning Council in February 2005, willfurther enhance the quality of euro areagovernment finance aggregates and will bean additional step in establishing the qualityof and standards for a more complete setof government finance data for fiscalsurveillance.


The objective of economic research at the ECBis to provide a strong conceptual and empiricalbasis for policy-making. Economic researchwithin the Eurosystem thus focuses onincreasing knowledge of the functioning of theeuro area economy and providing analyses,models and other tools relevant to the conductof the ECB’s monetary policy and thefulfilment of other tasks of the Eurosystem.

Five years after its establishment the ECBasked three independent external experts toevaluate the economic research activities at theECB against high academic standards and toassess the extent to which research conductedat the ECB since 1998 has contributed to theachievement of its objectives. The experts’report,5 which is available on the ECB’swebsite, gave a positive overall assessment ofthe research conducted at the ECB in terms ofscientific quality and value added, relevancefor the conduct of monetary policy and for theother tasks and functions of the ECB, andinfluence on the academic community and onother policy-making institutions. As requested

5 ECONOMIC RESEARCHin their terms of reference, the evaluators alsomade a number of recommendations to furtherimprove research activities. Recommendationswere made in five areas: incentives for staff toconduct high-quality research; long-termmanagement of human capital; coverage andcoordination of research activities in thedifferent ECB business areas; researchsupport; and communication and disseminationof research. Many of the suggestions forimprovement coincided with the ECB’s ownassessment, and measures have been taken toimplement these improvements.

5.1 RESEARCH AGENDA

The research agenda in 2004 can be brokendown into six main areas: macroeconomicsand monetary economics; internationalmacroeconomics and finance; financial stability;financial integration; the macroeconometric

5 M. Goodfriend, R. König and R. Repullo, “External evaluation of theeconomic research activities of the European Central Bank”, 2004.

Char t 41 ECB Work ing Paper se r i e s : J ourna l o f Economic L i t e ra ture c l a s s i f i c a t ion

(percentages)

Source: ECB.

20041999-2004

1 Mathematical and quantitative methods2 Microeconomics3 Macroeconomics and monetary economics4 International economics5 Financial economics

0

10

20

30

40

50

0

10

20

30

40

50

6 Public economics 7 Labour and demographic economics 8 Industrial organisation 9 Economic development, technological change and growth10 Others

1 2 3 4 5 6 7 8 9 10

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Annual Report2004

modelling of the euro area; and generaleconomic and structural issues. Considerableefforts were also directed towards researchon euro area enlargement and the economiesof the new EU Member States. In thiscontext, preparatory work for the subsequentenlargement of the euro area was carried out, inparticular with regard to the analytical toolsused for macroeconomic projections.

Most of the results of the research activitiescarried out within or in cooperation with theECB were presented in the ECB’s WorkingPaper series and – to a lesser extent – the ECB’sOccasional Paper series, as well as at variousconferences and workshops. 126 ECB WorkingPapers were published in 2004 (as comparedwith 97 in 2003). A considerable number of theWorking Papers released since the series waslaunched in 1999 have already been publishedor are forthcoming in academic journals (130)or books (30). Given the long lags inpublication resulting from the peer reviewprocess, this already significant proportion isexpected to increase in 2005. Chart 41illustrates the clear focus on policy-relevantresearch at the ECB. It categorises ECBWorking Papers by topic, using the Journalof Economic Literature classification types.“Macroeconomics and monetary economics”is the most common topic covered inthe series, followed by “mathematical andquantitative methods”, “financial economics”and “international economics”.

Throughout 2004 the ECB hosted a number ofconferences and workshops, such as the thirdECB Central Banking Conference on “Thenew EU Member States: convergence andstability”, which covered three main topics: theeconomic and structural transformation of thenew EU Member States; international linksand the macroeconomic performance of thenew EU Member States; and macroeconomicadjustment in these countries. Together withthe BIS and the G10 central banks, the ECBhas launched a new publication entitled the“International Journal of Central Banking”(see Chapter 6).

5.2 RESEARCH NETWORKS

ECB research is often conducted within theframework of organised networks. These aregroups of researchers jointly engaged in broad,multi-purpose projects and may includeeconomists from the ECB, euro area NCBs,other central banks and policy-makingorganisations, as well as academics. The ECBprovides coordination and organisationalsupport for these networks, alone or with otherinstitutions.

The Eurosystem Inflation PersistenceNetwork, which brings together researchersfrom all Eurosystem central banks, was createdin 2003 for the purpose of analysing thedynamics of inflation in the euro area and in thenational economies. A wide range of data isbeing used to study the phenomenon, includingindividual and sectoral data on consumer andproducer prices, macroeconomic inflation ratesand survey results, with the final results of theanalysis expected in 2005. In 2004 a largeproportion of the empirical analysis wasperformed, a sub-set of results was released inthe ECB’s Working Paper series and feedbackfrom the academic community was collected. Aselection of results was also presented atseveral international workshops and conferences,including a conference organised by thenetwork in December 2004 and hosted by the


ECB. The input received at these events will beused in the concluding phase of the network’sanalysis. The network has so far found thatprices of individual consumer goods andservices change relatively infrequently in theeuro area, namely once a year on average.When price adjustments occur, they tend to belarge and almost equally divided between priceincreases and price decreases. Price rigiditiesare more widespread in the services sector thanin the goods sector, and they tend to be higheron average in the euro area than in the UnitedStates. Furthermore, the network’s findingssuggest that inflation persistence may dependon the inflation and monetary policy regimes inplace, and that, other things being equal, ittends to be lower when expectations of pricestability are well rooted in the economy.

The Euro Area Business-Cycle Network,organised in collaboration with the Centre forEconomic Policy Research (CEPR), provides aforum for the study of the euro area businesscycle. It brings together researchers fromacademia, central banks and other policyinstitutions. In 2004 the network organised asecond training school on factor models andmethodologies for the analysis of the businesscycle, hosted by the Nationale Bank vanBelgië/Banque Nationale de Belgique andBocconi University. Two workshops were alsoorganised, one on the business cycle in the newMember States and acceding countries, hostedby the Oesterreichische Nationalbank, and thesecond on recent advances in forecastingcombination, hosted by the Nationale Bank vanBelgië/Banque Nationale de Belgique. Sinceearly 2004 a substantial part of the network’soutput has been channelled through a newdiscussion paper series jointly launched withthe CEPR.

The Research Network on Capital Markets andFinancial Integration in Europe, launched in2002 by the ECB and the Center for FinancialStudies (CFS), aims to stimulate policy-relevant research on the integration of thefinancial systems in Europe and theirinternational links. The network concluded

its first two years of work with a symposiumin Frankfurt am Main in May 2004 (seeBox 12). The ECB and the CFS have decidedto continue the activities of the network until2007, adding three priority areas: (i) therelationship between financial integration andfinancial stability, (ii) EU accession, financialdevelopment and financial integration and(iii) financial system modernisation andeconomic growth in Europe. The “LamfalussyFellowship” research programme, establishedwithin the framework of the network, was alsoextended to these areas.

5.3 MACROECONOMETRIC MODELLING OF THEEURO AREA

A notable development in the field ofmacroeconometric modelling in 2004 was thework launched on a new generation of theECB’s Area-Wide Model. The model is beingrevised in line with the latest developmentsin macroeconomic theory and estimationmethods. In contrast to earlier models, thenew generation of macroeconometric models,known as dynamic stochastic generalequilibrium models, are based to a much largerextent on microeconomic foundations. Withthe contribution of research undertaken at theECB, they are now sufficiently sophisticated tobe used in the policy realm.6 They are rapidlybecoming the standard for policy analysis and,increasingly, forecasting in central banksand policy organisations. To facilitate theconstruction of the new Area-Wide Model, theECB has established a forum for cooperationwith the Board of Governors of the FederalReserve System and with the IMF, institutionsthat are engaged in the construction and use ofsimilar models. The ECB and the FederalReserve System cooperate through theInternational Research Forum on Monetary

6 Eurosystem staff have made key contributions in this area. SeeF. Smets and R. Wouters, “An estimated stochastic dynamicgeneral equilibrium model of the euro area”, ECB WorkingPaper 171, published in Journal of the European EconomicAssociation, vol. 1, issue 5, 2003, pp. 1,123-1,175. This workwas awarded the European Economic Association’s prestigiousHicks-Tinbergen Medal for outstanding research.

105ECB

Annual Report2004

Policy, an initiative that promotes research onmonetary policy issues that are relevant from aglobal perspective. It is expected that thetechnical work on the Area-Wide Model willcontinue throughout 2005 and that the finalresults will be made public at an openconference.


6.1 COMPLIANCE WITH THE PROHIBITIONS OFMONETARY FINANCING AND PRIVILEGEDACCESS

Pursuant to Article 237(d) of the Treaty, theECB is entrusted with the task of monitoringthe fulfilment by the 25 EU NCBs and the ECBof their obligations under Articles 101 and 102of the Treaty and Council Regulations (EC)Nos 3603/93 and 3604/93. Article 101prohibits the ECB and the NCBs fromproviding overdraft facilities or any other typeof credit facility to governments andCommunity institutions or bodies, as well asfrom purchasing debt instruments directly fromthem. Article 102 prohibits any measure, notbased on prudential considerations, whichestablishes privileged access by governmentsand Community institutions or bodies tofinancial institutions. In parallel with the ECB,the European Commission monitors MemberStates’ compliance with the above provisions.

The ECB also monitors the EU central banks’secondary market purchases of debtinstruments issued by both the domestic publicsector and the public sector of other MemberStates. According to the recitals of CouncilRegulation (EC) No 3603/93, the acquisition ofpublic sector debt instruments in the secondarymarket must not be used to circumvent theobjective of Article 101 of the Treaty. Suchpurchases should not become a form of indirectmonetary financing of the public sector.

6.2 ADVISORY FUNCTIONS

Article 105(4) of the Treaty and Article 4 of theStatute of the ESCB require that the ECB beconsulted by the relevant Communityinstitution and the responsible nationalauthorities,7 as appropriate, on any proposedCommunity or national legislation which fallswithin the ECB’s fields of competence. Thelimits and conditions applicable to theconsultation of the ECB by national authoritiesin respect of draft legislation are set out in

6 OTHER TASKS AND ACTIVITIESCouncil Decision 98/415/EC of 29 June 1998.All ECB opinions are published on the ECB’swebsite. As of January 2005 opinions on draftnational legislation are, as a rule, publishedimmediately following their adoption andsubsequent transmission to the consultingauthority, as was already the case for opinionson draft EU legislation.

In total 41 consultations were initiated in2004, 32 by a national authority and nineby the EU Council. A list of the opinionsadopted in 2004 is annexed to this AnnualReport. The following opinions adopted atthe request of national authorities warrantspecific mention:

The ECB was consulted by a number ofMember States, in particular Hungary andItaly, on legislative proposals that, in theECB’s view, required modification in order toensure the compliance of NCBs’ statutes withthe provisions of central bank independencelaid down in the Treaty and the Statuteof the ESCB, including the personalindependence of the members of NCBs’decision-making bodies.8

The ECB was consulted by Italy, theNetherlands and Slovakia on significantlegislative reforms of the financial supervisoryframework. The ECB examined draftlegislative proposals in Italy and theNetherlands that were based on a “twin peaks”financial supervisory model whereby theNCB would be responsible for prudentialsupervision of the entire financial sector and anational financial markets authority would beresponsible for the supervision of marketconduct.9 The ECB welcomed the proposedinstitutional framework in both countries,

7 In accordance with the Protocol on certain provisions relating tothe United Kingdom of Great Britain and Northern Ireland, asannexed to the Treaty, Article 105(4) of the Treaty and Article 4of the Statute of the ESCB shall not apply to the UnitedKingdom. Hence, the obligation to consult the ECB does notextend to the national authorities of the United Kingdom.

8 CON/2004/16; CON/2004/35.9 CON/2004/16; CON/2004/21.

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10 CON/2004/31.11 CON/2004/34.12 CON/2004/20.

noting in its opinion on the Dutch proposal thatthis approach recognised the distinct characterof the two goals of financial stability andinvestor protection, taking into accountwidening systemic risk due to the closerlinks between credit institutions, insurancecompanies, investment firms and pensionfunds. The ECB considered that the legislativeproposal in Slovakia, which would extend theNCB’s supervisory powers by making itdirectly and fully responsible for thesupervision of Slovakia’s entire financialmarket, would establish a supervisory structurethat – although currently unique within the EU– was fully compatible with the ESCB-relatedtasks of an NCB.10

The ECB was consulted by Belgium on aproposed “Tobin tax” which would take theform of a tax on all foreign exchangetransactions in Belgium, provided thatcomparable legislation were to be introducedby other Member States or at the Communitylevel.11 Although the ECB acknowledged thegood intentions underlying the draft law, itconcluded that the economic and monetaryusefulness of such a tax was highlyquestionable. Moreover, in the form proposedby the draft Belgian legislation, the tax wouldbe incompatible with Article 56 of the Treatyon the free movement of capital and paymentsbetween Member States, and between MemberStates and third countries.

The ECB was consulted by France on draftlegislation authorising inflation-indexed loansfrom credit institutions.12 The ECB expressedits understanding of the objective to extend thefreedom of contract and allow economic agentsto hedge against inflation risk, but stressed thatwidespread use of the indexation clause wouldgive rise to considerable concern, as awidespread indexation in wage and price-setting might generate excessive rigidity in therelative price system and would risk fuellinginflation spirals.

The ECB also delivered an opinion, pursuant toArticle 112(2)(b) of the Treaty and Article 11.2

of the Statute of the ESCB, concerning arecommendation from the EU Council on theappointment of a new member of the ExecutiveBoard of the ECB.

6.3 ADMINISTRATION OF THE BORROWINGAND LENDING OPERATIONS OF THEEUROPEAN COMMUNITY

In accordance with Article 123(2) of the Treatyand Article 9 of Council Regulation (EC)No 332/2002 of 18 February 2002, the ECBcontinues to have responsibility for theadministration of the borrowing and lendingoperations of the European Community underthe Medium-Term Financial Assistancemechanism. In 2004 the ECB did not performany administration tasks. There was nooutstanding balance at the end of 2003 and nonew operations were initiated during 2004.


Box 11

EUROSYSTEM RESERVE MANAGEMENT SERVICES

In 2004 the Eurosystem completed the work started in 2003 on a new framework for theprovision of a comprehensive set of reserve management services in euro to central banks,monetary authorities and government agencies located outside the euro area, and internationalorganisations. The new framework, developed in response to the continuously increasing useof the euro as an international reserve currency, builds on the well-established reservemanagement services and experience of individual Eurosystem central banks. The servicesrange from the provision of custody accounts and related custodian (safekeeping) andsettlement services to cash and investment services. Examples of key services covered by thenew framework include (i) the provision of an automatic overnight investment facility whichenables customers to invest funds directly with the respective service provider and/or in themarket at attractive remuneration rates, (ii) the facilitation of automatic securities lendingprogrammes and (iii) the execution of orders and standing instructions in line with customers’specific investment preferences.

One of the key aspects of the new framework is the provision of high-quality services forcustomers’ euro-denominated reserve assets through a single access point in the euro area. Thisconcept is comparable to the way in which reserve management services are offered by leadingcentral banks around the world. The individual Eurosystem central banks that act as singleaccess points are known as “Eurosystem service providers” and offer the complete set ofreserve management services covered by the new framework. As a result of the implementationof the single access point concept, customers can now settle and hold in safekeeping anextensive range of fixed income euro-denominated securities, issued across the entire euroarea, using one single custody account. A high degree of harmonisation has been established,with each of the Eurosystem service providers offering the same set of reserve managementservices subject to harmonised terms and conditions and in line with general market standards.

There are currently six Eurosystem service providers, namely the Deutsche Bundesbank, theBanco de España, the Banque de France, the Banca d’Italia, the Banque centrale duLuxembourg and De Nederlandsche Bank. The remaining Eurosystem central banks may offersome of the services covered by the new framework. Furthermore, both Eurosystem serviceproviders and the other central banks of the Eurosystem may offer additional reservemanagement services in euro on an individual basis. The ECB performs an overall coordinationrole, ensuring the smooth functioning of the framework.

In line with the way in which reserve management services have been provided for many years,the new framework is based on the core principles characterising the management of officialreserves, such as financial and legal security and, most importantly, confidentiality. Thereserve management services under the new framework are offered to traditional central bankcustomers, thus meeting the special needs and concerns of those institutions that operate in thesame area of central banking activity as the Eurosystem itself.

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The new framework, launched on 1 January 2005, will be a flexible and constantly evolvingone, closely following the latest developments in the financial industry and promptlyresponding to customers’ needs for a comprehensive and up-to-date set of euro-denominatedreserve management services.

ArtistJacob DahlgrenTitleKrakow, 2002MaterialYoghurt pots mounted on aluminiumFormat184 × 148 × 10 cm© VG Bild-Kunst, Bonn 2005

CHAP T E R 3

FINANCIAL STABILITYAND INTEGRATION


1 F I N ANC I A L S TA B I L I T YThe Eurosystem contributes to the smoothconduct of policies pursued by the competentnational authorities relating to the prudentialsupervision of credit institutions and thestability of the financial system. It also offersadvice to these authorities and the EuropeanCommission on the scope and implementationof Community legislation in these fields.

1.1 FINANCIAL STABILITY MONITORING

The ECB, in collaboration with the ESCB’sBanking Supervision Committee (BSC),monitors risks to financial stability in order toassess the financial system’s shock-absorbingcapacity.1 The focus is on banks, as theycontinue to be the main intermediaries in thechannelling of funds from depositors toborrowers in the euro area and as such are animportant channel through which risks mayspread to the rest of the financial system.However, owing to the increasing importanceof other financial institutions and markets andtheir interlinkages with banks, vulnerabilitiesin these components of the financial systemmay spread to banks. Thus the monitoring alsocovers developments in these othercomponents.

CYCLICAL DEVELOPMENTSIn 2004 the capacity of the euro area financialsystem to absorb shocks improved. Financialinstitutions benefited from a better thanexpected strengthening of global economicactivity, a bolstering of the balance sheets oflarge firms and a continued appetite for riskon the part of investors. As a result, theprofitability of banks and insurance companiesimproved. However, earlier signs of fragility inglobal financial markets remained, resultingfrom the perceived risk of long-term interestrates rising from very low levels.

In the euro area banking sector, large banksconsolidated the trend started in 2003,continuing to show signs of improvedprofitability. The main sources of improvementin 2004 were continued cost-cutting and

reduced loan loss provisioning. Profitabilityincreases were broadly based, with theweakest-performing banks also managing toimprove their return on equity.

To support their profitability, cost control wasa priority for banks. Costs were primarily cutby reducing the size of branch networks andstaff numbers. Provisioning for loan losses fellin 2004, as in 2003. The main underlying factorappeared to be a more favourable assessment ofcredit risk by banks owing to the economicrecovery. This reappraisal appeared to reflectexpectations of a consolidation of corporatesector profitability and of further balance sheetstrengthening by large euro area firms.However, there were indications that theoutlook for small and medium-sizedenterprises continued to be less favourable thanfor large firms.

Notwithstanding the improvement inprofitability, net interest income – the corecomponent of banking sector profitability –continued to decline in 2004. This was despiteinitial signs of a pick-up in corporate lendingand the continued buoyancy of lending tohouseholds for house purchase. The decline innet interest income was mainly a product of thelow interest rate environment and a flatteningof the market yield curves which, whileboosting loan demand, weighed on euro areabanks’ lending and deposit margins. As forbanks’ non-interest income, the exceptionaltrading profits recorded by many institutions in2003 thanks to buoyant stock markets andnarrowing credit spreads were not repeated in2004. There were indications that some majoreuro area banks increased their market risk inthe course of 2004. Banks enjoyed stronger feeincome, mostly due to increased activityassociated with financial markets, both on theirown account and from wealth management.

1 In 2004 the ECB published, for the f irst time, a report on thestability of the euro area f inancial system entitled “FinancialStability Review”. It also published the third edition of “EUbanking sector stability”, which presents the main f indings ofthe regular monitoring by the BSC of banking sector stability.These publications are available on the ECB’s website.

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The key regulatory solvency ratios of largeeuro area banks improved further in 2004. It isnotable that the banks with the weakestsolvency ratios managed to put their solvencyonto a more solid footing. The improved shock-absorbing capacity of these banks contributedpositively to financial system stability in theeuro area.

The financial performance of insurancecompanies also improved further in 2004. Inthe non-life sector, the main factor was thestrength of net premium income, driven bymore risk-sensitive pricing and stricterunderwriting conditions. This improvement incore business allowed the already comfortablesolvency position of non-life firms to be furtherstrengthened. Life insurers in most countrieswitnessed growth in premium income that wasunderpinned by an increased demand forproducts whose performance is linked to thestock market. Together with growing netinvestment income, this contributed to animprovement in their solvency position.However, the financially weakest lifeinsurance companies still remain underpressure.

The global hedge fund industry continued togrow in 2004. Despite the low returns that wereachieved in 2004, there were no clear signs thatinvestors withdrew their money. The financialstability implications of the growth in thisindustry stem mainly from its links with thebanking sector. Strong competition amongprime brokers improved the access of hedgefunds to credit. Prime brokers are typicallybanks and securities firms that providefinancing, brokerage and other services tohedge funds, with some large players comingfrom the euro area. The prime brokers’counterparty risk management, whichimproved after the near-failure of Long-TermCapital Management in 1998, benefited fromthe extensive use of Value-at-Risk measuresand stress tests.

STRUCTURAL DEVELOPMENTSStructural changes in the banking industry canhave important consequences for financialstability in the longer term. Strategic choicesmade by banks affect the risk/profitabilitytrade-off, ultimately having a bearing on theshock-absorbing capacity of the financialsystem. In addition to the changes inthe regulatory and supervisory environment(see Section 2 of this chapter), themost important structural developments in2004 continued to concern consolidation,internationalisation, intermediation andoutsourcing.2

The euro area banking sector has beencharacterised by a continuous process ofconsolidation over recent years. In the period1997-2004 nearly 2,300 credit institutionsdisappeared. This consolidation has been partlydue to mergers and acquisitions (M&As), butalso to the internal restructuring of bankinggroups. Restructuring may help banks tomaintain or improve their profitability, whichshould ultimately lead to a more resilientbanking system. However, to the extent thatthis leads to the creation of large and complexfinancial institutions that are systemicallyrelevant, the ultimate impact may be moreambiguous. This highlights the need forenhanced mechanisms for internal risk controlas well as for efficient supervision.

M&A activity has been mostly confined todomestic deals. Over the past ten years, cross-border European banking deals accounted foronly 15% of the total volume of mergers in thebanking sector, against an average of around40% in the industrial sector. This continueddomestic orientation may be due to, inter alia,the possibility of achieving greater costsynergies through domestic consolidation, aswell as differences in tax rules, consumerprotection standards and corporate cultures.

2 A more detailed analysis of the structural developments can befound in the BSC’s report entitled “Review of structuraldevelopments in the EU banking sector”, November 2004.


Despite the relatively low cross-border M&Aactivity, the process of internationalisation iscontinuing. The assets held by euro area banksin their branches and subsidiaries in othercountries of the area now represent more than10% of the area’s unconsolidated bankingassets. Furthermore, banks have increasinglybeen providing financial services on a cross-border basis without having a localestablishment in the country where therecipient is located. Progress has been mostvisible in the interbank and wholesale areas,whereas the volume of retail activity performedon a cross-border basis remains very low.

The importance of retail operations has grownover the past few years, in particular owing tothe rapidly rising demand for loans for housepurchase. This underscores the importance foreuro area banks of focusing on core activitiesand improving their knowledge of theircustomer base.

In 2004 the outsourcing of activities continuedto gain in importance. Two types ofoutsourcing are taking place: outsourcing toexternal suppliers and intra-group outsourcing.Typically, support and back-office activitiesare outsourced externally, while core activitiesremain within the bank. In larger groupstructures, some core activities are carriedout by specialised affiliates and their productsare distributed by other group entities.Outsourcing is mainly driven by the desireto reduce costs, but the acquisition ofprofessional management and expertise and thefreeing-up of resources for core activities areoften additional motives. There is a need tomonitor the financial stability implications ofthis development, particularly where multiple

financial institutions are outsourcing to asingle service provider.

1.2 COOPERATION IN CRISIS SITUATIONS

The framework for cooperation among centralbanks and banking supervisory authorities inthe area of crisis management continued to beenhanced. In June 2004 the central banks andbanking supervisors of the new Member Statesagreed to adhere to the Memorandum ofUnderstanding (MoU) on cooperation in crisismanagement situations, which had been signedby the other EU central banks and bankingsupervisors in March 2003. This MoU consistsof a set of principles and procedures for cross-border cooperation between these institutionsin crisis situations.

Moreover, the BSC and the Committee ofEuropean Banking Supervisors (CEBS) set up ajoint task force on crisis managementcomprising representatives from all EUbanking supervisors and central banks. Its taskis to develop proposals for further enhancingcooperation, particularly in terms ofidentifying best practices for handlingfinancial crises in a cross-border context. Itwill also contribute to the work of theEconomic and Financial Committee in the fieldof crisis management.

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2 F I N ANC I A L R EGU L AT I ON AND S U P E RV I S I ON2.1 BANKING

In the field of banking supervision, the reformof the capital adequacy framework remained amajor issue in 2004. In June the central bankgovernors and the heads of the bankingsupervisory authorities of the G10 countriesendorsed the new framework, known as theNew Basel Capital Framework, or Basel II.This was a major achievement as it brings closeto completion the five-year-long effort by theBasel Committee on Banking Supervision(BCBS) and its member authorities in this area.The new framework will be implemented as ofend-2006. However, the use of the mostadvanced approaches to calculating banks’capital requirements will only be allowed oneyear later.

Following the endorsement of the newframework, the focus of international andEuropean activities in this area has shiftedtowards implementation issues and the workcarried out by the BCBS’s AccordImplementation Group. A number of countries,both within the G10 and beyond, are expectedto carry out a fourth quantitative impact study(known as the “QIS4”). The results should beavailable at the end of 2005 and may lead tofurther quantitative adjustments of theframework in 2006. The BCBS has alsoidentified technical areas that requireadditional work. The ECB will continue tosupport this process of implementation andcontribute to it through its participation asan observer in the BCBS and its mainsub-structures, including the AccordImplementation Group.

At the European level, the new EU capitaladequacy framework, which will be based onBasel II, will be introduced into EU legislationby amending the Codified Banking Directiveand the Capital Adequacy Directive. Incontrast to Basel II, which applies only tointernationally active banks, the EU capitalframework will apply to all credit institutionson a consolidated and individual basis, as wellas to investment firms. The EU framework

provides for improved cooperation andcoordination among banking supervisoryauthorities by enhancing the role of the“consolidating supervisor”. This is, as a rule,the national supervisory authority of theMember State where the group’s parentinstitution received its banking licence andwhich is responsible for the top level ofsupervision of an EU cross-border bankinggroup. The role of this supervisor would beenhanced by making it responsible for thecoordination of the processing and approval ofan EU cross-border group’s application touse the more sophisticated approachesto calculating capital requirements.Strengthening the role of the consolidatingsupervisor would therefore reduce the overallsupervisory burden on such a banking group.

After being consulted by the EU Council, theECB delivered an opinion on the new EUcapital framework in which it generallysupported the thrust of the new set of rules. TheECB placed emphasis on the parallelimplementation of the new EU framework andthe revised Basel framework, which is essentialto ensure a level playing-field betweenEuropean banks and their competitors fromother countries. The ECB also stressed the needfor enhanced cooperation among supervisoryauthorities to pursue consistent transpositionand implementation of EU legislation intonational laws and practices. In the latter field,the CEBS is expected to play a major role.

2.2 SECURITIES

As one of the most significant measures of theFinancial Services Action Plan (FSAP), the EUCouncil adopted in May 2004 the FinancialInstruments Markets Directive, replacing theregime set up by the Investment ServicesDirective of 1993. The new Directive laysdown a comprehensive set of rules concerningall trading venues, namely regulated markets,multilateral trading facilities andintermediaries that execute client ordersinternally. This Directive reinforces the


3 The letter, together with the annex containing the main findingsof the empirical analysis, is available on the ECB’s website.

cooperation among financial regulators withthe purpose of achieving an effectivesupervisory framework across the EU.

Work is under way to further harmonisedisclosure rules applicable to companies withsecurities listed on European capital markets.The EU Council reached a political agreementon a new directive, known as the TransparencyDirective, in May 2004. The introduction ofharmonised and enhanced disclosure standardswill have beneficial effects on the Europeaneconomy.

In view of their importance for the integrationof European financial markets and theenhancement of financial stability, theEurosystem fully supports both regulatoryinitiatives and has followed the relatedlegislative process closely. The ECB alsocontributed to the process via input provided tothe European Securities Committee.

2.3 ACCOUNTING

The Eurosystem has an interest in thedevelopment of a harmonised accountingframework in the EU because of its potentialimpact on banks and ultimately on financialstability. The Eurosystem also supports thedevelopment of the new standards as they willfoster further financial integration andcontribute to the increased efficiency offinancial markets in Europe. During 2004 theInternational Accounting Standards Board(IASB) continued its work on the newaccounting standards, and especially onInternational Accounting Standard 39 (IAS 39)dealing with the use of fair values for financialinstruments, which account for a large part ofbanks’ balance sheets.

The concerns regarding the potential financialstability implications voiced mainly by theGoverning Council and prudential supervisorsprompted the IASB to issue a revised exposuredraft on IAS 39, which introduced certainrestrictions on the optional use of fair values

for financial instruments. The assessment ofthe exposure draft by the Governing Council,which was also based on quantitative elements,was broadly supportive of this initiative, on theassumption that banks implement the fair valueoption in a prudent manner. This assessmentwas conveyed in a letter sent by the President ofthe ECB to the IASB in September 2004, whichalso called for the fair value option to belimited to reducing artificial volatility.3 Thedialogue with the IASB will continue in 2005.

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3 F I N ANC I A L I N T EGRAT I ONThe ESCB is committed to the integration ofEuropean financial markets and marketinfrastructures because of their key role in thetransmission of monetary policy and infinancial stability. Moreover, the integration offinancial markets should help to create a levelplaying-field for all economic agentsregardless of their location within the EU. Inaddition, Article 105 of the Treaty states thatwithout prejudice to the objective of pricestability, the ESCB shall support the generaleconomic policies in the Community, amongwhich financial integration occupies aprominent position. This support takes the formof direct action and catalysis of collectiveaction by market participants.

CONTRIBUTION TO THE EU FINANCIAL SERVICESPOLICYThe FSAP, launched by the EuropeanCommission in May 1999, aimed to completethe necessary legislative regime to enable theeffective exercise of market freedoms infinancial services throughout the EU. Theadoption of 39 of the 42 Community measureslisted in the FSAP by the end of the term of theEuropean Parliament in mid-2004 led to asubstantive improvement in EU financialsector regulation and represents an importantstep forward in the process of integration ofEuropean financial markets and marketinfrastructures. In June 2004 the ECBcontributed to the high-level conference onEuropean financial integration organised bythe European Commission, which was a firststocktaking exercise on the FSAP’sachievements. The ECB’s view, widely sharedby other participants, was that the extent towhich the FSAP would contribute to theeffective establishment of a single financialmarket would hinge on the consistentimplementation and enforcement of itsmeasures by the Member States. It is likely thatthe impact of the FSAP on financial institutionsand markets will take some time to fullymanifest itself, as a significant number of thekey measures have been adopted only recentlyand most still require implementation at thenational level.

Regarding future work, the ECB considers thata streamlined regulatory framework forfinancial institutions should be developed as amatter of priority. Such a framework should beboth more harmonised across Member Statesthan the current set-up and flexible enough toadapt to a changing environment. This projectshould be complemented by a considerableeffort to converge supervisory practices, to beachieved through enhanced cooperationbetween national authorities, inter alia in theLevel 3 committees. This should also beaccompanied by a thorough analysis of therelationship between financial integration andfinancial stability. In particular, the impact ofthe development of cross-border banking onthe home country control approach, which iscentral to the EU regulatory framework, shouldbe further analysed. Competition policy shouldalso be part of the post-FSAP environment, as itis crucial for the development of a pan-European market. A larger role for the privatesector, via self-regulation, could also beeffective in fostering integration. The ECB willcontribute to the definition of post-FSAPinitiatives. This contribution will benefit fromthe ECB’s research activities on financialintegration issues (see Box 12).

THE SHORT-TERM EUROPEAN PAPER INITIATIVEThe private sector can contribute to financialintegration via collective action aimed atpromoting the convergence of marketpractices. The ECB can act as a catalyst in thisprocess, as exemplified by its role in the Short-Term European Paper (STEP) initiative. TheACI, the Financial Markets Association,launched this initiative to foster theconvergence of standards and practicesprevailing in the fragmented European short-term securities markets. This convergence willbe achieved through market players’ voluntarycompliance with standards set out in a marketconvention, which will cover informationdisclosure, documentation, settlement and theprovision of data to the ESCB for theproduction of statistics. The ACI will grant aSTEP label to existing issuance programmesthat meet these standards. However, the label


Box 12

RESEARCH NETWORK ON CAPITAL MARKETS AND FINANCIAL INTEGRATION IN EUROPE

In 2002 the ECB and the Center for Financial Studies (CFS) launched a research network topromote research on capital markets and financial integration in Europe. The network wasinitially set up for a period of two years, which ended in May 2004 with a symposium organisedaround its five priority areas.

Research presented in the priority area of European bond markets was particularly insightful.The introduction of a common pan-European electronic trading platform (Euro MTS) reducedtransaction costs substantially. Not only did it improve the integration of this market segment,it also resulted in higher liquidity and lower yields, in particular for regularly issued Treasurybills. However, some cross-country differences in yield spreads remain, notably for longer-term bonds, and are largely explained by an international risk factor. Liquidity differentialsonly play a role in conjunction with this latter factor. The dynamically developing corporatebond market exhibits a relatively high level of integration, while factors related to the countrywhere a bond is issued account for only a marginal part of corporate bond yield spreads.

The work done by the research network in its first two years helped to identify three key policyareas: (i) addressing the structural features of clearing and settlement systems that arehampering further integration, (ii) actively using competition policy to prevent practices thatdiscriminate against foreign financial service providers and (iii) removing the remainingdifferences in national financial regulations that make the pan-European provision of financialservices more costly than necessary.

Following the successful conclusion of the first phase, the ECB and the CFS decided that theactivities of the network would continue until 2007. The scope of the network has beenextended to the new EU Member States for this second phase. Possible areas for study in thissecond phase are the initial effects of the FSAP on the functioning of the European financialsystem, as well as a number of areas that were not addressed in the first phase. The mainpriorities of the network have been broadened to include three areas not addressed in the firstphase: (i) the relationship between financial integration and financial stability, (ii) EUaccession, financial development and financial integration, and (iii) financial systemmodernisation and economic growth in Europe.1

1 Comprehensive summaries of the results from the f irst phase of the network were published in the report entitled “ResearchNetwork on capital markets and financial integration in Europe: Results and experiences after two years”, ECB and CFS, 2004, andin a special issue of the Oxford Review of Economic Policy, vol. 20(4), 2004, on “European f inancial integration”, produced incooperation with the network.

will not refer to the financial soundness of theissuer, the liquidity of the assets or theaccuracy of information provided in theinformation memorandum. Moreover, nationalrules applicable to the debt instruments willcontinue to apply. The initiative’s promotersset out their recommendations in a reportpublished in March 2004, which also included

some recommendations addressed to theESCB.

The Governing Council assessed the ACI’srecommendations and took an overallfavourable attitude towards them. With respectto the recommendations addressed to theESCB, it was decided that under certain

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conditions the ESCB would technicallysupport the activities pertaining to theintroduction of a STEP label during the firsttwo years after its launch. However,responsibility for the STEP label would restwith the STEP Market Committee. Such atechnical contribution to the labelling processwould not lead to the ESCB taking any action,such as prohibition or suspension of issuance,in the event of an issuer not complying with theconvention’s requirements. In such a case, theonly consequence would be that the ACI wouldwithdraw the STEP label from the issuanceprogramme. The Governing Council alsodecided to act on the recommendation toproduce and publish statistics on yields andvolumes, subject to a check regarding theefficiency of the collection process. The ACI iscurrently carrying out the STEP project, takinginto account the Governing Council’sdecisions.

SINGLE EURO PAYMENTS AREAThe ECB also plays a catalyst role in theestablishment of a Single Euro Payments Area(SEPA), a project that was launched by theEuropean banking industry in 2002. Theobjective is to enable cross-border payments tobe made from a single bank account throughoutthe euro area as easily and safely as domesticpayments can be made. All payments shouldreach a level of safety and efficiency at leastas high as in the best-performing nationalpayment systems. The ECB participates as anobserver in the European Payments Council(EPC), set up by the European banking industryto steer this project. Throughout 2004 theEurosystem continued to cooperate closelywith market participants through the ContactGroup on Euro Payments Strategy. It alsoworked closely with the European Commissionin view of the complementary roles playedby the Commission and the Eurosystem infacilitating the SEPA.

In a third progress report on the SEPA, theGoverning Council formally assessed thebanking sector’s achievements in this area.4 Itwelcomed the objective of the banking sector to

have a fully-fledged SEPA infrastructure byend-2010 and recommended that a SEPA forcitizens should be achieved by as early as 2008by offering citizens and commercialenterprises the chance to use pan-Europeaninstruments and standards also for nationalpayments. The EPC is responsible for definingthe SEPA objectives and the overall strategy,but the implementation may differ dependingon local conditions. In order to drive nationalimplementation, the Eurosystem has invitedeuro area banking communities to presentto the EPC during 2005 national plans forthe gradual transition to a SEPA beforeend-2010.

E-PAYMENTSE-payments are payments that are generatedand handled electronically. Eurosystemactivities related to e-payments comprisepromoting cooperation and consensus-buildingin the e-payments market, monitoring itsdevelopment, fostering its security andimproving related statistical information. In2004 the ECB continued to operate the websiteof the e-Payment Systems Observatory(ePSO)5. It held a conference entitled“E-payments without frontiers” in November2004, prior to which an issues paper waspublished for public comments. Although someprogress has been made overall, considerableeffort is still needed to achieve secure, user-friendly and efficient cross-border e-paymentschemes. This is particularly the case forelectronic retail payment transactions, whereoperational features, charges and regulationsstill differ substantially.

CARD PAYMENT SCHEMESThe Eurosystem attaches great importance topayment cards as one of the most prominentcashless payment instruments, in particular in across-border context. The ECB carried out asurvey to gain more information on thestructure of the card payment business in

4 “Towards a Single Euro Payments Area – Third progressreport”, ECB, December 2004.

5 ePSO is a platform for sharing information on electronicpayments. Its website can be found at www.e-pso.info.


Europe and on the different ways in which cardpayments are processed and settled. The surveycovered aspects related to governance, issuingand acquiring, the general technicalinfrastructure, as well as risk management andthe legal set-up. The ECB also organised aPayment Card Roundtable, which broughttogether the major stakeholders and players inthis field. At this event, the Eurosystemexpressed its increasing interest in this field aspart of its actions to promote a SEPA, and anumber of issues were identified as requiringfollow-up, such as interchange fees, cardacceptance, the regulatory framework andfraud prevention.

SECURITIES CLEARING AND SETTLEMENTINFRASTRUCTUREIn April 2004 the European Commissionreleased a communication on clearing andsettlement for public consultation, outliningthe actions that it intends to take to fosterEuropean integration and efficiency in thisarea. The Eurosystem responded positively tothis consultation.6

The ECB fosters the integration and reform ofsecurities clearing and settlement through itsparticipation in the Clearing and SettlementAdvisory and Monitoring Experts Group,which the Commission set up in 2004. In thisway, it contributes to the coordination ofprivate and public sector initiatives and liaiseswith the market, with a view to supporting theremoval of the technical barriers identified bythe Giovannini Group, a forum of financialexperts which advises the Commission onfinancial sector issues. Furthermore, the ECBheld a joint meeting with the European CentralSecurities Depositories Association and theCentral and Eastern European CentralSecurities Depositories Association, whichfocused on the integration of the EU clearingand settlement industry. The ECB wouldwelcome further steps towards the creation ofa single European association for centralsecurities depositories.

The process of consolidation of the Europeansecurities infrastructure continued in 2004with the merger between the Finnish andSwedish central securities depositories. Thelong-term plan of the new group is to use acommon technological platform.

MONITORING FINANCIAL INTEGRATIONThe ECB has been developing variousindicators to measure the degree of financialintegration in the euro area. A set of suchindicators was included in an ECB OccasionalPaper published in 2004.7 The indicators serveas a basis for evaluating the progress ofintegration in various financial markets.Box 13 provides further information on theintegration of the euro area credit market. TheECB intends to continue measuring progress infinancial integration in the future.

6 “Communication on clearing and settlement – the Eurosystem’sresponse”, ECB, July 2004.

7 See L. Baele et al., “Measuring f inancial integration in the euroarea”, ECB Occasional Paper No 14, May 2004.

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Box 13

FINANCIAL INTEGRATION IN THE EURO AREA CREDIT MARKET

The comparison of interest rates across countries provides an important indication ofintegration in the retail banking market. As integration increases, interest rate differentials forsimilar banking products can be expected to decrease across countries. However, differences inproducts and institutions make it difficult to verify in practice whether differentials actually dodecrease. This is especially true in retail banking, as markets remain predominantly local in theeuro area. Apart from geographical barriers, there are many other reasons for cross-countrydifferentials, such as economic, structural and institutional factors. These factors relate, forexample, to differences in regulation, competition, bank-customer relationships and theoverall development of the financial system.

The ECB’s harmonised interest rate statistics can be used to measure integration in the euroarea credit market. However, when interpreting the data, it should be borne in mind that, withineach interest rate category, there might still be considerable heterogeneity among nationalseries. This is due, for example, to the aggregation of various instruments within the currentlydefined maturity bands and the aggregation of secured and unsecured loans within the samecategory. Taking into account the data limitations, several measures of integration based on thedispersion of interest rates across euro area countries indicate that the degree of integrationvaries significantly across different market segments. For instance, it seems to be higher forloans to households for house purchase and for short-term loans to non-financial corporations,and lower for bank overdrafts to non-financial corporations and for loans to households forconsumption.


One of the statutory roles of the Eurosystem isto exercise oversight over payment andclearing systems. The oversight aims to ensurethat the general organisation of payment flowswithin the economy is efficient and safe. TheEurosystem also takes a general interest inother infrastructures which are used for thetransfer of securities, such as securitiesclearing and settlement systems, becausefailures during the settlement of collateralcould jeopardise the implementation ofmonetary policy and the smooth functioning ofpayment systems.

4.1 OVERSIGHT OF LARGE-VALUE EUROPAYMENT SYSTEMS ANDINFRASTRUCTURES

The oversight role of the Eurosystem extends toall euro payment systems, including thosemanaged by the Eurosystem itself. TheEurosystem applies the same oversightstandards to both its own systems and those thatare privately operated. These standards are theCore Principles for Systemically ImportantPayment Systems adopted by the GoverningCouncil in 2001 as the basis for its oversightpolicy on systemically important paymentsystems.

TARGET AND OTHER LARGE-VALUE EUROPAYMENT SYSTEMSThe oversight framework for TARGET hasbeen further developed through the definitionof minimum methodological requirements withwhich all NCBs and the ECB should complyin conducting TARGET oversight. TARGEToverseers have also started looking atTARGET2 from an oversight perspective.

In 2004 large-value euro payment systems wereassessed against the Core Principles on thebasis of the situation in mid-2003. The overallresults were published in May 2004. It wasfound that all TARGET components achieve ahigh degree of compliance with the CorePrinciples. A small number of enhancements tobe made were identified in the areas of

4 OVERSIGHT OF MARKET INFRASTRUCTURESeconomic efficiency and business continuityarrangements. These issues will be followed upby TARGET overseers and operators. TheTARGET overseers acknowledged theimportant role played by TARGET operators inensuring the safe operation of TARGETthrough risk management. The overseers’assessment of the status report prepared by theTARGET operators on the risk situation inTARGET was generally positive. The reviewof the privately owned large-value europayment systems did not reveal any majorshortcomings.

EURO 1Oversight of EURO 1 focused on plans by EBAClearing (EBA), the operator of EURO 1, tofurther develop the Flexible SettlementMechanism, allowing banks to settle theirSTEP 2 positions in EURO 1 without becomingdirect members/shareholders of EURO 1.STEP 2 is EBA’s retail payment system.Subject to the ECB’s approval as overseer,EBA envisages extending this function, whichis specifically limited at present to “pre-fundparticipants” in EURO 1, to allow all EURO 1members to transfer central bank money toEURO 1 via the TARGET system in order toincrease their processing capacity in EURO 1.

CONTINUOUS LINKED SETTLEMENT SYSTEMThe Continuous Linked Settlement (CLS)system settles foreign exchange transactionson a payment versus payment basis, thuseliminating foreign exchange settlement riskto a very large extent. It currently settlestransactions in 15 internationally tradedcurrencies, including, since December 2004,the Hong Kong dollar, the New Zealand dollar,the Korean won and the South African rand.

In December 2004 CLS processed an average of69,000 trades per day with an average dailyvalue of USD 960 billion.8 According to asurvey conducted by the BIS in April 2004,CLS was covering about one-quarter of the

8 Each trade consists of two transactions, one in each currencyinvolved. Thus, in December 2004 CLS settled transactions withan average daily value equivalent to USD 1,920 billion.

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entire foreign exchange market at the time ofthe survey. After the US dollar, the euro is themost important currency for settlement. InDecember 2004 euro settlements in CLSaveraged €309 billion per day and accountedfor 22% of total settlements in terms of value(US dollar settlements represented 46%). Theshare of the euro decreased slightly bycomparison with 2003 as a result of the highernumber of currencies settled in CLS as well asvaluation effects.

The ECB performs a dual role with regard toCLS. It is involved in the oversight of thesystem and it provides settlement services. TheECB participates in the cooperative oversightof CLS, which is performed by the G10 andnon-G10 central banks of the currencies settledin the system, with the Federal Reserve Systemacting as lead overseer. In 2004 the ECBdevoted most of its oversight attention tofurther strengthening the resilience of CLS andto ensuring the development of an objectiveframework for adding new currencies.

The ECB considers CLS a very convincingsolution for the reduction of foreign exchangesettlement risk for euro transactions. However,only a minority of the wholesale foreignexchange transactions involving the euro aresettled in CLS. Therefore, banks have beeninvited to review their settlement practices forforeign exchange transactions and to assesswhether their methods of reducing this risk areappropriate.

SWIFTThe Society for Worldwide Interbank FinancialTelecommunication (SWIFT) is a messagingnetwork provider which facilitates the secureexchange of financial messages betweenfinancial institutions. Although it is not a bankor a financial institution itself, it is overseen bycentral banks because of its importance to thesmooth functioning of the worldwide financialsystem. The ECB contributes to the oversightof SWIFT, which is carried out by means ofcooperation between the G10 central banks,with the Nationale Bank van België/Banque

Nationale de Belgique as lead overseer. In 2004the oversight arrangements were strengthenedin order to ensure the adequate involvement ofall G10 overseers and to allow for morestreamlined reporting and communicationbetween SWIFT and its overseers. Oversightattention focused on SWIFT’s resilience tocrises, internal risk management processes andthe replacement of SWIFT’s old messagingnetwork with SWIFTNet, an internet-basedtechnology infrastructure.

CORRESPONDENT BANKINGBanks often have arrangements to provide oneanother with payment services and relatedfacilities, primarily for payments acrossnational borders. Such arrangements arereferred to as correspondent banking. In 2004the Eurosystem conducted its fourth survey oncorrespondent banking, which confirmed thateuro correspondent banking is highlyconcentrated among a few players in the EU. Atpresent this does not pose any immediatesystemic risk; however, the Eurosystem willcontinue to monitor developments in this fieldin view of its interest in the stability of thefinancial system as a whole.

4.2 RETAIL PAYMENT SERVICES

OVERSIGHT OF RETAIL PAYMENT SYSTEMSOn the basis of the “Oversight standards foreuro retail payment systems” adopted by theGoverning Council in 2003, a classificationexercise carried out in 2004 identified 15 euroretail payment systems which fall within thescope of the Eurosystem’s oversight. Six wereclassified as being of systemic importance andthus have to comply with all ten CorePrinciples. Seven are considered to be ofprominent importance and are thus required tocomply with the Eurosystem Retail Standards(a sub-set of the Core Principles). Two did notfall into either category and will be subject tooversight standards as and when defined forthem by the relevant overseer. The systems ofsystemic and prominent importance areassessed against the oversight standards by the


relevant NCBs, while the ECB is responsiblefor assessing EBA’s STEP 2 system. Theoverall assessment exercise and cross-countryconsistency is coordinated at the Eurosystemlevel.

E-MONEY SYSTEMSFollowing the definition of the electronicmoney system security objectives in 2003 andbased upon voluntary assessments by somee-money schemes, the Eurosystem in 2004started to fine-tune the methodologicalrequirements and terms of reference for theassessment of relevant schemes which isplanned in 2005.

4.3 SECURITIES CLEARING AND SETTLEMENTSYSTEMS

The Eurosystem plays two roles in the smoothfunctioning of securities clearing and settlementsystems and their oversight. First, theGoverning Council assesses the compliance ofEU securities settlement systems (SSSs) withnine specific user standards.9 Second, theEurosystem cooperates with other authoritiesresponsible for the regulation and oversight ofsecurities clearing and settlement systems at theEU level. In this context, the ECB encourageddebate about the development of a pan-Europeanregulatory framework for clearing andsettlement through its participation in theCommission’s Clearing and SettlementAdvisory and Monitoring Experts Group. TheESCB’s cooperation with the Committee ofEuropean Securities Regulators (CESR) hasbeen central to the development of pan-European standards which will apply to clearingand settlement. Furthermore, the ECBcontributed to the Group of Thirty, aninternational think-tank, with a view to ensuringthat the Group’s recommendations concerningclearing and settlement, published in 2003, wereimplemented in such a way as to be consistentwith EU initiatives. The ECB also shaped theCommission’s initiative to update theSettlement Finality Directive first adopted in1998. Finally, the ECB contributed to the

recommendations for central counterpartiesdeveloped by the Committee on Payment andSettlement Systems (CPSS) and theInternational Organization of SecuritiesCommissions (IOSCO).

ASSESSMENT OF SECURITIES SETTLEMENTSYSTEMSAll Eurosystem credit operations have to becovered by adequate collateral in the form ofeligible assets. These include securities whichare provided to the Eurosystem via SSSs,i.e. service providers that specialise in the transferof legal ownership of, or equivalent rights in,eligible securities from one party to another. Toensure that it is not exposed to undue risk in thisprocess, the Eurosystem annually assesses theSSSs that it uses against the nine userstandards.10 The 2004 assessment exercisecovered 18 SSSs. It concluded that thecompliance of these SSSs with the userstandards was high and that efforts were beingmade to introduce further improvements. Somesystems have increased their operationalreliability, and measures to improve thefinancial soundness of system operators havebeen taken. The Eurosystem monitors andwelcomes all efforts to improve the efficiencyand safety of the SSSs used in its creditoperations.

COOPERATION WITH THE COMMITTEE OFEUROPEAN SECURITIES REGULATORSIn 2001 the Governing Council approved aframework for cooperation on securitiesclearing and settlement systems between theESCB and CESR. A working group was set up,composed of a representative from each centralbank of the ESCB and from each securitiesregulator in CESR. This working group drewup a report on “Standards for securitiesclearing and settlement in the European

9 In the absence of harmonised EU oversight standards, the userstandards have been regarded as de facto common standards forEU SSSs and, therefore, are dealt with in this chapter.Nevertheless, the user standards are not intended to be acomprehensive set of standards for the oversight or supervisionof SSSs.

10 “Standards for the use of EU securities settlement systems inESCB credit operations”, January 1998.

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Union”11, which was approved by both theGoverning Council and CESR in October 2004.Using as a basis the recommendations forSSSs made by the CPSS and IOSCO (known asthe “CPSS-IOSCO Recommendations”), theESCB-CESR report contains 19 standards thataim to increase the safety, soundness andefficiency of securities clearing and settlementin the EU (see Box 14). In comparison with theCPSS-IOSCO Recommendations, the ESCB-CESR standards seek to deepen and strengthenrequirements in some areas on account of thespecific features of the European markets. Theoverall objective of the ESCB-CESR standardsis to promote the integration of EU capitalmarkets, and they thus place greater emphasison common solutions and interoperability. TheCommission’s work in this area has been takeninto account.

The working group has conducted its work in anopen and transparent manner. Interested partiesin the field of securities clearing and settlementwere invited to comment on the work on anumber of occasions. The contributionsreceived were considered carefully and theworking group has made every effort to ensurethat the views expressed have been addressedin the standards. The standards will become

applicable once the methodology for assessingthe systems has been developed as a follow-upto the report. Since October 2004 the grouphas continued its work in the followingfour fields: (i) developing the assessmentmethodology for the standards for SSSs,(ii) developing standards and a methodologyfor the assessment of central counterparties,(iii) analysing issues relating to significantcustodians and (iv) analysing the topics ofinterest for cooperation among regulatory,supervisory and oversight authorities.

Box 14

STANDARDS FOR SECURITIES CLEARING AND SETTLEMENT IN THE EUROPEAN UNION

Standard 1: Legal frameworkSecurities clearing and settlement systems and links between them should have a well-founded, clear and transparent legal basis in the relevant jurisdictions.

Standard 2: Trade confirmation and settlement matchingConfirmation of trades between direct market participants should occur as soon as possibleafter trade execution, but no later than trade date (T+0). Where confirmation of trades byindirect market participants (such as institutional investors) is required, it should occur as soonas possible after trade execution, preferably on T+0, but no later than T+1.Settlement instructions should be matched as soon as possible and, for settlement cycles thatextend beyond T+0, this should occur no later than the day before the specified settlement date.

Standard 3: Settlement cycles and operating timesRolling settlement should be adopted in all securities markets. Final settlement should occur

11 Available on the ECB’s website.


no later than T+3. The benefits and costs of EU-wide settlement cycles shorter than T+3 shouldbe evaluated.CSDs and, where relevant, CCPs should harmonise their operating hours and days and be openat least during the TARGET operating times for transactions denominated in euro.

Standard 4: Central counterparties (CCPs)The benefits and costs of establishing a CCP should be evaluated. Where such a mechanism isintroduced, the CCP should rigorously control the risks it assumes.

Standard 5: Securities lendingSecurities lending and borrowing (or repurchase agreements and other economicallyequivalent transactions) should be encouraged as a method for avoiding settlement failures andexpediting the settlement of securities. Barriers that inhibit the practice of lending securitiesfor this purpose should be removed. The arrangements for securities lending should be sound,safe and efficient.

Standard 6: Central securities depositories (CSDs)Securities should be immobilised or dematerialised and transferred by book entry in CSDs tothe greatest possible extent. To safeguard the integrity of securities issues and the interests ofinvestors, the CSD should ensure that the issue, holding and transfer of securities areconducted in an adequate and proper manner.

Standard 7: Delivery versus payment (DVP)Principal risk should be eliminated by linking securities transfers to funds transfers in a waythat achieves delivery versus payment.

Standard 8: Timing of settlement finalityIntraday settlement finality should be provided through real-time and/or multiple-batchprocessing in order to reduce risks and allow effective settlement across systems.

Standard 9: Credit and liquidity risk controlsFor systemic stability reasons, it is important that CSDs operate without interruption.Therefore, when allowed by national legislation to grant credit, CSDs should limit their creditactivities exclusively to what is necessary for the smooth functioning of securities settlementand asset servicing. CSDs that extend credit (including intraday and overnight credit) shouldfully collateralise their credit exposures whenever practicable. Uncollateralised credit shouldbe restricted to a limited number of well-identified cases and subject to adequate risk controlmeasures including limits on risk exposure, the quality of the counterparty and the duration ofcredit.Most custodians are subject to EU banking regulations. For those that manage significantarrangements for settling securities transactions, and in order to contain the systemic risks thatare linked to their securities settlement activity, national securities regulators, bankingsupervisors and overseers should examine the risk management policies applied by thosecustodians to assess whether they are in line with the risks created for the financial system. Inparticular, the possibility of increasing the level of collateralisation of credit exposures,including intraday credit, should be investigated.

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Operators of net settlement systems should institute risk controls that, as a minimum, ensuretimely settlement in the event that the participant with the largest payment obligation is unableto settle. The most reliable set of controls is a combination of collateral requirements andlending limits.

Standard 10: Cash settlement assetsAssets used to settle payment obligations arising from securities transactions should carrylittle or no credit or liquidity risk. If central bank money is not used, steps must be taken toprotect the participants in the system from potential losses and liquidity pressures arising fromthe failure of the cash settlement agent whose assets are used for that purpose.

Standard 11: Operational reliabilitySources of operational risk arising in the clearing and settlement process should be identified,monitored and regularly assessed. This risk should be minimised through the development ofappropriate systems and effective controls and procedures. Systems and related functionsshould (i) be reliable and secure, (ii) be based on sound technical solutions, (iii) be developedand maintained in accordance with proven procedures, (iv) have adequate, scalable capacity,(v) have appropriate business continuity and disaster recovery arrangements, and (vi) besubject to frequent and independent audit of the procedures that allow for the timely recoveryof operations and the completion of the settlement process.

Standard 12: Protection of customers’ securitiesEntities holding securities in custody should employ accounting practices and safekeepingprocedures that fully protect customers’ securities. It is essential that customers’ securities beprotected against the claims of the creditors of all entities involved in the custody chain.

Standard 13: GovernanceGovernance arrangements for CSDs and CCPs should be designed to fulfil public interestrequirements and to promote the objectives of owners and market participants.

Standard 14: AccessCSDs and CCPs should have objective and publicly disclosed criteria for participation thatpermit fair and open access. Rules and requirements that restrict access should be aimed atcontrolling risk.

Standard 15: EfficiencyWhile maintaining safe and secure operations, securities clearing and settlement systemsshould be efficient.

Standard 16: Communication procedures, messaging standards and straight-throughprocessing (STP)Entities providing securities clearing and settlement services, and participants in their systemsshould use or accommodate the relevant international communication procedures andstandards for messaging and reference data in order to facilitate efficient clearing andsettlement across systems. This will promote straight-through processing (STP) across theentire securities transaction flow.


Service providers should move towards STP in order to help achieve timely, safe and cost-effective securities processing, including confirmation, matching, netting, settlement andcustody.

Standard 17: TransparencyCSDs and CCPs should provide market participants with sufficient information for them toidentify and accurately evaluate the risks and costs associated with securities clearing andsettlement services.Significant custodians should provide sufficient information to enable their customers toidentify and accurately evaluate the risks associated with securities clearing and settlementservices.

Standard 18: Regulation, supervision and oversightEntities providing securities clearing and settlement services should be subject to, as aminimum, transparent, consistent and effective regulation and supervision. Securities clearingand settlement systems/arrangements should be subject to, as a minimum, transparent,consistent and effective central bank oversight. Central banks, securities regulators andbanking supervisors should cooperate with each other, both nationally and across borders (inparticular within the European Union), in an effective and transparent manner.

Standard 19: Risks in cross-system links1

CSDs that establish links to settle cross-system trades should design and operate such links sothat they effectively reduce the risks associated with cross-system settlements.

1 This standard does not cover links established by CCPs. This issue will be covered by the future work of the ESCB-CESR on CCPs.

ArtistAna Luísa RibeiroTitleUntitled, 2002MaterialOil on canvasFormat150 × 230 cm© European Central Bank

CHAP T E R 4

EUROPEAN ANDINTERNATIONAL RELATIONS


1 EUROPEAN ISSUES1.1 POLICY ISSUES

THE STABILITY AND GROWTH PACTIn 2004 two euro area countries, namely Greeceand the Netherlands, and six of the ten new EUMember States, namely the Czech Republic,Cyprus, Hungary, Malta, Poland and Slovakia,were found to be in a situation of excessivedeficit (see also Section 2.5 of Chapter 1). Theexcessive deficit procedures launched in 2003for France and Germany continued to apply,although they were de facto held in abeyancefollowing the ECOFIN Council conclusions of25 November 2003. These conclusions statedthat France and Germany should correct theirexcessive deficits by 2005, instead of 2004 asforeseen in the recommendations for thesecountries issued by the ECOFIN Council itselfunder Article 104(7) of the Treaty. Theexcessive deficit procedure for Portugal wasabrogated.

In July 2004 the European Court of Justiceannulled the ECOFIN Council’s conclusions of25 November 2003 with regard to France andGermany in so far as they contained a decisionto hold the excessive deficit procedures inabeyance and to modify the earlierrecommendations for the two countries. TheCourt stressed that the rules and proceduresforeseen in the Treaty and the Stability andGrowth Pact and the Commission’s right ofinitiative must always be respected.

The ECB expressed its satisfaction that thejudgement confirmed the need for the rules andprocedures foreseen in the Treaty and the Pactto be fully applied. It called upon theinstitutions concerned to undertake thenecessary steps to ensure the fullimplementation of the rules and procedures.

In September 2004 the Commission issued acommunication on strengthening economicgovernance and clarifying the implementationof the Stability and Growth Pact. Thiscommunication set out a number of proposalsto reform the Pact. Proposals regarding thepreventive arm of the Pact included ensuring

earlier actions to correct inadequatedevelopments through a more timely and activeuse of early warnings, redefining the medium-term objectives for budget balances to allow forcountry-specific circumstances and placinggreater emphasis on debt and sustainability inthe surveillance of budgetary positions.Proposals regarding the corrective armincluded modifying the definition of theexceptional circumstances under which adeficit ratio above the reference value of 3% ofGDP is not excessive, changing the adjustmentpath for the correction of an excessive deficitand clarifying the debt criterion.

In the debate on the reform of the Stabilityand Growth Pact, the Governing Councilexpressed the view that improvements in theimplementation of the Pact were possible andwould be beneficial. In this regard, the EuropeanCommission’s proposals for improving theimplementation of the preventive arm of the Pactwere useful. At the same time, the GoverningCouncil warned against changes to the Pact and,in particular, to the excessive deficit procedure.It considered the credibility of the 3% deficitlimit essential to anchoring expectations offiscal discipline.

In September 2004 Greece reported deficit anddebt figures for the period from 2000 to 2003which were considerably higher than thepreviously released figures. The deficit ratioexceeded the 3% of GDP reference value.Subsequently, revised figures for the periodfrom 1997 to 1999 were released, which alsoshowed deficits in excess of 3% of GDP (seealso Section 2.5 of Chapter 1). The ECB seesthe reliable compilation and the accurateand timely reporting of government financestatistics as being of vital importance to thecredibility of budgetary surveillance and ofEMU in general. The European accountingrules must be fully respected when recordingall types of expenditure and revenue, andapplied in a manner that is consistent and stableover time and homogeneous across MemberStates.

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THE LISBON STRATEGYAt its meeting in Lisbon in March 2000, theEuropean Council set out a ten-year strategy –the Lisbon strategy – which, by 2010, was torender the EU “the most dynamic andcompetitive knowledge-based economy in theworld, capable of sustainable economic growthwith more and better jobs and greater socialcohesion”. The results achieved under theLisbon strategy by 2004 were mixed. Advanceshad been made in some areas, for exampleregarding labour markets. However, in mostrespects, progress was mediocre. It was clearthat the pace of reform would have to besignificantly stepped up if the Lisbon targetswere to be achieved by 2010.

Against this background, the European Councildecided at its spring 2004 meeting to undertakea mid-term review of the Lisbon strategy. As afirst step, it invited the Commission toestablish a high-level group – chaired by WimKok – to carry out an independent assessmentof the progress made under the Lisbon strategy,which would serve as the basis for the mid-termreview by the Commission and the EU Council.The review is scheduled to be completed intime for the spring European Council of March2005.

The high-level group presented its report,entitled “Facing the challenge”, in November2004. The report stressed that, in the face of thetwin challenges of global competition andageing populations, maintaining the status quois not an option for the EU, especially if it is tosafeguard its social model. The reportconcluded that the ambitious objectives of theLisbon strategy, as well as the 2010 deadlinefor achieving these objectives, shouldtherefore be upheld. It called for a betterprioritisation of objectives and urgent actionin five key policy areas: the knowledgesociety, the internal market, the businessclimate, the labour market and environmentalsustainability.

The ECB has repeatedly endorsed theambitions of the Lisbon strategy and has

expressed its support for the efforts undertakenby governments and social partners. It has alsocalled for faster implementation of the requiredmeasures and for more effective benchmarkingof reform progress. Reform is essential toensure future growth and employmentopportunities and to enhance the euro area’sability to adjust to economic shocks. Reformsin labour, capital, goods and services marketsin particular can promote investment, andreduce inflation persistence through increasedcompetition. The EU should take advantage ofthe mid-term review to revitalise the Lisbonstrategy and increase the pace of structuralreform.

1.2 INSTITUTIONAL ISSUES

THE EUROPEAN CONSTITUTIONAt the final meeting of the IntergovernmentalConference (IGC) on 17-18 June 2004, theHeads of State or Government reachedagreement on the Treaty establishing aConstitution for Europe (the EuropeanConstitution). The European Constitution wassigned in Rome on 29 October 2004. Onceratified by all 25 Member States in accordancewith their national procedures, it will enter intoforce on 1 November 2006. In a number ofMember States, ratification procedures willinvolve holding a referendum.


The ECB monitored the IGC closely and madeboth formal and informal contributions to thenegotiations on issues of relevance to the tasksand mandate of the ECB, the Eurosystem andthe ESCB. In accordance with Article 48 of theTreaty on European Union, the ECB wasconsulted and the Governing Council on19 September 2003 adopted an opinion on thedraft Treaty establishing a Constitution forEurope1. In addition, the President of the ECBsent letters to the President of the EU Councilin November 2003 and April 2004 to expand onthis opinion.

The ECB welcomed the efforts made by theEuropean Convention on the Future of Europeand the subsequent IGC to simplify, streamlineand clarify the legal and institutionalframework of the EU. It also made it clear thatthe current provisions governing EMU weresound in terms of both their objectives and theallocation of responsibilities.

In particular, the ECB considered it essentialthat price stability should remain not only theprimary objective of the ECB and the ESCB butalso a stated objective of the EU. The EuropeanConstitution fully confirms this view.

The ECB also deemed it indispensable to thesuccessful performance of its tasks that thespecial institutional features of the ECB andthe ESCB, which set the ECB apart from otherEuropean institutions, be preserved. TheEuropean Constitution preserves these specialinstitutional features by confirming theindependence of the ECB, the ESCB and theNCBs as well as the legal personality andregulatory powers of the ECB. It furtherunderlines the special character of the ECB byclassifying it as one of the “other UnionInstitutions and advisory bodies”. The ECB isthus listed separately from the “Union’sInstitutions”, namely the European Parliament,the European Council, the Council ofMinisters, the European Commission and theCourt of Justice of the European Union, whichare categorised as the EU’s “institutionalframework”.

At the specific request of the ECB, the term“Eurosystem” has been introduced in theEuropean Constitution. This term, which refersto the ECB and the NCBs of the euro area andwas adopted by the Governing Council in 1999,helps to distinguish between the ESCB, whichcomprises all EU central banks, and the centralbanking system of the euro area. The term“Eurosystem” also appropriately reflectsthe fact that the ECB and the euro area NCBsare integral parts of one system (see alsoChapter 8).

In view of the above, the ECB considers that theEuropean Constitution confirms the existingEU monetary framework. It would welcomethe successful completion of the ratificationprocess.

THE NEW WORKING METHODS OF THEEUROGROUPDuring the informal ECOFIN Council meetingof 10-11 September 2004 in Scheveningen (theNetherlands), the ministers of economy andfinance of the euro area agreed on new workingmethods for the Eurogroup. These newmethods are intended to improve theEurogroup’s efficiency and effectiveness.

The new methods include more forward-looking strategic discussions, in particular onstructural reform, and the creation of a stableEurogroup presidency for a period of two yearsinstead of a rotating presidency of six months.The Eurogroup President is elected by a simplemajority of the Eurogroup members. InScheveningen, the Prime Minister and FinanceMinister of Luxembourg, Jean-Claude Juncker,was elected as the first Eurogroup President fora two-year period from 2005 to 2006.

The ECB, which is regularly invited to take partin the meetings of the Eurogroup, participatedin the review of its working methods. The ECBtook the view that these new working methods,including the creation of a stable Eurogrouppresidency, would help to make the functioning

1 CON/2003/20.

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of the Eurogroup more efficient and effective.The new methods do not imply any changes inthe allocation of tasks between the ECB and theeuro area finance ministers in the framework ofEMU. However, they underline the commonresponsibility of governments for the conductof sound fiscal and structural policies, whichare necessary for the continued success of thesingle currency.


2 I N T E RNAT I ONA L I S S U E S2.1 KEY DEVELOPMENTS IN THE

INTERNATIONAL MONETARY ANDFINANCIAL SYSTEM

SURVEILLANCE OF MACROECONOMIC POLICIESIN THE GLOBAL ECONOMYMacroeconomic policies in the globaleconomy, in particular the policies conductedby major industrial countries, are an essentialelement of the international environmentwhich the ECB has to take into account in theconduct of its monetary policy and other tasks.The Eurosystem participates in thesurveillance of these macroeconomic policiesby international financial institutions and fora,which takes place mainly at meetings of theIMF Executive Board, the Organisation forEconomic Co-operation and Development(OECD), the G7 finance ministers and centralbank governors, and the G10 central bankgovernors. The aim of the ECB is to exchangeviews and review policy options conducive to astable macroeconomic environment, soundmacroeconomic policies and price stability inthe euro area.

The global policy environment in 2004 wascharacterised by strong economic growth andmostly contained inflationary pressures. Therewas a welcome rebound in output in manyadvanced economies, as well as in LatinAmerica, coinciding with continued stronggrowth rates in emerging markets in Asia andeastern Europe. On the downside, however,global imbalances – including externalimbalances of the US economy – persisted oreven widened further.

On various occasions, the ECB stressed therisks and uncertainties related to thecontinuation of such imbalances. Overall, theECB shares the view of the internationalcommunity that there are three keyrequirements for the adjustment process:addressing the savings/investment shortfallin the deficit countries; fostering highersustainable growth through structural reformsin countries with relatively low potentialgrowth; and promoting exchange rate

flexibility for major countries and regions thatlack such flexibility. With regard to exchangerate developments, the G7 communiqués in2004 and February 2005 emphasised thatexchange rates should reflect economicfundamentals and that excess volatility anddisorderly movements in exchange rates wereundesirable for economic growth.

The increasing relevance of East Asiancountries for the global economy, as reflectedin their remarkable contribution to worldoutput growth and trade, was a major issue in2004. The ECB closely monitoreddevelopments in these countries andstrengthened its direct relations with Asiancentral banks by organising, together with theMonetary Authority of Singapore, a high-levelseminar bringing together the 11 governorsfrom the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP)2, thegovernors of the euro area NCBs and thePresident of the ECB. The event, which tookplace in Singapore in July 2004, focused on thegrowing economic weight of many East Asiancountries, the role of international currencies,and regional integration and cooperation.

Capital flows to emerging market economies,which the ECB continuously monitors onaccount of their relevance for internationalfinancial stability, remained robust in 2004, asdid the economic performance of thesecountries in general. Crucial factors werefavourable external financing conditions, highinternational prices of export commodities anda pick-up in import demand from advancedeconomies. As a result, current accountsurpluses were recorded and external debtlevels generally decreased, althoughindebtedness remained high in a numberof countries. Accommodative financingconditions induced public and privateemerging market borrowers to strongly tapinternational bond markets, locking in lowinterest rates. Having temporarily widened in

2 The EMEAP countries are Australia, China, Hong Kong SAR,Indonesia, Japan, Malaysia, New Zealand, the Philippines,Korea, Singapore and Thailand.

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the second quarter of 2004, emerging marketbond spreads returned to low levels byhistorical standards later in the year.

Finally, the euro area itself was examined aspart of the international policy surveillanceexercises. Both the IMF and the OECDconducted their regular reviews of themonetary, financial and economic policies ofthe euro area, in addition to their reviews of theindividual euro area countries. The Article IVconsultations of the IMF and the review by theOECD’s Economic and Development ReviewCommittee provided an opportunity for afruitful exchange of views between theseinternational organisations and the ECB, theEurogroup presidency and the EuropeanCommission. Following these discussions, theIMF and the OECD each produced a reportcontaining an assessment of euro areapolicies.3 Special attention was paid to theaccession of ten new Member States to the EUon 1 May 2004 in both reviews conducted in2004.

INTERNATIONAL FINANCIAL ARCHITECTUREIn view of the high degree of integration of theEU in the global economy, the ESCB and theEurosystem have an interest in the smoothfunctioning of the global financial system.Therefore, they actively contribute to ongoingdiscussions on the international financialarchitecture, including through participation inthe relevant international institutions and fora.In some of these institutions and fora the ECBparticipates directly, and in others it has beengranted observer status. The ESCB also takespart in this work at the European level, inparticular in the Economic and FinancialCommittee.

In the context of work by the G10 financeministers and central bank governors, the ECBwelcomed the increasing inclusion ofcollective action clauses (CACs) – contractualprovisions designed mainly to facilitate theorderly restructuring of defaulted debts – insovereign bond issues. Within less than twoyears, the use of CACs has become the market

standard for the issuance of sovereign bondsunder New York law, although without fullymeeting the G10 recommendations.

The ECB also discussed other aspects ofprivate sector involvement in the resolution offinancial crises and reviewed the experiencewith various instruments for promotingsuch involvement. Furthermore, it monitoredprogress in the development of the “Principlesfor Stable Capital Flows and Fair DebtRestructuring in Emerging Markets”, whichwere released in November 2004 by a group ofemerging market sovereign issuers and privatesector creditors. Previously known as the“Code of Conduct”, these principles aimto promote disclosure of information onindebtedness, regular dialogue betweendebtors and creditors, debt restructuringnegotiations in good faith and fair treatment ofall affected creditors. The principles, whichwere welcomed by the G20 finance ministersand central bank governors, address someremaining gaps in the architecture of globalfinance. Once implemented, they shouldsubstantially contribute to the longer-termefforts to build a system which promotes globalcooperation, growth and financial stability.

Another topic monitored by the ECB was theIMF’s financial position. At their meeting inOctober 2004, the G10 finance ministers andcentral bank governors noted that the IMF’sstrong financial position, which was essentialfor the fulfilment of its responsibilities, wouldface challenges in the context of an evolvingworld economy. Coping with these challengeswould require a number of policy measures,among which were strengthened surveillance,more emphasis on debt sustainability inlending decisions, strict adherence to therecently agreed exceptional access frameworkas well as possible further changes in theIMF’s financial structure to promote timelyrepayment and fewer successor arrangements.

3 IMF: “Euro Area Policies: Staff Report”, August 2004; OECD:“Economic Survey – Euro Area 2004”, July 2004.


REGIONAL INTEGRATION AND COOPERATIONAs the EU is the outcome of a lengthy processof regional economic integration itself, theECB has become a natural partner to monetaryauthorities in several regional groupings inthe world, which call on the ECB to shareits experience with policy-makers and,occasionally, academics. In this context,the ECB is interested not only in explainingthe European case, especially in the fieldof monetary cooperation, but, equallyimportantly, in understanding regionaleconomic integration outside the EU.

In September 2004 a G20 workshop on regionaleconomic integration in a global frameworktook place in Beijing, organised by thePeople’s Bank of China and the ECB. Amongthe issues examined were the preconditionsfor regional cooperation arrangements, theoptimal sequencing of the processes ofintegration and monetary and financialcooperation, and the compatibility betweenregional trade integration and World TradeOrganization rules.

In 2004 the ECB also strengthened itsrelations with regional monetary institutionsin Africa. In this respect, the ECB, togetherwith a number of euro area NCBs, hasextended technical assistance to the WesternAfrican Monetary Institute (based in Accra,Ghana), the body undertaking the technical

preparations for monetary integration amongEnglish-speaking countries in West Africa.

INTERNATIONAL ROLE OF THE EUROIn 2004 the role of the euro remained largelystable in international capital and foreignexchange markets and as an anchor, reserve andintervention currency. There was someevidence of increased use of the euro as aninvoicing and settlement currency in theinternational trade of selected euro areacountries. For most of these countries, the useof the euro appears to be more widespread inthe case of exports than in the case of importsand, within exports, it is higher for goods thanfor services. For most of the new EU MemberStates and for the candidate countries, anotable increase in the share of the euro ininternational trade was also observed (on thebasis of data for 2003). The increase in the useof the euro in many cases exceeded the increasein trade relations with the euro area, suggestingthat the euro is being increasingly used inthe international trade of those countries withnon-euro area trading partners.4

The ECB continued to develop the statisticalcoverage required for its analysis of the euro’sinternational role. On the basis of previousresearch, two new datasets were constructed toidentify salient features of the market for euro-denominated bonds issued by non-euro arearesidents.

2.2 COOPERATION WITH COUNTRIES OUTSIDETHE EU

The Eurosystem continued to build up itscontacts within the central banking communityoutside the EU, mainly through the organisationof seminars and workshops but also throughtechnical assistance. The objective is to gatherinformation and exchange views on economicand monetary developments in differentregions of the world with a potential bearing on

4 See “Review of the international role of the euro”, ECB,December 2004.

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5 Algeria, Egypt, Israel, Jordan, Lebanon, Morocco, thePalestinian Authority, Syria, Tunisia and Turkey.

6 The six member states of the GCC are Bahrain, Kuwait, Oman,Qatar, Saudi Arabia and the United Arab Emirates.

the global economic environment ordevelopments in the euro area.

The Eurosystem’s technical assistance projectwith the Central Bank of the RussianFederation (CBR), funded by the EU within theframework of its Technical Assistance for theCommonwealth of Independent States(TACIS) programme, is being implemented asplanned. Launched in November 2003, the aimof the two-year project is to further strengthenthe CBR’s banking supervision function as akey measure to foster a more stable financialenvironment in Russia. The project’s trainingplan, which was agreed in January 2004between the CBR on the one hand, and nineeuro area NCBs, three supervisory authoritiesand the ECB on the other, foresees 64 courses,eight study visits and four high-level seminars.By end-2004, 34 courses, four study visits andtwo seminars had taken place. Roughly 400CBR staff took part in this training plan. Inaddition to the TACIS project, in May 2004 theEurosystem held its first bilateral high-levelseminar with the CBR in Helsinki, coordinatedby Suomen Pankki – Finlands Bank and theECB. This seminar focused on monetary andexchange rate policies, free capital mobility,economic links between the EU and Russia,including trade policies, as well as bankingsystem developments and financial sectorstability issues.

The Eurosystem has established a frameworkfor cooperation with central banks in theMediterranean region. In January 2004 its firsthigh-level seminar with central bank governorsof the Barcelona partner countries5 took placein Naples, jointly organised by the ECB andthe Banca d’Italia. Following a technicalworkshop in September 2004, the second high-level seminar took place in Cannes in February2005, jointly organised by the ECB and theBanque de France. This seminar focused onrecent financial and monetary developments inthe Mediterranean region, economic linkagesbetween the euro area and the Mediterraneancountries (with a particular focus on workers’

remittances), as well as central bankindependence.

In the western Balkans, the ECB has initiatedrelations with central banks at seniormanagement level through a number of visits,including to the Central Bank of Bosnia andHerzegovina and the National Bank of Serbia.These visits served the purpose of developing adialogue between the ECB and the centralbanks of these countries, given that they arepotential EU candidate countries.

The Eurosystem also aimed to improve itsunderstanding of developments in systemicallyimportant economies in Latin America. To thisend, the ECB, together with the Banco Centraldo Brasil, the Banco de Portugal and the Bancode España, organised the second high-levelseminar of the Eurosystem and Latin Americancentral banks, which took place in Rio deJaneiro in November 2004 and was precededby a preparatory technical workshop held inLisbon. Participants discussed the possibleconstraints on the conduct of monetarypolicy arising from fiscal policies, debtvulnerabilities and financial systemcharacteristics.

In the Middle East, the ECB further developedits relations with the Secretariat General of theGulf Cooperation Council (GCC) and GCCmember states’ monetary agencies and centralbanks in view of the plan to introduce a singlecurrency in the GCC member states6 by 2010.

ArtistXenia HausnerTitleTraumspiel, 2004MaterialChromolithograph on handmade paper (ed. 16/25)Format96 × 129 cm© VG Bild-Kunst, Bonn 2005

CHAP T E R 5

ACCOUNTABILITY


1 ACCOUNTABILITY VIS-À-VIS THE GENERAL PUBLICAND THE EUROPEAN PARLIAMENT

Accountability can be understood as the legaland institutional obligation of an independentcentral bank to explain its decisions clearly andthoroughly to citizens and their electedrepresentatives, thereby enabling them to holdthe central bank responsible for achieving itsobjectives. Accountability thus constitutes animportant counterpart to the independence of acentral bank.

From its inception, the ECB has acknowledgedthe fundamental importance of itsaccountability obligations and has maintaineda regular dialogue with citizens and theirelected representatives. The Treaty laysdown a number of reporting requirements forthe ECB, ranging from the publication of anannual report, a quarterly report and aweekly consolidated financial statement toappearances before the European Parliament.The ECB fully complies with theserequirements and even exceeds them, forinstance by publishing a Monthly Bulletinrather than a quarterly report, by holdingmonthly press conferences and, sinceDecember 2004, by making public on amonthly basis Governing Council decisionstaken in addition to interest rate decisions (seealso Section 1 of Chapter 6). At theinstitutional level, the Treaty assigns aprominent role to the European Parliament withregard to the accountability of the ECB.

The members of the Governing Councilcontinued during 2004 to deliver numerousspeeches throughout the euro area in order toexplain the ECB’s policies to the public. In linewith the provisions of Article 113 of the Treaty,the ECB also continued to report regularly tothe European Parliament on the decisions takenin the field of monetary policy and on its othertasks. As in past years, the quarterlytestimonies by the President of the ECB beforethe Committee on Economic and MonetaryAffairs served as the main forum for theseregular exchanges of views. The President alsopresented the ECB’s Annual Report 2003 to theCommittee and to the plenary of the EuropeanParliament.

The Committee on Economic and MonetaryAffairs also invited another member of theExecutive Board to present the ECB’s views onthe economic environment and key issues in thearea of structural reform. In addition, the ECBparticipated in a hearing organised by theCommittee on the issue of the Single EuroPayments Area.

Beyond the scope of its Treaty obligations, theECB continued its voluntary practice ofreplying to written questions submitted bymembers of the European Parliament on issuesrelated to the ECB’s mandate. Furthermore, asin previous years, a delegation of members ofthe Committee on Economic and MonetaryAffairs visited the ECB for informaldiscussions on a variety of issues with themembers of the Executive Board.

Article 112 of the Treaty provides that theEuropean Parliament will give its opinion onnominees to the Executive Board prior to theirappointment by common accord by the Headsof State or Government of the Member Statesthat have adopted the euro. Following arecommendation by the EU Council, theEuropean Parliament invited José ManuelGonzález-Páramo to appear before theCommittee on Economic and Monetary Affairsto present his views and answer questions fromCommittee members. Following this hearing,the plenary of the European Parliamentendorsed his appointment as successor toEugenio Domingo Solans in the ExecutiveBoard.

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During the President’s appearances before theEuropean Parliament, a wide variety of issueswere addressed. The main focus was on theassessment of economic and monetarydevelopments and the conduct of the ECB’smonetary policy. Some of the issues raised bythe European Parliament during its exchangesof views with the ECB and in its resolution onthe Annual Report 2003, adopted in October2004, are discussed below.

THE CONTRIBUTION OF THE SINGLE MONETARYPOLICY TO THE GENERAL ECONOMIC POLICIESIN THE COMMUNITYThe contribution of the single monetary policyto the general economic policies in theCommunity was a key issue raised during theappearances of the President before theEuropean Parliament. While some members ofthe Committee on Economic and MonetaryAffairs took the view that maintaining pricestability did not suffice to support growth andemployment and that a trade-off existedbetween inflation and unemployment, otherCommittee members felt that the provisions setout in Article 105 of the Treaty were fullyappropriate and that the maintenance of pricestability should remain the primary objectiveof the single monetary policy.

The President pointed out that by crediblypursuing price stability and by solidlyanchoring medium and long-term inflationexpectations, the ECB makes its best possiblecontribution to creating an economicenvironment conducive to sustainable growth.In its resolution on the ECB’s Annual Report2003, the European Parliament endorsed thisview and commended the ECB forconcentrating on the maintenance of pricestability.

FINANCIAL INTEGRATION AND REGULATIONWithin the framework of the quarterlytestimonies, the members of the Committee onEconomic and Monetary Affairs also asked thePresident for the ECB’s views on issues relatedto financial integration and regulation. Inparticular, the European Parliament paid close

2 VIEWS OF THE ECB ON SELECTED TOPICS RAISEDAT MEETINGS WITH THE EUROPEAN PARLIAMENT

attention to the activities of the ESCB and theCommittee of European Securities Regulators(CESR) in the field of securities clearing andsettlement. More specifically, the resolution onthe ECB’s Annual Report 2003 expressedconcern that the standards proposed by theESCB and CESR might pre-empt the upcominglegislative process in this area.

The President stressed that the proposedstandards were not intended to pre-empt futurelegislative acts. He stated that if a directive onclearing and settlement were to be adopted at alater stage, the standards would need to beassessed from the point of view of theirconformity with the provisions of such adirective and, if warranted, adaptedaccordingly (see also Section 4 of Chapter 3).

ACCOUNTABILITY AND TRANSPARENCY OFTHE ECBIn its resolution on the ECB’s Annual Report2003, the European Parliament considered thedialogue with the ECB a success, as the regularexchanges of views made the ECB’s monetarypolicy more transparent and accessible tothe public. At the same time, the ECB andthe European Parliament continued to holddiverging views on some issues relatedto accountability and transparency. In itsresolution, the European Parliament reiteratedits call for the publication of minutes and thebalance of votes in Governing Councilmeetings.

As regards the request for the publication ofminutes, the President emphasised that thecommunication channels chosen by the ECBwere more effective in terms of timeliness. Inparticular, the monthly press conferences heldimmediately after Governing Council meetingsprovide, in real time, a comprehensive accountof the reasons underpinning the GoverningCouncil’s decisions, and thus essentially servethe same purpose as minutes. Furthermore, thereasoning of the Governing Council is madeavailable to the public at a much earlier stagethan would be the case for formally adoptedminutes. These press conferences, together


with additional communication tools such asthe Monthly Bulletin and the monthlycommunication on Governing Councildecisions taken in addition to interest ratedecisions, make the ECB one of the mosttransparent central banks in the world.

With regard to the request for the disclosure ofinformation on the voting behaviour ofGoverning Council members, the Presidentrecalled that, in view of the specificinstitutional environment in which the singlemonetary policy operates, the publication ofvotes carries the risk of putting undue nationalpressure on members of the Governing Councilto deviate from the euro area perspective. TheECB therefore continues its policy of notproviding any indications of individual viewsor voting behaviour. This approach helps tofocus public attention on the economicrationale of policy decisions rather than onindividual voting behaviour and is consistentwith the collegial nature of the GoverningCouncil and its euro area perspective.

COUNTERFEITING AND BANKNOTE SECURITYThe members of the Committee on Economicand Monetary Affairs also addressed the issueof euro counterfeiting. In its resolution on theECB’s Annual Report 2003, the EuropeanParliament called upon the ECB to be very alertwith regard to counterfeiting and to takeexperience into account in the design of a newgeneration of banknotes.

During his appearances before the Committeeon Economic and Monetary Affairs, thePresident stressed that the ECB took the issueof counterfeiting very seriously andcontinuously sought to improve its policiesagainst counterfeiting. In this respect,cooperation agreements in the fight againstcounterfeiting have been concluded withvarious national and international authorities.Moreover, the experience with counterfeitbanknotes is guiding the research anddevelopment of new security features for thenew generation of banknotes. Information onall counterfeit euro banknotes is stored in an

ECB database which is accessible to all EUcentral banks and national law enforcementauthorities (see also Section 3 of Chapter 2).

ArtistPhilippe CognéeTitle

MaterialEncaustic on canvasFormat154 × 153 cm© VG Bild-Kunst, Bonn 2005

Foule, Place St Pierre de Rome, Pâques, 1999

CHAP T E R 6

EXTERNALCOMMUNICATION


1 COMMUN I C AT I ON PO L I C YCommunication is an integral part of the ECB’smonetary policy and the performance of itsother tasks. Two key elements – opennessand transparency – guide the ECB’scommunication activities. Both contribute tothe effectiveness, efficiency and credibility ofthe ECB’s monetary policy. They also supportthe ECB’s efforts to give full account ofits actions, as explained in more detail inChapter 5.

In the field of communication, the ECB has sethigh standards. Monetary policy decisions areexplained at a press conference immediatelyafter the Governing Council has taken them. Acomprehensive introductory statement is madeand the President and Vice-President are at themedia’s disposal to answer questions. Theconcept of real-time, regular and detailedexplanations of the ECB’s monetary policyassessment and decisions, which wasintroduced in 1999, represents a uniquely openand transparent approach to central bankcommunication.

Moreover, communication on other decisionshas been further enhanced. Since December

2004 a text presenting decisions taken by theGoverning Council in addition to interest ratedecisions has been published every month onthe websites of the Eurosystem central banks.

As part of the institutional framework of theEU, the ECB has to make its legal acts andstatutory publications available in all officialCommunity languages, the number of whichincreased from 11 to 20 with the enlargementof the EU on 1 May 2004. The statutorypublications are the Annual Report, thequarterly version of the Monthly Bulletin, theweekly consolidated financial statement ofthe Eurosystem and the Convergence Report.For the purposes of accountability andtransparency vis-à-vis the European citizensand their elected representatives, the ECBalso publishes other documentation in allofficial languages, in particular press releaseson monetary policy decisions, Eurosystemstaff macroeconomic projections and policypositions of relevance to the general public.The preparation, publication and distributionof the national language versions of theECB’s key publications are undertaken incollaboration with the NCBs.

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2 COMMUNICATION ACTIVITIESThe ECB’s communication relies on severalpublications and tools, which are constantlybeing refined in order to inform the generalpublic and interested parties more effectively.

The Annual Report presents a comprehensivereview of the ECB’s activities in the previousyear and thus helps to hold the ECBaccountable for its actions. The MonthlyBulletin provides a continual update of theECB’s assessment of economic and monetarydevelopments and detailed informationunderlying its decisions. It also containsarticles on general central banking topics.The ECB contributes to the disseminationof research findings by publishing workingpapers and occasional papers and byorganising academic conferences, seminarsand workshops.

Together with the BIS and the G10 centralbanks, the ECB launched a new publicationentitled the “International Journal of CentralBanking” in 2004. It features policy-relevantarticles on the theory and practice of centralbanking, with special emphasis on researchrelated to monetary policy and financialstability. The first quarterly issue will bepublished in 2005.

All members of the Governing Council directlytake part in the efforts to enhance publicknowledge and understanding of the ECB’stasks and policies through testimonies beforethe European Parliament and nationalparliaments, public speeches and the media. In2004 the six Executive Board members gavearound 220 speeches and numerous interviews,as well as contributing articles to journals,magazines and newspapers. Visits by thePresident and other members of the ExecutiveBoard to EU Member States and other countriesthroughout 2004 helped to bring the messagesof the ECB directly to the citizens of Europeand beyond. The ECB’s communication effortswere increasingly directed towards audiencesin the new EU Member States, both before andafter their accession to the EU in 2004.

The euro area NCBs also play an important rolein ensuring the dissemination at the nationallevel of information on the euro and theactivities of the Eurosystem to the generalpublic and interested parties. They address avariety of regional and national audiences intheir own languages and environments.

A further important channel for providinginformation to financial markets is the ECB’sautomated information system. This systemprovides real-time information to a number of


news agencies, which display on their screenspages showing the key ECB interest rates,market operations and liquidity conditions inthe euro area. The pages are provided andregularly updated by the ECB. Following anapplication procedure, the number of newsagencies granted access to this system by theECB rose from three to five in 2004.

All documents published by the ECB and itsvarious activities are presented on the ECB’swebsite (www.ecb.int). In 2004 a new versionof the website was launched. Its design hasbeen modernised and contents restructured inorder to make it more user-friendly. Thewebsite also serves as a contact point forqueries from the public and as a platform for thelaunch of ECB public consultations. Around47,000 queries were received through variouschannels and handled in 2004.

The ECB also practices openness in a literalsense, by welcoming visitor groups to itspremises in Frankfurt. In 2004 around 8,000visitors received first-hand information in theform of lectures and presentations given byECB staff. University students andprofessionals from the financial sector made upthe majority of visitors.

ArtistJan FabreTitleUntitled, 1987MaterialBallpoint ink on paperFormat200 × 158 cm© VG Bild-Kunst, Bonn 2005

CHAP T E R 7

ENLARGEMENT OF THEEUROPEAN UNION


On 1 May 2004 ten countries of central andeastern Europe and the Mediterranean – theCzech Republic, Estonia, Cyprus, Latvia,Lithuania, Hungary, Malta, Poland, Sloveniaand Slovakia – joined the EU. The NCBs of thenew Member States were integrated into theESCB and their governors became fullmembers of the General Council. Experts fromthese NCBs have full-member status in themeetings of the ESCB committees wheneverthey deal with matters that fall within the fieldof competence of the General Council.

The integration of the new members into theESCB went smoothly. On the basis of theECB’s Accession Master Plan, set out in 2003,preparations were undertaken in particular inthe fields of central bank operations, paymentand settlement systems, statistics, banknotes,and IT infrastructure and applications. Therelevant ESCB IT infrastructure was enhancedand now connects all 25 NCBs and the ECB,providing increased reliability and enhancedsecurity services. The key for subscription tothe ECB’s capital was expanded and the NCBsof the new Member States paid up a percentageof their subscribed capital as a contribution tothe operational costs of the ECB.

The fifth high-level seminar on the accessionprocess, held in Paris in March 2004, markedthe final phase of the preparations foraccession. The seminar, jointly organised bythe ECB and the Banque de France, broughttogether the governors and high-levelrepresentatives of the central banks of theESCB, the ten acceding countries and the twocandidate countries – Bulgaria and Romania –which were about to finalise negotiations foraccession to the EU. The seminar focused onmonetary and exchange rate policies and thepractical functioning of ERM II, budgetarydiscipline in the context of the Stability andGrowth Pact, and issues relating to financialstandards, accounting regulations andcorporate governance.

The practical experience gained during theenlargement process has been assessed and will

1 SU C C E S S F U L A C C E S S I ON O F T EN N EW MEMBERS TAT E S

be taken into account in the preparations forfuture enlargements of the EU and the euroarea.

On 20 October 2004 the European Commissionand the ECB published their respectiveConvergence Reports on the progress made inthe fulfilment of the obligations regarding theachievement of EMU by the Member Stateswith a derogation status, including the newMember States. The ECB’s ConvergenceReport concluded that none of the countriesassessed fulfilled all the conditions foradopting the euro, including the legislativerequirements for safeguarding effectiveindependence of the NCBs.

In terms of the number of countries joining, thisenlargement was the most important in thehistory of European integration. However, theeconomic weight of the new Member States isrelatively small compared with previousenlargements. As a result, the accession of thenew Member States has not fundamentallychanged the key characteristics of the EUeconomy. Economic diversity within the EUhas increased, however, as the institutional andstructural features of the new Member Statesare in many respects different from those of theother Member States. The majority of the newMember States have been engaged in atransition process from a centrally planned toa market economy, involving fundamentalinstitutional and structural changes in theireconomies. Over a longer time horizon,enlargement is likely to contribute positively toeconomic growth in the EU; indeed, a positiveimpact was already observed during the decadeof preparations for enlargement. This sectionpresents a number of key macroeconomicfeatures of the EU before and after theaccession of the new Member States togetherwith corresponding data for the United Statesand Japan.

POPULATION AND ECONOMIC ACTIVITYAs indicated in Table 16, the 2004 enlargementincreased the population of the EU by almost20%, bringing the total population to 457.7

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million. Measured in these terms, the EUcontinues to be the largest entity in theindustrialised world.

Economic activity in the countries forming theEU25, as measured by GDP, was €9,752 billionin 2003, to which, on the basis of currentexchange rates, the accession of the newMember States contributed 4.5%. From ahistorical perspective, the economic size ofthis enlargement was relatively limited. Forexample, the accession of Spain and Portugal tothe European Community in 1986 (which at thetime consisted of ten countries) raised theCommunity’s total GDP by slightly more than8%, and the enlargement to Austria, Finlandand Sweden in 1995 increased economic outputby just over 7%. On the basis of GDP data and

Reporting Unitedperiod Unit EU15 EU25 States Japan

Population 2004 millions 384.5 457.7 293.9 127.5GDP (share of world GDP) 1) 2003 % 30.4 31.8 30.4 11.9GDP 2003 € billions 9,310 9,752 9,673 3,800

2003 PPP billions 9,310 10,193 9,957 3,254GDP per capita 2003 € thousands 24.2 21.3 32.9 29.8

2003 PPP thousands 24.3 22.3 34.2 25.5Exports of goods and services 2003 % of GDP 14.0 12.4 9.3 12.2Imports of goods and services 2003 % of GDP 13.3 12.1 13.8 10.6Sectors of production 2)

Agriculture, fishing, forestry 2003 % of GDP 2.0 2.1 0.8 1.2Industry (including construction) 2003 % of GDP 26.6 26.8 19.7 29.2Services 2003 % of GDP 71.4 71.1 79.5 69.6

Unemployment rate 2003 % 8.1 9.1 6.0 5.3Labour force participation rate 3) 2003 % 70.0 69.3 75.8 78.2Employment rate 4) 2003 % 64.4 63.0 71.2 68.4General government 5)

Surplus (+) or deficit (-) 2003 % of GDP -2.7 -2.8 -4.6 -7.5Expenditure 2003 % of GDP 48.5 48.5 34.4 39.1Revenue 2003 % of GDP 45.8 45.6 29.8 31.6Gross debt 2003 % of GDP 64.2 63.2 63.1 156.9

Bank deposits 6) 2003 % of GDP 83.9 82.4 47.8 120.2Stock of loans to the private sector 7) 2003 % of GDP 99.2 96.3 51.4 118.8Stock market capitalisation 2003 % of GDP 66.3 65.2 126.7 61.6

Sources: Eurostat, European Commission, IMF, BIS, ECB and ECB calculations.1) GDP shares are based on country GDPs in current US dollars.2) Based on gross value added at current prices.3) Def ined as the ratio of the labour force to the working age population (those aged between 15 and 64).4) Def ined as the ratio of the number of employed persons to the working age population (those aged between 15 and 64).5) Based on the ESA 95.6) EU15 and EU25: total deposits with MFIs; United States: demand, time and savings deposits with banking institutions;Japan: demand and time deposits with deposit money banks.7) EU15 and EU25: MFI loans to other residents; United States: loans by commercial banks, savings institutions and credit unions;Japan: loans to the private sector.

Tab le 16 Key charac te r i s t i c s o f the EU economy inc lud ing and exc lud ing the newMember S ta te s

exchange rates for 2003, the accession of thenew Member States led to a rise in the EU’sshare of global GDP from 30.4% to 31.8%.It should be noted, however, that theseinternational comparisons are heavilyinfluenced by developments in exchange rates.One way to overcome the variability andpotential distortions associated with marketprices is to use a comparison on the basis ofpurchasing power parities (PPPs), even if thesemeasures have their own caveats. In PPP termsand on the basis of 2003 data, the most recentenlargement increased the EU’s GDP by 9.5%,making it larger than that of the United States.

As the new Member States have a relativelylarge population in relation to their currentlevel of economic activity, their accession


implies a decline in the average level of GDPper capita in the EU. This, however, is expectedto change gradually in line with progress inthe catching-up process. Compared with theUnited States and Japan, GDP per capita in theEU25 is relatively low, although the differencevis-à-vis Japan is much more limited in PPPterms (on the basis of figures for 2003).

The accession of the new Member States willalso have a longer-term effect on economicactivity as it affects incentives for andimpediments to the flow of goods, services,capital and persons (the “four freedoms”)between the new Member States and the otherEU countries, although migration flows will berestricted for a number of years. For example,the extension of the Single Market, byincreasing the scope for these four freedoms to25 countries, is likely to enhance competitionand create economies of scale. The extent ofthese effects and the speed at which theymaterialise will, however, depend on manyfactors, such as the future economic policies ofEU Member States.

INTERNATIONAL TRADEFollowing enlargement, EU15 trade with thenew Member States and trade among thoseMember States is naturally recorded as intra-EU trade instead of international trade. Bycontrast, trade between the new Member Statesand the rest of the world excluding the EU15countries now counts as extra-EU25 trade. Theaccession of the new Member States hasslightly reduced the trade openness of the EU,despite the fact that most new Member Statesare very open economies, as EU15 trade withthe new Member States is more significant thanthe new Member States’ trade with countriesoutside the EU. According to data for 2003,exports of goods and services represented12.4% of GDP in the enlarged EU, comparedwith 9.3% and 12.2% for the United States andJapan respectively.

PRODUCTION STRUCTUREThe structure of production in the new MemberStates is characterised by a larger share of

agriculture (3.2%) and industry (31.9%) and asmaller share of services (64.9%) in GDP thanthe average of the other EU countries. Sectoraldifferences tend to be more pronounced in thenew Member States than in the EU15 in termsof the distribution of employment acrossthese sectors. Nevertheless, enlargement hasresulted in only slight changes in the shares ofthese broad sectors in the EU’s GDP and thedistribution of employment. Relative to othermajor economic blocs, the agricultural sectorin the EU is large by comparison with that ofthe United States and Japan, whereas the EU’sindustrial sector is larger than that of theUnited States but smaller than that of Japan. Itsservices sector is larger than that of Japan butsmaller than that of the United States.

LABOUR MARKETThe average unemployment rate in the newMember States is higher than that in the EU15countries, and enlargement has thus led to asomewhat higher average unemployment ratefor the EU25. Despite falling during the late1990s, the unemployment rate in both the EU15and the EU25, at 8.1% and 9.1% respectively in2003, remains significantly higher than inthe United States and Japan, where it stoodat 6.0% and 5.3% respectively. In the newcentral and eastern European Member States,unemployment rates have risen and regionalunemployment differences have grown duringthe past decade, owing to structuraladjustments associated with the transition to amarket economy. Prospects for employmentcould improve in the years ahead, however,as job-cutting associated with businessrestructuring may ease. In the longer run, thenew Member States’ potential for catching upin terms of GDP per capita may also contributeto favourable employment trends and lowerunemployment.

The accession of the new Member Stateshas lowered the employment rate in the EU by1.4 percentage points, so that it now standsat 63.0%. A breakdown of the employment ratein the new Member States suggests thatthe participation rate of men in particular is

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considerably below the level in the EU15countries, whereas the gap for women is lesspronounced. The employment rate of olderworkers (i.e. those aged between 55 and 64) isalso substantially lower in the new MemberStates than in the EU15. In comparison with theUnited States and Japan, the EU labour forceparticipation rate is low. The combinationof a lower participation rate and a higherunemployment rate in the EU is reflected in anemployment rate which is below that of theUnited States and Japan.

FISCAL POSITION AND THE SIZE OF THEGOVERNMENT SECTORThe accession of the new Member States hasnot substantially changed the weighted averagegovernment deficit ratio in the EU, despite thefact that most new Member States have highfiscal deficits (see also Section 2.5 of Chapter1). The public expenditure and revenue sharesin GDP are somewhat smaller in most of thenew EU countries, although they are high inrelation to their income levels. The small sizeof the new Member States’ economies meansthat the share of the general government sectorin the EU25 is nevertheless broadly unchangedcompared with the EU15. As the public debtratio in the new Member States is generallysignificantly below the level in the EU15, theaverage EU debt-to-GDP ratio is somewhatlower than before enlargement.

The general government deficit, which stood at2.8% in the EU25 in 2003, is currently lowerthan in the United States and Japan. At the sametime, the general government sector makes up alarger share of the economy in the EU25 than inthe United States and Japan. In the EU25, thegovernment expenditure ratio stands at almost49% and the government revenue ratio at justbelow 46%. In the United States, the generalgovernment sector accounts for somewhatmore than 34% of GDP in terms of expenditureand slightly less than 30% of GDP in terms ofrevenue. In Japan, the large public deficit isaccounted for by a government expenditureratio of just over 39% of GDP and a governmentrevenue ratio of almost 32%. The past

accumulation of public deficits has led tosimilarly high public debt ratios in the EU andthe United States, but they are nonethelesssignificantly lower than in Japan.

FINANCIAL STRUCTUREEnlargement has not involved significantchanges to the financial structure of the EU as awhole, although financial intermediation is onaverage more focused on banks in the newMember States than in the EU15. In most newMember States the financial sector is relativelysmall, as measured by total banking sectorassets and securities market capitalisation.However, the level of financial intermediation,i.e. the channelling of new funds by financialinstitutions into new claims to financeinvestment, has recently advanced fairlyrapidly in some new Member States. Incomparison with the United States, the EU’sfinancial sector continues to be more orientedtowards the banking sector, whereas the role ofstock markets in financial intermediation isless important. By comparison with Japan,however, the banking sector plays a smallerrole in the EU’s financial sector, while stockmarkets are more significant.


There are currently four countries which havethe status of candidate for EU membership:Bulgaria, Croatia, Romania and Turkey.Following the successful completion of theaccession negotiations with Bulgaria andRomania, the European Council in December2004 called for the Accession Treaty with thesetwo countries to be finalised with a view tosigning it in April 2005. Bulgaria and Romaniawould then be expected to join the EU inJanuary 2007. Croatia has been a candidatecountry since June 2004 and, provided thatthere is full cooperation with the InternationalCriminal Tribunal for the former Yugoslavia,negotiations for EU accession will start inMarch 2005. Turkey was granted the status ofcandidate country by the Helsinki EuropeanCouncil in 1999. In December 2004 theEuropean Council decided that, in the light of aCommission report and recommendation,Turkey sufficiently fulfils the Copenhagenpolitical criteria to open accession negotiationsprovided that it brings into force specificpieces of legislation. Against this background,the European Council requested theCommission to prepare a proposal for aframework for negotiations with a view toopening negotiations on 3 October 2005.

The Eurosystem continued to monitormonetary and economic developments in thecandidate countries and paid particularattention to the disinflation process, financialsector issues and structural convergencetowards the EU.

The ECB further strengthened its bilateralrelations with the central banks of Bulgaria andRomania. The first visits to the BulgarianNational Bank and the National Bank ofRomania by the ECB at the Executive Boardlevel took place in October. The main purposeof these visits was to discuss future cooperationwith the Eurosystem, which will include apre-accession dialogue between the ECB andthe central banks of countries negotiatingaccession. Following the signing of theAccession Treaty, the governors of thesecentral banks will be invited to attend the

2 RELATIONS WITH EU CANDIDATE COUNTRIESmeetings of the General Council in an observercapacity. Experts from these central banks willbe granted observer status in the ESCBcommittees whenever the committees deal withmatters that fall within the field of competenceof the General Council. A visit to the CroatianNational Bank is expected to take place inMarch 2005.

The ECB also continued its high-level policydialogue with the Central Bank of the Republicof Turkey, including annual meetings at theExecutive Board level. The discussionsfocused on Turkey’s macroeconomicstabilisation process, the Central Bank of theRepublic of Turkey’s monetary and exchangerate policy and the economic situation in theeuro area. In addition to the policy dialogue,technical cooperation between business areasof the ECB and the Central Bank of theRepublic of Turkey continued.

ArtistReinhold A. GoellesTitleUntitledMaterialAcrylic on canvasFormat152 × 100 cm© European Central Bank

CHAP T E R 8

INSTITUTIONALFRAMEWORK,

ORGANISATION ANDANNUAL ACCOUNTS


1 D E C I S I ON -MAK I NG BOD I E S AND CORPORAT EGOVERNANC E O F T H E E C B

EU

RO

PE

AN

SY

ST

EM

OF

CE

NT

RA

L B

AN

KS

(E

SC

B) ��

��

��

��

European Central Bank (ECB)European Central Bank (ECB)

Nationale Bank van België/Banque Nationale de Belgique

Deutsche Bundesbank

Bank of Greece

Banco de España

Banque de France

Central Bank and FinancialServices Authority of Ireland

Banca d’Italia

Banque centrale duLuxembourg

De Nederlandsche Bank

Oesterreichische Nationalbank

Banco de Portugal

Suomen Pankki – Finlands Bank

Ge

ne

ral

Co

un

cil

Ge

ne

ral

Co

un

cil

Governing ExecutiveCouncil Board

Governing ExecutiveCouncil Board

Česká národní banka

Danmarks Nationalbank

Eesti Pank

Central Bank of Cyprus

Latvijas Banka

Lietuvos bankas

Magyar Nemzeti Bank

Central Bank of Malta

Narodowy Bank Polski

Banka Slovenije

Národná banka Slovenska

Sveriges Riksbank

Bank of EnglandE

UR

OS

YS

TE

M

1 .1 THE EUROSYSTEM AND THE EUROPEAN SYSTEM OF CENTRAL BANKS

The Eurosystem is the central banking systemof the euro area. It comprises the ECB and theNCBs of the 12 Member States whose commoncurrency is the euro. The Governing Counciladopted the term “Eurosystem” in order tofacilitate understanding of the structure ofcentral banking in the euro area. The termunderlines the shared identity, teamwork andcooperation of all of its members and has alsobeen introduced into the Treaty establishing aConstitution for Europe, which was signed inRome on 29 October 2004. The GoverningCouncil has also approved a mission statementfor the Eurosystem together with strategicintents and organisational principles for thefulfilment of the Eurosystem functions by allmembers of the Eurosystem (see Box 15).

The ESCB is composed of the ECB and theNCBs of all EU Member States (25 since 1 May2004), i.e. it includes the NCBs of the MemberStates which have not yet adopted the euro. Aslong as there are Member States which have notyet adopted the euro, it will be necessary tomake a distinction between the Eurosystem andthe ESCB.

The ECB has legal personality under publicinternational law. It was established as the coreof the Eurosystem and the ESCB and ensuresthat their respective tasks are carried out eitherthrough its own activities or via the NCBs.

Each NCB has legal personality according tothe national law of its respective country. The

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euro area NCBs, which form an integral part ofthe Eurosystem, carry out the tasks conferredupon the Eurosystem in accordance with therules established by the ECB’s decision-making bodies. The NCBs also contribute tothe work of the Eurosystem and the ESCBthrough their participation in the variousEurosystem/ESCB committees (see Section 1.5of this chapter). They may perform non-Eurosystem functions on their ownresponsibility, unless the Governing Councilfinds that such functions interfere with theobjectives and tasks of the Eurosystem.

The Eurosystem and the ESCB are governed bythe decision-making bodies of the ECB: theGoverning Council and the Executive Board.Decision-making within the Eurosystem andthe ESCB is centralised. However, the ECBand the euro area NCBs jointly contribute,strategically and operationally, to attaining thecommon goals, with due respect to the

principle of decentralisation in accordancewith the Statute of the ESCB. The GeneralCouncil is constituted as a third decision-making body of the ECB, for as long as thereare Member States which have not yet adoptedthe euro. The functioning of the decision-making bodies is governed by the Treaty, theStatute of the ESCB and the relevant Rules ofProcedure1. In 2004, with a view to adaptingthese rules to developments since 1999 and toanticipate the changes resulting from ESCBenlargement, both the Rules of Procedure of theECB and the Rules of Procedure of the GeneralCouncil of the ECB were reviewed.

Box 15

THE EUROSYSTEM MISSION STATEMENT

In January 2005 the Eurosystem mission statement was published. Its adoption by theGoverning Council, which followed the adoption by the Executive Board of the missionstatement of the ECB in August 2003, builds on the experience since 1999 with a commoncentral banking system for the euro area and the specific expertise and indispensablecontributions of all the central banks of the Eurosystem. The mission statement reads asfollows:

“The Eurosystem, which comprises the European Central Bank and the national central banksof the Member States whose currency is the euro, is the monetary authority of the euro area. Wein the Eurosystem have as our primary objective the maintenance of price stability for thecommon good. Acting also as a leading financial authority, we aim to safeguard financialstability and promote European financial integration.

In pursuing our objectives, we attach utmost importance to credibility, trust, transparency andaccountability. We aim for effective communication with the citizens of Europe and the media.We are committed to conducting our relations with European and national authorities in fullaccordance with the Treaty provisions and with due regard to the principle of independence.

We jointly contribute, strategically and operationally, to attaining our common goals, withdue respect to the principle of decentralisation. We are committed to good governance and to

1 For the ECB’s Rules of Procedure, see Decision ECB/2004/2 of19 February 2004 adopting the Rules of Procedure of theEuropean Central Bank, OJ L 80, 18.3.2004, p. 33; DecisionECB/2004/12 of 17 June 2004 adopting the Rules of Procedureof the General Council of the ECB, OJ L 230, 30.6.2004, p. 61;and Decision ECB/1999/7 of 12 October 1999 concerning theRules of Procedure of the Executive Board of the ECB, OJ L 314,8.12.1999, p. 34. These rules are also available on the ECB’swebsite.


performing our tasks effectively and efficiently, in a spirit of cooperation and teamwork.Drawing on the breadth and depth of our experiences as well as on the exchange of know-how,we aim to strengthen our shared identity, speak with a single voice and exploit synergies,within a framework of clearly defined roles and responsibilities for all members of theEurosystem.”

This mission statement sets out what the Eurosystem central banks aim to achieve together andthe way they interact and cooperate on the basis of shared values. It is based on an agreed set oforganisational principles and a number of strategic intents (more information can be found onthe ECB’s website). It also seeks to provide clear guidance to all members of staff and informthe public on how the Eurosystem performs the tasks and achieves the objectives that theTreaty and the Statute of the ESCB entrust to it.

1.2 THE GOVERNING COUNCIL

The Governing Council comprises all themembers of the Executive Board and thegovernors of the NCBs of the Member Stateswhich have adopted the euro. According to theTreaty, its main responsibilities are:

– to adopt the guidelines and take thedecisions necessary to ensure theperformance of the tasks entrusted to theEurosystem;

– to formulate the monetary policy of the euroarea, including, as appropriate, decisionsrelating to intermediate monetaryobjectives, key interest rates and the supplyof reserves in the Eurosystem, and toestablish the necessary guidelines for theirimplementation.

The Governing Council meets, as a rule, twice amonth at the ECB’s premises in Frankfurt amMain, Germany. It conducts, inter alia, an in-depth assessment of monetary and economicdevelopments and takes related decisionsspecifically at its first meeting of the month,while the second meeting usually focuses onissues related to other tasks andresponsibilities of the ECB and theEurosystem. In 2004 two meetings were heldoutside Frankfurt: one was hosted by SuomenPankki – Finlands Bank in Helsinki and the

other by the Nationale Bank van België/Banque Nationale de Belgique in Brussels.

When taking decisions on monetary policy andon other tasks of the ECB and the Eurosystem,the members of the Governing Council do notact as national representatives, but in a fullyindependent personal capacity. This isreflected by the principle of “one member, onevote” applied within the Governing Council.

Pursuant to the “enabling clause” contained inthe Treaty of Nice, the EU Council, meeting inthe composition of Heads of State orGovernment, on the basis of an ECBrecommendation, unanimously adopted aDecision to amend Article 10.2 of the Statute ofthe ESCB (voting modalities in the GoverningCouncil) on 21 March 2003. After beingratified by all Member States, this Decisionentered into force on 1 June 2004. Inaccordance with this Decision, all members ofthe Governing Council will continue to attendmeetings and participate in the deliberations.However, the number of NCB governorsholding a voting right at any one time will notexceed 15. When the number of NCB governorsin the Governing Council exceeds 15, they willexercise a voting right on the basis of a rotationsystem. The 15 voting rights will rotate amongthe governors according to pre-establishedrules. The six members of the Executive Boardwill each maintain a permanent voting right.

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THE GOVERNING COUNCIL

Jean-Claude TrichetPresident of the ECBLucas D. PapademosVice-President of the ECBJaime CaruanaGovernor of the Banco de EspañaVítor ConstâncioGovernor of the Banco de PortugalEugenio Domingo Solans (until 31 May 2004)Member of the Executive Board of the ECBAntonio FazioGovernor of the Banca d’ItaliaNicholas C. GarganasGovernor of the Bank of GreeceJosé Manuel González-Páramo(from 1 June 2004)Member of the Executive Board of the ECBJohn HurleyGovernor of the Central Bank and FinancialServices Authority of IrelandOtmar IssingMember of the Executive Board of the ECBKlaus LiebscherGovernor of the OesterreichischeNationalbankErkki Liikanen (from 12 July 2004)Governor of Suomen Pankki – Finlands BankMatti Louekoski(from 1 April to 11 July 2004)Acting Governor of Suomen Pankki –Finlands BankYves MerschGovernor of the Banque centrale duLuxembourgChristian NoyerGovernor of the Banque de France

Tommaso Padoa-SchioppaMember of the Executive Board of the ECBGuy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueJürgen Stark (from 7 to 29 April 2004)Acting President of the Deutsche BundesbankGertrude Tumpel-GugerellMember of the Executive Board of the ECBMatti Vanhala (until 31 March 2004)Governor of Suomen Pankki – Finlands BankAxel A. Weber (from 30 April 2004)President of the Deutsche BundesbankNout WellinkPresident of De Nederlandsche BankErnst Welteke (until 6 April 2004)President of the Deutsche Bundesbank

On 29 September 2004 Matti Vanhala, memberof the Governing Council (1998-2004), passedaway. On 9 November 2004 Eugenio DomingoSolans, member of the Executive Board and theGoverning Council (1998-2004), passed away.

Back row (left to right):Klaus Liebscher, Nout Wellink,Erkki Liikanen,Tommaso Padoa-Schioppa,Antonio Fazio, Jaime Caruana

Middle row (left to right):Axel A. Weber, Nicholas C.Garganas, Christian Noyer,Vítor Constâncio, José ManuelGonzález-Páramo, Guy Quaden

Front row (left to right):Gertrude Tumpel-Gugerell,Lucas D. Papademos,Jean-Claude Trichet, Yves Mersch,Otmar Issing, John Hurley


1.3 THE EXECUTIVE BOARD

Back row (left to right):José Manuel González-Páramo,

Tommaso Padoa-Schioppa,Otmar Issing

Front row (left to right):Gertrude Tumpel-Gugerell,

Jean-Claude Trichet,Lucas D. Papademos

Jean-Claude TrichetPresident of the ECB

Lucas D. Papademos

Vice-President of the ECB

Eugenio Domingo Solans (until 31 May 2004)

Member of the Executive Board of the ECB

José Manuel González-Páramo(from 1 June 2004)


The Executive Board comprises the Presidentand Vice-President of the ECB and four othermembers appointed by common accord by theHeads of State or Government of the MemberStates which have adopted the euro. The mainresponsibilities of the Executive Board, whichas a rule meets once a week, are:

– to prepare the meetings of the GoverningCouncil;

– to implement the monetary policy of the euroarea in accordance with the guidelines and

decisions laid down by the GoverningCouncil and, in doing so, to give thenecessary instructions to the euro areaNCBs;

– to manage the current business of the ECB;– to exercise certain powers delegated to it by

the Governing Council, including some of aregulatory nature.

The Management Committee, which is chairedby a member of the Executive Board, advisesand assists the Executive Board with regard tothe ECB’s management, business planning andannual budget process.

Otmar IssingMember of the Executive Board of the ECB

Tommaso Padoa-Schioppa


Gertrude Tumpel-GugerellMember of the Executive Board of the ECB

DirectorateInternal Audit

Klaus Gressenbauer

DirectoratePlanning and Controlling

Koenraad de Geest

Directorate GeneralEconomics

Wolfgang SchillDeputy: Philippe Moutot

DirectorateCommunications

Elisabeth Ardaillon-Poirier

Directorate GeneralInternational and

European Relations Pierre van der Haegen

Deputy: Georges Pineau

Directorate GeneralPayment Systems and Market Infrastructure

Jean-Michel GodeffroyDeputy: N.N.

Directorate GeneralResearch

Lucrezia ReichlinDeputy: Ignazio Angeloni

Directorate GeneralStatistics

Steven KeuningDeputy: Werner Bier

Directorate GeneralAdministrationGerald Grisse

DirectorateBanknotes

Antti Heinonen

Directorate GeneralSecretariat and

Language Services Frank Moss

Deputy: Julio Durán

Directorate GeneralMarket Operations Francesco Papadia

Deputies: Paul Mercier,Werner Studener

Directorate GeneralLegal Services

Antonio Sáinz de VicuñaDirectorate

Financial Stabilityand Supervision

Mauro Grande

Counselto the Executive Board

Gilles Noblet

ECB Permanent Representation in Washington, D.C.

Johannes Onno de Beaufort Wijnholds

Directorate GeneralInformation Systems

Jim EtheringtonDeputy: Hans-Gert Penzel

1 Includes the data protection function.2 Reports directly to the Executive Board on specific issues.

Divisions: � Juristes-Linguistes � Linguistic Services � Secretariat � Translation

Divisions: � Euro Area Accounts and Economic Statistics � External Statistics � Monetary, Financial Institutions and Markets Statistics � Statistical Information Management and User Services � Statistics Development and Coordination

Divisions: � Banknote Issue � Banknote Printing

Divisions: � Official Publications and Library � Press and Information � Protocol and Conferences

Divisions: � Econometric Modelling � Monetary Policy Research � Financial Research

Divisions: � Budget and Projects � Organisational Planning 1

Divisions: � Payment Systems Policy � Securities Settlement Systems Policy � TARGET

Divisions: � Financial Law � Institutional Law

Divisions: � EU Institutions and Fora � EU Neighbouring Regions � Multilateral, Asia/Pacific and Western Hemisphere

Divisions: � Back Office � Front Office � Investment � Market Operations Analysis � Market Operations Systems � Risk Management 2

Divisions: � ECB Audit � ESCB Audit

Divisions: � Financial Stability � Financial Supervision

Divisions: � Office Services � Premises � Security Directorate Internal Finance: Ian IngramDivisions: � Accounting � Financial Reporting and PolicyDirectorate Human Resources: Berend van BaakDivisions: � Compensation and Staff Relations � Recruitment and Staff Development

Directorate IT Projects: Magí ClavéDivisions: � IT Management Functions � IT Operations and Support

Division: � Fiscal Policies Directorate Economic DevelopmentsHans-Joachim KlöckersDivisions: � Euro Area Macroeconomic Developments � EU Countries � External Developments

Directorate Monetary PolicyPhilippe MoutotDivisions: � Capital Markets and Financial Structure � Monetary Policy Stance � Monetary Policy Strategy

Executive BoardBack row (left to right): José Manuel González-Páramo, Tommaso Padoa-Schioppa, Otmar Issing

Front row (left to right): Gertrude Tumpel-Gugerell, Jean-Claude Trichet (President), Lucas D. Papademos (Vice-President)

Executive Board


1.4 THE GENERAL COUNCIL

The General Council is composed of thePresident and the Vice-President of the ECBand the governors of the NCBs of all EUMember States. It carries out those tasks takenover from the EMI which still have to beperformed by the ECB on account of the factthat not all the Member States have adopted the

euro. In 2004 the General Council met fivetimes. On 17 June 2004 the governors of thecentral banks of the new Member States, whohad been attending, as from the date of thesigning of the Accession Treaty, the meetingsof the General Council in an observer capacity,participated for the first time as members in ameeting of the General Council.

Jean-Claude Trichet President of the ECBLucas D. Papademos Vice-President of the ECBBodil Nyboe AndersenGovernor of Danmarks NationalbankLeszek BalcerowiczPresident of Narodowy Bank PolskiMichael C. BonelloGovernor of the Central Bank of MaltaJaime CaruanaGovernor of the Banco de EspañaChristodoulos ChristodoulouGovernor of the Central Bank of CyprusVítor ConstâncioGovernor of the Banco de PortugalAntonio Fazio Governor of the Banca d’ItaliaNicholas C. GarganasGovernor of the Bank of GreeceMitja Gaspari Governor of Banka SlovenijeLars HeikenstenGovernor of Sveriges RiksbankJohn HurleyGovernor of the Central Bank and FinancialServices Authority of IrelandZsigmond JáraiPresident of Magyar Nemzeti BankMarián Jusko (until 31 December 2004)Governor of Národná banka SlovenskaMervyn King Governor of the Bank of EnglandVahur Kraft Governor of Eesti Pank

Klaus LiebscherGovernor of the Oesterreichische NationalbankErkki Liikanen (from 12 July 2004)Governor of Suomen Pankki – Finlands BankMatti Louekoski(from 1 April to 11 July 2004)Acting Governor of Suomen Pankki – Finlands BankYves MerschGovernor of the Banque centrale du LuxembourgChristian NoyerGovernor of the Banque de FranceGuy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueIlmārs Rimšēvičs Governor of Latvijas BankaReinoldijus ŠarkinasChairman of the Board of Lietuvos bankasIvan Šramko (from 1 January 2005)Governor of Národná banka SlovenskaJürgen Stark (from 7 to 29 April 2004)Acting President of the Deutsche BundesbankZdeněk TůmaGovernor of Česká národní bankaMatti Vanhala (until 31 March 2004)Governor of Suomen Pankki – Finlands BankAxel A. Weber (from 30 April 2004)President of the Deutsche BundesbankNout Wellink President of De Nederlandsche BankErnst Welteke (until 6 April 2004)President of the Deutsche Bundesbank

Back row (left to right):Vahur Kraft, Lars Heikensten,

Reinoldijus Šarkinas,Guy Quaden, Zdeněk Tůma,

Nicholas C. Garganas,Nout Wellink

Middle row (left to right):Christian Noyer, Axel A. Weber,

Vítor Constâncio, Ilmārs Rimšēvičs,Leszek Balcerowicz, Bodil Nyboe

Andersen, Klaus Liebscher,Mitja Gaspari, Jaime Caruana,

Antonio Fazio

Front row (left to right):Erkki Liikanen, Zsigmond Járai,

Christodoulos Christodoulou,Michael C. Bonello,

Lucas D. Papademos,Jean-Claude Trichet, Yves Mersch,

Marián Jusko, John Hurley

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1.5 EUROSYSTEM/ESCB COMMITTEES AND THE BUDGET COMMITTEE

Accounting and Monetary Income Committee (AMICO)Ian Ingram

EUROSYSTEM / ESCB COMMITTEES , BUDGET COMMITTEE AND THE IR CHA IRPERSONS

Banking Supervision Committee (BSC)Edgar Meister

Banknote Committee (BANCO)Antti Heinonen

External Communications Committee (ECCO)Elisabeth Ardaillon-Poirier

Information Technology Committee (ITC)Jim Etherington

Internal Auditors Committee (IAC)Klaus Gressenbauer

International Relations Committee (IRC)Hervé Hannoun

Legal Committee (LEGCO)Antonio Sáinz de Vicuña

Market Operations Committee (MOC)Francesco Papadia

Monetary Policy Committee (MPC)Wolfgang Schill

Payment and Settlement Systems Committee (PSSC)Jean-Michel Godeffroy

Statistics Committee (STC)Steven Keuning

Budget Committee (BUCOM)Liam Barron

The Eurosystem/ESCB committees havecontinued to play an important role in assistingthe ECB’s decision-making bodies in theperformance of their tasks. At the request ofboth the Governing Council and the ExecutiveBoard, the committees have provided expertisein their fields of competence and havefacilitated the decision-making process.Membership of the committees is usuallyrestricted to staff of the Eurosystem centralbanks. However, the NCBs of the MemberStates which have not yet adopted the euro takepart in the meetings of a committee whenever itdeals with matters that fall within the field ofcompetence of the General Council. Whereappropriate, other competent bodies, such asnational supervisory authorities in the case ofthe Banking Supervision Committee, may alsobe invited. At present there are 12 Eurosystem/ESCB committees, all of which wereestablished under Article 9 of the Rules ofProcedure of the ECB.

The Budget Committee, which was establishedunder Article 15 of the Rules of Procedure ofthe ECB, assists the Governing Council inmatters related to the ECB’s budget.

1.6 CORPORATE GOVERNANCE

In addition to the decision-making bodies, thecorporate governance of the ECB encompassesa number of external and internal controllayers, as well as rules concerning publicaccess to ECB documents.

EXTERNAL CONTROL LAYERSThe Statute of the ESCB provides for twolayers, namely the external auditor2, which isappointed to audit the annual accounts of the

2 Following a tender procedure in 2002, KPMG DeutscheTreuhand-Gesellschaft AG Wirtschaftsprüfungsgesellschaftwas appointed as the ECB’s external auditor with a f ive-yearmandate covering financial years 2003 to 2007.


ECB (Article 27.1 of the Statute of the ESCB),and the European Court of Auditors, whichexamines the operational efficiency of themanagement of the ECB (Article 27.2). Theannual report of the European Court ofAuditors, together with the ECB’s reply, ispublished in the Official Journal of theEuropean Union and on the ECB’s website.

In August 2002 the Governing Council decidedthat, in order to give the fullest publicassurance as to the independence of the ECB’sexternal auditor, the principle of audit firmrotation should be applied. This decision wasimplemented as part of the procedure for theappointment of the ECB’s external auditor.

INTERNAL CONTROL LAYERSIn 2004 the ECB’s internal auditors continuedto perform audit missions under theresponsibility of the Executive Board. Theirmandate is defined in the ECB Audit Charter.3

The internal auditors assess and evaluate, on anad hoc basis, the adequacy and effectiveness ofthe ECB’s system of internal control and thequality of the ECB’s performance in carryingout assigned responsibilities. They adhere tothe International Standards for the ProfessionalPractice of Internal Auditing established by theInstitute of Internal Auditors.

A Eurosystem/ESCB committee, the InternalAuditors Committee, which is composed of theheads of internal audit at the ECB and theNCBs, is responsible for the coordination ofaudit coverage for Eurosystem/ESCB jointprojects and operational systems.

The internal control structure of the ECB isbased on a functional approach. Eachorganisational unit (section, division,directorate or directorate general) isresponsible for its own internal control andefficiency. In this respect, organisational unitsimplement operational control procedureswithin their area of responsibility. Forexample, a set of rules and procedures – knownas a Chinese wall – are in place to preventinside information, for instance originating in

the areas responsible for monetary policy, fromreaching the areas responsible for themanagement of the ECB’s foreign reserves andown funds portfolio. In addition to the controlsimplemented by each organisational unit, theDirectorate Planning and Controlling, the RiskManagement Division and the DirectorateInternal Audit make proposals on controlissues affecting the ECB as a whole.

The members of the Governing Council adhereto a Code of Conduct, which reflects theirresponsibility to safeguard the integrity andreputation of the Eurosystem and to maintainthe effectiveness of its operations.4 TheGoverning Council has also appointed anadviser to provide guidance to its members onsome aspects of professional conduct. Inaddition, the Code of Conduct of the ECB givesguidance to, and sets benchmarks for, the staffof the ECB and the members of the ExecutiveBoard, all of whom are expected to maintainhigh standards of professional ethics in theperformance of their duties.5

In accordance with the rules against insidertrading, the ECB’s staff and the members of theExecutive Board are prohibited from takingadvantage of inside information whenconducting private financial activities at theirown risk and for their own account, or at therisk and for the account of a third party.6 AnEthics Adviser appointed by the ExecutiveBoard ensures a consistent interpretation ofthese rules.

3 This Charter is published on the ECB’s website to foster thetransparency of audit arrangements in place at the ECB.

4 See the Code of Conduct for the members of the GoverningCouncil, OJ C 123, 24.5.2002, p. 9 and the ECB’s website.

5 See the Code of Conduct of the European Central Bank inaccordance with Article 11.3 of the Rules of Procedure of theEuropean Central Bank, OJ C 76, 8.3.2001, p. 12 and the ECB’swebsite.

6 See Part 1.2 of the ECB Staff Rules containing the rules onprofessional conduct and professional secrecy, OJ C 92,16.4.2004, p. 31 and the ECB’s website.

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7 Regulation (EC) No 1073/1999 of the European Parliament andof the Council of 25 May 1999 concerning investigationsconducted by the European Anti-Fraud Off ice (OLAF), OJ L136, 31.5.1999, p. 1.

8 Decision ECB/2004/11 concerning the terms and conditions forEuropean Anti-Fraud Off ice investigations of the EuropeanCentral Bank, in relation to the prevention of fraud, corruptionand any other illegal activities detrimental to the EuropeanCommunities’ f inancial interests and amending the Conditionsof Employment for Staff of the European Central Bank, OJ L230, 30.6.2004, p. 56. This Decision was adopted in response tothe judgement of the European Court of Justice on 10 July 2003in Case C-11/00 Commission v. ECB.

9 OJ L 80, 18.3.2004, p. 42.

ANTI-FRAUD MEASURESIn 1999 the European Parliament and the EUCouncil adopted a regulation7 on investigationscarried out by the European Anti-Fraud Office(OLAF), in order to step up the fight againstfraud, corruption and any other illegal activitydetrimental to the Communities’ financialinterests. This “OLAF Regulation” providesinter alia for the internal investigation ofsuspected fraud by OLAF within theCommunity institutions, bodies, offices andagencies.

The OLAF Regulation foresees that each of thelatter adopt decisions in order for OLAF to beable to carry out its investigations within eachof them. In June 2004 the Governing Counciladopted a decision8 concerning the terms andconditions for investigations by OLAF of theECB, which entered into force on 1 July 2004.The ECB and OLAF have established contactwith a view to ensuring the proper functioningof this framework for OLAF investigations.

PUBLIC ACCESS TO ECB DOCUMENTSIn March 2004 the Governing Council adoptedDecision ECB/2004/3 on public access to ECBdocuments9. This Decision aims to ensure thatthe ECB’s legal framework is in line with theobjectives and standards applied by otherCommunity institutions and bodies with regardto public access to their documents. It enhancestransparency, while at the same time takinginto account the independence of the ECB andof the NCBs and ensuring the confidentiality ofcertain matters specific to the performance ofthe ECB’s tasks.


2 ORGAN I S AT I ONA L D E V E LOPMENT S2.1 HUMAN RESOURCES

STAFFINGThe total number of budgeted staff positionsfor 2004 was 1,362.5 full-time equivalent(FTE) positions. At the end of 2004 the numberof staff employed by the ECB on permanent orfixed-term contracts of at least 12 months was1,314 (which corresponds to 1,309.0 FTEpositions). This compares with 1,213.5 FTEpositions at the end of 2003. The averagenumber of staff employed by the ECB in 2004was 1,261, compared with 1,160 in 2003. Of thetotal of 1,309, 71 are staff members from theten new EU Member States currently employedon contracts of more than a year. In 2004 137new staff were recruited and 41 members ofstaff left the service of the ECB. The number ofFTE positions for 2005 has been set at 1,369.5,representing a 0.5% increase over 2004.

In addition 128 experts from NCBs came to theECB for short periods of approximately fivemonths on average. Of these experts, 63 camefrom the new EU Member States. These short-term assignments proved particularly useful forboth the ECB and the NCBs of the new MemberStates in preparing for EU enlargement and insupporting the integration of these NCBs intothe ESCB.

In 2004 the ECB offered 123 short-termcontracts of less than a year to replace staffon maternity, parental and unpaid leave,compared with 113 in 2003.

The ECB provided traineeships to 172 studentsand graduates, mainly with an economicsbackground, for an average duration ofapproximately three months. 166 suchtraineeships were offered in 2003. In 2004 54 ofthe trainees were nationals of one of the newMember States, and a further six were fromRomania or Bulgaria. Of the 172 traineeships,11 (12 in 2003) were offered in the frameworkof the Graduate Research Programme, which isaimed at highly talented research students at anadvanced stage of their doctoral studies.

Under the Research Visitors Programme,which focuses on specific high-level researchprojects in the field of monetary policy, 18research visitors were welcomed in 2004,compared with 24 in 2003.

INTERNAL MOBILITYIn 2004 95 staff members took up new positionsafter successfully applying for internalvacancies. In addition, the ECB encouragedtemporary internal mobility. 51 staff memberstook on another job for a limited period in orderto gain work experience or to address an urgentbut temporary business need, subsequentlyreturning to their previous position.

EXTERNAL MOBILITYUnder the External Work Experience Scheme,set up in 2003 to support staff development,staff may be seconded to NCBs and otherrelevant international and Europeaninstitutions. Seven staff members participatedin this scheme during 2004 for a period of fourto ten months. In addition, the ECB acceptsapplications for unpaid leave for up to threeyears for staff who want to take up employmentat other related financial organisations. In 200412 staff members took advantage of this option.The Eurosystem’s organisational principlesapproved by the Governing Council andpublished in January 2005 state that “theexchange of personnel, know-how andexperience shall be promoted by and among allmembers of the Eurosystem”.

ECB IN MOTIONIn October 2003 the Executive Board set up aprogramme office to monitor and assess theimplementation of measures which it hadendorsed in the context of an organisationalchange programme called ECB in Motion.This initiative aimed to improve the efficiencyand effectiveness of the organisation andcovers management, professional development,internal communication and bureaucracyissues. In 2004 significant progress was madein all four areas and the programme officesubmitted its final report. Given that the impactof some measures will only be felt in the

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medium term, progress will continue to bemonitored.

REVIEW OF THE HUMAN RESOURCES STRATEGYSince 1998 the ECB’s priorities have been theestablishment of its functions, the formulationand implementation of the single monetarypolicy and the introduction of the euro. Thishas inevitably involved a focus of humanresources policy on technical expertise forspecific jobs. In the light of this, an in-depthreview of the human resources strategy wasundertaken and the conclusions were presentedin 2004.

The main conclusion was that recruitmentpolicies should emphasise broadercompetencies. Moreover, staff developmentand mobility measures should be strengthenedin order to increase synergies and broadenexpertise within the ECB. Human resourcesmanagement has been made more flexible byfocusing external recruitment on career starterswith a more general background andintroducing fixed-term contracts for all newstaff and new managerial appointments. Thesemeasures will be complemented by theestablishment of an ECB Graduates’Programme in 2005 aimed at recent graduateswith a broad educational background. A new,junior management layer has been created inorder to establish a reasonable span of controlafter a period of rapid staff growth. Leadershipskills will be developed by increasing trainingand coaching for managers. Based on theECB’s mission statement, six common valueshave been identified and statements explainingtheir meaning at the ECB have been developed.These values are: competence, effectivenessand efficiency, integrity, team spirit,transparency and accountability, and workingfor Europe. The values will play an integralrole in human resources policies, together withan ECB-wide competency model andcompetency profiles that are being developed.

DIVERSITY MANAGEMENTDiversity management seeks to harnessdifferences among staff in order to createa productive and respectful workingenvironment in which talents are fully utilisedand organisational goals are met. Diversitymanagement is important for the ECB as itemploys staff from all EU Member States,works closely with the 25 NCBs of the EU andserves the European public. The ECB is thusintegrating diversity management into itsday-to-day business so that the individualcompetencies of staff are recognised and feedinto the high performance necessary for theECB to fulfil its tasks.

2.2 NEW ECB PREMISES

Decisive progress was made in 2004 in theplanning of the new ECB premises. In Februaryan international jury, chaired by the ECB’sVice-President, revealed the three winningdesign proposals in the architectural designcompetition. The first prize was awarded toCOOP HIMMELB(L)AU from Vienna, thesecond prize to ASP Schweger Assoziiertefrom Berlin and the third prize to 54farchitekten + ingenieure from Darmstadt incooperation with T. R. Hamzah & Yeang fromSelangor in Malaysia. Of the 12 candidatesshortlisted in 2003, these architects best metthe criteria set for the competition, namely:

– overall town-planning, architecture andlandscape;

– compliance with the main features of thefunctional and spatial programme;

– feasible energy/environmental concept andcompliance with the main features of theECB’s technical requirements; and


– compliance with the relevant regulations, inparticular in the field of building law andenvironmental law.

The new ECB premises will be built on the siteof the Grossmarkthalle, a listed building whichformerly housed Frankfurt’s wholesale fruitand vegetable market. One of the mainchallenges for the architects was to incorporatethe large, red-brick building into a modernoffice structure without changing itsfundamental appearance.

The announcement of the prize-winners wasfollowed by an exhibition at the DeutschesArchitektur Museum in Frankfurt in which thedesign proposals of all 71 architects whosubmitted designs for the competition wereshown to the public.

In March 2004 the Governing Council decidedto invite the three prize-winning architects toparticipate in a revision phase, the mainpurpose of which was to review the designproposals and take account of therecommendations and requirements of the jury,the ECB and the City of Frankfurt.

Following the wholesalers’ move to their newheadquarters, the city authorities began to clearthe site in and around the Grossmarkthalle,which was purchased by the ECB from the Cityof Frankfurt in 2002, in preparation for thehandover to the ECB. The handover took placein December 2004. In line with the preservationorders, great care was taken to ensure that thecentral building and the east and west wingswere left untouched. Those parts of the site thatwould be appropriate for a memorial andinformation space commemorating thedeportation of Jewish citizens from theGrossmarkthalle were also retained. The ECB,the Frankfurt Jewish Community and the Cityof Frankfurt agreed to cooperate closely inconducting a competition for the design of amemorial. It is planned that the competitionwill be launched by the end of 2005.

The Governing Council reached a decisionon the design of the ECB’s future home on13 January 2005. After extensive discussionsand careful evaluation, based on the selectioncriteria, of the strengths and weaknesses of allthree prize-winning designs, the GoverningCouncil concluded that the revised designconcept of COOP HIMMELB(L)AU best metthe functional and technical requirementsspecified by the ECB, and had features thatreflected the ECB’s values and translated theminto architectural language. This decisionconfirmed the judgement of the internationaljury, who had awarded the first prize to thisproject. The next step will be an “optimisation”phase in which the design will again bereviewed, in particular to ensure the optimaluse of resources and to minimise costs. Moredetails on the competition and the winningdesign can be found on the ECB’s website.

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The ESCB Social Dialogue is a consultativeforum involving the ECB and employeerepresentatives from all the central banks of theESCB and European trade union federations.Its purpose is to provide information and todiscuss decisions of the General Council andthe Governing Council in so far as they mayhave a major impact on the employmentsituation at the central banks of the ESCB.

The ninth meeting of the ESCB SocialDialogue welcomed employee representativesfrom the NCBs of seven of the new EU MemberStates. The participants confirmed theircommitment to the process of integrationwithin the ESCB in general, and their owninvolvement in the ESCB Social Dialogue inparticular. The ECB encouraged the NCBs ofall the new Member States to facilitate theparticipation of employee representatives inthe ESCB Social Dialogue.

The main items on the agenda for both the ninthand tenth meetings of the ESCB SocialDialogue were TARGET2, the production ofbanknotes and the follow-up to the EuropeanCommission’s Financial Services Action Plan.There were also discussions on more generaltopics, such as ways to develop a sharedidentity and to foster cooperation on the basisof common principles. The ECB emphasisedthat the ESCB is committed to providingcentral bank services of a high quality at thelowest possible cost, which requires efficiencyand effectiveness. The participants wereinformed that the Governing Council hadadopted a mission statement, strategicintents and organisational principles for theEurosystem. The employee representativesunderscored the importance of theirinvolvement in developing these issues and ofrespecting differences in culture among thecentral banks. Finally, at the tenth meeting ofthe ESCB Social Dialogue, the ECB and thestaff representatives reaffirmed the value ofthis unique consultative forum.

3 ESCB SOCIAL DIALOGUE

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4 ANNUA L A C COUNT S O F TH E E C B


1 PRINCIPAL ACTIVITIES

The Bank’s activities in 2004 are described indetail in the relevant chapters of the AnnualReport.

2 FINANCIAL ACCOUNTS

Under Article 26.2 of the ESCB Statute, theAnnual Accounts of the ECB are drawn up bythe Executive Board, in accordance with theprinciples established by the GoverningCouncil. The Accounts are subsequentlyapproved by the Governing Council andpublished thereafter.

3 FINANCIAL RESULTS

The ECB’s Annual Accounts for the yearending 31 December 2004, as set out on pages180 to 197, show a net loss of €1,636 million,following a net loss of €477 million in 2003. Aswas the case last year, the loss was mainly dueto the continued strengthening of the externalvalue of the euro, which resulted in write-downs in the euro value of the ECB’s holdingsof US dollar-denominated assets. The net lossis stated after taking into account all incomeearned by the ECB, including €733 million ofincome earned on its banknotes in circulation.The ECB’s interest income continued to beaffected in 2004 by historically low levels ofdomestic and foreign interest rates.

Since most of the ECB’s assets and liabilitiesare periodically revalued at current marketexchange rates and security prices, the ECB’sprofitability is very dependent on exchangerate movements and, to a lesser extent, interestrate exposures. These exposures stem mainlyfrom its large official holdings of theEurosystem’s foreign reserve assets, which areinvested in interest-bearing instruments.

The harmonised accounting policies for theECB and the Eurosystem, which are describedin the notes to the Annual Accounts, have been

MANAGEMENT R E PORT F OR TH E Y E A REND I NG 3 1 D E C EMBER 2 0 0 4

developed to take these substantial risks intoaccount and are based primarily on theprinciple of prudence. In particular, they aim toensure that unrealised gains arising from therevaluation of assets and liabilities are notrecognised as income and are therefore notdistributable as profit. Conversely, unrealisedlosses resulting from revaluations are expensedin the profit and loss account at the end of theyear.

The bulk of the ECB’s foreign reserve assets isheld in US dollars, but they also includeholdings of Japanese yen, gold and SDRs. Theeuro appreciated against the US dollar,from USD 1.2630 on 31 December 2003 toUSD 1.3621 on 31 December 2004 (some 8%)and to a lesser extent against the Japanese yen.Consequently, the revaluation of the netholdings of these currencies resulted in adecline of €2.1 billion in their euro value.

At the end of 2004, the ECB employed 1,309staff (including 131 at managerial levels)compared with 1,213 one year earlier. Theincrease in 2004 was primarily due to theconsequences of EU enlargement. For furtherdetails, please refer to Chapter 8 of theAnnual Report, Section 2 “OrganisationalDevelopments” and the Annual Accounts –“Notes on the Profit and Loss Account”.

Total administrative expenses of the ECB,including depreciation, rose by 18% from€316 million in 2003 to €374 million in 2004.The main single factor in this increase was therise in the ECB’s pension fund obligations, ascalculated by the actuary, which contributedsubstantially to an increase in staff costsfrom €130 million to €161 million. In 2004,the emoluments of the Executive Board ofthe ECB amounted in total to €2.1 million(2003: €2.0 million).

Some €90 million were invested in fixed assets.The principal item (some €61 million) was thecapitalisation of the cost of the site of theECB’s new premises, following the finalpayment.

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Funding of the ECB’s 2004 reported lossOn 11 March 2005, the Governing Councildecided to offset the loss for 2004 by (a) usingthe entire remaining general reserve fund ofsome €296 million, and (b) using the NCBs’monetary income of some €1,340 million, inaccordance with the provisions of Article 33.2of the ESCB Statute. The amount of the NCBs’monetary income used came to some 15% ofthe total monetary income of the Eurosystem.The way in which the loss was to be allocatedwas authorised, in principle, by the GoverningCouncil before the NCBs had closed theirAnnual Accounts for 2004, with the result thatit affected their profits for that year too. EachNCB contributed a share of its monetaryincome in accordance with its weighting in thecapital key of the ECB.

4 CHANGES IN THE ECB’S CAPITAL STRUCTUREIN 2004

Under Article 29.3 of the ESCB Statute, thecapital key for the NCBs’ subscriptions to theECB’s capital must be adjusted every fiveyears. The first such adjustment followingthe establishment of the ECB took place on1 January 2004. On 1 May 2004, a secondchange of the ECB’s capital key followed as aresult of the accession of ten new MemberStates. Taken together, these two steps had thefollowing effects:

(a) a reduction in the overall weighting of theeuro area NCBs in the ECB’s capital key;

(b) a concomitant reduction in the euro areaNCBs’ claims on the ECB that arose fromthe transfer of foreign reserve assets to theECB on entry into the euro area; and

(c) an increase in the paid-up capitalcontributions of the non-euro area NCBsfollowing the accession of ten new MemberStates, which also reflects an increase from5% to 7% in the minimal percentage ofsubscribed capital paid by the 13 non-euroarea NCBs.

Details of these changes are contained in note15 of the Annual Accounts.

5 INVESTMENT ACTIVITIES AND RISKMANAGEMENT

The ECB’s foreign reserve portfolio iscomposed of foreign reserve assets transferredto it by the Eurosystem NCBs in accordancewith the provisions of Article 30 of the ESCBStatute and income thereon. Its purpose is tofund the ECB’s operations in the foreignexchange market for the purposes set out in theTreaty.

The ECB’s own funds portfolio reflects theinvestment of its paid-up capital, the generalreserve fund and income accumulated on theportfolio in the past. Its purpose is to providethe ECB with a reserve to meet possible losses.

The ECB’s investment activities and itsmanagement of the associated risks aredescribed in greater detail in Chapter 2 of theAnnual Report.

6 GOVERNANCE OF THE ECB

Information relating to the governance of theECB is outlined in Chapter 8 of the AnnualReport.

7 EMPLOYEES

The ECB’s human resources strategy, togetherwith further information on the number of staffemployed, is described in Chapter 8 of theAnnual Report.


BA L ANC E S H E E T A S AT 3 1 D E C EMBER 2 0 0 4AS S E T S NO T E 2 0 0 4 2 0 0 3

NUMBER € €

Gold and gold receivables 1 7,928,308,842 8,145,320,117

Claims on non-euro area residentsdenominated in foreign currency 2

Receivables from the IMF 163,794,845 211,651,948Balances with banks and security investments,external loans and other external assets 26,938,993,980 28,593,384,857

27,102,788,825 28,805,036,805

Claims on euro area residentsdenominated in foreign currency 2 2,552,016,565 2,799,472,504

Claims on non-euro area residentsdenominated in euro 3

Balances with banks, securityinvestments and loans 87,660,507 474,743,402

Other claims on euro area creditinstitutions denominated in euro 4 25,000 25,000

Intra-Eurosystem claims 5Claims related to the allocation ofeuro banknotes within the Eurosystem 40,100,852,165 34,899,471,205Other claims within the Eurosystem (net) 3,410,918,324 4,599,894,403

43,511,770,489 39,499,365,608

Other assets 6Tangible fixed assets 187,318,304 128,911,950Other financial assets 6,428,319,567 5,573,756,258Accruals and prepaid expenses 770,894,480 590,646,023Sundry 6,933,022 37,791,421

7,393,465,373 6,331,105,652

Loss for the year 1,636,028,702 476,688,785

Total assets 90,212,064,303 86,531,757,873

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L I A B I L I T I E S NO T E 2 0 0 4 2 0 0 3NUMBER € €

Banknotes in circulation 7 40,100,852,165 34,899,471,205

Liabilities to other euro area residentsdenominated in euro 8 1,050,000,000 1,065,000,000

Liabilities to non-euro area residentsdenominated in euro 9 137,462,706 146,867,501

Liabilities to euro area residentsdenominated in foreign currency 10 4,967,080 0

Liabilities to non-euro area residentsdenominated in foreign currency 10

Deposits, balances and other liabilities 1,254,905,957 1,452,432,822

Intra-Eurosystem liabilities 11Liabilities equivalent to the transfer offoreign reserves 39,782,265,622 40,497,150,000

Other liabilities 12Accruals and income collected in advance 1,136,708,542 1,162,299,071Sundry 327,802,782 174,890,973

1,464,511,324 1,337,190,044

Provisions 13 110,636,285 87,195,777

Revaluation accounts 14 1,921,117,190 2,176,464,065

Capital and reserves 15Capital 4,089,277,550 4,097,229,250Reserves 296,068,424 772,757,209

4,385,345,974 4,869,986,459

Total liabilities 90,212,064,303 86,531,757,873


PRO F I T AND LO S S A C COUNT F OR TH E Y E A REND I NG 3 1 D E C EMBER 2 0 0 4

Frankfurt am Main, 4 March 2005

EUROPEAN CENTRAL BANK

Jean-Claude TrichetPresident

N O T E 20 0 4 2 0 0 3NUMBER € €

Interest income on foreign reserve assets 422,418,698 541,294,375Interest income arising from the allocationof euro banknotes within the Eurosystem 733,134,472 698,245,187Other interest income 1,456,650,188 1,449,963,923Interest income 2,612,203,358 2,689,503,485Remuneration of NCBs’ claims in respectof foreign reserves transferred (693,060,433) (807,683,148)Other interest expense (1,229,369,015) (1,166,693,660)Interest expense (1,922,429,448) (1,974,376,808)

Net interest income 18 689,773,910 715,126,677

Realised gains/losses arising fromfinancial operations 19 136,045,810 525,260,622Write-downs on financial assets and positions 20 (2,093,285,109) (3,972,689,560)Transfer to/from provisions for foreignexchange rate and price risks 0 2,568,708,838

Net result of financial operations, write-downsand risk provisions (1,957,239,299) (878,720,100)

Net expense from fees and commissions 21 (261,517) (63,466)

Other income 22 5,956,577 2,911,280

Total net income (1,261,770,329) (160,745,609)

Staff costs 23 & 24 (161,192,939) (129,886,988)

Administrative expenses 25 (176,287,651) (153,549,282)

Depreciation of tangible fixed assets (33,655,824) (30,410,140)

Banknote production services 26 (3,121,959) (2,096,766)

Loss for the year (1,636,028,702) (476,688,785)

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A C COUNT I NG PO L I C I E S 1

FORM AND PRESENTATION OF THE FINANCIALSTATEMENTSThe financial statements of the EuropeanCentral Bank (ECB) have been designed topresent fairly the financial position of the ECBand the results of its operations. They havebeen drawn up in accordance with thefollowing accounting policies2, which theGoverning Council of the ECB considers to beappropriate to the nature of central bankactivity.

ACCOUNTING PRINCIPLESThe following accounting principles have beenapplied: economic reality and transparency,prudence, recognition of post-balance-sheetevents, materiality, the accruals principle,going concern, consistency and comparability.

BASIS OF ACCOUNTINGThe accounts have been prepared on ahistorical cost basis, modified to includemarket valuation of marketable securities, goldand all other on-balance-sheet and off-balance-sheet assets and liabilities denominated inforeign currency. Transactions in financialassets and liabilities are reflected in theaccounts on the basis of the date on which theyare settled.

GOLD AND FOREIGN CURRENCY ASSETS ANDLIABILITIESAssets and liabilities denominated in foreigncurrency are converted into euro at the exchangerate prevailing on the balance sheet date. Incomeand expenses are converted at the exchange rateprevailing at the time of the transaction. Therevaluation of foreign exchange assets andliabilities is performed on a currency-by-currency basis, including on-balance-sheet andoff-balance-sheet instruments.

Revaluation to the market price for assets andliabilities denominated in foreign currency istreated separately from the exchange raterevaluation.

Gold is valued at the market price prevailing atthe year-end. No distinction is made between

1 The detailed accounting policies of the ECB are laid down in aDecision of the Governing Council of the ECB of 5 December2002 (ECB/2002/11), OJ L 58, 3.3.2003, pp. 38-59.

2 These policies are consistent with the provisions of Article 26.4of the Statute of the ESCB, which require a harmonised approachto the rules governing the accounting and financial reporting ofEurosystem operations.

the price and currency revaluation differencesfor gold. Instead, a single gold valuation isaccounted for on the basis of the price in europer fine ounce of gold, which is derived fromthe exchange rate of the euro against the USdollar on 31 December 2004.

SECURITIESAll marketable securities and similar assets arevalued at the mid-market prices prevailing atthe balance sheet date on a security-by-securitybasis. For the year ending 31 December 2004,mid-market prices on 30 December 2004 wereused. Non-marketable securities are valued atcost.

INCOME RECOGNITIONIncome and expenses are recognised in theperiod in which they are earned or incurred.Realised gains and losses arising from the saleof foreign exchange, gold and securities aretaken to the profit and loss account. Suchrealised gains and losses are calculated byreference to the average cost of the respectiveasset.

Unrealised gains are not recognised as income,but are transferred directly to a revaluationaccount.

Unrealised losses are taken to the profit andloss account if they exceed previousrevaluation gains registered in thecorresponding revaluation account. Unrealisedlosses in any one security, currency or in goldare not netted against unrealised gains in othersecurities, currencies or gold. In the event of anunrealised loss on any item at the year-end, theaverage cost of that item is reduced to the year-end exchange rate and/or market price.

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Premiums or discounts arising on purchasedsecurities are calculated and presented as partof interest income and are amortised over theremaining life of the assets.

REVERSE TRANSACTIONSUnder a repurchase agreement, securities aresold for cash with a simultaneous agreement torepurchase them at an agreed price on a setfuture date. These agreements to repurchase arereflected on the liability side of the balancesheet and also lead to an interest expense in theprofit and loss account. Securities sold undersuch an agreement remain on the balance sheetof the ECB.

Under a reverse repurchase agreement securitiesare bought for cash with a simultaneousagreement to sell them back to the counterpartyat an agreed price on a set future date. Theseagreements to sell are recorded on the asset sideof the balance sheet, but are not included in theECB’s security holding and give rise to interestincome in the profit and loss account.

Reverse transactions (including securitylending transactions) conducted under anautomated security lending programme arerecorded on the balance sheet only wherecollateral is provided to the ECB in the form ofcash over the maturity of the transaction. In2004 the ECB did not receive any collateral inthe form of cash over the maturity of suchtransactions.

OFF-BALANCE-SHEET INSTRUMENTSCurrency instruments, namely foreignexchange forward transactions, forward legs offoreign exchange swaps and other currencyinstruments involving an exchange of onecurrency for another at a future date, areincluded in the net foreign currency positionfor the purpose of calculating foreign exchangegains and losses. Interest rate instruments arerevalued on an item-by-item basis. Outstandinginterest rate futures positions are recorded inoff-balance-sheet accounts. Daily changes inthe variation margin are recorded in the profitand loss account.

POST-BALANCE-SHEET EVENTSAssets and liabilities are adjusted for eventsthat occur between the annual balance sheetdate and the date on which the GoverningCouncil of the ECB approves the financialstatements, if such events materially affect thecondition of assets and liabilities at the balancesheet date.

INTRA-ESCB BALANCES/INTRA-EUROSYSTEMBALANCESIntra-ESCB transactions are cross-bordertransactions that occur between two EU centralbanks. These transactions are processedprimarily via TARGET – the Trans-EuropeanAutomated Real-time Gross settlementExpress Transfer system (see Chapter 2) – andgive rise to bilateral balances in accounts heldbetween those EU central banks connected toTARGET. These bilateral balances are thenassigned to the ECB on a daily basis, leavingeach NCB with a single net bilateral positionvis-à-vis the ECB only. This position in thebooks of the ECB represents the net claim orliability of each NCB against the rest of theESCB.

Intra-ESCB balances of the euro area NCBswith the ECB (except for the capital of the ECBand positions resulting from the transfer offoreign reserve assets to the ECB) aredescribed as intra-Eurosystem claims orliabilities and are presented in the balancesheet of the ECB as a single net asset or liabilityposition.

Intra-Eurosystem balances arising from theallocation of euro banknotes within theEurosystem are included as a single net assetunder “Claims related to the allocation of eurobanknotes within the Eurosystem” (see“Banknotes in circulation” in the notes onaccounting policies).

Intra-ESCB balances of the non-euro areaNCBs (Danmarks Nationalbank, SverigesRiksbank and the Bank of England) with theECB are disclosed under “Liabilities to non-euro area residents denominated in euro”.

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Computers, related hardware andsoftware, and motor vehicles 4 years

Equipment, furniture and plantin building 10 years

Capitalised building and refurbishmentexpenditure 25 years

Fixed assets costing less than €10,000 Writtenoff in the

year ofacquisition

TREATMENT OF FIXED ASSETSFixed assets, with the exception of land, arevalued at cost less depreciation. Land is valuedat cost. Depreciation is calculated on a straight-line basis, beginning in the quarter afteracquisition and continuing over the expectedeconomic lifetime of the asset, namely:

The depreciation period for capitalisedbuilding and refurbishment expenditurerelating to the ECB’s existing premises hasbeen reduced in order to ensure that these assetsare completely written off before the ECBmoves to its final premises.

THE ECB’S RETIREMENT PLANThe assets of the plan, which exist solely for thepurpose of providing benefits for members ofthe plan and their dependants, are included inthe other assets of the ECB and are identifiedseparately in the notes on the balance sheet.Valuation gains and losses arising on the assetsof the pension fund are recognised as incomeand expenditure of the retirement plan in theyear in which they arise. The benefits payablefrom the core benefit account, resulting fromthe contributions of the ECB, have minimumguarantees underpinning the definedcontribution benefits.

BANKNOTES IN CIRCULATIONThe ECB and the 12 euro area NCBs, whichtogether comprise the Eurosystem, issue eurobanknotes.3 The total value of euro banknotesin circulation is allocated to the Eurosystemcentral banks on the last working day of eachmonth in accordance with the banknoteallocation key.4 The ECB has been allocated ashare of 8% of the total value of euro banknotes

in circulation, which is disclosed under thebalance sheet liability item “Banknotes incirculation”. The ECB’s share of the total eurobanknote issue is backed by claims on theNCBs. These claims, which bear interest5, aredisclosed under the sub-item “Intra-Eurosystem claims: claims related to theallocation of euro banknotes within theEurosystem” (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies). Interest income on theseclaims is included within the item “Net interestincome”. The Governing Council has decidedthat this income shall be distributed separatelyto the NCBs in the form of an interimdistribution after the end of each quarter.6 Itwill be distributed in full unless the ECB’s netprofit for the year is less than its income earnedon euro banknotes in circulation, and subject toany decision by the Governing Council toreduce this income in respect of costs incurredby the ECB in connection with the issue andhandling of euro banknotes.

OTHER ISSUESTaking account of the ECB’s role as a centralbank, the Executive Board of the ECBconsiders that the publication of a cash flowstatement would not provide the readers of thefinancial statements with any additionalrelevant information.

In accordance with Article 27 of the Statute ofthe ESCB, and on the basis of arecommendation of the Governing Council ofthe ECB, the Council of the European Union

3 ECB Decision of 6 December 2001 on the issue of eurobanknotes (ECB/2001/15), OJ L 337, 20.12.2001, pp. 52-54 asamended by ECB/2003/23, OJ L 9,15.01.2004, pp. 40-41 andECB/2004/9, OJ L 205, 9.06.2004, pp. 17-18.

4 “Banknote allocation key” means the percentages that resultfrom taking into account the ECB’s share in the total eurobanknote issue and applying the subscribed capital key to theNCBs’ share in that total.

5 ECB Decision of 6 December 2001 on the allocation of monetaryincome of the national central banks of participating MemberStates from the financial year 2002 (ECB/2001/16), OJ L 337,20.12.2001, pp. 55-61, as amended by ECB/2003/22, OJ L 9,15.01.2004, p. 39.

6 ECB Decision of 21 November 2002 on the distribution of theincome of the European Central Bank on euro banknotes incirculation to the national central banks of the participatingMember States (ECB/2002/9), OJ L 323, 28.11.2002, pp. 49-50.


has approved the appointment of KPMGDeutsche Treuhand-Gesellschaft Aktienge-sellschaft Wirtschaftsprüfungsgesellschaft asthe external auditors of the ECB for a five-yearperiod up to the end of the financial year 2007.

187ECB

Annual Repor t2004

NOT E S ON TH E B A L ANC E S H E E T

Claims onnon-euro area 2004 2003 Changeresidents € € €

Currentaccounts 2,682,171,017 1,365,187,080 1,316,983,937

Money marketdeposits 848,227,002 1,197,220,582 (348,993,580)

Reverserepurchaseagreements 2,408,046,989 3,834,025,154 (1,425,978,165)

Securityinvestments 21,000,548,972 22,196,952,041 (1,196,403,069)

Total 26,938,993,980 28,593,384,857 (1,654,390,877)

Claims oneuro area 2004 2003 Changeresidents € € €

Currentaccounts 26,506 26,740 (234)

Money marketdeposits 2,547,022,979 2,799,445,764 (252,422,785)

Reverserepurchaseagreements 4,967,080 0 4,967,080

Total 2,552,016,565 2,799,472,504 (247,455,939)

1 GOLD AND GOLD RECEIVABLES

The ECB holds 24.7 million ounces of fine gold(2003: 24.7 million ounces). No transactions ingold took place in 2004. The balance sheetmovement compared with 2003 is due to theyear-end revaluation of these holdings (see“Gold and foreign currency assets andliabilities” in the notes on accounting policies).

2 CLAIMS ON NON-EURO AREA AND EURO AREARESIDENTS DENOMINATED IN FOREIGNCURRENCY

Receivables from the IMFThis asset represents the ECB’s holdings ofSpecial Drawing Rights (SDRs) as at31 December 2004. It arises as the result of atwo-way SDR buying and selling arrangementwith the International Monetary Fund (IMF),whereby the IMF is authorised to arrange salesor purchases of SDRs against euro, on behalf ofthe ECB, within minimum and maximumholding levels. The SDR is defined in terms of abasket of currencies. Its value is determined asthe weighted sum of exchange rates of the fourmajor currencies (euro, Japanese yen, poundsterling and US dollar). For accountingpurposes, SDRs are treated as a foreigncurrency (see “Gold and foreign currencyassets and liabilities” in the notes onaccounting policies).

Balances with banks and security investments,external loans and other external assetsClaims on euro area residents denominated inforeign currencyThese claims consist of balances with banks,loans denominated in foreign currency andinvestments in securities, denominated in USdollar and Japanese yen, as follows:

The reduction in these positions in 2004 isprimarily due to the year-end revaluation of theECB’s US dollar-denominated assets. Thedepreciation of the US dollar and, to a lesserextent, the Japanese yen vis-à-vis the euroresulted in a significant decline in their euroequivalent value (see “Gold and foreigncurrency assets and liabilities” and “Incomerecognition” in the notes on accountingpolicies).

3 CLAIMS ON NON-EURO AREA RESIDENTSDENOMINATED IN EURO

As at 31 December 2004, this claim consistedof bank deposits with non-euro area residents.


Net book Net bookvalue as at value as at

31 Dec. 2004 31 Dec. 2003 Change€ € €

Land andbuildings 135,997,016 54,929,962 81,067,054

Computers 43,089,388 45,407,622 (2,318,234)

Equipment,furniture, plantin building andmotor vehicles 3,809,292 2,149,813 1,659,479

Assets underconstruction 3,215,050 23,259,861 (20,044,811)

Other fixed assets 1,207,558 3,164,692 (1,957,134)

Total 187,318,304 128,911,950 58,406,354

2004 2003€ €

Due from euro areaNCBs in respect ofTARGET 64,024,554,579 49,646,309,854

Due to euro area NCBsin respect of TARGET (61,149,859,140) (45,579,175,620)

Net TARGET position 2,874,695,439 4,067,134,234

Due from/(to) euro areaNCBs in respect of theinterim distribution ofthe ECB’s income derivedfrom banknotes 536,222,885 532,760,169

Other claims within theEurosystem (net) 3,410,918,324 4,599,894,403

4 OTHER CLAIMS ON EURO AREA CREDITINSTITUTIONS DENOMINATED IN EURO

As at 31 December 2004, this claim consistedof a bank deposit with a euro area resident.

5 INTRA-EUROSYSTEM CLAIMS

Claims related to the allocation of eurobanknotes within the EurosystemThis item consists of the claims of the ECBvis-à-vis the euro area NCBs relating to theallocation of euro banknotes within theEurosystem (see “Banknotes in circulation” inthe notes on accounting policies).

Other claims within the Eurosystem (net)This item consists of the TARGET balances ofthe euro area NCBs vis-à-vis the ECB andamounts due in respect of the interimdistributions of the ECB’s income derived frombanknotes. As at 31 December 2004, an amountof €536 million was due from the euro areaNCBs in respect of interim distributions of theECB’s income derived from banknotes. Thisrepresents the interim distributions of suchincome to the euro area NCBs for the first threequarters of the year, which were subsequentlyrecalled (see “Banknotes in circulation” in thenotes on accounting policies and note 18 in the“Notes on the Profit and Loss Account”).

6 OTHER ASSETS

Tangible fixed assetsThese assets comprised the following mainitems on 31 December 2004:

The principal increase, under the heading“Land and buildings”, relates to:

(a) the acquisition of the land for the ECB’sfinal premises. Based on a predefined areaof construction floor space, the minimumpurchase price was set at €61.4 million,payable in instalments by 31 December2004 at the latest, when legal title wouldpass to the ECB. This amount has now beenpaid in full and is consequently includedunder “Land and buildings”; and

(b) transfers from the category “Assets underconstruction” of capitalised refurbishmentcosts at the ECB’s third site, followingcommencement of use of the assets.

189ECB

Annual Repor t2004

2004 2003 Change€ € €

Securitiesdenominatedin euro 5,399,222,333 5,276,052,927 123,169,406

Reverserepurchaseagreementsin euro 869,977,933 167,100,400 702,877,533

Claims relatingto the ECBpension fund 120,243,662 91,727,194 28,516,468

Other financialassets 38,875,639 38,875,737 (98)

Total 6,428,319,567 5,573,756,258 854,563,309

Other financial assetsThe main components of this item are asfollows:

(a) Securities denominated in euro and reverserepurchase agreements in euro constitutethe investment of the ECB’s own funds (seealso note 12).

(b) The investment portfolios relating to theECB pension fund are valued at €120.2million (2003: €91.7 million). The assetsheld represent the investments ofaccumulated pension contributions by theECB and the staff of the ECB as at31 December 2004, and are managed byan external fund manager. The regularcontributions of the ECB and members ofthe plan have been invested on a monthlybasis. The assets of the plan are not fungiblewith other financial assets of the ECB, andnet income thereon does not constituteincome of the ECB, but is reinvested in thefunds concerned, pending payment ofbenefits. The external fund manager valuesthe assets of the pension fund using year-end market prices.

(c) The ECB holds 3,000 shares in the Bank forInternational Settlements (BIS) which areincluded at the acquisition cost of €38.5million.

Accruals and prepaid expensesIn 2004, this position included accrued interestreceivable of €197 million (2003: €165million) on the ECB’s claims related to theallocation of euro banknotes within theEurosystem for the final quarter (see“Banknotes in circulation” in the notes onaccounting policies).

The remainder of this balance consistsprincipally of accrued interest on securities andother financial assets.

SundryIn 2004 the main component of this item is aclaim against the German Federal Ministry ofFinance in respect of recoverable value addedand other indirect taxes paid. Such taxes arerefundable under the terms of Article 3 of theProtocol concerning the Privileges andImmunities of the European Communities,which applies to the ECB by virtue of Article40 of the Statute of the ESCB.

7 BANKNOTES IN CIRCULATION

This item consists of the ECB’s share of thetotal euro banknotes in circulation (see“Banknotes in circulation” in the notes onaccounting policies).

8 LIABILITIES TO OTHER EURO AREA RESIDENTSDENOMINATED IN EURO

This item comprises deposits by members ofthe Euro Banking Association (EBA) which areused in order to provide the ECB with collateralin respect of the EBA’s payments settledthrough the TARGET system.

9 LIABILITIES TO NON-EURO AREA RESIDENTSDENOMINATED IN EURO

These liabilities principally represent balancesheld at the ECB by non-euro area NCBs arisingfrom transactions processed via the TARGET


system (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies).

10 LIABILITIES TO EURO AREA AND NON-EUROAREA RESIDENTS DENOMINATED IN FOREIGNCURRENCY

The liabilities arising from repurchaseagreements conducted with euro area and non-euro area residents in connection with themanagement of the foreign currency reserves ofthe ECB are as follows:

Liabilities toeuro area 2004 2003 Changeresidents € € €

Repurchaseagreements 4,967,080 0 4,967,080

Liabilities tonon-euro area 2004 2003 Changeresidents € € €

Repurchaseagreements 1,254,905,957 1,452,432,822 (197,526,865)

11 INTRA-EUROSYSTEM LIABILITIES

These represent the liabilities to euro areaNCBs that arose from the transfer of foreignreserve assets to the ECB. The liabilities aredenominated in euro at a value fixed at the timeof their transfer. They are remunerated atthe latest available marginal rate for theEurosystem’s main refinancing operations,adjusted to reflect a zero return on the goldcomponent (see note 18 in the “Notes on theProfit and Loss Account”).

Given the decrease in the weighting in the ECBcapital key of the euro area NCBs on 1 January2004 and the subsequent change to the ECBcapital key on 1 May 2004 (see note 15), theinitial total liability of €40,497,150,000 wasreduced in two stages to €39,782,265,622 byDecisions of the Governing Council pursuantto Article 30.3 of the ESCB Statute. This

adjustment was made in order to provide thenecessary headroom to allow NCBs joining theEurosystem at a future date to make fulltransfers of foreign reserve assets in proportionto their prevailing shares in the ECB’s capitalkey. The reduction of the euro-denominatedliability did not require re-transfers of foreignreserve assets between the ECB and the NCBs.

Until 31 From 1 January FromDecember to 30 April 1 May

2003 2004 2004€ € €

Nationale Bankvan België/BanqueNationalede Belgique 1,432,900,000 1,414,850,000 1,419,101,951

DeutscheBundesbank 12,246,750,000 11,702,000,000 11,761,707,508

Bank ofGreece 1,028,200,000 1,080,700,000 1,055,840,343

Banco deEspaña 4,446,750,000 4,390,050,000 4,326,975,513

Banque deFrance 8,416,850,000 8,258,750,000 8,275,330,931

Central Bankand FinancialServicesAuthority ofIreland 424,800,000 512,700,000 513,006,858

Banca d’Italia 7,447,500,000 7,286,300,000 7,262,783,715

Banquecentrale duLuxembourg 74,600,000 85,400,000 87,254,014

DeNederlandscheBank 2,139,000,000 2,216,150,000 2,223,363,598

OesterreichischeNationalbank 1,179,700,000 1,150,950,000 1,157,451,203

Banco dePortugal 961,600,000 1,006,450,000 982,331,062

SuomenPankki –Finlands Bank 698,500,000 714,900,000 717,118,926

Total 40,497,150,000 39,819,200,000 39,782,265,622

191ECB

Annual Repor t2004

2004 2003 Change€ € €

Gold 1,853,957,106 2,070,968,381 (217,011,275)

Foreigncurrency 0 1,901 (1,901)

Securities 67,160,084 105,493,783 (38,333,699)

Total 1,921,117,190 2,176,464,065 (255,346,875)

12 OTHER LIABILITIES

This item consists mainly of interest due to theNCBs in respect of their claims relating to theforeign reserves transferred (see note 11). TheECB’s obligations in respect of the pension fund,including a provision based on the actuary’sreport (see note 13), amount to €148.8 million(2003: €100.6 million). Also included within thisbalance are other accruals and outstandingrepurchase transactions of €200 millionconducted in connection with the management ofthe ECB’s own funds (see note 6).

13 PROVISIONS

This position includes provisions relating topensions and expenditure on goods andservices, together with an appropriateprovision against the contractual obligation ofthe ECB to restore its current premises to theiroriginal condition when they are vacated andthe ECB moves to its final site.

14 REVALUATION ACCOUNTS

These accounts represent revaluation reservesarising from unrealised gains on assets andliabilities.

must be adjusted every five years. The firstsuch adjustment following the establishment ofthe ECB was made on 1 January 2004. On1 May 2004 a second change in the ECB’scapital key followed as a result of the accessionof ten Member States. Based on the CouncilDecision of 15 July 2003 on the statistical datato be used for the determination of the key forsubscription of the capital of the EuropeanCentral Bank, the capital keys of NCBs wereadjusted as follows on 1 January 2004 and1 May 2004:

15 CAPITAL AND RESERVES

Capital

(a) Changes to the ECB’s capital keyUnder Article 29.3 of the ESCB Statute, the keyof NCBs for subscription of the ECB’s capital

Until 31 From 1 FromDecember January to 30 1 May

2003 April 2004 2004% % %

Nationale Bankvan België/BanqueNationalede Belgique 2.8658 2.8297 2.5502

DeutscheBundesbank 24.4935 23.4040 21.1364

Bank ofGreece 2.0564 2.1614 1.8974

Banco deEspaña 8.8935 8.7801 7.7758

Banque deFrance 16.8337 16.5175 14.8712

Central Bankand FinancialServicesAuthority ofIreland 0.8496 1.0254 0.9219

Bancad’Italia 14.8950 14.5726 13.0516

Banquecentrale duLuxembourg 0.1492 0.1708 0.1568

DeNederlandscheBank 4.2780 4.4323 3.9955

OesterreichischeNationalbank 2.3594 2.3019 2.0800

Banco dePortugal 1.9232 2.0129 1.7653

SuomenPankki –Finlands Bank 1.3970 1.4298 1.2887

Totaleuro area NCBs 80.9943 79.6384 71.4908


Until 31 From 1 FromDecember January to 30 1 May

2003 April 2004 2004% % %

Česká národníbanka 0.0000 0.0000 1.4584

DanmarksNationalbank 1.6709 1.7216 1.5663

Eesti Pank 0.0000 0.0000 0.1784

Central Bankof Cyprus 0.0000 0.0000 0.1300

Latvijas Banka 0.0000 0.0000 0.2978

Lietuvos bankas 0.0000 0.0000 0.4425

MagyarNemzeti Bank 0.0000 0.0000 1.3884

Central Bankof Malta/Bank C

.entrali

ta’ Malta 0.0000 0.0000 0.0647

NarodowyBank Polski 0.0000 0.0000 5.1380

Banka Slovenije 0.0000 0.0000 0.3345

Národná bankaSlovenska 0.0000 0.0000 0.7147

Sveriges Riksbank 2.6537 2.6636 2.4133

Bank of England 14.6811 15.9764 14.3822

Totalnon-euro areaNCBs 19.0057 20.3616 28.5092

Totaleuro area andnon-euro areaNCBs 100.0000 100.0000 100.0000

(b) Capital of the ECBDue to the overall reduction of 1.3559% in theweighting of the euro area NCBs (with fullypaid-up subscriptions) in the ECB’s capital of€5 billion, their share in the ECB’s subscribedcapital decreased from €4,049,715,000 to atotal of €3,981,920,000 on 1 January 2004.It was further reduced to €3,978,226,562 on

1 May 2004 as a result of the accession of theten new Member States.

In accordance with Article 49.3 of the Statuteof the ESCB, which was added to the Statute bythe Treaty of Accession, the ECB’s subscribedcapital will in future be automaticallyincreased when a new member joins the EU andits NCB joins the ESCB. The increase isdetermined by multiplying the prevailingamount of the subscribed capital (i.e.€5 billion) by the ratio, within the expandedcapital key, between the weighting of theentering NCB(s) and the weighting of thoseNCBs that are already members of the ESCB.Therefore, on 1 May 2004, the subscribedcapital of the ECB was increased to €5.565billion.

The 13 non-euro area NCBs are required to payup a minimal percentage of their subscribedcapital as a contribution to the operationalcosts of the ECB. On 1 May 2004 thispercentage was increased from 5% to 7%.Including the amounts received from the tennew non-euro area NCBs, this contributionamounted to a total of €111,050,988 at thatdate. Unlike the euro area NCBs, the non-euroarea NCBs are not entitled to receive any shareof the distributable profits of the ECB,including income arising from the allocation ofeuro banknotes within the Eurosystem, nor arethey liable to fund any loss of the ECB.

The combined effect of the above threedevelopments was that the paid-up capitaldecreased from €4,097,229,250 on31 December 2003 to €4,032,824,000 on1 January 2004 and then increased to€4,089,277,550 on 1 May 2004, as shown in thetable below:

193ECB

Annual Repor t2004

Subscribed Paid-up Subscribed Paid-up Subscribed Paid-upcapital until capital until capital from capital from capital capital

31 December 31 December 1 January to 1 January to from from 2003 2003 30 April 2004 30 April 2004 1 May 20041) 1 May 2004

€ € € € € €

Nationale Bank vanBelgië/BanqueNationale de Belgique 143,290,000 143,290,000 141,485,000 141,485,000 141,910,195 141,910,195

Deutsche Bundesbank 1,224,675,000 1,224,675,000 1,170,200,000 1,170,200,000 1,176,170,751 1,176,170,751

Bank of Greece 102,820,000 102,820,000 108,070,000 108,070,000 105,584,034 105,584,034

Banco de España 444,675,000 444,675,000 439,005,000 439,005,000 432,697,551 432,697,551

Banque de France 841,685,000 841,685,000 825,875,000 825,875,000 827,533,093 827,533,093

Central Bank andFinancial ServicesAuthority of Ireland 42,480,000 42,480,000 51,270,000 51,270,000 51,300,686 51,300,686

Banca d’Italia 744,750,000 744,750,000 728,630,000 728,630,000 726,278,371 726,278,371

Banque centraledu Luxembourg 7,460,000 7,460,000 8,540,000 8,540,000 8,725,401 8,725,401

De Nederlandsche Bank 213,900,000 213,900,000 221,615,000 221,615,000 222,336,360 222,336,360

OesterreichischeNationalbank 117,970,000 117,970,000 115,095,000 115,095,000 115,745,120 115,745,120

Banco de Portugal 96,160,000 96,160,000 100,645,000 100,645,000 98,233,106 98,233,106

Suomen Pankki –Finlands Bank 69,850,000 69,850,000 71,490,000 71,490,000 71,711,893 71,711,893

Total euro area NCBs 4,049,715,000 4,049,715,000 3,981,920,000 3,981,920,000 3,978,226,562 3,978,226,562

Česká národní banka 0 0 0 0 81,155,136 5,680,860

Danmarks Nationalbank 83,545,000 4,177,250 86,080,000 4,304,000 87,159,414 6,101,159

Eesti Pank 0 0 0 0 9,927,370 694,916

Central Bank of Cyprus 0 0 0 0 7,234,070 506,385

Latvijas Banka 0 0 0 0 16,571,585 1,160,011

Lietuvos bankas 0 0 0 0 24,623,661 1,723,656

Magyar Nemzeti Bank 0 0 0 0 77,259,868 5,408,191

Central Bank of Malta /Bank C

.entrali ta’ Malta 0 0 0 0 3,600,341 252,024

Narodowy Bank Polski 0 0 0 0 285,912,706 20,013,889

Banka Slovenije 0 0 0 0 18,613,819 1,302,967

Národná bankaSlovenska 0 0 0 0 39,770,691 2,783,948

Sveriges Riksbank 132,685,000 6,634,250 133,180,000 6,659,000 134,292,163 9,400,451

Bank of England 734,055,000 36,702,750 798,820,000 39,941,000 800,321,860 56,022,530

Total non-euro areaNCBs 950,285,000 47,514,250 1,018,080,000 50,904,000 1,586,442,685 111,050,988

Total euro areaand non-euro areaNCBs 5,000,000,000 4,097,229,250 5,000,000,000 4,032,824,000 5,564,669,247 4,089,277,550

1) Individual amounts are shown rounded to the nearest euro. Totals may not add up due to rounding.


ReservesThis position represents the general reservefund of the ECB, established under Article 33of the Statute of the ESCB.

OFF-BALANCE-SHEET INSTRUMENTS

16 AUTOMATIC SECURITY LENDING PROGRAMME

As part of the management of the ECB’s ownfunds, the ECB has concluded an automaticsecurity lending programme agreement,whereby an appointed agent enters intosecurity lending transactions on behalf of theECB with a number of counterparties,designated by the ECB as eligiblecounterparties. Under this agreement, reversetransactions with a value of €1 billion (2003:€0.4 billion) were outstanding as at31 December 2004 (see “Reverse transactions”in the notes on accounting policies).

17 INTEREST RATE FUTURES

In 2004 foreign currency interest rate futureswere used within the management of the ECB’sforeign reserves. As at 31 December 2004, thefollowing transactions were outstanding,stated at nominal value:

Foreign currency interest Contract valuerate futures €

Purchases 1,077,349,366

Sales 91,770,061

195ECB

Annual Repor t2004

NOT E S ON TH E P RO F I T AND LO S S A C COUNT

2004 2003 Change€ € €

Interest on currentaccounts 3,744,188 3,679,287 64,901

Money marketdeposit income 49,854,512 45,699,455 4,155,057

Reverserepurchaseagreements 63,759,141 66,206,740 (2,447,599)

Net income onsecurities 317,073,827 445,357,205 (128,283,378)

Total interestincome on foreignreserve assets 434,431,668 560,942,687 (126,511,019)

Interest expenseon currentaccounts (32,020) (73,292) 41,272

Repurchaseagreements (11,947,990) (19,575,020) 7,627,030

Other interestexpense (net) (32,960) 0 (32,960)

Interest incomeon foreign reserveassets (net) 422,418,698 541,294,375 (118,875,677)

18 NET INTEREST INCOME

Interest income on foreign reserve assetsThis item includes interest income, net ofinterest expense, in respect of the assets andliabilities denominated in foreign currency, asfollows:

Interest income arising from the allocation ofeuro banknotes within the EurosystemThis item consists of the interest income of theECB relating to its 8% share in the total eurobanknote issue. Interest on the claims of theECB in respect of its share of banknotes isearned at the latest available marginal rate forthe Eurosystem’s main refinancing operations.This income is distributed to the NCBs asoutlined in “Banknotes in circulation” in thenotes on accounting policies.

Based on the ECB’s estimated financial resultfor the year ending 31 December 2004, theGoverning Council decided in December 2004:

(a) to recall the three interim quarterlydistributions already paid to the NCBsduring the year, amounting to €536 millionin total;

(b) to withhold the final quarterly interimdistribution of €197 million.

Remuneration of NCBs’ claims in respect offoreign reserves transferredRemuneration paid to euro area NCBs on theirclaims on the ECB in respect of the foreignreserve assets transferred under Article 30.1 ofthe Statute of the ESCB is disclosed under thisitem.

Other interest income and Other interestexpenseThese positions include interest income andexpenses on balances arising from TARGETand in respect of other assets and liabilitiesdenominated in euro.

In 2004, net interest income continued to beaffected by low levels of domestic and foreigninterest rates.

19 REALISED GAINS/LOSSES ARISING FROMFINANCIAL OPERATIONS

Net realised gains arising from financialoperations in 2004 were as follows:

2004 2003 Change€ € €

Net realisedprice gains onsecurities 94,643,135 528,606,147 (433,963,012)

Net realisedexchange rategains/(losses) 41,402,675 (3,345,525) 44,748,200

Realised gainsarising fromfinancialoperations 136,045,810 525,260,622 (389,214,812)


2004 2003 Change€ € €

Income from feesand commissions 297,964 700,271 (402,307)

Expenses relatingto fees andcommissions (559,481) (763,737) 204,256

Net expensefrom feesand commissions (261,517) (63,466) (198,051)

2004 2003 Change€ € €

Unrealisedprice losses onsecurities (28,485,006) (10,349,709) (18,135,297)

Unrealisedexchange ratelosses (2,064,800,103) (3,962,339,851) 1,897,539,748

Total (2,093,285,109) (3,972,689,560) 1,879,404,451

20 WRITE-DOWNS ON FINANCIAL ASSETS ANDPOSITIONS

This expense is primarily due to the write-downof the average acquisition cost of the ECB’sUS dollar holding to its end-of-year exchangerate as at 31 December 2004, following thedepreciation of this currency against the euroover the year.

21 NET EXPENSE FROM FEES AND COMMISSIONS

Income under this heading arose primarily frompenalties imposed on credit institutions fornon-compliance with the minimum reserverequirements. Expenses primarily relate to feespayable on current accounts and in connectionwith the execution of foreign currency interestrate futures (see note 17 in the “Notes on theBalance Sheet”).

22 OTHER INCOME

Other miscellaneous income during the yeararose principally from the transfer of unused

administrative provisions to the profit andloss account. As from 2004, this item alsoincludes the contribution by the NCBs of theten new Member States to the local annualservice fees, resulting from their localconnection, on their accession, to the secureESCB IT infrastructure. In the first instance,these costs are borne centrally by the ECB.

NCBs’ contributions will cease on therespective Member States’ entry into the euroarea.

23 STAFF COSTS

Salaries, allowances and staff insurance costsof €120.0 million (2003: €108.2 million) andemployer’s contributions to the ECB’s pensionfund are included under this heading. Theemoluments of the Executive Board of the ECBamounted to a total of €2.1 million (2003: €2.0million). No pensions were paid to formermembers of the Executive Board or theirdependants during the year. Transitionalpayments were made to departing members ofthe Executive Board. Salaries and allowances,including the emoluments of holders of seniormanagement positions, are modelled in essenceon, and are comparable with, the remunerationscheme of the European Communities.

The increase in this item in 2004 is primarilydue to an increase in the ECB’s obligation inrespect of the pension fund, as calculated by theactuary (see also note 24).

At the end of 2004 the ECB employed 1,309staff, of whom 131 held managerial positions.The change in the number of staff during 2004was as follows:

2004 2003

As at 1 January 1,213 1,105

New staff 137 149

Resignations 41 41

As at 31 December 1,309 1,213

Average number of staff employed 1,261 1,160

197ECB

Annual Repor t2004

24 THE ECB’S RETIREMENT PLAN

In accordance with the rules of the ECB’sretirement plan, a triennial full actuarialvaluation is required. The latest full actuarialvaluation was carried out as at 31 December2003, assuming all members left service, andpensionable service ceased, on that date.

The pension cost relating to the plan is assessedin accordance with the advice of a qualifiedactuary. The total pension cost to the ECBincluding a provision for disability and post-retirement benefits was €41.1 million (2003:€21.7 million). This cost includes a provisionfor pensions to members of the ExecutiveBoard of €1.8 million (2003: €1.9 million) andany supplementary contributions. The requiredrate of future service contributions by the ECBis 16.5% of pensionable earnings of all staff.

25 ADMINISTRATIVE EXPENSES

These cover all other current expenses relatingto the renting and maintenance of premises,goods and equipment of a non-capital nature,professional fees and other services andsupplies, together with staff-related expensesincluding recruitment, relocation, installation,training and resettlement.

26 BANKNOTE PRODUCTION SERVICES

In 2004, as in 2003, this expense related tocross-border transportation costs of eurobanknotes between NCBs to meet unexpectedfluctuations in demand. These costs are bornecentrally by the ECB.


NOT E ON TH E A L LO C AT I ON O F L O S S E S

1 Under Article 32.5 of the Statute of the ESCB, the sum of thenational central banks’ monetary income is to be allocated to thenational central banks in proportion to their paid-up shares in thecapital of the ECB.

This note is not part of the financial statementsof the ECB for the year 2004. It is published inthe Annual Report for information purposesonly.

INCOME RELATED TO THE ECB’S BANKNOTE ISSUE

Following a decision by the Governing Councilof the ECB, the amount of €733 million wasretained by the ECB to ensure that the totalprofit distribution for the year did not exceedthe ECB’s net profit for the year. This amountrepresents the full income relating to the ECB’sshare of total euro banknotes in circulation for2004.

COVERAGE OF ECB LOSSES

Under Article 33.2 of the Statute of the ESCB,in the event of a loss incurred by the ECB, theshortfall may be offset against the generalreserve fund of the ECB and, if necessary,following a decision by the Governing Council,against the monetary income of the relevantfinancial year in proportion and up to theamounts allocated to the national central banksin accordance with Article 32.5 of the Statute.1

On 11 March 2005, the Governing Council ofthe ECB decided to cover the loss for the yearending 31 December 2004 as follows:

2004 2003€ €

Loss for the year (1,636,028,702) (476,688,785)

Withdrawals fromgeneral reserve fund 296,068,424 476,688,785

Transferfrom monetaryincome pooled 1,339,960,278 0

Total 0 0

Auditor’s report

President and Governing Councilof the European Central Bank

Frankfurt am Main

We have audited the accompanying balance sheet of the European Central Bank as of31 December 2004 and the related profit and loss account for the year then ended as well as the notes.These annual accounts are the responsibility of the European Central Bank’s Executive Board. Ourresponsibility is to express an opinion on these annual accounts based on our audit.

We conducted our audit in accordance with International Standards on Auditing. Those Standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the annualaccounts are free of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the annual accounts. An audit also includes assessing theaccounting principles used and significant estimates made by management, as well as evaluating theoverall presentation of the annual accounts. We believe that our audit provides a reasonable basis forour opinion.

In our opinion, the annual accounts give a true and fair view of the financial position of the EuropeanCentral Bank as of 31 December 2004 and of the results of its operations for the year then ended inaccordance with the accounting policies as described in the first part of the notes.

Frankfurt am Main, 4 March 2005

KPMG Deutsche Treuhand-GesellschaftAktiengesellschaftWirtschaftsprüfungsgesellschaft

(Wohlmannstetter) (Dr. Lemnitzer)Wirtschaftsprüfer Wirtschaftsprüfer

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Aufsichtsratsvorsitzender:WP StB Dipl.-Kfm.Gerhard Brackert

Vorstand:WP StB Dipl.-Kfm.Axel BergerWP RA StBDr. Bernd ErleWP StB Dipl.-Kfm.Prof. Dr. Gerd GeibWP Dr. Martin Hoyos

RA StBDr. Hartwich LüßmannWP Dipl.-Kfm. Ulrich MaasWP StBProf. Dr. Rolf NonnenmacherWP StB Dipl.-Kfm.Rüdiger ReinkeCPA Kenneth D. RussellWP Dipl.-Oec.Bernd Ulrich SchmidWP Dipl.-Kfm.Prof. Dr. Wienand SchruffWP StB Dr. Peter Wesner

WP RA StBProf. Dr. Harald WiedmannSprecherWP StB CPA Dipl.-Kfm. MScGottfried WohlmannstetterWP StB Dipl.-Kfm.Hans ZehnderWP StB Dipl.-Kfm.Wolfgang Zielkestellv. Sprecher

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Sitz: Berlin undFrankfurt am Main

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USt.-IdNr.: DE 136 751 547


5 C O N S O L I DAT E D B A L A N C E S H E E T O F T H E E U RO S YS T E MA S AT 3 1 D E C E M B E R 2 0 0 4

(EUR M I L L I ON S )

A S S E T S 3 1 D E C EMBER 3 1 D E C EMBER2004 2 0 0 3

1 Gold and gold receivables 125,730 130,344

2 Claims on non-euro area residents denominatedin foreign currency 153,856 175,5792.1 Receivables from the IMF 23,948 29,1302.2 Balances with banks and security investments,

external loans and other external assets 129,908 146,449

3 Claims on euro area residents denominated inforeign currency 16,974 17,415

4 Claims on non-euro area residents denominated in euro 6,849 6,0494.1 Balances with banks, security investments and loans 6,849 6,0494.2 Claims arising from the credit facility under ERM II 0 0

5 Lending to euro area credit institutions related tomonetary policy operations denominated in euro 345,112 298,1635.1 Main refinancing operations 270,000 253,0015.2 Longer-term refinancing operations 75,000 45,0005.3 Fine-tuning reverse operations 0 05.4 Structural reverse operations 0 05.5 Marginal lending facility 109 1345.6 Credits related to margin calls 3 28

6 Other claims on euro area credit institutions denominatedin euro 3,763 729

7 Securities of euro area residents denominated in euro 70,244 54,466

8 General government debt denominated in euro 41,317 42,686

9 Other assets 120,479 109,365

Total assets 884,324 834,796

Totals/subtotals may not add up due to rounding.

201ECB

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L I A B I L I T I E S 3 1 D E C EMBER 31 D E C EMBER2004 2 0 0 3

1 Banknotes in circulation 501,256 436,128

2 Liabilities to euro area credit institutions related to monetarypolicy operations denominated in euro 138,735 147,3282.1 Current accounts (covering the minimum reserve system) 138,624 147,2472.2 Deposit facility 106 802.3 Fixed-term deposits 0 02.4 Fine-tuning reverse operations 0 02.5 Deposits related to margin calls 5 1

3 Other liabilities to euro area credit institutions denominatedin euro 126 257

4 Debt certificates issued 0 1,054

5 Liabilities to other euro area residents denominated in euro 42,187 39,8655.1 General government 35,968 34,1065.2 Other liabilities 6,219 5,759

6 Liabilities to non-euro area residents denominated in euro 10,912 10,279

7 Liabilities to euro area residents denominated inforeign currency 247 499

8 Liabilities to non-euro area residents denominated inforeign currency 10,679 11,2058.1 Deposits, balances and other liabilities 10,679 11,2058.2 Liabilities arising from the credit facility under ERM II 0 0

9 Counterpart of special drawing rights allocated by the IMF 5,573 5,761

10 Other liabilities 51,791 54,757

11 Revaluation accounts 64,581 67,819

12 Capital and reserves 58,237 59,844

Total liabilities 884,324 834,796

ANNEXES


ANNEXES

LEGAL INSTRUMENTS ADOPTED BY THE ECB

Number Title OJ reference

The following table lists the legal instrumentsthat were adopted by the ECB in 2004 and early2005 and published in the Official Journal ofthe European Union. Copies of the OfficialJournal can be obtained from the Office for

Official Publications of the EuropeanCommunities. For a list of all the legalinstruments adopted by the ECB since itsestablishment and published in the OfficialJournal, see the ECB’s website.

ECB/2004/1 Guideline of the European Central Bank of 13 February 2004amending Guideline ECB/2003/2 concerning certainstatistical reporting requirements of the European CentralBank and the procedures for reporting by the national centralbanks of statistical information in the field of money andbanking statistics

ECB/2004/2 Decision of the European Central Bank of 19 February 2004adopting the Rules of Procedure of the European Central Bank

ECB/2004/3 Decision of the European Central Bank of 4 March 2004on public access to European Central Bank documents

ECB/2004/4 Guideline of the European Central Bank of 21 April 2004amending Guideline ECB/2001/3 on a Trans-EuropeanAutomated Real-time Gross settlement Express Transfersystem (TARGET)

ECB/2004/5 Decision of the European Central Bank of 22 April 2004 on thenational central banks’ percentage shares in the key forsubscription to the European Central Bank’s capital

ECB/2004/6 Decision of the European Central Bank of 22 April 2004 layingdown the measures necessary for the paying-up of theEuropean Central Bank’s capital by the participating nationalcentral banks

ECB/2004/7 Decision of the European Central Bank of 22 April 2004 layingdown the terms and conditions for transfers of the EuropeanCentral Bank’s capital shares between the national centralbanks and for the adjustment of the paid-up capital

ECB/2004/8 Decision of the European Central Bank of 22 April 2004 layingdown the measures necessary for the contribution to theEuropean Central Bank’s accumulated equity value, foradjusting the national central banks claims equivalent to thetransferred foreign reserve assets, and for related financialissues

OJ L 83,20.3.2004,p. 29

OJ L 80,18.3.2004,p. 33

OJ L 80,18.3.2004,p. 42

OJ L 205,9.6.2004,p. 1

OJ L 205,9.6.2004,p. 5

OJ L 205,9.6.2004,p. 7

OJ L 205,9.6.2004,p. 9

OJ L 205,9.6.2004,p. 13

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ECB/2004/9 Decision of the European Central Bank of 22 April 2004amending Decision ECB/2001/15 of 6 December 2001 on theissue of euro banknotes

ECB/2004/10 Decision of the European Central Bank of 23 April 2004 layingdown the measures necessary for the paying-up of theEuropean Central Bank’s capital by the non-participatingnational central banks

ECB/2004/11 Decision of the European Central Bank of 3 June 2004concerning the terms and conditions for European Anti-FraudOffice investigations of the European Central Bank, in relationto the prevention of fraud, corruption and any other illegalactivities detrimental to the European Communities’ financialinterests and amending the Conditions of Employment forStaff of the European Central Bank

ECB/2004/12 Decision of the European Central Bank of 17 June 2004adopting the Rules of Procedure of the General Council of theEuropean Central Bank

ECB/2004/13 Guideline of the European Central Bank of 1 July 2004 on theEurosystem’s provision of reserve management services ineuro to non-European Union central banks, countries outsidethe European Union and international organisations

ECB/2004/14 Decision of the European Central Bank of 9 July 2004amending Decision ECB/2003/15 of 28 November 2003 on theapproval of the volume of coin issuance in 2004

ECB/2004/15 Guideline of the European Central Bank of 16 July 2004 on thestatistical reporting requirements of the European CentralBank in the field of balance of payments and internationalinvestment position statistics, and the international reservestemplate

ECB/2004/16 Recommendation of the European Central Bank of 16 July2004 on the statistical reporting requirements of the EuropeanCentral Bank in the field of balance of payments andinternational investment position statistics, and theinternational reserves template

ECB/2004/17 Recommendation of the European Central Bank of 30 July 2004to the Council of the European Union on the external auditorsof the Banca d’Italia

ECB/2004/18 Guideline of the European Central Bank of 16 September 2004on the procurement of euro banknotes

OJ L 205,9.6.2004,p. 17

OJ L 205,9.6.2004,p. 19

OJ L 230,30.6.2004,p. 56

OJ L 230,30.6.2004,p. 61

OJ L 241,13.7.2004,p. 68

OJ L 248,22.7.2004,p. 14

OJ L 354,30.11.2004,p. 34

OJ C 292,30.11.2004,p. 21

OJ C 202,10.8.2004,p. 1

OJ L 320,21.10.2004,p. 21



ECB/2004/19 Decision of the European Central Bank of 14 December 2004on the approval of the volume of coin issuance in 2005

ECB/2004/20 Guideline of the European Central Bank of 16 December 2004amending Guideline ECB/2004/13 of 1 July 2004 on theEurosystem’s provision of reserve management services ineuro to non-European Union central banks, countries outsidethe European Union and international organisations

ECB/2004/21 Regulation of the European Central Bank of 16 December 2004amending Regulation ECB/2001/13 concerning theconsolidated balance sheet of the monetary financialinstitutions sector and Regulation ECB/2001/18 concerningstatistics on interest rates applied by monetary financialinstitutions to deposits and loans vis-à-vis households andnon-financial corporations

ECB/2005/1 Guideline of the European Central Bank of 21 January 2005amending Guideline ECB/2001/3 on a Trans-EuropeanAutomated Real-time Gross settlement Express Transfersystem (“TARGET”)

ECB/2005/2 Guideline of the European Central Bank of 3 February 2005amending Guideline ECB/2000/7 on monetary policyinstruments and procedures of the Eurosystem

ECB/2005/3 Recommendation of the European Central Bank of 11 February2005 to the Council of the European Union on the externalauditors of the Banco de Portugal

ECB/2005/4 Guideline of the European Central Bank of 15 February 2005amending Guideline ECB/2003/2 concerning certainstatistical reporting requirements of the European CentralBank and the procedures for reporting by the national centralbanks of statistical information in the field of money andbanking statistics

ECB/2005/5 Guideline of the European Central Bank of 17 February 2005on the statistical reporting requirements of the EuropeanCentral Bank and the procedures for exchanging statisticalinformation within the European System of Central Banks inthe field of government finance statistics

OJ L 379,24.12.2004,p. 107

OJ L 385,29.12.2004,p. 85

OJ L 371,18.12.2004,p. 42

OJ L 30,3.2.2005,p. 21

Not yetpublished inthe OfficialJournal

OJ C 50,26.2.2005,p. 6

Not yetpublished

Not yetpublished

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OPINIONS ADOPTED BY THE ECB

(a) ECB opinions following a consultation by a Member State1

Number2 Originator Subject

The following table lists the opinions adoptedby the ECB in 2004 and early 2005 underArticle 105(4) of the Treaty and Article 4 of theStatute of the ESCB, Article 112(2)(b) of the

Treaty and Article 11.2 of the Statute. For a listof all the opinions adopted by the ECB since itsestablishment, see the ECB’s website.

1 In December 2004 the Governing Council decided that ECB opinions issued at the request of national authorities would, as a rule, bepublished immediately following their adoption and subsequent transmission to the consulting authority.

2 Consultations are numbered in the order in which the Governing Council adopted them.

CON/2004/1 Finland Measures affecting Suomen Pankki’s financial position andprovisions relating to its power to issue norms

CON/2004/2 Sweden MFIs’ reporting of money and banking statistics

CON/2004/3 Luxembourg Establishment of a specific legal framework for securitisationtransactions

CON/2004/5 Austria Supplementary supervision in a financial conglomerate

CON/2004/6 France Cover for exchange losses suffered by the Banque de France

CON/2004/8 France Legal framework for recycling euro coins and banknotes

CON/2004/9 Belgium Insolvency and bankruptcy proceedings of credit institutions,clearing institutions and investment undertakings

CON/2004/15 France Negotiable debt securities

CON/2004/16 Italy Protection of savings

CON/2004/17 Sweden Old banknotes and coins ceasing to be legal tender

CON/2004/18 Portugal Reorganisation and winding up of credit institutions

CON/2004/20 France Inflation indexed loans from credit institutions

CON/2004/21 Netherlands Financial sector supervision

CON/2004/22 France Transfer of ownership of financial instruments

CON/2004/23 Germany Statistical reporting requirements in relation to cross-bordertransactions between residents and non-residents

CON/2004/24 Austria Collection of statistics concerning imports and exports ofservices

CON/2004/25 Estonia Regulatory authorities for e-money institutions

CON/2004/26 Austria Balance of payments reporting with the exception of servicesand transfers


Number2 Originator Subject

CON/2004/27 Belgium Financial collateral arrangements

CON/2004/28 Sweden Circulation of banknotes and coins

CON/2004/29 Malta Exemption to the Maltese minimum reserves regime

CON/2004/30 France Completion of the legal framework for securitisation funds

CON/2004/31 Slovakia Supervision of the financial market by Národná bankaSlovenska

CON/2004/33 Hungary Statistical reporting requirements for the central bank’sinformation system

CON/2004/34 Belgium Tax on foreign exchange transactions

CON/2004/35 Hungary Monetary policy decision-making

CON/2004/36 Czech Programme of statistical surveys for 2005Republic

CON/2004/37 Czech Introduction of e-money institutionsRepublic

CON/2004/38 Denmark Creation of a specific legal and supervisory basis for hedgefunds

CON/2004/39 Spain New management structure for the clearing system for retailpayments

CON/2005/3 Hungary Cash processing and distribution

CON/2005/5 Malta The Central Bank of Malta’s statistical reporting requirementsfor credit institutions

209ECB

Annual Report2004

(b) ECB opinions following a consultation by a European Institution3

Number4 Originator Subject OJ reference

3 Also published on the ECB’s website.4 Consultations are numbered in the order in which the Governing Council adopted them.

CON/2004/4 Council Compilation of quarterly non-financialaccounts by institutional sector

CON/2004/7 Council New EU financial services committeeorganisational structure, extending theLamfalussy process to all financial sectors

CON/2004/10 Council Conversion rates between the euro and thecurrencies of Member States adopting theeuro

CON/2004/11 Council Appointment of a new member of the ECB’sExecutive Board

CON/2004/12 Council Agreement on monetary relations withAndorra

CON/2004/13 Council Medals and tokens similar to coins

CON/2004/14 Council Compilation and transmission of data on thequarterly government debt

CON/2004/19 Council Short-term statistics

CON/2004/32 Council Opening of negotiations concerning anagreement on monetary relations withAndorra

CON/2005/2 Council Prevention of the use of the financial systemfor money laundering and terrorist financing

CON/2005/4 Council Capital adequacy framework for creditinstitutions and investment firms

OJ C 42,18.2.2004,p. 23

OJ C 58,6.3.2004,p. 23

OJ C 88,8.4.2004,p. 20

OJ C 87,7.4.2004,p. 37

OJ C 88,8.4.2004,p. 18

OJ C 134,12.5.2004,p. 11

OJ C 134,12.5.2004,p. 14

OJ C 158,15.6.2004,p. 3

OJ C 256,16.10.2004,p. 9

OJ C 40,17.2.2005,p. 9

OJ C 52,2.3.2005,p. 37

211ECB

Annual Report2004

This list is designed to inform readers about selected documents published by the EuropeanCentral Bank since January 2004. For Working Papers, the list only refers to publications releasedbetween December 2004 and February 2005. The publications are available to interested partiesfree of charge from the Press and Information Division. Please submit orders in writing to thepostal address given on the back of the title page.

For a complete list of documents published by the European Central Bank and by the EuropeanMonetary Institute, please visit the ECB’s website (http://www.ecb.int).

ANNUAL REPORT“Annual Report 2003”, April 2004.

MONTHLY BULLETIN ARTICLES

“EMU and the conduct of fiscal policies”, January 2004.“Opinion survey on activity, prices and labour market developments in the euro area: featuresand uses”, January 2004.“Measuring and analysing profit developments in the euro area”, January 2004.“The acceding countries’ economies on the threshold of the European Union”,February 2004.“Developments in private sector balance sheets in the euro area and the United States”,February 2004.“The impact of fair value accounting on the European banking sector – a financial stabilityperspective”, February 2004.“Fiscal policy influences on macroeconomic stability and prices”, April 2004.“Future developments in the TARGET system”, April 2004.“The Barcelona partner countries and their relations with the euro area”, April 2004.“The EU economy following the accession of the new Member States”, May 2004.“The natural real interest rate in the euro area”, May 2004.“Risk mitigation methods in Eurosystem credit operations”, May 2004.“Labour productivity developments in the euro area: aggregate trends and sectoral patterns”,July 2004.“Accounting for the resilience of the EU banking sector since 2000”, July 2004.“The European Constitution and the ECB”, August 2004.“Properties and use of general government quarterly accounts”, August 2004.“Euro banknotes: first years of experience”, August 2004.“Monetary analysis in real time”, October 2004.“Economic integration in selected regions outside the European Union”, October 2004.“Oil prices and the euro area economy”, November 2004.“Extracting information from financial asset prices”, November 2004.“Developments in the EU framework for financial regulation, supervision andstability”, November 2004.“The new Basel Capital Accord: main features and implications”, January 2005.“Financial flows to emerging market economies: changing patterns and recentdevelopments”, January 2005.“Bank market discipline”, February 2005.“Initial experience with the changes to the Eurosystem’s operational framework for monetarypolicy implementation”, February 2005.

DOCUMENT S P UB L I S H ED B Y TH EEUROPE AN C EN TR A L B ANK S I N C E J A NUARY 2 0 0 4


“Euro area balance of payments and international investment position vis-à-vis maincounterparts”, February 2005.

STATISTICS POCKET BOOKAvailable monthly since August 2003.

OCCASIONAL PAPER SERIES9 “Fiscal adjustment in 1991-2002: stylised facts and policy implications” by

M. G. Briotti, February 2004.10 “The acceding countries’ strategies towards ERM II and the adoption of the euro:

an analytical review” by a staff team led by P. Backé and C. Thimann and includingO. Arratibel, O. Calvo-Gonzalez, A. Mehl and C. Nerlich, February 2004.

11 “Official dollarisation/euroisation: motives, features and policy implications of currentcases” by A. Winkler, F. Mazzaferro, C. Nerlich and C. Thimann, February 2004.

12 “Understanding the impact of the external dimension on the euro area: trade, capital flowsand other international macroeconomic linkages” by R. Anderton, F. di Mauro andF. Moneta, April 2004.

13 “Fair value accounting and financial stability” by a staff team led by A. Enria includingL. Cappiello, F. Dierick, S. Grittini, A. Maddaloni, P. Molitor, F. Pires and P. Poloni,April 2004.

14 “Measuring financial integration in the euro area” by L. Baele, A. Ferrando,P. Hördahl, E. Krylova and C. Monnet, April 2004.

15 “Quality adjustment of European price statistics and the role for hedonics” by H. Ahnert andG. Kenny, May 2004.

16 “Market dynamics associated with credit ratings: a literature review” by F. Gonzalez,F. Haas, R. Johannes, M. Persson, L. Toledo, R. Violi, M. Wieland and C. Zins,June 2004.

17 “Corporate ‘excesses’ and financial market dynamics” by A. Maddaloni and D. Pain,July 2004.

18 “The international role of the euro: evidence from bonds issued by non-euro area residents”by A. Geis, A. Mehl and S. Wredenborg, July 2004.

19 “Sectoral specialisation in the EU: a macroeconomic perspective” by an MPC task force ofthe ESCB, July 2004.

20 “The supervision of mixed financial services groups in Europe” by F. Dierick,August 2004.

21 “Governance of securities clearing and settlement systems” by D. Russo, T. Hart,M. C. Malaguti and C. Papathanassiou, October 2004.

22 “Assessing potential output growth in the euro area – a growth accounting perspective”by A. Musso and T. Westermann, January 2005.

23 “The bank lending survey for the euro area” by J. Berg, A. Van Rixtel, A. Ferrando,G. de Bondt and S. Scopel, February 2005.

24 “Wage diversity in the euro area – an overview of labour cost differentials across industries”by V. Genre, D. Momferatou and G. Mourre, February 2005.

213ECB

Annual Report2004

WORKING PAPER SERIES419 “The design of fiscal rules and forms of governance in European Union countries”

by M. Hallerberg, R. Strauch and J. von Hagen, December 2004.420 “On prosperity and posterity: the need for fiscal discipline in a monetary union”

by C. Detken, V. Gaspar and B. Winkler, December 2004.421 “EU fiscal rules: issues and lessons from political economy” by L. Schuknecht,

December 2004.422 “What determines fiscal balances? An empirical investigation in determinants of

changes in OECD budget balances” by M. Tujula and G. Wolswijk, December 2004.423 “Price setting in France: new evidence from survey data” by C. Loupias and

R. Ricart, December 2004.424 “An empirical study of liquidity and information effects of order flow on exchange

rates” by F. Breedon and P. Vitale, December 2004.425 “Geographic versus industry diversification: constraints matter” by P. Ehling

and S. Brito Ramos, January 2005.426 “Security fungibility and the cost of capital: evidence from global bonds”

by D. P. Miller and J. J. Puthenpurackal, January 2005.427 “Interlinking securities settlement systems: a strategic commitment?” by K. Kauko,

January 2005.428 “Who benefits from IPO underpricing? Evidence from hybrid bookbuilding

offerings” by V. Pons-Sanz, January 2005.429 “Cross-border diversification in bank asset portfolios” by C. M. Buch, J. C. Driscoll

and C. Ostergaard, January 2005.430 “Public policy and the creation of active venture capital markets” by M. Da Rin,

G. Nicodano and A. Sembenelli, January 2005.431 “Regulation of multinational banks: a theoretical inquiry” by G. Calzolari

and G. Loranth, January 2005.432 “Trading European sovereign bonds: the microstructure of the MTS trading

platforms” by Y. Chung Cheung, F. de Jong and B. Rindi, January 2005.433 “Implementing the Stability and Growth Pact: enforcement and procedural

flexibility” by R. Beetsma and X. Debrun, January 2005.434 “Interest rates and output in the long run” by Y. Aksoy and M. León-Ledesma,

January 2005.435 “Reforming public expenditure in industrialised countries: are there trade-offs?”

by L. Schuknecht and V. Tanzi, February 2005.436 “Measuring market and inflation risk premia in France and in Germany”

by L. Cappiello and S. Guéné, February 2005.437 “What drives international bank flows? Politics, institutions and other determinants”

by E. Papaioannou, February 2005.438 “Quality of public finances and growth” by A. Afonso, W. Ebert, L. Schuknecht

and M. Thöne, February 2005.439 “A look at intraday frictions in the euro area overnight deposit market”

by V. Brousseau and A. Manzanares, February 2005.440 “Estimating and analysing currency options’ implied risk-neutral density functions

for the largest new EU Member States” by O. Castrén, February 2005.441 “The Phillips curve and long-term unemployment” by R. Llaudes, February 2005.442 “Why do financial systems differ? History matters” by C. Monnet and E. Quintin,

February 2005.


443 “Explaining cross-border large-value payment flows: evidence from TARGET andEURO 1 data” by S. Rosati and S. Secola, February 2005.

444 “Keeping up with the Joneses, reference dependence, and equilibrium indeterminacy”by L. Stracca and A. al-Nowaihi, February 2005.

445 “Welfare implications of joining a common currency” by M. Ca’Zorzi, R. A. De Santisand F. Zampolli, February 2005.

446 “Trade effects of the euro: evidence from sectoral data” by R. E. Baldwin,F. Skudelny and D. Taglioni, February 2005.

447 “Foreign exchange option and returns-based correlation forecasts: evaluation and twoapplications” by O. Castrén and S. Mazzotta, February 2005.

OTHER PUBLICATIONS“Assessment of accession countries’ securities settlement systems against the standards for theuse of EU securities settlement systems in Eurosystem credit operations”, January 2004.“The monetary policy of the ECB”, January 2004.“The implementation of monetary policy in the euro area: General documentation onEurosystem monetary policy instruments and procedures”, February 2004.“Guidance notes on the MFI balance sheet statistics relating to EU enlargement as laid down inRegulation ECB/2003/10”, February 2004.“Comments on the communication from the Commission to the Council and the EuropeanParliament concerning a new legal framework for payments in the internal market (consultativedocument)”, February 2004.“Foreign direct investment task force report”, March 2004.“External evaluation of the economic research activities of the European Central Bank”,April 2004.“Payment and securities settlement systems in the accession countries – Addendumincorporating 2002 figures” (“Blue Book”), April 2004.“Payment and securities settlement systems in the European Union – Addendum incorporating2002 figures” (“Blue Book”), April 2004.“TARGET compensation claim form”, April 2004.“Letter from the ECB President to the President of the Council of the European Union:negotiations on the draft Treaty establishing a Constitution for Europe”, April 2004.“The use of central bank money for settling securities transactions”, May 2004.“TARGET Annual Report 2003”, May 2004.“Assessment of euro large-value payment systems against the Core Principles”,May 2004.“Credit risk transfer by EU banks: activities, risks and risk management”, May 2004.“Risk management for central bank foreign reserves”, May 2004.“Comparison of household saving ratios, euro area/United States/Japan”, June 2004.“The development of statistics for Economic and Monetary Union” by P. Bull,July 2004.“ECB staff macroeconomic projections for the euro area”, September 2004.“Letter from the ECB President to the Chairman of the International Accounting StandardsBoard of 6 September 2004: Exposure draft of proposed amendments to IAS 39 – the fair valueoption”, September 2004.“Institutional provisions: Statute of the ESCB and of the ECB; Rules of Procedure”, October 2004.“Convergence Report 2004”, October 2004.

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“Standards for securities clearing and settlement in the European Union”, October 2004.“The European Central Bank – History, role and functions”, October 2004.“E-payments without frontiers”, October 2004.“European Union balance of payments/international investment position statistical methods”,November 2004.“Bond markets and long-term interest rates in non-euro area Member States of the EuropeanUnion and in accession countries”, November 2004.“Report on EU banking structure 2004”, November 2004.“EU banking sector stability 2004”, November 2004.“Letter from the ECB President to the President of the European Parliament”, November 2004.“Letter from the ECB President to Mr Paolo Cirino Pomicino, Member of the Committee onEconomic and Monetary Affairs”, November 2004.“Eurosystem staff macroeconomic projections for the euro area”, December 2004.“Towards a single euro payments area – third progress report”, December 2004.“The euro bond market study 2004”, December 2004.“Financial Stability Review”, December 2004.“Review of the requirements in the field of general economic statistics”, December 2004.“Research network on capital markets and financial integration in Europe – results andexperience after two years”, December 2004.“Recycling of euro banknotes: framework for the detection of counterfeits and fitness sorting bycredit institutions and other professional cash handlers”, January 2005.“Review of the international role of the euro”, January 2005.“Euro area balance of payments and international investment position statistics – Annualquality report”, January 2005.“Banking structures in the new EU Member States”, January 2005.“Progress report on TARGET2”, February 2005.“The implementation of monetary policy in the euro area: General documentation on Eurosystemmonetary policy instruments and procedures”, February 2005.“Review of the application of the Lamfalussy framework to EU securities markets legislation”,February 2005.“Payment and securities settlement systems in the European Union – Addendum incorporating2003 figures” (“Blue Book”), February 2005.

INFORMATION BROCHURES“Information guide for credit institutions using TARGET”, July 2003.“TARGET2 – the future TARGET system”, September 2004.“TARGET – the current system”, September 2004.

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CHRONOLOGY O F MONE TARY PO L I C YMEA SUR E S O F T H E E URO S Y S T EM 1

1 The chronology of monetary policy measures of the Eurosystemtaken between 1999 and 2003 can be found on pages 176 to 180of the ECB’s Annual Report 1999, on pages 205 to 208 of theECB’s Annual Report 2000, on pages 219 and 220 of the ECB’sAnnual Report 2001, on pages 234 and 235 of the ECB’s AnnualReport 2002 and on pages 217 and 218 of the ECB’s AnnualReport 2003 respectively.

8 JANUARY 2004

The Governing Council of the ECB decides thatthe minimum bid rate on the main refinancingoperations and the interest rates on themarginal lending facility and the depositfacility will remain unchanged at 2.0%, 3.0%and 1.0% respectively.

12 JANUARY 2004

The Governing Council of the ECB decidesto increase the allotment amount for eachof the longer-term refinancing operations tobe conducted in 2004 from €15 billion to€25 billion. This increased amount takes intoconsideration the higher liquidity needs of theeuro area banking system anticipated for 2004.The Eurosystem will, however, continue toprovide the bulk of liquidity through its mainrefinancing operations. The GoverningCouncil may decide to adjust the allotmentamount again at the beginning of 2005.

5 FEBRUARY, 4 MARCH 2004


10 MARCH 2004

In accordance with the Governing Council’sdecision of 23 January 2003, the maturityof the Eurosystem’s main refinancingoperations is reduced from two weeks to oneweek and the maintenance period for theEurosystem’s required reserve system isredefined to start on the settlement day of themain refinancing operation following theGoverning Council meeting at which themonthly assessment of the monetary policy

stance is pre-scheduled, rather than on the24th day of the month.

1 APRIL, 6 MAY, 3 JUNE, 1 JULY,5 AUGUST, 2 SEPTEMBER, 7 OCTOBER,4 NOVEMBER, 2 DECEMBER 2004 AND13 JANUARY 2005


14 JANUARY 2005

The Governing Council of the ECB decides toincrease the allotment amount for each of thelonger-term refinancing operations to beconducted in 2005 from €25 billion to €30billion. This increased amount takes intoconsideration the higher liquidity needs of theeuro area banking system anticipated for 2005.The Eurosystem will, however, continue toprovide the bulk of liquidity through its mainrefinancing operations. The GoverningCouncil may decide to adjust the allotmentamount again at the beginning of 2006.

3 FEBRUARY, 3 MARCH 2005


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G L O S S A RYThis glossary contains selected terms that are used in the Annual Report. A more comprehensiveand detailed glossary can be found on the ECB’s website.

Acceding countries: refers to those ten countries which signed the EU Accession Treaty in 2003before they joined the EU on 1 May 2004: the Czech Republic, Estonia, Cyprus, Latvia, Lithuania,Hungary, Malta, Poland, Slovenia and Slovakia.

Balance of payments (b.o.p.): a statistical statement that summarises, for a specific time period,the economic transactions of an economy with the rest of the world. The transactions consideredare those involving goods, services and income; those involving financial claims on, andliabilities to, the rest of the world; and those (such as debt forgiveness) that are classified astransfers.

Benchmark portfolio: in relation to investments, a reference portfolio or index constructed onthe basis of the objectives for the liquidity and risk of, as well as the return on, the investments.The benchmark portfolio serves as a basis for comparison of the performance of the actualportfolio.

Bond market: the market in which longer-term debt securities are issued and traded.

Central counterparty: an entity that interposes itself between the counterparties to trades,acting as the buyer to every seller and the seller to every buyer.

Central government: the government as defined in the European System of Accounts 1995 butexcluding regional and local governments (see also general government).

Central securities depository (CSD): an entity that holds and administrates securities andenables securities transactions to be processed by book entry. Securities can be held in a physical(but immobilised) or dematerialised form (i.e. so that they exist only as electronic records). Inaddition to the safekeeping and administration of securities, a CSD may incorporate clearing andsettlement functions.

Collateral: assets pledged (e.g. by credit institutions with central banks) as a guarantee for therepayment of loans, as well as assets sold (e.g. to central banks by credit institutions) underrepurchase agreements.

Consolidated balance sheet of the MFI sector: a balance sheet obtained by netting out inter-MFI positions (e.g. inter-MFI loans and deposits) in the aggregated MFI balance sheet. Itprovides statistical information on the MFI sector’s assets and liabilities vis-à-vis residents of theeuro area not belonging to this sector (i.e. general government and other euro area residents)and vis-à-vis non-euro area residents. It is the main statistical source for the calculation ofmonetary aggregates, and it provides the basis for the regular analysis of the counterparts of M3.

Corporate governance: procedures and processes according to which an organisation is directedand controlled. The corporate governance structure specifies the distribution of rights andresponsibilities among the different participants in the organisation – such as the board,managers, shareholders and other stakeholders – and lays down the rules and procedures fordecision-making.


Counterparty: the opposite party in a financial transaction (e.g. any party transacting with acentral bank).

Credit institution: (i) an undertaking whose business is to receive deposits or other repayablefunds from the public and to grant credit for its own account; or (ii) an undertaking or any otherlegal person, other than those under (i), which issues means of payment in the form of electronicmoney.

Credit risk: the risk that a counterparty will not settle an obligation at full value, either when itbecomes due or at any time thereafter. Credit risk includes replacement cost risk and principalrisk. It also includes the risk of settlement bank failure.

Debt security: a promise on the part of the issuer (i.e. the borrower) to make one or morepayment(s) to the holder (the lender) at a specified future date or dates. Such securities usuallycarry a specific rate of interest (the coupon) and/or are sold at a discount to the amount that will berepaid at maturity.

Deposit facility: a standing facility of the Eurosystem which counterparties may use to makeovernight deposits, remunerated at a pre-specified interest rate, at an NCB (see also key ECBinterest rates).

Direct investment: cross-border investment for the purpose of obtaining a lasting interest in anenterprise resident in another economy (assumed, in practice, for ownership of at least 10% of theordinary shares or voting power).

ECOFIN Council: the EU Council meeting in the composition of the ministers of economy andfinance.

Economic analysis: one pillar of the European Central Bank’s framework for conducting acomprehensive analysis of the risks to price stability, which forms the basis for the GoverningCouncil’s monetary policy decisions. The economic analysis focuses mainly on the assessment ofcurrent economic and financial developments and the implied short to medium-term risks to pricestability from the perspective of the interplay between supply and demand in goods, services andfactor markets at those horizons. In this respect, due attention is paid to the need to identify thenature of shocks affecting the economy, their effects on cost and pricing behaviour and the shortto medium-term prospects for their propagation in the economy (see also monetary analysis).

Economic and Financial Committee (EFC): a consultative Community body which contributesto the preparation of the work of the EU Council. Its tasks include reviewing the economic andfinancial situation of the Member States and of the Community, and budgetary surveillance.

Economic and Monetary Union (EMU): the Treaty describes the process of achieving EMU inthe EU in three stages. Stage Three, the last stage, started on 1 January 1999 with the transfer ofmonetary competence to the European Central Bank and the introduction of the euro. The cashchangeover on 1 January 2002 completed the process setting up EMU.

Effective exchange rates (EERs) of the euro (nominal/real): weighted averages of bilateraleuro exchange rates against the currencies of the euro area’s important trading partners. TheEuropean Central Bank publishes nominal EER indices for the euro against two groups of

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trading partners: the EER-23 (comprising the 13 non-euro area EU Member States and 10 maintrading partners outside the EU) and the EER-42 (composed of the EER-23 and 19 additionalcountries). The weights used reflect the share of each partner country in euro area trade andaccount for competition in third markets. Real EERs are nominal EERs deflated by a weightedaverage of foreign, relative to domestic, prices or costs. They are thus measures of price and costcompetitiveness.

EONIA (euro overnight index average): a measure of the effective interest rate prevailing in theeuro interbank overnight market. It is calculated as a weighted average of the interest rates onunsecured overnight lending transactions denominated in euro, as reported by a panel ofcontributing banks.

Equities: securities representing ownership of a stake in a corporation. They comprise sharestraded on stock exchanges (quoted shares), unquoted shares and other forms of equity. Equitiesusually produce income in the form of dividends.

Equity market: the market in which equities are issued and traded.

ERM II (exchange rate mechanism II): the exchange rate arrangement that provides theframework for exchange rate policy cooperation between the euro area countries and the EUMember States not participating in Stage Three of Economic and Monetary Union.

EURIBOR (euro interbank offered rate): the rate at which a prime bank is willing to lend fundsin euro to another prime bank, computed daily for interbank deposits with different maturities ofup to 12 months.

Euro area: the area encompassing those Member States in which the euro has been adopted as thesingle currency in accordance with the Treaty and in which a single monetary policy is conductedunder the responsibility of the Governing Council of the European Central Bank. The euro areacurrently comprises Belgium, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, theNetherlands, Austria, Portugal and Finland.

European Central Bank (ECB): the ECB lies at the centre of the Eurosystem and the EuropeanSystem of Central Banks (ESCB) and has legal personality under Community law. It ensuresthat the tasks conferred upon the Eurosystem and the ESCB are implemented either through itsown activities or through those of the NCBs, pursuant to the Statute of the ESCB. The ECB isgoverned by the Governing Council and the Executive Board, and, as a third decision-makingbody, by the General Council.

European Monetary Institute (EMI): a temporary institution established at the start of StageTwo of Economic and Monetary Union on 1 January 1994. It went into liquidation following theestablishment of the European Central Bank on 1 June 1998.

European System of Accounts 1995 (ESA 95): a system of uniform statistical definitions andclassifications aimed at achieving a harmonised quantitative description of the economies of theMember States. The ESA 95 is the Community’s version of the world System of NationalAccounts 1993 (SNA 93).


European System of Central Banks (ESCB): composed of the European Central Bank (ECB)and the NCBs of all 25 EU Member States, i.e. it includes, in addition to the members of theEurosystem, the NCBs of those Member States that have not yet adopted the euro. The ESCB isgoverned by the Governing Council and the Executive Board of the ECB, and, as a thirddecision-making body of the ECB, by the General Council.

Eurosystem: the central banking system of the euro area. It comprises the European CentralBank and the NCBs of the Member States that have adopted the euro in Stage Three of Economicand Monetary Union.

Excessive deficit procedure: the provision set out in Article 104 of the Treaty and specified inProtocol No 20 on the excessive deficit procedure requires EU Member States to maintainbudgetary discipline, defines the criteria for a budgetary position to be considered an excessivedeficit and regulates steps to be taken following the observation that the requirements for thebudgetary balance or government debt have not been fulfilled. This is supplemented by CouncilRegulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation ofthe excessive deficit procedure, which is one element of the Stability and Growth Pact.

Executive Board: one of the decision-making bodies of the European Central Bank (ECB). Itcomprises the President and the Vice-President of the ECB and four other members appointed bycommon accord by the Heads of State or Government of the countries that have adopted the euro.

Fine-tuning operation: a non-regular open market operation executed by the Eurosystemmainly in order to deal with unexpected liquidity fluctuations in the market.

Foreign exchange swap: simultaneous spot and forward transactions exchanging one currencyagainst another.

General Council: one of the decision-making bodies of the European Central Bank (ECB). Itcomprises the President and the Vice-President of the ECB and the governors of all EU NCBs.

General government: a sector defined in the European System of Accounts 1995 as comprisingresident entities that are engaged primarily in the production of non-market goods and servicesintended for individual and collective consumption and/or in the redistribution of national incomeand wealth. Included are central, regional and local government authorities as well as socialsecurity funds. Excluded are government-owned entities that conduct commercial operations,such as public enterprises.

Governing Council: the supreme decision-making body of the European Central Bank (ECB).It comprises all the members of the Executive Board of the ECB and the governors of the NCBs ofthe countries that have adopted the euro.

Harmonised Index of Consumer Prices (HICP): a measure of consumer prices that is compiledby Eurostat and harmonised for all EU Member States.

Implied volatility: a measure of expected volatility (standard deviation in terms of annualisedpercentage changes) in the prices of, for example, bonds and stocks (or of corresponding futurescontracts), which can be extracted from option prices.

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International investment position (i.i.p.): the value and composition of an economy’soutstanding net financial claims on (or financial liabilities to) the rest of the world.

Key ECB interest rates: the interest rates, set by the Governing Council, which reflect themonetary policy stance of the European Central Bank. They are the minimum bid rate on themain refinancing operations, the interest rate on the marginal lending facility and the interestrate on the deposit facility.

Liquidity risk: the risk that a counterparty will not settle an obligation at its full value when duebut on some unspecified date thereafter.

Longer-term refinancing operation: a regular open market operation executed by theEurosystem in the form of reverse transactions. Such operations are carried out through amonthly standard tender and normally have a maturity of three months.

M1: a narrow monetary aggregate that comprises currency in circulation plus overnight depositsheld with MFIs and central government (e.g. at the post office or treasury).

M2: an intermediate monetary aggregate that comprises M1 plus deposits redeemable at a periodof notice of up to and including three months (i.e. short-term savings deposits) and deposits withan agreed maturity of up to and including two years (i.e. short-term time deposits) held with MFIsand central government.

M3: a broad monetary aggregate that comprises M2 plus marketable instruments, in particularrepurchase agreements, money market fund shares/units and debt securities with a maturity ofup to and including two years issued by MFIs.

Main refinancing operation: a regular open market operation executed by the Eurosystem inthe form of reverse transactions. As of 10 March 2004 such operations are carried out through aweekly standard tender and normally have a maturity of one week.

Maintenance period: the period over which credit institutions’ compliance with reserverequirements is calculated. As of 10 March 2004 the maintenance period begins on thesettlement day of the first main refinancing operation following the meeting of the GoverningCouncil at which the monthly assessment of the monetary policy stance is pre-scheduled. TheEuropean Central Bank publishes a calendar of the reserve maintenance periods at least threemonths before the start of the year.

Marginal lending facility: a standing facility of the Eurosystem which counterparties mayuse to receive overnight credit from an NCB at a pre-specified interest rate against eligible assets(see also key ECB interest rates).

MFIs (monetary financial institutions): financial institutions which together form the money-issuing sector of the euro area. These include the European Central Bank, the NCBs of the euroarea countries, and credit institutions and money market funds located in the euro area.

MFI credit to euro area residents: MFI loans granted to non-MFI euro area residents(including the general government and the private sector) and MFI holdings of securities(shares, other equity and debt securities) issued by non-MFI euro area residents.


MFI interest rates: the interest rates that are applied by resident MFIs, excluding central banksand money market funds, to euro-denominated deposits and loans vis-à-vis households and non-financial corporations resident in the euro area.

MFI longer-term financial liabilities: deposits with an agreed maturity of over two years,deposits redeemable at a period of notice of over three months, debt securities issued by euroarea MFIs with an original maturity of more than two years and the capital and reserves of theeuro area MFI sector.

MFI net external assets: the external assets of the euro area MFI sector (such as gold, foreigncurrency banknotes and coins, securities issued by non-euro area residents and loans granted tonon-euro area residents) minus the external liabilities of the euro area MFI sector (such as non-euro area residents’ deposits and repurchase agreements, as well as their holdings of moneymarket fund shares/units and debt securities issued by MFIs with a maturity of up to andincluding two years).

Minimum bid rate: lower limit to the interest rates at which counterparties may submit bids inthe variable rate tenders of the main refinancing operations. This is one of the key ECB interestrates reflecting the stance of monetary policy.

Monetary analysis: one pillar of the European Central Bank’s framework for conducting acomprehensive analysis of the risks to price stability, which forms the basis for the GoverningCouncil’s monetary policy decisions. Monetary analysis helps to assess medium to long-termtrends in inflation, in view of the close relationship between money and prices over extendedhorizons. The monetary analysis takes into account developments in a wide range of monetaryindicators including M3, its components and counterparts, notably credit, and various measuresof excess liquidity (see also economic analysis).

Monetary income: income accruing to the NCBs in the performance of the Eurosystem’smonetary policy function, derived from assets earmarked in accordance with guidelinesestablished by the Governing Council and held against banknotes in circulation and depositliabilities to credit institutions.

Money market: the market in which short-term funds are raised, invested and traded usinginstruments which generally have an original maturity of up to and including one year.

Open market operation: an operation executed on the initiative of the central bank in thefinancial market. With regard to their aims, regularity and procedures, Eurosystem open marketoperations can be divided into four categories: main refinancing operations; longer-termrefinancing operations; fine-tuning operations; and structural operations. As for theinstruments used, reverse transactions are the main open market instrument of the Eurosystemand can be employed in all four categories of operations. In addition, the issuance of debtcertificates and outright transactions are available for structural operations, while outrighttransactions, foreign exchange swaps and the collection of fixed-term deposits are available forthe conduct of fine-tuning operations.

Option: a financial instrument that gives the owner the right, but not the obligation, to buy or sellspecific assets (e.g. a bond or a stock) at a predetermined price (the strike or exercise price) at orup to a certain future date (the exercise or maturity date).

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Portfolio investment: euro area residents’ net transactions and/or positions in securities issuedby non-residents of the euro area (“assets”) and non-residents’ net transactions and/or positions insecurities issued by euro area residents (“liabilities”). Included are equity securities and debtsecurities (bonds and notes, and money market instruments), excluding amounts recorded indirect investment or reserve assets.

Price stability: the maintenance of price stability is the primary objective of the Eurosystem.The Governing Council defines price stability as a year-on-year increase in the HarmonisedIndex of Consumer Prices for the euro area of below 2%. The Governing Council has also madeit clear that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to,2% over the medium term.

Primary balance: government net borrowing or net lending excluding interest payments onconsolidated government liabilities.

Projections: the results of exercises conducted four times a year to project possible futuremacroeconomic developments in the euro area. Eurosystem staff projections are published inJune and December whereas ECB staff projections are published in March and September. Theyform part of the economic analysis pillar of the monetary policy strategy of the EuropeanCentral Bank and are thus one of several inputs into the Governing Council’s assessment of therisks to price stability.

Real-time gross settlement (RTGS) system: a settlement system in which processing andsettlement take place on an order-by-order basis (without netting) in real time (continuously) (seealso TARGET).

Reference value for M3 growth: the annual growth rate of M3 over the medium term that isconsistent with the maintenance of price stability. At present, the reference value for annual M3growth is 4½%.

Repurchase agreement: an agreement to sell an asset and to repurchase it at a specified price ona predetermined future date or on demand. Such an agreement is similar to collateralisedborrowing, although it differs in that the seller does not retain ownership of the assets.

Reserve base: the sum of the eligible balance sheet items (in particular liabilities) that constitutethe basis for calculating the reserve requirement of a credit institution.

Reserve ratio: the ratio defined by the central bank for each category of eligible balance sheetitems included in the reserve base. The ratio is used to calculate reserve requirements.

Reserve requirement: the minimum amount of reserves a credit institution is required to holdwith the Eurosystem. Compliance is determined on the basis of the average of the daily balancesover a maintenance period of around one month.

Reverse transaction: an operation whereby the central bank buys or sells assets under arepurchase agreement or conducts credit operations against collateral.


Securities settlement system (SSS): a system which permits the holding and transfer ofsecurities, either free of payment or against payment (delivery versus payment) or against anotherasset (delivery versus delivery). It comprises all the institutional and technical arrangementsrequired for the settlement of securities trades and the safekeeping of securities. The system canoperate on a real-time gross settlement, gross settlement or net settlement basis. A settlementsystem allows for the calculation (clearing) of the obligations of participants.

Settlement risk: a general term used to designate the risk that settlement in a transfer system willnot take place as expected. This risk may comprise both credit and liquidity risk.

Stability and Growth Pact: consists of two Council Regulations, namely (i) Regulation (EC)No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and thesurveillance and coordination of economic policies and (ii) Regulation (EC) No 1467/97 of 7 July1997 on speeding up and clarifying the implementation of the excessive deficit procedure, and ofa European Council Resolution on the Stability and Growth Pact adopted at the Amsterdamsummit on 17 June 1997. It is intended to serve as a means of safeguarding sound governmentfinances in Stage Three of Economic and Monetary Union in order to strengthen the conditionsfor price stability and for strong, sustainable growth conducive to employment creation. Morespecifically, budgetary positions close to balance or in surplus are required as the medium-termobjective for Member States.

Standing facility: a central bank facility available to counterparties on their own initiative. TheEurosystem offers two overnight standing facilities: the marginal lending facility and thedeposit facility.

Straight-through processing (STP): the automated end-to-end processing of trades/paymenttransfers including the automated completion of generation, confirmation, clearing andsettlement of instructions.

Systemic risk: the risk that the inability of one institution to meet its obligations when due willcause other institutions to be unable to meet their obligations when due. Such a failure may causesignificant liquidity or credit problems and, as a result, could threaten the stability of orconfidence in markets.

TARGET (Trans-European Automated Real-time Gross settlement Express Transfersystem): the real-time gross settlement (RTGS) system for the euro. It is a decentralised systemconsisting of 15 national RTGS systems, the ECB payment mechanism (EPM) and theinterlinking mechanism.

Treaty: refers to the Treaty establishing the European Community (“Treaty of Rome”). TheTreaty has been amended on several occasions, in particular by the Treaty on European Union(“Maastricht Treaty”) which laid the foundations for Economic and Monetary Union andcontained the Statute of the ESCB.

Documents

ANNUAL REPORT 2004 - ecb.europa.eu · 3 ECB Annual Report 2004 CONTENTS FOREWORD 10 CHAPTER 1 ECONOMIC DEVELOPMENTS AND MONETARY ... 2.3 Accounting 116 3 FINANCIAL INTEGRATION 117