ANNUAL REPORT 2008 - Polymer Bank Notes of the World

EN2008EUROPEAN CENTRAL BANK ANNUAL REPORT20082008200820082008200820082008200820082008ANNUAL REPORT2008

In 2009 all ECBpublicationsfeature a motiftaken from the€200 banknote.ANNUAL REPORT2008

© European Central Bank, 2009AddressKaiserstrasse 2960311 Frankfurt am MainGermanyPostal addressPostfach 16 03 1960066 Frankfurt am MainGermanyTelephone+49 69 1344 0Websitehttp://www.ecb.europa.euFax+49 69 1344 6000All rights reserved.Reproduction for educational andnon-commercial purposes ispermitted provided that the source isacknowledged.Photographs:Claudio HilsMartin JoppenThe cut-off date for the data included inthis report was 27 February 2009.ISSN 1561-4573 (print)ISSN 1725-2865 (online)

CONTENTSFOREWORD 9CHAPTER 1ECONOMIC DEVELOPMENTSAND MONETARY POLICY1 MONETARY POLICY DECISIONS 162 MONETARY, FINANCIAL AND ECONOMICDEVELOPMENTS 222.1 The global macroeconomicenvironment 222.2 Monetary and financialdevelopments 262.3 Price and cost developments 532.4 Output, demand and labourmarket developments 622.5 Fiscal developments 692.6 Exchange rates and balance ofpayments developments 783 ECONOMIC AND MONETARYDEVELOPMENTS IN NON-EURO AREAEU MEMBER STATES 86CHAPTER 2CENTRAL BANK OPERATIONS AND ACTIVITIES1 MONETARY POLICY OPERATIONS,FOREIGN EXCHANGE OPERATIONS ANDINVESTMENT ACTIVITIES 981.1 Monetary policy operations 981.2 Foreign exchange operations 1091.3 Investment activities 1102 PAYMENT AND SECURITIES SETTLEMENTSYSTEMS 1122.1 The TARGET system 1122.2 TARGET2-Securities 1142.3 Settlement procedures forcollateral 1153 BANKNOTES AND COINS 1183.1 The circulation of banknotes andcoins and the handling of currency 1183.2 Banknote counterfeiting andcounterfeit deterrence 1193.3 Banknote production and issuance 1214 STATISTICS 1234.1 New or enhanced euro areastatistics 1234.2 Other statistical developments 1244.3 The medium-term workprogramme for the ECB’sstatistical function (2009-12) 1255 ECONOMIC RESEARCH 1275.1 Research priorities andachievements 1275.2 Research dissemination:publications and conferences 1286 OTHER TASKS AND ACTIVITIES 1306.1 Compliance with the prohibitionof monetary financing andprivileged access 1306.2 Advisory functions 1316.3 Administration of the borrowingand lending operations of theEuropean Community 1346.4 Eurosystem reserve managementservices 134CHAPTER 3ENTRY OF SLOVAKIA INTO THE EURO AREA1 ECONOMIC AND MONETARYDEVELOPMENTS IN SLOVAKIA 1382 LEGAL ASPECTS OF THE INTEGRATIONOF NÁRODNÁ BANKA SLOVENSKA INTOTHE EUROSYSTEM 1423 OPERATIONAL ASPECTS OF THEINTEGRATION OF NÁRODNÁ BANKASLOVENSKA INTO THE EUROSYSTEM 1433.1 Monetary policy operations 1433.2 Contribution to the ECB’s capital,reserves and foreign reserve assets 1434 THE CASH CHANGEOVER IN SLOVAKIA 145ECBAnnual Report20083

CHAPTER 4FINANCIAL STABILITY AND INTEGRATION1 FINANCIAL STABILITY 1501.1 Financial stability monitoring 1501.2 Financial stability arrangements 1522 FINANCIAL REGULATION ANDSUPERVISION 1552.1 General issues 1552.2 Banking 1562.3 Securities 1573 FINANCIAL INTEGRATION 1584 PAYMENT SYSTEMS AND MARKETINFRASTRUCTURE OVERSIGHT 1634.1 Large-value payment systems andinfrastructure service providers 1634.2 Retail payment systems andinstruments 1664.3 Securities and derivatives clearingand settlement 1664.4 Other activities 168CHAPTER 5EUROPEAN AND INTERNATIONAL RELATIONS1 EUROPEAN ISSUES 1721.1 Policy issues 1721.2 Institutional issues 1751.3 Developments in and relationswith EU candidate countries 1762 INTERNATIONAL ISSUES 1772.1 Key developments in theinternational monetary andfinancial system 1772.2 Cooperation with countriesoutside the EU 180CHAPTER 6ACCOUNTABILITY1 ACCOUNTABILITY VIS-À-VIS THEGENERAL PUBLIC AND THE EUROPEANPARLIAMENT 1842 SELECTED TOPICS RAISED AT MEETINGSWITH THE EUROPEAN PARLIAMENT 185CHAPTER 7EXTERNAL COMMUNICATION1 COMMUNICATION POLICY 1902 COMMUNICATION ACTIVITIES 191CHAPTER 8INSTITUTIONAL FRAMEWORK,ORGANISATION AND ANNUAL ACCOUNTS 1951 DECISION-MAKING BODIES ANDCORPORATE GOVERNANCE OF THE ECB 1961.1 The Eurosystem and the EuropeanSystem of Central Banks 1961.2 The Governing Council 1971.3 The Executive Board 2001.4 The General Council 2021.5 Eurosystem/ESCB committees,the Budget Committee, theHuman Resources Conferenceand the Eurosystem IT SteeringCommittee 2031.6 Corporate governance 2042 ORGANISATIONAL DEVELOPMENTS 2072.1 Human resources 2072.2 The Human Resources Conference 2092.3 New ECB Premises 2092.4 The Eurosystem ProcurementCoordination Office 2103 ESCB SOCIAL DIALOGUE 2114 ANNUAL ACCOUNTS OF THE ECB 212Management report for the yearending 31 December 2008 213Balance Sheet as at 31 December 2008 216Profit and Loss Account for the yearending 31 December 2008 218Accounting policies 219Notes on the Balance Sheet 224Notes on the Profit and Loss Account 236Auditor’s report 239Note on profit distribution/allocationof losses 2414ECBAnnual Report2008

5 CONSOLIDATED BALANCE SHEET OF THEEUROSYSTEM AS AT 31 DECEMBER 2008 242ANNEXESLEGAL INSTRUMENTS ADOPTED BY THE ECB 246OPINIONS ADOPTED BY THE ECB 250CHRONOLOGY OF MONETARY POLICYMEASURES OF THE EUROSYSTEM 258OVERVIEW OF THE ECB’S COMMUNICATIONRELATED TO THE PROVISION OF EUROLIQUIDITY 261DOCUMENTS PUBLISHED BY THE EUROPEANCENTRAL BANK SINCE 2008 269GLOSSARY 275LIST OF BOXES1 The impact of financial market tensionson monetary developments 27Chart A Monthly flows into or out ofmoney market fund shares/units and short-term MFIdebt instruments 27Chart B Monthly flows into or outof currency in circulationand overnight deposits 28Chart C Monthly flows of loansto OFIs, debt securitiespurchased by MFIs andMFIs’ derecognised loans 29Chart D Credit institutions’ assetholdings and loans to theprivate sector 292 Developments in the euro area moneymarket in the context of the financialturmoil 31Chart A ECB interest rates and theovernight interest rate 32Chart B Implied volatility derivedfrom options on threemonthEURIBOR futuresmaturing in March 2009 343 Volatility and liquidity in equity andgovernment bond markets 43Chart A Realised volatility ofweekly stock and bond returns 44Chart B Correlation between weeklystock and bond returns 44Chart C Trading volumes forgovernment bond futures 45Chart D Trading volumes in equitymarkets 454 Commodity prices and HICP inflation 55Chart A Commodity prices 55Chart B HICP inflation 56Chart C Selected sub-components ofthe HICP services component 56Chart D Longer-term inflationexpectations from surveysand the break-eveninflation rate 575 Labour market developments in theeuro area in 2008 67Chart A Euro area real GDP andtotal employment growth 68Chart B Breakdown of growth inhours worked 68Chart C Breakdown of employmentgrowth by type of contract 69Chart D Part-time work in the euroarea 696 Developments in the issuance andyield spreads of euro area governmentdebt securities 71Table A Annual growth rates of debtsecurities issued by euroarea governments 71Chart A Breakdown of the changein interest payments for theperiod 1999-2008 71Table B Structure of amountsoutstanding of debtsecurities issued by euroarea governments 72Chart B Government bond yieldspreads against Germangovernment bonds 73Chart C Sovereign credit defaultswaps 73ECBAnnual Report20085

7 Statistical accounting consequencesof the financial crisis on governmentdeficit and debt 758 The financial crisis and fiscal policy 779 Recent developments in euro areacompetitiveness 81Chart A Nominal and real effectiveexchange rates of the euro 81Chart B Changes in harmonisedcompetitiveness indicatorsacross euro area countries 82Chart C Developments in intra- andextra-euro area harmonisedcompetitiveness indicators 8310 Monetary policy operations during therecent financial market volatility 99Chart A Liquidity supply throughopen market operations anduse of standing facilities 101Chart B Spread between the EONIAand the MRO rate 10111 Statistical implications of theenlargement of the euro area toinclude Slovakia 14012 Ten years of EMU174LIST OF TABLES1 Price developments 542 Labour cost indicators 603 Composition of real GDP growth 634 Labour market developments 665 Fiscal positions in the euro areaand euro area countries 706 Real GDP growth in the non-euroarea EU Member States and theeuro area 867 HICP inflation in the non-euroarea EU Member States and theeuro area 878 Fiscal positions in the non-euroarea EU Member States and theeuro area 889 Balance of payments of the noneuroarea EU Member States andthe euro area 8910 Official monetary policy strategiesof the non-euro areaEU Member States 9311 Payment traffic in TARGET 11312 Allocation of euro banknoteproduction in 2008 12113 Main economic indicators forSlovakia 139LIST OF CHARTS1 ECB interest rates and moneymarket rates 172a Main developments in majorindustrialised economies 222b Main developments in majoremerging economies 243 Main developments in commoditymarkets 254 M3 and loans to the private sector 265 Main components of M3 356 MFI interest rates on short-termdeposits and a money marketinterest rate 367 Sectoral deposits 368 Credit to euro area residents 379 Unsecured money market interestrates 4010 Three-month EUREPO,EURIBOR and overnight indexswap 4011 Long-term government bondyields 4112 Euro area zero coupon break-eveninflation rates 4213 Major stock market indices 4614 Implied stock market volatility 4715 MFI loans to households 4816 Interest rates for lending tohouseholds and non-financialcorporations 4817 Household debt and interestpayments 4918 Real cost of the external financingof euro area non-financialcorporations 506ECBAnnual Report2008

19 Breakdown of the real annualgrowth rate of external financingto non-financial corporations 5120 Profit ratios of listed euro areanon-financial corporations 5221 Non-financial corporations’financing gap and its maincomponents 5222 Debt ratios of non-financialcorporations 5323 Breakdown of HICP inflation:main components 5424 Contributions to HICP inflationfrom main components 5825 Breakdown of industrial producerprices 5926 Sectoral compensation peremployee 6027 Residential property pricedevelopments in the euro area 6128 Euro area consumers’ qualitativeinflation perceptionsand expectations 6229 Contributions to quarterly realGDP growth 6430 Confidence indicators 6431 Unemployment 6632 Fiscal developments, 1999-2009 7633 Current account balance and itscomponents 8034 Euro area export volumes toselected trading partners 8035 Extra-euro area import prices 8436 Euro area direct and portfolioinvestment 8537 Net international investmentposition 8538 Developments in ERM II 9039 Developments in non-ERM IIEU currencies 9140 Key ECB interest rates and theEONIA 9841 Liquidity factors in the euro areain 2008 10442 Banknotes in circulation 10443 Eligible collateral by asset type 10744 Collateral put forward inEurosystem credit operationsversus outstanding credit inmonetary policy operations 10845 Breakdown of assets (includingcredit claims) put forward ascollateral by asset type 10846 Number of euro banknotesin circulation between2002 and 2008 11847 Value of euro banknotesin circulation between2002 and 2008 11848 Number of euro banknotesin circulation between2002 and 2008 11949 Number of counterfeit eurobanknotes recovered fromcirculation between2002 and 2008 12050 Distribution of euro banknotecounterfeits by denominationin 2008 120ECBAnnual Report20087

ABBREVIATIONSCOUNTRIESOTHERSBE Belgium BIS Bank for International SettlementsBG Bulgaria BPM5 IMF Balance of PaymentsCZ Czech Republic Manual (5th edition)DK Denmark c.i.f. cost, insurance and freight atDE Germany the importer’s borderEE Estonia CPI Consumer Price IndexIE Ireland ECB European Central BankGR Greece EEA European Economic AreaES Spain EER effective exchange rateFR France EMI European Monetary InstituteIT Italy EMU Economic and Monetary UnionCY Cyprus ESA 95 European System of Accounts 1995LV Latvia ESCB European System of Central BanksLT Lithuania EU European UnionLU Luxembourg EUR euroHU Hungary f.o.b. free on board at the exporter’s borderMT Malta GDP gross domestic productNL Netherlands HICP Harmonised Index of Consumer PricesAT Austria ILO International Labour OrganizationPL Poland IMF International Monetary FundPT Portugal MFI monetary financial institutionRO Romania NCB national central bankSI Slovenia OECD Organisation for EconomicSK Slovakia Co-operation and DevelopmentFI Finland PPI Producer Price IndexSE Sweden ULCM unit labour costs in manufacturingUK United KingdomJP Japan In accordance with Community practice, the EUUS United States Member States are listed in this report using thealphabetical order of the country names in thenational languages.8ECBAnnual Report2008

In 2008 the European Central Bank celebratedits tenth anniversary. With annual inflationaveraging only slightly above 2% in the euroarea, we have witnessed a decade of relativelystable prices, in line with the ECB’s mandateto deliver price stability. Likewise, longer-terminflation expectations have remained broadlyanchored at levels in line with price stabilityduring this time, reflecting the high degree ofcredibility enjoyed by the ECB’s monetarypolicy. This success is also tangible proofof the institutional robustness, coherence andunity of the Eurosystem – of its capacity to actin a truly European spirit on the basisof shared values, high standards andcommon principles. From the outset, theeuro has been a stable currency. It is nowused by 329 million fellow citizens in16 euro area countries and is also widelyaccepted in international financial markets.I would like to take this opportunity to welcomethe citizens of Slovakia to the euro area.Following the adoption of the euro by Cyprusand Malta in 2008, Slovakia joined the euro areaas the 16th member on 1 January 2009.2008 was an exceptional year which wascharacterised by extraordinary economicand financial developments. Owing to strongrises in commodity prices, inflation rosesignificantly in the first half of 2008 andupside risks to price stability mounted overthis period. Annual HICP inflation peakedin the middle of the year, reaching 4.0%in both June and July. In particular, therewere increasing indications of rising wagepressures. The monetary analysis confirmedthe assessment that upside risks to pricestability prevailed. In order to prevent broadbasedsecond-round effects and to preservethe solid anchoring of inflation expectations,the Governing Council of the ECB raised itskey interest rates in July 2008. From mid-September the financial tensions intensifiedconsiderably and increasingly spread to thereal economy throughout the world. Togetherwith strong declines in energy and othercommodity prices, this led to a reduction inglobal and euro area inflationary pressures.At the same time, uncertainty increased toan exceptional extent, affecting liquidity,asset prices and balance sheets. Overall, thesedevelopments implied significantly higherdownside risks to growth and a considerablereduction in inflationary pressures in themedium term.In a coordinated move, the ECB and other majorcentral banks announced reductions in theirpolicy interest rates on 8 October 2008. Overall,between October 2008 and March 2009, theGoverning Council lowered the key ECBinterest rates by 275 basis points. The overnightmoney market rates fell even more steeply overthis period, as the ECB significantly enlargedits liquidity provision to euro area banks. Theseunprecedented decisions were fully in line withthe ECB’s mandate to maintain price stability,in the light of declining inflationary pressuresand risks. The monetary analysis indicated thatupside risks to price stability were graduallyabating, as the underlying pace of monetaryexpansion decelerated, particularly in thesecond half of 2008. The growth of loans tothe non-financial private sector also moderated10 ECBAnnual Report2008

in the course of the year, in line with thetightening of financing conditions and weakereconomic activity.Overall, despite the clear deceleration ininflation rates from mid-2008 onwards, averageannual HICP inflation in 2008 reached 3.3%,the highest level recorded since the introductionof the euro. This compared with rates of around2% in the preceding years. Notwithstandingsharp fluctuations in headline inflation rates, theECB’s monetary policy succeeded in keepingmedium and long-term inflation expectationsfirmly anchored at levels broadly consistent withprice stability throughout 2008. At the sametime, real GDP growth in the euro area slowedto 0.8% in 2008, following solid growth rates of2.7% in 2007 and 3.0% in 2006. While economicgrowth in the euro area at the beginning of 2008was relatively resilient, it deteriorated rapidlylater in the year in the face of a pronouncedslowdown in world economic activity.With regard to fiscal policy, the relativelyfavourable fiscal outcomes achieved in recentyears were reversed in 2008 as the financialcrisis unfolded and the macroeconomicenvironment deteriorated rapidly. Accordingto the European Commission’s interimforecast of January 2009, the averagegeneral government deficit in the euro areaincreased from 0.6% of GDP in 2007 to1.7% in 2008, and it is expected to increaseconsiderably further to 4.0% of GDP in 2009.In October 2008 euro area countries agreedon coordinated action to stabilise the bankingsystem, including the recapitalisation offinancial institutions and guarantees for loansand deposits. In December 2008 the EuropeanCouncil approved a European EconomicRecovery Plan which is intended to supporteconomic recovery by strengthening aggregatedemand and increasing efforts to implementthe structural reforms envisaged by the Lisbonstrategy. The rising fiscal deficit and debtratios and the highly uncertain outlook poseconsiderable challenges for fiscal policy inthe euro area. To support public confidence inthe sustainability of public finances, a crediblecommitment to a path of consolidation inorder to return to sound fiscal positions, fullyrespecting the provisions of the Stability andGrowth Pact, is of the essence.Turning to structural policies, the ongoingweakness of economic activity and high levelsof uncertainty about the economic outlookimply the need to strengthen the resilience ofthe euro area economy. At the current juncture,it is essential to pursue economic policiesin line with the principle of an open marketeconomy with free competition, resisting anyprotectionist pressure. Moreover, productand services market reforms should fostercompetition. Labour market reforms shouldhelp to facilitate appropriate wage-setting,thereby protecting employment and fosteringlabour mobility across sectors and regions. Thiswill be particularly important for those areasand sectors hit strongly by the negative demandshock. In several countries, it is also crucial totake measures to address competitiveness lossesaccumulated over recent years.***Challenges in financial markets mountedconsiderably during 2008. Euro moneymarkets continued to be characterised by highcredit spreads and very low trading volumes,notwithstanding the stabilising effect on thesevariables of the special measures which the ECBhad started to introduce in 2007 and extendedin 2008. These measures mainly consisted of“frontloading” the liquidity provision to thebanking sector within reserve maintenanceperiods, increasing the average maturity of theEurosystem’s refinancing operations and, incooperation with the Federal Reserve System,providing liquidity in US dollars.As tensions across all money market segmentsand maturities intensified very significantlyin mid-September 2008, the Eurosystemtook further liquidity management measuresto ensure the continued ability of banks torefinance themselves. In particular, a fixedrate tender procedure with full allotment wasECBAnnual Report200811

adopted for main refinancing operations andall longer-term refinancing operations, and theset of eligible collateral accepted in refinancingoperations was temporarily widened. Moreover,the corridor formed by the interest rates on thestanding facilities was temporarily narrowed.As a result of these measures, banks generallycontinued to have broad access to euro liquidity,although tensions remained, especially at longermaturities.***The ECB actively contributed to the key policyand regulatory responses which were adoptedin 2008 to address the financial crisis and tostrengthen the financial system. At the globallevel, the ECB participated in the deliberationsleading to the recommendations of the FinancialStability Forum to the G7 finance ministers andcentral bank governors in April 2008. Theserecommendations aim to strengthen prudentialrequirements, transparency and valuationframeworks, as well as improve the use of creditratings, the authorities’ responsiveness to risksand arrangements for dealing with stress in thefinancial system. The ECB also contributed toother major global policy responses, namelythe action plan agreed by the G20 countries on15 November 2008.At the European level, the ECB gave advice onthe design of measures by public authorities tosupport the functioning of the banking sector.The Paris Declaration of the euro area countriesof 12 October 2008 – subsequently endorsed bythe European Council on 16 October – set out anaction plan of coordinated measures to restoreconfidence and improve financing conditionsin the economy. These measures included thegranting of government guarantees on bank debtissuance and the recapitalisation of banks. TheGoverning Council issued recommendationson the main features and pricing of governmentguarantees and recapitalisation instruments.The aims of the recommendations wereto preserve the level playing-field amongfinancial institutions, enhance the stabilityof the financial system, facilitate a return tonormal market conditions, and ensure the properfinancing of the economy. The recommendationswere duly taken into consideration by theMember States in their actions and reflectedin the guidance issued by the EuropeanCommission regarding compliance with thestate aid rules of the Treaty.In early 2009 the ECB contributed to thedefinition of guiding principles on asset reliefmeasures aimed at removing the uncertaintysurrounding the valuation of certain securitisedassets on the balance sheets of financialinstitutions. The contribution of the ECB wasreflected in the guidance issued by the EuropeanCommission on such measures.***During 2008 the ECB continued to activelyfoster the process of European financialintegration. The ECB provided advice inparticular on financial regulation and supervision,as well as on securities clearing and settlementand payment systems. In addition, the ECBcontinued to act as a catalyst for private sectoractivities by facilitating collective action. TheSingle Euro Payments Area (SEPA) initiative,which the ECB has strongly supported since itsinception, reached its first major milestone withthe launch of the SEPA credit transfer and theSEPA cards framework in January 2008. Sincethen, the first benefits of SEPA have materialisedfor banks and, more importantly, have started toreach the end-users of payment services.In the field of central bank services that also fosterfinancial integration, the decentralised firstgenerationTARGET system, the Eurosystem’slarge-value payment system, was fully replacedby a second-generation single platform system(TARGET2) in May 2008. TARGET2 is thefirst market infrastructure to be completelyintegrated and harmonised at the Europeanlevel. Furthermore, in July 2008 the GoverningCouncil decided to build a new securitiessettlement platform called TARGET2-Securities(T2S). By offering harmonised, borderless andneutral settlement services in euro and other12 ECBAnnual Report2008

currencies, T2S will be a major step towardsan integrated securities market in Europe. InJuly 2008 the Governing Council also decidedto establish a single shareable platform(CCBM2) for collateral mobilisation, withliquidity and collateral management facilitiesfor Eurosystem counterparties.***At the end of 2008 the ECB had an approvedheadcount ceiling of 1,357.5 full-timeequivalent positions, compared with 1,348 atthe end of 2007. The members of staff of theECB come from all 27 countries of the EUand are recruited by means of open selectioncampaigns to fill vacancies published on theECB’s website. In line with the ECB’s mobilitypolicy, 165 members of staff moved internallyto other positions in 2008, while 23 members ofstaff were seconded to other organisations and30 were granted unpaid leave, in most cases totake up employment with other organisations.The continuous acquisition and development ofskills and competencies by all members of staff,including management, remained a cornerstoneof the ECB’s human resources strategy.In 2008, in order to take into account the latestdevelopments in terms of life expectancy andfinancial sustainability, the ECB started areview of the retirement plan it offers to its staff.The results of this review are expected to beimplemented in spring 2009.the background of further research conductedon the construction market, the ECB remainsdetermined to complete the project within thegiven budget.***The ECB earned a surplus of €2.66 billion in2008 compared with a surplus of €0.29 billionin 2007. The Governing Council decided totransfer, as at 31 December 2008, an amountof €1.34 billion to the provision against foreignexchange rate, interest rate and gold price risks.The size of this provision, which, followingthe 2008 transfer, amounts to €4.01 billion,is reviewed annually. The ECB’s net resultin 2008, after the transfer to the provision hadbeen made, was €1.32 billion. This amount wasdistributed to the euro area NCBs in proportionto their paid-up shares in the ECB’s capital.Frankfurt am Main, March 2009Jean-Claude Trichet***The year 2008 brought fresh challenges withregard to the New ECB Premises project, as thepublic tender procedure for a general contractordid not produce a satisfactory economic result.Consequently, during the summer months allpossible options were thoroughly examined,and the cost calculations and tender strategywere reviewed. Based on this analysis, theGoverning Council decided to divide theprocurement of construction works into themain separate trades and lots, and to restart thepublic tender procedure accordingly. AgainstECBAnnual Report200813

The first Governing Council of the European Central Bank in 1998The Governing Council of the European Central Bank in 2008Note: Mario Draghi and Athanasios Orphanides were not present when the photograph was taken.

CHAPTER 1ECONOMICDEVELOPMENTS ANDMONETARY POLICY

1 MONETARY POLICY DECISIONSIn 2008 the ECB conducted its monetarypolicy against the backdrop of the financialturmoil observed since August 2007. TheGoverning Council kept the key ECB interestrates unchanged in the first half of 2008,before raising them by 25 basis points in Julyand then lowering them in three stages by atotal of 175 basis points in the fourth quarterof the year. Developments in key ECB interestrates in 2008 reflected the evolution of risksto price stability over the medium term,which were strongly influenced by two globalphenomena: developments in internationalcommodity prices, particularly energy andfood prices; and the economic impact of theongoing financial turmoil, which intensified inmid-September.In the first half of 2008 inflationary pressures inthe euro area increased, largely as a result of avery rapid increase in international commodityprices. Annual HICP inflation remained wellabove 2% during this period, increasing from3.2% in January to peak at 4.0% in June and July,mainly owing to developments in energy andfood prices. With inflationary pressures rising inthe presence of relatively tight labour markets,the risk of second-round effects increased.In addition, the underlying pace of broad moneygrowth remained vigorous, despite moderatinggradually from the peaks seen in the second halfof 2007. In order to contain upside risks to pricestability and ensure that long-term inflationexpectations remained solidly anchored in linewith the ECB’s definition of price stability, theGoverning Council raised the minimum bid ratein the main refinancing operations by 25 basispoints to 4.25% in July 2008.Moving into the third quarter of the year, untilmid-September available data suggested thatrisks to price stability over the medium termremained on the upside. Uncertainty regardingthe outlook for economic activity remainedconsiderable, owing, among other things, tothe very high and volatile commodity pricesand the ongoing tensions in financial markets.Overall, downside risks to the economic outlookprevailed.As of mid-September, the financial turbulenceintensified significantly, causing severedisruptions and liquidity shortages in manyfinancial market segments and leading to asubstantial deterioration in the global economicoutlook. Inflation also fell sharply in the last fewmonths of the year and inflationary pressuresweakened. Driven by declines in commodityprices, particularly oil prices, annual HICPinflation fell in the second half of the year,reaching 1.6% in December. Monetary trends,which continued to moderate in the second halfof the year, supported the view that inflationarypressures were weakening. In this context, themain refinancing rate was cut by 50 basis pointsto 3.75% on 8 October in a coordinated movetogether with other major central banks. Themain refinancing rate was then lowered by afurther 50 basis points in November and another75 basis points in December and stood at 2.50%at the end of the year (see Chart 1).Real GDP growth in the euro area was sustained,but somewhat below trend in the first half of theyear, although the impact that unusual weatherconditions had on construction activity createdvolatility in the quarterly growth rates. Economicconditions worsened in the second half of2008, particularly after the intensification of thefinancial market tensions in mid-September.The financial crisis spread to the real economymore broadly than had previously been expected.In the third quarter real GDP in the euro areacontracted by 0.2% quarter on quarter, primarilyreflecting the large negative contribution of nettrade, which stemmed from weak export growthcombined with a strong rebound in imports.The fourth quarter saw a broad-based economiccontraction amid heightened uncertainty, withreal GDP contracting by a further 1.5%. Overall,euro area real GDP grew by 0.8% in 2008,significantly less than the 2.7% recorded in 2007.Average annual HICP inflation was veryhigh in 2008, standing at 3.3%, the highestlevel since the introduction of the euro,after standing close to 2% in previous years(e.g. 2.1% in 2007). Inflation increased from3.2% in January to peak at 4.0% in June and July,16 ECBAnnual Report2008

Chart 1 ECB interest rates and money market rates(percentages per annum; daily data)6.0minimum bid rate/fixed rate in the main refinancing operationsdeposit ratemarginal lending rateovernight interest rate (EONIA)6.05.05.04.04.03.03.02.02.01.01.00.01999 2000 2001 2002 2003 2004 2005 2006 2007 2008Source: ECB.Note: The last observation relates to 27 February 2009.0.0before declining to reach 1.6% in December.These inflation developments were drivenmainly by global developments in commodityprices, especially energy and food prices.In particular, oil prices increased from aroundUSD 100 per barrel in January to peak at almostUSD 150 in July, before falling to aroundUSD 40 per barrel in December. For most of2008 the inflation rate stood significantly abovethe ECB’s definition of price stability, mainly onaccount of those commodity price developments.Unit labour cost growth remained strong, drivenby stronger wage increases in the presence oftighter labour markets and some second-roundeffects, but also a cyclical slowdown in labourproductivity growth later in the year. Signs of anupward drift in long-term inflation expectationsderived from financial market instruments wereapparent towards the middle of the year, butthese disappeared after the interest rate increasein July and the reversal observed in the price ofcommodities, in particular oil, which reducedconcerns regarding the emergence of secondroundeffects. Overall, in spite of the sharpmovements observed in inflation owing to largechanges in commodity prices, survey-basedmeasures of long-term inflation expectationsremained broadly anchored at levels consistentwith price stability, in line with the mediumtermorientation of the ECB’s monetary policy.The underlying pace of monetary expansionmoderated over the course of 2008, but remainedvigorous. While M3 growth tended to overstatetrend monetary dynamics owing to the impactof the flat yield curve and other temporaryfactors, particularly in the first half of the year, abroad-based assessment of the components andcounterparts of M3 confirmed that underlyingmoney growth remained strong. The growth ofloans to the non-financial private sector alsomoderated in the course of the year, in linewith the tightening of financing conditions andweaker economic activity. The increased stressobserved in the financial system as a result ofthe intensification of the financial tensionsin September was apparent in the monetarydata towards the end of the year. As regardsmonetary aggregates, that increased stressmainly triggered shifts between the componentsof M3, rather than having an impact on M3itself. The subdued developments in loans at theend of the year confirmed that corporate credithad weakened significantly following a longECBAnnual Report200817

period of dynamic growth. Those developmentsmainly reflected the slowdown in real economicactivity, although supply factors may also haveplayed a role, as indicated by the Eurosystem’sbank lending survey. Overall, monetary trendssupported the view that inflationary pressuresweakened towards the end of 2008.INFLATIONARY PRESSURES LED TO AN INCREASEIN KEY ECB INTEREST RATES IN JULY 2008Looking more closely at the monetary policydecisions taken in 2008, the year can be dividedinto two parts: the period up until summer 2008,when the data available at the time indicatedincreasing upside risks to price stability; andthe post-summer period, when new informationindicated that the ongoing financial turmoil andthe global economic slowdown were having astronger impact on euro area activity and thatinflationary pressures were weakening.In the first half of the year economic conditionswere characterised by high levels of uncertaintyregarding the ongoing reappraisal of risk infinancial markets and its potential impact onthe real economy. Quarterly growth had begunto moderate in the course of 2007. Indicatorsof business and consumer confidence had alsobegun to decline, but in early 2008 remainedat levels that pointed to sustained growth. Theoutlook for economic growth had moderatedsomewhat, but was still relatively favourableat the beginning of 2008. It was expected thatdomestic and foreign demand would moderate,but continue to support ongoing growth. Despitethe dampening effect of higher commodityprices, consumption growth was expected tocontribute to economic expansion, in line withrising employment, as unemployment rateshad fallen to levels not seen for 25 years. Withresilient economic activity in emerging marketeconomies expected to mitigate the impact thatthe US economic slowdown would have on theeuro area’s foreign demand, external demandwas expected to provide sustained support toeuro area exports.Indeed, in the first half of the year incomingmacroeconomic data suggested that realGDP growth would moderate, but only slightly.The June 2008 Eurosystem staff macroeconomicprojections foresaw average annual realGDP growth of between 1.5% and 2.1% in 2008and between 1.0% and 2.0% in 2009. While theprojections for 2008 remained at the lower endof the range published in December 2007, theprojections for 2009 were revised downwardssomewhat. The uncertainty surrounding theoutlook for economic growth was considerable,and risks were considered to lie on the downside.Those risks related mainly to the potential forfinancial market developments to have a broaderthan expected impact on financing conditionsand economic sentiment, with a negative impacton world and euro area growth. Further downsiderisks stemmed from the scope for additionalincreases in oil and other commodity prices,concerns regarding protectionist pressuresand the possibility of disorderly developmentsowing to global imbalances.At the same time, the euro area was experiencinga period of rising annual rates of inflation, mainlyas a result of sharp increases in energy and foodprices at the global level. Annual HICP inflationwas above 3% at the start of 2008 and increasedfrom 3.2% in January to 3.7% in May, withstrong upward pressure on headline inflationin the short term. Consequently, the GoverningCouncil noted in June that risks to price stabilityover the medium term had increased further.HICP inflation was expected to remain highfor a more protracted period than previouslythought. There were also signs of an upwarddrift in long-term inflation expectations. TheJune 2008 Eurosystem staff projections foresawaverage annual HICP inflation of between 3.2%and 3.6% in 2008 and between 1.8% and 3.0% in2009. The ranges projected for inflation in 2008and 2009 were thus markedly higher than thosein previous staff projections, mainly reflectinghigher oil and food prices and increasinginflationary pressures in the services sector.There was also a concern that wage growthmight turn out to be stronger than expected,taking into account the high levels of capacityutilisation, the tight labour market conditionsand the risk of second-round effects.18 ECBAnnual Report2008

Despite moderating, the annual growth rate ofthe monetary aggregate M3 remained vigorous.A number of temporary factors, particularlythe relatively flat yield curve, suggested thatM3 growth was overstating the pace of theunderlying monetary expansion. Even takingsuch effects into account, a broad-basedassessment of the monetary data confirmed thatthe underlying rate of money and credit growthremained strong. The growth of householdborrowing had moderated somewhat, reflectingthe impact of the increases in key ECB interestrates as of December 2005 and the coolinghousing markets in several parts of the euro area.However, the growth of loans to non-financialcorporations remained robust.In this context, the Governing Council consideredthat the risks to price stability remained clearlyon the upside and had increased further. Thoserisks stemmed in particular from the possibilityof second-round effects on wage and pricesetting,but also from the potential for furtherrises in oil and food prices. The possibility ofincreases in administered prices and indirecttaxes that exceeded those foreseen at the timealso constituted an upside risk to the inflationoutlook. This assessment was supported bycross-checking with data on money and creditgrowth. Given the strong growth seen in moneyand credit aggregates, the monetary analysisconfirmed the indications from the economicanalysis that upside risks to price stabilityprevailed over the medium to longer term. TheGoverning Council stressed its determination tofirmly anchor medium and long-term inflationexpectations in line with price stability.In order to prevent broad-based second-roundeffects and counteract the increasing upsiderisks to price stability over the medium term, theGoverning Council decided to raise the key ECBinterest rates by 25 basis points on 3 July 2008,having kept rates unchanged since June 2007in view of the heightened level of uncertaintyin the context of the ongoing financial turmoil.The Governing Council emphasised its strongdetermination to keep medium and longterminflation expectations firmly anchored inline with price stability. This would preservepurchasing power in the medium term andcontinue to support sustainable growth andemployment in the euro area.Moving into the third quarter of 2008, the realGDP growth figures that were to be releasedfor the second quarter of 2008 were expectedto be substantially weaker than those for thefirst quarter of the year. While this was partlya technical reaction to the strong growth seen inthe first few months of the year, it also reflecteda weakening of GDP growth owing to slowerexpansion at the global level and the dampeningeffects of high and volatile oil and food prices.Uncertainty regarding the outlook for economicactivity remained considerable, owing, amongother things, to the very high and volatilecommodity prices and the ongoing tensionsin financial markets. Overall, downside riskscontinued to prevail.At the same time, information available inAugust and September confirmed that annualinflation rates were likely to remain wellabove levels consistent with price stabilityfor a protracted period of time. The data alsosuggested that risks to price stability over themedium term remained on the upside. Havingreached 4.0% in June, inflation had remained at4.0% in July and stood at 3.8% in August, largelyas a result of both the direct and the indirecteffects of previous strong increases in energyand food prices at the global level. Moreover, itwas confirmed that wage growth had acceleratedsignificantly. With labour productivity growthslowing, this resulted in sharp increases in unitlabour costs.WEAKENING INFLATIONARY PRESSURES LED TOMONETARY POLICY EASING IN THE LATTER PARTOF 2008The financial tensions intensified in September,dominated by events in US markets, particularlyfollowing the bankruptcy of Lehman Brotherson 15 September. This led to substantialvolatility in all financial market segments, lowlevels of liquidity across a number of marketsegments, significant restructuring at severalECBAnnual Report200819

large financial institutions, a financial crisisin Iceland and contagion effects for othercountries, and unprecedented policy action bygovernments. The financial market turmoilalso resulted in a significant increase in riskaversion. This could be seen, inter alia, in thesubstantial widening of corporate and sovereignbond spreads, which had a significant downwardimpact on the real economy. At its meeting on2 October the Governing Council discussedextensively the recent intensification of thefinancial market turmoil and its possible impacton economic activity and inflation, recognisingthe extraordinarily high level of uncertaintystemming from recent developments. As theworld economy as a whole was feeling theadverse effects of this prolonged and intenseperiod of financial market turmoil, economicactivity was also weakening in the euro area.Inflationary pressures had begun to moderate inthe euro area, as well as in a number of othermajor countries in the world economy, mainlyreflecting a marked decline in energy andother commodity prices. Inflation expectationshad declined, returning to levels consistentwith the ECB’s definition of price stability.By increasing the downside risks to growth, theintensification of the financial crisis had alsoreduced the upside risks to price stability.In a coordinated move, the Bank of Canada, theBank of England, the ECB, the Federal ReserveSystem, Sveriges Riksbank and the SwissNational Bank announced reductions in policyinterest rates on 8 October. In this context, theGoverning Council lowered key ECB interestrates by 50 basis points, acknowledging thatupside inflationary risks in the euro area hadrecently decreased and inflationary pressures hadbegun to moderate. The Governing Council alsoadopted two temporary measures to support theimplementation of monetary policy, narrowingthe corridor formed by the rates on the standingfacilities and announcing full allotment at fixedrates in its tender operations.Tensions increasingly spilled over from thefinancial sector to the real economy and fromadvanced economies to emerging marketeconomies. The outlook for global growthdeteriorated sharply, implying a contractionin foreign demand that would have a negativeimpact on euro area activity. Business confidenceindicators, which had started to decline inmid-2007, began to fall faster and reachednew record lows every month. The fourthquarter was marked by a broad-based economicslowdown with a high level of uncertainty, andgovernments announced substantial economicstimulus packages. Incoming informationon current economic developments justifiedthe more pessimistic outlook, which was duenotably to the materialisation of previouslyidentified risks stemming from the financialmarket tensions. Looking ahead, globaleconomic weakness and very sluggish domesticdemand were expected to persist in the followingfew quarters. In fact, the December 2008Eurosystem staff macroeconomic projectionsfor the euro area indicated that the outlook hadsignificantly deteriorated. Annual real GDPgrowth was projected to lie between -1.0% and0.0% for 2009 and between 0.5% and 1.5%for 2010. These figures represented substantialdownward revisions relative to the previous staffprojections. The economic outlook continued tobe surrounded by an exceptionally high degreeof uncertainty, and risks to economic growthremained on the downside.With regard to price developments, annualHICP inflation had declined substantially,falling to 2.1% in November, down from 3.2%in October and 3.6% in September. Inflationrates were expected to continue to decline inthe coming months. The intensification andbroadening of the financial market turmoil waslikely to dampen global and euro area demandfor a protracted period of time. In such anenvironment, taking into account the strongdeclines observed in commodity prices in recentmonths, price, cost and wage pressures in theeuro area were also expected to moderate. TheDecember 2008 Eurosystem staff projectionsforesaw annual HICP inflation of between 1.1%and 1.7% for 2009 and between 1.5% and 2.1%for 2010. For 2009, these projections constituted20 ECBAnnual Report2008

substantial downward revisions in relation to theprevious staff projections, mainly reflecting thelarge declines observed in commodity prices andthe impact of weakening demand. Risks to pricestability at the policy-relevant medium-termhorizon were considered to be more balancedthan in the previous quarter.Turning to the monetary analysis, dataavailable towards the end of 2008 showed thatthe annual growth rates of broad money andcredit aggregates, while still remaining strong,continued to decline. The intensification ofthe financial market turmoil observed sincemid-September had been seen as a potentialwatershed in the evolution of monetarydevelopments, with money and credit data forOctober indicating a significant impact on thebehaviour of market participants. However, inNovember there were some signs of a returnto the pattern of monetary developments seenprior to Lehman Brothers’ default. Overall, boththe broad aggregate M3 and, in particular, thecomponents of M3 most closely related to theongoing financial tensions – such as holdingsof money market funds – showed considerablemonth-to-month volatility in the final monthsof 2008. Looking through this volatility,the underlying pace of broad money growthcontinued to gradually decline from the peak seenin 2007. However, the intensification of financialtensions observed as of September 2008 led tosignificant substitution among the componentsof M3. Monetary analysis also indicated thecontinued moderation of the growth rate ofloans to the non-financial private sector. Priorto December this was largely on account ofweakness in loans to households, especiallyfor house purchase, but by the turn of the yeara clear decline was also observed in the growthrate of loans to non-financial corporations. Thesesubdued developments in loans seem mainly toreflect the slowdown in real economic activity,although the Eurosystem’s bank lending surveysuggests that supply factors may also haveplayed a role. The heightened level of stressin the financial system remained apparent inthe monetary data towards the end of the year.Overall, monetary trends supported the view thatinflationary pressures were weakening further.These revisions to the outlook for economicactivity, and therefore also for inflation, warrantedsignificant monetary policy easing. On the basisof its regular economic and monetary analyses,the Governing Council decided to reduce thekey ECB interest rates by a further 50 basispoints at its meeting on 6 November, in line withthe reduction in upside risks to price stabilityarising from the materialisation of downsiderisks to growth. At its meeting on 4 Decemberthe Governing Council then decided to reducethe key ECB interest rates by a further 75 basispoints. Evidence obtained since its last meetingshowed that inflationary pressures had weakenedfurther and, looking ahead, inflation rates wereexpected to be in line with price stability overthe policy-relevant horizon.ECBAnnual Report200821

2 MONETARY, FINANCIAL AND ECONOMICDEVELOPMENTS2.1 THE GLOBAL MACROECONOMICENVIRONMENTREPERCUSSIONS OF THE FINANCIAL MARKETTURMOIL ON GLOBAL ACTIVITYIn 2008 the financial market turbulenceintensified and reached levels not seen indecades, with severe consequences for the realeconomy in the latter part of the year. In thefirst half of the year, the economic weakness inthe United States extended beyond the housingsector, and the global repercussions of thefinancial turmoil translated into a slowdownin economic growth in major developedeconomies. Overall, global economic activityremained relatively well supported by theresilience in the economic conditions ofemerging markets. However, from mid-September, when the financial crisis resultedin the collapse of a major US investment bankand the unravelling of a number of large actorsin the global financial system, the challengesfacing economic activity intensified. Globaleconomic conditions deteriorated rapidlyin view of faltering consumer and businessconfidence, tighter credit conditions worldwideand adverse wealth effects stemming fromdeclining house prices and equity valuations.While important and unprecedented measureswere taken by governments and central banksaround the world to limit systemic risks and torestore financial stability, the financial marketturmoil led to the global downturn becomingincreasingly synchronised, which amplifiedthe adverse feedback between the financialcrisis and real economic activity. Towardsthe end of the year, most advanced economieswere already in or on the brink of recession.Moreover, the economic weakness began tospread more forcefully to emerging economies.In particular, economic conditions in countrieswith large external and domestic imbalancesdeteriorated rapidly, and economic growth insmall open economies moderated significantlyin a very short space of time.Global inflation developments were stronglyaffected by the sharp movements in commodityprices and global economic conditions. Inthe first half of the year, global inflationarypressures mounted. In the OECD countries,annual headline inflation peaked at 4.8%in July 2008. This was mostly due to risingfood and energy prices. On 11 July 2008Brent crude oil prices surged to a record levelof USD 147.5 per barrel. Emerging economies,with a higher weight of food in the consumptionbasket, experienced even stronger inflationarypressures. In the second half of the year,however, a sharp reversal in commodity pricesassociated with the global economic slowdownsignificantly alleviated global inflation rates.Oil prices plummeted in the second half of theyear and stood close to USD 40 per barrel by theend of 2008. Accordingly, after passing its peakChart 2a Main developments in majorindustrialised economies543210-1-2-3-4-56543210-1-2euro areaJapanUnited StatesUnited KingdomOutput growth 1)(year-on-year percentage changes; quarterly data)1999 2000 2001 2002 2003 2004 2005 2006 20072008Inflation rates 2)(consumer prices; annual percentage changes; monthly data)543210-1-2-3-4-5-21999 2000 2001 2002 2003 2004 2005 2006 2007 2008Sources: National data, BIS, Eurostat and ECB calculations.1) Eurostat data are used for the euro area and the UnitedKingdom; national data are used for the United States and Japan.GDP figures have been seasonally adjusted.2) HICP for the euro area and the United Kingdom; CPI for theUnited States and Japan.6543210-122 ECBAnnual Report2008

in July, annual inflation in the OECD countriesslowed to 1.5% in December. Excluding foodand energy, consumer prices rose by 2.0% in theyear to December.UNITED STATESIn the United States, economic activitydecelerated markedly in 2008. For the wholeof 2008, real GDP increased at a rate of 1.1%.While there was positive growth in the firsthalf of the year partly due to temporary fiscalstimulus measures and support from foreigntrade, intensifying financial market strains,restrictive credit conditions and weaker foreigndemand all contributed to an outright contractionin output throughout the second half of 2008.Private consumption was negatively affectedby deteriorating consumer sentiment and labourmarket conditions, in addition to a decline inhousehold wealth owing to falling house pricesand equity valuations. At the same time, businessinvestment weakened amid declining corporateprofits, tighter lending standards, as well as thebroadly weakening outlook for demand. Theongoing housing market correction – intensifiedby the financial turmoil – continued to be amajor drag on the economy, with residentialinvestment subtracting 0.9 percentage pointfrom GDP growth in 2008. Foreign trade wasa major contributor to growth throughout mostof 2008, reflecting buoyant external demandearlier in the year and the lagged effects of pastUS dollar depreciation. However, the positivetrade effect faded towards the end of the yearas a sharp economic slowdown in a number ofUS trading partners weighed on foreign demandand exports. Nonetheless, the current accountdeficit narrowed from 5.3% of GDP in 2007 to5.0% on average in the first three quarters of2008, although this improvement was limitedsomewhat by the higher price of oil and othercommodities during most of that period, whichpushed up the average value of imported goodsrelative to the previous year.As regards US price developments, the averageannual rate of change in the CPI for 2008 was3.8%, up from 2.9% the year before. Headlineinflation oscillated in a wider than usual range,reflecting volatility in oil and other commodityprices. CPI inflation was at elevated levels duringthe first half of 2008 and peaked at 5.6% in Julyamid rapidly rising energy costs. Towards theend of the year, the annual rate of change in theCPI fell sharply to 0.1% in December owing tosharp falls in commodity prices and increasingslack in the economy as the recession deepened.Excluding food and energy, annual CPI inflationstood at 2.3% in 2008 (the same as in 2007).The declining trend throughout most of the yearreflected to some extent a deceleration in theowner-equivalent rent component.The Federal Open Market Committee (FOMC)of the Federal Reserve System decreased thetarget for the federal funds rate from 4.25% atthe beginning of 2008 to a range from 0.0% to0.25% by the end of the year. At its meeting inDecember 2008, the Committee anticipated thatweak economic conditions were likely to warrantexceptionally low levels in the policy rate forsome time to come. The FOMC undertook anumber of targeted programmes to enhanceliquidity and provide support to financialmarkets in view of deteriorating conditions.As regards fiscal policy, the federal budgetdeficit widened in the 2008 fiscal year – whichstarted in October 2007 – compared with theprevious year. This stemmed from a combinationof lower tax receipts as the economy slowedand an increase in government spending, partlyreflecting the implementation of fiscal stimulusmeasures. According to estimates from theCongressional Budget Office, the federal budgetdeficit stood at 3.2% in the 2008 fiscal year.JAPANIn Japan, economic expansion ended abruptlyin 2008, with slightly positive growth in thefirst quarter followed by a marked decrease inoverall production thereafter. Strong externaldemand and domestic investment supportedreal GDP growth in the first quarter. However,substantial declines in net exports and businessinvestment – which had been the driving force ofthe Japanese recovery in previous years – alongwith restrained consumption owing to increasingECBAnnual Report200823

labour market uncertainty and declining realincomes offset the positive growth of the firstquarter and resulted in negative GDP growthrates for the rest of the year. Consumer priceinflation accelerated noticeably in the first halfof the year, peaking at 2.3% in July, but slowedto 0.4% in December. While the Japanesebanking sector remained relatively resilient tothe global financial market turmoil, substantialstock market losses and the intensification ofthe financial turmoil had a negative impacton firms’ investment and consumption in thesecond half of the year. A strong appreciationin effective terms of the Japanese yen putadditional downward pressure on profitabilityand investment in export-oriented industries.In view of the rapid deterioration in economicconditions, the Bank of Japan decided to lowerits target for the uncollateralised overnightcall rate cumulatively by 40 basis pointsto 0.1% at its meetings on 31 October and19 December 2008, after having left the targetunchanged since February 2007.Chart 2b Main developments in majoremerging economies14121086420252015RussiaChinaIndiaBrazilOutput growth(year-on-year percentage changes; quarterly data)2002 2003 2004 2005 2006 2007 2008Inflation rates(consumer prices; year-on-year percentage changes;monthly data)14121086420252015EMERGING ASIAIn the course of 2008 economic activity sloweddown gradually in emerging Asia. Amid thebroadening of the economic slowdown andtight global financial conditions, export growthdeclined sharply in the second half of the year,especially in small open economies, such asSingapore, Taiwan P.o.C. and Hong KongS.A.R. The overall slowdown in economicactivity was also driven by a weakening ofdomestic demand owing to deterioratingconsumer and business confidence, and thedownturn in real estate investment.Rising commodity and food prices led consumerprice inflation to increase in many countries inthe first half of the year. In some countries,this led to an erosion of consumer purchasingpower and some weakening in consumptionexpenditure. However, inflationary pressuresstarted to ease in the second half of the year,owing to a significant decline in the prices ofoil and food products. Given these countries’relatively sound macroeconomic performanceand limited direct exposure to derivatives linked1050-52002 2003 2004 2005 2006 2007 2008Sources: National data and ECB calculations.to sub-prime mortgages, until mid-Septemberthere were only low levels of spillover fromthe financial turmoil into economic activity.Since then, however, the sudden shift towardsrisk aversion and the strong deleveraging atthe global level have induced a significantsell-off on equity markets and a sharpdepreciation of local currencies in most ofemerging Asia. Financial market volatilityhas varied across countries. Its impact onChina was more contained owing to therelatively closed and less developed state ofits financial system, while stronger financialmarket volatility in Korea and Indonesia wasobserved amid concerns about the high levelof domestic debt and falling commodity pricesrespectively.1050-524 ECBAnnual Report2008

As regards the Chinese economy, real GDPgrowth declined from 13% in 2007 to 9% in2008. The economic slowdown was driven byboth external and domestic factors. Reflectingthe trade surplus and money inflows induced byexpectations of steady exchange rate appreciationand a positive interest rate differentialuntil September 2008, the foreign reservescontinued to rise, totalling USD 1.9 trillionin 2008. Consumer price inflation peaked inFebruary at 8.7%, but then dropped significantlyin response to the stabilisation of domestic foodprices. In September, when inflation had recededand the global financial crisis was intensifying,Chinese authorities shifted policies towardsmeasures aimed at enhancing economic growth.The People’s Bank of China started to ease itsmonetary policy stance: the one-year benchmarklending and deposit rates were cut respectivelyfive and four times by a total of 216 and189 basis points, and the reserve requirementratio was lowered by 200-400 basis points,depending on the institution. Furthermore, thesteady pace of appreciation of the renminbiagainst the US dollar halted in the fourth quarter.LATIN AMERICAEconomic growth in Latin America was robustin the first half of 2008 (around 5% in SouthAmerica, but only 2.1% in Mexico), whileinflationary pressures were elevated and rosethroughout the year, with inflation rates forthe region increasing to 8.7% in 2008 from6.1% in 2007. Countries with fixed or quasifixedexchange rates recorded higher inflationthan those with an inflation-targeting regime.Improved macroeconomic fundamentals, highcommodity prices and strong domestic demandcontinued to support the economic outlookin the first half of 2008, but also resulted inincreased inflationary pressures. However,from mid-September 2008 external financialconditions deteriorated as the global financialcrisis unfolded. In particular, spreads on creditdefault swaps on Latin American sovereigndebt widened considerably, especially inArgentina and Venezuela (by around 4,000and 3,000 basis points respectively at the endof the year). In addition, currencies fell visà-visthe US dollar, equity markets droppedsignificantly by around 50% over the year andliquidity shortages emerged. Brazil and Mexicowere particularly hit by liquidity shortages, aslarge outflows affected the financial landscapeof the region.SHARP DECLINES IN COMMODITY PRICES IN THESECOND HALF OF 2008Commodity price developments attracted agreat amount of attention throughout 2008. Inthe first half of the year, oil prices continued tosurge with increasing momentum and peakedon 11 July at USD 147.5 per barrel of Brentcrude oil (see Chart 3). Thereafter, pricesstarted to decline, and the downward trend wasexacerbated by the financial market turmoil. Atthe end of 2008, prices stood at USD 39.5 perbarrel. Measured in euro terms, this correspondsto roughly the level recorded in December 2004.For the year as a whole, the average price ofBrent crude oil was USD 98.3, which was 35%above the average of the previous year.The first half of the year was characterised byvery tight market conditions. On the supplyside, non-OPEC supply figures repeatedlyChart 3 Main developments in commoditymarkets15014013012011010090807060504030Brent crude oil (USD/barrel; left-hand scale)non-energy commodities(USD; index: 2000 = 100; right-hand scale)2005 2006 20072008300285270255240225210195180165150135120Sources: Bloomberg and Hamburg Institute of InternationalEconomics.ECBAnnual Report200825

disappointed expectations. This developmentforced OPEC to increase production to matchdemand. In turn, this led to an exceptionallylow spare capacity in OPEC member countries,amplifying concerns over possible supplydisruptions owing to geopolitical events. On theother hand, demand continued to grow robustly.While increasing prices caused demand tomoderate in OECD countries, this did not happenin emerging economies, where oil imports werebuoyant owing to strong economic growth andgovernment subsidies. Against this background,stocks in OECD countries declined, and pricesproved extremely reactive to any news orrumours suggesting gloomier conditions for thesupply-demand balance.In mid-July stocks in the United States startedto increase counter-seasonally, which triggeredthe subsequent price correction. The decline wasexacerbated by the financial market turmoil andits impact on the global economic outlook. Thisled to the heavy downward revision of demandprojections, including for emerging economies.Against this background, OPEC acted to stabiliseprices by means of sizeable supply cuts.The prices of non-energy commodities werealso extremely volatile throughout the year (seeChart 3). The index increased strongly in the firstquarter of 2008, mainly driven by agriculturalcommodities, and moved sideways thereafter.As energy prices started to decline, non-energycommodity prices followed, with the subsequentfinancial market turmoil hitting metals pricesin particular. In aggregate terms, non-energycommodity prices (denominated in US dollars)increased by an average of approximately 14%in 2008 compared with the previous year.2.2 MONETARY AND FINANCIAL DEVELOPMENTSTHE UNDERLYING PACE OF BROAD MONEYGROWTH MODERATED IN THE COURSE OF THEYEAR, WHILE NONETHELESS REMAINING ROBUSTHaving peaked in the fourth quarter of 2007,the underlying pace of broad money andcredit growth in the euro area moderated inChart 4 M3 and loans to the private sector(annual percentage changes; adjusted for seasonal and calendareffects)14121086422001 2002 2003 2004 2005 2006 2007Source: ECB.M3loans to the private sector2008the course of 2008. This is reflected in thedeclining annual growth rates of both the broadmonetary aggregate M3 and MFI loans to theprivate sector, which fell to 7.3% and 5.8%respectively in December 2008, substantiallylower than the 11.5% and 11.2% seen a yearearlier (see Chart 4).Despite moderating steadily, M3 growthremained robust in 2008. This partly reflected astimulative effect stemming from the relativelyflat euro area yield curve, which encouragedshifts from longer-term assets into shorttermmonetary instruments (notably MFItime deposits) that offered similar levels ofremuneration but were subject to less risk. Sucheffects are unlikely to continue once the slopeof the yield curve normalises. However, whenthese and other temporary effects are taken intoaccount using a broad-based analysis of themonetary data, the trend rate of broad monetaryexpansion remained robust at the end of the year,as reflected, for instance, in the strong growth ofhousehold deposits.The moderation of broad money and creditgrowth in the course of 2008 largely reflectedthe impact of past increases in interest rates,141210864226 ECBAnnual Report2008

generally tighter financing conditions and theslowdown in economic activity. Although attimes the prevailing financial tensions had asignificant impact on those specific componentsand counterparts of M3 that were most closelyrelated to the nature of the turmoil (e.g. holdingsof money market fund shares/units), the financialturmoil did not, overall, give rise to sharpbreaks in the moderating trend of broad moneyand credit growth. Meanwhile, the results ofthe Eurosystem’s bank lending survey suggesta progressive tightening of credit standardsover the course of the year. For a more detailedanalysis of the impact that the financial turmoilhas had on monetary analysis at the euro arealevel, see Box 1.Box 1THE IMPACT OF FINANCIAL MARKET TENSIONS ON MONETARY DEVELOPMENTSThe financial tensions that started in August 2007 have had a profound impact on shortertermdevelopments in some items on the MFI balance sheet, leading in a number of cases tosignificantly higher volatility and changes in the direction of growth. This box discusses examplesof such visible effects in different phases of the period of tension. Three broad phases are usedas reference points: the phase in which the tensions started, covering the period from August2007 to February 2008 (including the uncertainties that prevailed at the end of 2007), the phasefrom March 2008 to mid-September 2008, and the phase from mid-September 2008 onwards, inwhich the tensions intensified.Visible effects on the components of M3One example of the financial tensions having a clear impact on the components of the monetaryaggregate M3 is their effect on marketable instruments such as money market fund shares/units orshort-term MFI debt securities. The volatility ofthe monthly flows into/out of these instrumentshas increased, although there have been distinctperiods of outflows and inflows (see Chart A).That increased volatility has coincided withsubstantial declines in the annual growth ratesof these instruments.Chart A Monthly flows into or out of moneymarket fund shares/units and short-termMFI debt instruments(EUR billions; adjusted for seasonal and calendar effects)30money market fund shares/unitsshort-term MFI debt instruments30The increases in uncertainty observed duringthe first phase of the tensions were reflectedin sizeable outflows from money market fundsboth at the very start of the tensions in August2007 and again in December 2007, driven byconcerns about the exposure of some euro areamoney market funds to asset-backed securities.However, these outflows appear to have beenreversed in subsequent months, and the reboundin January 2008 was the largest inflow recordedsince the start of Monetary Union. In the secondphase, the monthly flows were mostly negative20100-10-20-30Jan. Apr. July2007Source: ECB.Oct.Jan.Apr. July2008Oct.20100-10-20-30ECBAnnual Report200827

ut small, and those cumulative outflows were more or less offset by a strong inflow in August,just before the tensions intensified. The third phase then saw outflows in September and October,which, by contrast with the outflows in the first phase, were due to an increase in risk aversiontowards money market funds on a wider scale triggered by the collapse of Lehman Brothers andlosses incurred by US money market funds investing in its commercial paper. This was exacerbatedby the fact that banks’ funding behaviour led to a rechannelling of funds from money market fundsinto favourably remunerated bank deposits. However, in the final two months of 2008, despitethe fact that the enhanced deposit guarantee schemes announced by governments do not covermoney market funds, positive flows were recorded again, suggesting that euro area residents’ fearsregarding the possible failure of such funds have been fading away.Developments in short-term debt securities with a maturity of up to two years were, tosome extent, a mirror image of those in money market funds, implying that the overall effecton shorter-term developments in the broader monetary aggregates was limited. This can beexplained by the attractive remuneration of short-term debt securities, which may have ledinstitutional investors in particular to initially hold them as a substitute for money market fundshares when the latter were perceived to be exposed to counterparty credit risk. In the secondphase, the perceived counterparty credit risk gradually shifted to credit institutions and tended toresult in money holders acquiring a much smaller amount of short-term MFI debt securities. Inthe third phase, while there was a large inflow into debt securities in September, monthly flowsturned negative in the last three months of 2008, reflecting the reluctance of the money-holdingsector to acquire these instruments on a net basis.By contrast with marketable instruments, there has been little visible impact on other componentsof M3. An impact on M1 was visible only in the third phase of the crisis, when the default ofLehman Brothers triggered more widespread concerns about the stability of banking systemsand led to considerable withdrawals of cashfrom euro area banks (see Chart B). In October2008 currency in circulation was around€35 billion higher than in previous months.Flows normalised again in November andDecember, though the October increase did notunwind, suggesting that the sizeable share ofadditional currency in circulation may largelyreflect demand by non-residents. A similarpattern was observed for overnight deposits,with strong inflows in October as the high levelof uncertainty prompted money holders to keeptheir funds in highly liquid deposits. In thisrespect, overnight deposits have been used on atemporary basis to park funds transferred fromother types of deposit or received following thesale of long-term debt securities and shares.These inflows were reversed in November inline with the announcement of governmentmeasures to support the banking system andthus the return of remuneration considerationsin the allocation of funds. Renewed inflowsChart B Monthly flows into or out of currencyin circulation and overnight deposits(EUR billions; adjusted for seasonal and calendar effects)806040200-20-40-60-60Jan. Mar.May July Sep.Nov. Jan. Mar.May July Sep.Nov.2007 2008Source: ECB.currency in circulationovernight deposits806040200-20-4028 ECBAnnual Report2008

were recorded in December, but these could simply signal a desire on the part of money holders –and non-monetary financial intermediaries other than insurance corporations and pension funds(other financial intermediaries – OFIs) in particular – to hold liquid assets at the turn of the year.Visible effects on the counterparts of M3Turning to the counterparts of M3, the dynamics of overall credit to the private sector did notchange substantially as a consequence of the financial tensions. However, there were morevisible changes at more disaggregated levels.In particular, the flow of loans to OFIs was strong in the first phase of the tensions, reflectingthe fact that conduits set up by banks and classified as OFIs, faced with investors’ increasedreluctance to fund them, tapped credit lines granted by their sponsoring banks (see Chart C).The flow remained considerable for most of the second phase; however, it is probable thatthis increasingly reflected the short-term need for financing and liquidity buffers on the partof investment funds. Whereas during the first phase MFIs provided funding to their conduitsin the OFI sector directly through loans, in the second phase they did so by purchasingthose conduits’ debt securities. This increasingly took the form of “retained securitisationoperations”, whereby MFIs sold part of their loan book to special-purpose vehicles and boughtback the underlying securities in order to use them as collateral in Eurosystem operations.This led to a reduction in the contribution of loans to the expansion in overall MFI creditand a corresponding increase in the contribution of debt securities. In the third phase of thetensions, retained securitisation operations and their impact on the MFI balance sheet becameeven more important as the extent to which MFIs used debt securities to receive liquidityfrom the Eurosystem increased. At the same time, lending to OFIs declined, reflecting a fall inintermediation in connection with the slowdown in real activity.Chart C Monthly flows of loans to OFIs,debt securities purchased by MFIs and MFIs’derecognised loans(EUR billions; adjusted for seasonal and calendar effects)80706050403020100-10-20-30Jan. Apr. July Oct. Jan. Apr. July Oct.2007 2008Source: ECB.purchases of private sector debt securities by MFIsMFIs’ derecognised loansMFI loans to OFIs80706050403020100-10-20-30Chart D Credit institutions’ asset holdingsand loans to the private sector(quarterly flows; EUR billions; adjusted for seasonal effects)1,00090080070060050040030020010002003Source: ECB.assetsof which loans to the private sector (correctedfor the effects of securitisation)2004 2005 2006 2007 20081,0009008007006005004003002001000ECBAnnual Report200829

The large number of securitisation operations, especially in the second and third phases of thetensions, also had an impact on the dynamics of loans to the private sector (particularly loans tohouseholds), as the derecognition of securitised loans reduced net loan flows by up to €35 billionper month. Overall, this suggested a stronger decline in the availability of funding to thenon-financial private sector than was actually the case. Despite the decreasing growth rate ofloans to the private sector, their contribution to the changes in flows into and out of total MFIassets has typically been stable. The volatility observed in the flows of MFI assets was due mainlyto assets other than originated loans to the private sector (see Chart D). However, this changedin the last two months of the year, when an outflow was recorded from credit institutions’ assets,while in December loan flows to the private sector were negative even after correcting for theeffect of securitisation operations. This might be explained by increased deleveraging at the endof the year in order to “window dress” balance sheets.ConclusionsThe period of financial tensions has triggered considerable short-term movements in specificsub-components of the broad money and credit aggregates. This has made the extraction ofthe policy-relevant underlying trends in monetary developments more challenging, but at thesame time provided important insights as regards the conditions in the financial sector and thenon-financial sector’s access to financing.THE INTENSIFICATION OF THE FINANCIALTENSIONS IN MID-SEPTEMBER AFFECTEDMONETARY DEVELOPMENTSFinancial market developments followingthe bankruptcy of Lehman Brothers in mid-September triggered changes in the behaviour ofthe banking and money-holding sectors. Giventhe potential for the intensification of the financialturmoil to have an impact on asset prices, wealth,financial institutions and confidence, the MFIbalance sheet is likely to be affected in variousways with differing degrees of intensity and avariety of different time lags. For example, thisintensification of the financial market tensionscould trigger portfolio shifts both betweenmonetary and non-monetary assets and betweenindividual monetary instruments. Consequently,the overall impact is difficult to anticipate.The data available up to December 2008 suggestthat as the financial tensions became more acute,this led to significant shifts between the variouscomponents of broad money. For example,flows into M1 increased substantially duringSeptember and October, reflecting an increasedpreference for liquid assets in the presence offinancial uncertainty (including uncertaintyregarding the health of the banking sector),leading to a reversal of the overall downwardtrend of M1. However, the overall impact onheadline M3 was relatively minor, particularly ifone looks through the month-to-month volatility.Moreover, while banks had to resort to differentfunding mechanisms (as reflected in theirissuance and holdings of debt securities), thereis little indication of a sharp break in the supplyof bank loans after mid-September that wouldimply the drying-up of loans to the non-financialprivate sector, although monthly developmentshave moderated since then. However, theresults of the Eurosystem’s bank lending surveypoint to the progressive tightening of the creditstandards applied to loans.DEVELOPMENTS IN THE COMPONENTS OF M3WERE INFLUENCED MAINLY BY THE FLAT YIELDCURVEOn the components side, the annual growth rateof M1 continued to moderate up until the thirdquarter of 2008, standing at 0.2% in August,markedly below the rate of around 6% recordedin the fourth quarter of 2007. This moderation30 ECBAnnual Report2008

was driven mainly by developments inovernight deposits, for which a negative annualflow was observed in the third quarter. Overall,M1 growth in 2008 continued to be influencedmainly by the dampening effect resultingfrom the rising opportunity cost of holdingM1 associated with the increases in interestrates as of December 2005. That effect wasprobably partially offset by the desire to holdM1 as a buffer in the context of the financialmarket turmoil. From mid-September onwards,however, holdings of M1 appeared to gain somemomentum following the increase in financialtensions (see Box 2).Box 2DEVELOPMENTS IN THE EURO AREA MONEY MARKET IN THE CONTEXT OF THE FINANCIAL TURMOILThe financial turmoil that started in August 2007 continued into 2008 and intensified in theautumn of that year, posing considerable challenges as regards the functioning of the interbankmoney market and the Eurosystem’s liquidity management. This box describes the developmentsin the main segments of the euro area money market in 2008, relates developments to underlyingfactors in the global financial markets and explains the Eurosystem’s decisions on liquiditymanagement in response to the tensions.The origins of the crisisIn August 2007 the global financial system entered a period of considerable turbulence,triggered primarily by the impact that rising delinquency rates for US sub-prime mortgages hadon the valuation of a broad class of mortgage-based securities. The complexity and opacity ofthe structured securities, together with the absence in many cases of a market price for theseinstruments, made these products difficult to value, with adverse implications for the evaluationof banks’ overall balance sheets. More precisely, investors retreated from structured investmentvehicles (SIVs) and conduits that were based on asset-backed securities derived from thesecuritisation of US sub-prime mortgages and became reluctant to hold or roll over assetbackedcommercial paper (ABCP) issued by these investment vehicles. As a consequence,banks faced the risk of having to reintermediate such SIVs onto their balance sheets and/orprovide funding to SIVs and conduits issuing ABCP. As banks became increasingly concernedabout their liquidity and balance sheets, they became less willing to provide funds to otherbanks. The complexity and opacity of many of these products increased banks’ reluctanceto participate in interbank transactions, both because banks doubted the creditworthiness oftheir potential counterparties and because banks were uncertain about their own exposures(with regard to capital and liquidity) derived from conduits and SIVs. As a consequence,banks hoarded liquidity. Liquidity diminished in the interbank money market, impairing thefunctioning, in particular, of the longer-term unsecured deposit markets (owing to banks’preoccupation with the possible risk exposures of their counterparties), non-government repomarkets, commercial paper markets and foreign exchange swap markets.Although considerable progress has since been made in identifying and valuing exposures to thecomplex securities at the epicentre of the market turbulence, there is still uncertainty about thelosses that will ultimately be suffered by investors and financial institutions across the globe.Money markets therefore remained under strain throughout 2007 and 2008.ECBAnnual Report200831

The evolution of the crisis in 2008In reviewing developments in money markets in 2008, it is useful to divide the year into fourbroad periods: January to February; March to June; June to September; and September onwards.For each of these periods, the driving events, the market reactions and the measures adopted bythe ECB are described.The period from January to February 2008The first period covers the first two months of 2008, during which no major disruptive eventsoccurred in the euro area money market. However, unsecured money markets remainedvolatile, with interest rates generally falling from the peaks observed at the end of 2007 as theend-of-year effects wore off (see Chart 9). Secured rates remained largely stable, given that theECB’s monetary policy remained unchanged. As a consequence, the spread between the securedand unsecured money market rates broadly declined (see Chart 10).In 2008 the ECB continued to emphasise the separation it maintains between monetary policydecisions and the liquidity management necessary in order to ensure the smooth functioning ofthe markets. The ECB continued its policy of allocating liquidity in excess of the benchmarkamount in its main refinancing operations, while still aiming for balanced conditions at the end ofmaintenance periods. Moreover, the ECB increased the maturity of its operations by increasingthe amounts allotted in longer-term refinancing operations at the expense of main refinancingoperations with a view to smoothing outconditions in the term money markets andconducted fine-tuning operations at the end ofmaintenance periods in order to offset liquidityimbalances. Overall, the ECB made full use ofthe flexibility provided by its implementationframework. The liquidity framework was keptunchanged until September. As a consequence,the EONIA remained fairly close to theminimum bid rate in the main refinancingoperations, although it was relatively volatile(see Chart A).Chart A ECB interest rates and theovernight interest rate(percentages per annum; daily data)spread between the EONIA and the minimum bidrate/fixed rate in the main refinancing operations(right-hand scale)minimum bid rate/fixed rate in the main refinancingoperations (left-hand scale)marginal lending rate (left-hand scale)deposit rate (left-hand scale)overnight interest rate (EONIA; left-hand scale)marginal rate in the main refinancing operations(left-hand scale)5.504.00The period from March to June 2008The collapse in mid-March of Bear Stearns,one of the largest investment banks andsecurities trading and brokerage firms in theUnited States, triggered a period of renewedmarket tension amid concerns about continuingbank losses, the deteriorating macroeconomicenvironment and rising oil prices. This lasteduntil approximately mid-June. During thatperiod unsecured money market rates increasedmarkedly, particularly longer-term rates. Thisdevelopment partly reflected increased money5.004.504.003.503.002.502.001.501.00Jan. Mar. May July Sep. Nov.2008Sources: ECB, Bloomberg and Reuters.3.503.002.502.001.501.000.500.00-0.5032 ECBAnnual Report2008

market tensions, particularly for longer maturities, as well as increases in market expectationsregarding the future path of key ECB interest rates, which were at the time more pronouncedfor the latter part of 2008 and thus had a greater impact on rates with longer maturities. Securedrates continued to be broadly stable, with the result that the spread between unsecured andsecured rates was again determined mainly by the behaviour of unsecured rates. This period sawgreater volatility in the EONIA and an increased need for liquidity provided by the Eurosystem,as suggested by the higher marginal rates in the main refinancing operations. The continuation ofthe Eurosystem’s liquidity measures helped to address these needs to a large extent.The period from June to September 2008The period between mid-June and mid-September 2008 was, overall, a period of stability inthe markets. Further events related to financial stability in other major economies (such as theUS government takeover of government-sponsored enterprises Fannie Mae and Freddie Mac on7 September) did not trigger any agitation in money markets. Unsecured markets, albeit stillstrained, were more stable, while a slight increase tended to be observed in interest rates in thesecured markets, in line with the Governing Council’s decision to increase the minimum bid ratein the main refinancing operations to 4.25% on 3 July. As a consequence, the spread betweenunsecured and secured rates at the three-month horizon declined, but did not reach the low levels ofJanuary and February. The EONIA enjoyed a period of low volatility from July until the beginningof September, when tensions resurfaced prior to the events of mid-September.The period from September 2008 onwardsA more troubled period started in mid-September, strongly affecting the behaviour of moneymarkets until the end of the year. There was a resurgence in tensions, which reached unprecedentedlevels in mid-September, when, in the space of a few days, the markets witnessed the sellingoffof Merrill Lynch and the bankruptcy of Lehman Brothers (two of the four remaining globalinvestment banks), the US government’s provision of emergency liquidity to AIG, the biggestUS insurance company, and the seizing by federal regulators of Washington Mutual, the largestsavings and loan association in the United States. In October spillover effects were felt morewidely in the euro area, while money markets suffered further tensions as a result of a sharpslump in equity markets amid the deteriorating macroeconomic environment.Market tensions intensified significantly and credit risk premia increased to levels above thoseseen previously during the period of financial turmoil. Unsecured market rates, especially forshort maturities, rose sharply after the failure of Lehman Brothers as the effects of that defaultcascaded through the euro area banking system. The implied volatility derived from options onthree-month EURIBOR futures, which experienced a prolonged period of decline from Marchto September, increased dramatically in mid-September and reached unprecedented levels inOctober (see Chart B).The Eurosystem acted quickly and decisively in response to the acute reintensification of the turmoil.The Governing Council made a number of temporary changes to its liquidity implementationframework, aimed, in particular, at strengthening its intermediation function and reassuring themarkets about liquidity risks. Specifically, on 8 October the Eurosystem took the exceptionaldecision to temporarily conduct its main refinancing operations as fixed rate tender procedureswith full allotment at the main refinancing rate and to reduce the corridor formed by the standingECBAnnual Report200833

facilities around the interest rate on themain refinancing operations from 200 basispoints to 100 basis points (a decision that wasreversed on 18 December with effect from21 January 2009). Moreover, on 15 Octoberthe Eurosystem decided to provide enhancedlonger-term refinancing until the first quarterof 2009, as well as expanding its collateralframework. At the same time, governmentsacross the euro area made coordinated effortsto support bank solvency.Consequently, as of October 2008 unsecuredrates declined again, falling to levels lowerthan those observed earlier in the year. Thosedeclines were supported by market expectationsof further cuts in key ECB interest rates in thecoming months. The implied volatility derivedfrom options on three-month EURIBORfutures also tended to decline, albeit remainingmuch higher than the levels observed prior toSeptember.A significant and unprecedented increase wasrecorded in the spread between three-monthsecured and unsecured market rates in the weeksthat followed Lehman Brothers’ bankruptcy.During that period secured and unsecuredmarket rates moved in opposite directions, withChart B Implied volatility derived fromoptions on three-month EURIBOR futuresmaturing in March 2009(percentages per annum; basis points; daily data)secured rates dropping fast in anticipation of future cuts in key policy rates. That steep decline insecured rates continued from late October until the end of the year, in line with cuts in key ECBinterest rates and market expectations of further rate cuts. The fact that declines were observedfor both secured and unsecured market rates as of late October meant that the spread remainedrelatively large and volatile.Finally, looking at rates for very short maturities, the turmoil during the period from Septemberto October dramatically increased banks’ demand for liquidity, as attested to by the significantspread that developed between the marginal rate and the minimum bid rate in the main refinancingoperations. This led to the Eurosystem supplying generous amounts of liquidity, which tendedto drive the EONIA below the interest rate in the main refinancing operations. Before theintroduction of the new framework, these declines were reversed at the end of every maintenanceperiod. However, following the changes to the framework in mid-October and November, theEONIA tended to linger at levels below the fixed rate in the main refinancing operations, in linewith the abundant liquidity provided to the markets.Overall, the euro area money markets were relatively volatile during 2008 and were confrontedwith considerable challenges. In particular, in the fourth quarter of the year the tensions in thefinancial markets intensified greatly compared with 2007, as a number of adverse shocks hit the555045403530252015105percentages per annum (left-hand scale)basis points (right-hand scale)Jan. Mar. May July Sep. Nov.2008190180170160150140130120110100Sources: Bloomberg, Reuters and ECB calculations.Note: The basis point measure is obtained as the product ofimplied volatility in percentages and the corresponding interestrate (see also the box entitled “Measures of implied volatilityderived from options on short-term interest rate futures” in theMay 2002 issue of the ECB’s Monthly Bulletin).90807060504030201034 ECBAnnual Report2008

anking and financial system. At the same time, the macroeconomic conditions steadily worsenedand significantly burdened the already fragile financial markets. Consequently, the money markettensions in the fourth quarter of 2008 were much stronger and had a more lasting impact on moneymarket rates. Nevertheless, the Eurosystem stepped up its efforts to ensure that market participantshad access to liquidity, which – combined with government measures – helped to avoid anyfurther deterioration in the banking sector. In this regard, throughout the year the ECB made fulluse of the flexibility provided by its implementation framework and continued to emphasise in itscommunication the importance of separating monetary policy decisions from the implementationof liquidity policy in order to ensure the smooth functioning of the markets. The monetary policystance was aimed at achieving the price stability objective, while liquidity management measureswere aimed at supporting continuity and the smooth functioning of the money markets.In 2008 short-term deposits other than overnightdeposits (i.e. M2-M1) remained the mostdynamic component of M3. However, followingsustained strengthening as of mid-2004, whichcontinued – albeit more moderately – in the firsthalf of 2008, the annual growth rate of short-termdeposits other than overnight deposits declinedin the second half of the year, falling to 13.3%in December 2008 (see Chart 5). These deposits’contribution to annual M3 growth continuedto increase in the course of 2008, reaching7.4 percentage points in the third quarter, partlyoffsetting the declines observed for the othercomponents of M3. It lost momentum, though,in the fourth quarter of the year in line with thedecline in the growth rate. However, this stronggrowth masks divergent developments across thevarious sub-components, as the ongoing stronginflows for short-term time deposits (i.e. depositswith an agreed maturity of up to two years),which grew at an annual rate of around 40% in2008, were accompanied by a continued declinein the holdings of deposits redeemable at noticeof up to three months, which fell by more than2% on average in the course of the year.Up until the fourth quarter of the year theremuneration of short-term time depositsbroadly followed the rise in short-termmoney market interest rates. Thus, the spreadvis-à-vis the remuneration of short-termsavings deposits and overnight depositswidened, as the remuneration of these depositsgenerally increased more slowly and modestly(see Chart 6). This supported shifts within M3,namely from M1 and savings deposits into timedeposits. At the same time, with a relativelyflat yield curve, short-term time deposits offera rate of remuneration that is similar to that oflonger-term assets. Since longer-term assets areless liquid and holding them typically impliessomewhat greater risk, a flat yield curve tendsto increase the attractiveness of shifting fundsinto monetary assets from outside M3. Theintensification of the financial tensions in thefourth quarter of the year further increasedChart 5 Main components of M3(annual percentage changes; adjusted for seasonal and calendareffects)24201612840M1other short-term deposits (M2-M1)marketable instruments (M3-M2)2002 2003 2004 2005 2006 2007 2008Source: ECB.24201612840ECBAnnual Report200835

Chart 6 MFI interest rates on short-termdeposits and a money market interest rateChart 7 Sectoral deposits(percentages per annum)(annual percentage changes; not adjusted for seasonal orcalendar effects)overnight depositsdeposits with an agreed maturity of up to one yeardeposits redeemable at notice of up to three monthsdeposits with an agreed maturity of one to two yearsthree-month EURIBORnon-financial corporationshouseholdsOFIs6.06.030305.05.025254.04.020203.03.015152.02.010101.01.0550.02003 2004 2005 2006 200720080.002002 2003 2004 2005 2006 2007 20080Source: ECB.Source: ECB.Note: The reporting sector comprises MFIs excluding theEurosystem and central government.the attractiveness of time deposits, with banksmaking additional efforts to attract such depositsat a time when it was difficult to obtain fundingin the wholesale money markets and with bankdeposit guarantees being raised.Following sustained increases in 2007, theannual growth rate of marketable instruments(i.e. M3-M2) declined significantly in the courseof 2008, reaching a low of 1.7% in November,It then recovered slightly to stand at 3.0% inDecember, down from 20.0% in December 2007.Developments in these instruments resultedmainly from the marked declines recorded inthe annual growth rates of money market fundshares/units and debt securities with a maturityof up to two years. As a result, marketableinstruments’ contribution to the annual growthrate of M3 declined, standing at 0.6 percentagepoint in the fourth quarter of 2008, comparedwith 2.7 percentage points in the fourth quarterof 2007.THE GROWTH OF HOUSEHOLDS’ MONEYHOLDINGS REMAINED STRONGThe broadest aggregation of M3 componentsfor which reliable information is availableby holding sector is short-term deposits andrepurchase agreements (hereafter referred toas “M3 deposits”). The annual growth rateof households’ M3 deposits reached 8.8% inDecember 2008 (see Chart 7), thereby makingthe largest contribution to aggregate M3 depositgrowth. Thus, the upward trend observed sincemid-2004 in the growth rate of households’ M3deposits continued in 2008, despite showingsigns of stabilisation in line with the weakeningof economic activity. The continued robustgrowth of households’ M3 deposits – thesectoral component that captures the bulk oftraditional bank deposits, those that are leastaffected by financial innovation – supportsthe view that underlying broad money growthremained strong at the end of 2008.By contrast, having levelled off in mid-2007and declined somewhat in the second half ofthat year, the annual growth rate of M3 depositsheld by non-financial corporations declinedfurther in the course of 2008, standing at 0.3%in December, down from 11.3% at the end of2007. This may reflect an ongoing markeddeterioration in the cash flows of non-financialcorporations, given the cyclical nature of thissector’s money demand. It may also indicatethat non-financial corporations are using their36 ECBAnnual Report2008

cash flows to compensate for a reduction inloan growth. Similarly, the growth rate ofM3 deposits held by OFIs showed a highdegree of volatility in the course of the yearand declined by more than 5 percentage pointsin 2008 to reach 17.5% on an annual basis inDecember. However, the annual growth rateof OFIs’ M3 deposits remained significantlystronger than that observed in other sectors.This probably reflected the fact that, giventhe current financial environment, investmentfunds needed to maintain cash buffers in orderto accommodate possible redemptions. Thosebuffers may also have been bolstered by loansfrom parent MFIs.GROWTH IN CREDIT TO THE PRIVATE SECTORMODERATEDAfter strengthening in 2007, the annual growthrate of MFI credit to euro area residentsdeclined in 2008, falling from 10.1% inDecember 2007 to 6.5% in December 2008(see Chart 8). This mainly reflected a significantdecline in the annual growth rate of credit tothe private sector, while the annual growthrate of credit extended to general governmentturned positive. Three-month annualised growthrates, an indicator of short-term developments,declined more markedly, falling from 12.0% inDecember 2007 to 6.9% in September 2008 and3.9% in December 2008.In particular, MFI loans to general governmentincreased somewhat, especially in the secondhalf of the year, and while the amount ofgeneral government debt securities in MFIs’portfolios declined at the beginning of theyear, it increased strongly in the final quarter.It should also be mentioned in that regard thatsome volatility was observed towards the end ofthe year, with a decline recorded in Septemberand October in the MFI sector’s holdings ofgovernment securities. That decline is linked tothe deleveraging of credit institutions given theliquidity of government bond markets and thefavourable nature of price developments. Thisdecline can be seen as an indication that creditinstitutions have been using their more liquidassets as buffers in order to absorb the pressureson their capital positions and funding, with aview to shielding their core, relationship-basedbusiness, namely the granting of loans to firmsand households. By contrast, the November andDecember data indicate a substantial increase inthe holdings of government debt securities.The annual growth rate of MFI credit to theprivate sector remained robust in early 2008,continuing the trend observed in 2007, beforedeclining in the second half of the year. Loansto the private sector, despite deceleratingmarkedly, remained the dominant form ofcredit granted by MFIs in 2008, although thecontribution of MFIs’ purchases of securitiesother than shares increased moderately. Thatincreased contribution largely reflected MFIs’purchases of securities issued by OFIs in thecontext of securitisation activities.The annual growth rate of MFI loans to theprivate sector, the largest component of credit tothe private sector, declined to stand at 7.3% in thefourth quarter of 2008 and 5.8% in December,Chart 8 Credit to euro area residents(annual percentage changes; contributions in percentage points)121086420-2shares and other equityprivate sector securities other than sharesgeneral government securities other than sharesloans to the private sectorloans to general governmentcredit to euro area residents2002 2003 2004 2005 2006 20072008Source: ECB.Note: The reporting sector comprises MFIs excluding theEurosystem.121086420-2ECBAnnual Report200837

after hovering around 11% at the start of the year.This decline was in line with the expected impactof the increases seen in bank lending rates as oflate 2005, the ongoing slowdown in the housingmarket, the tightening observed in credit standardsin the course of the year and developments ineconomic activity more generally. The threemonthannualised growth rate declined sharplyin late 2008, falling from 6.8% in September to2.7% in December taking into account the effectof securitisation.The overall deceleration in lending to the privatesector was broadly based across the variousmoney-holding sectors, although the level ofadjustment varied from sector to sector. Theannual growth rate of loans to households showeda marked decline, continuing the trend observedin 2007, while the declines observed in the annualgrowth rates of loans to non-financial corporationsand non-monetary financial intermediarieswere slightly smaller. In fact, the momentumobserved at the end of 2007 in loans to nonfinancialcorporations and non-monetary financialintermediaries continued in the first quarter of2008, with a decline in the annual growth rateof loans to non-financial corporations not beingrecorded until the second quarter of the year.The moderation observed in the annual growthrate of loans to households was driven mainlyby the falling annual growth rate of loans forhouse purchase, which reflected the ongoingmoderation in the housing market dynamicsof a number of euro area economies, as wellas tightening financing conditions and theimpact of past increases in interest rates andweakening economic prospects. At the sametime, securitisation activity continued to distortloan growth to some extent. In fact, the impactthat true-sale securitisation activities had onannual flows reduced the annual growth rateof MFI loans to the private sector by around1.7 percentage points in December (slightlyabove the average for the year). However, thenature of these securitisation activities differedfrom that observed prior to the onset of themarket turmoil, as MFIs kept the securitisedassets on their own balance sheets in orderto submit them as collateral in Eurosystemoperations. Nevertheless, even taking thisadjustment into account, loan growth slowedsubstantially in the course of the year.The annual growth rate of MFI loans to nonfinancialcorporations declined in 2008,although it remained strong in historical terms.Those corporations’ demand for loans remainedrobust in the first half of the year, although theEurosystem’s bank lending survey pointed toa slight moderation. The annual growth rate ofloans to non-financial corporations began todecline in the second half of 2008, but remainedrobust. Various factors may be supporting theongoing dynamism of such loans. First, thefact that longer-maturity loans are the mostresilient component may indicate that somefrontloading of borrowing has been taking placein anticipation of a future deterioration in theavailability of credit. Moreover, this may alsoreflect a shift from debt securities to loans inMFIs’ financing of non-financial corporations.The data for the fourth quarter of 2008 point toa further moderation in the short-term dynamicsof loans to non-financial corporations, whichis in line with the cyclical environment andthe tighter financing conditions, although it isimpossible to rule out the possibility of supplyfactors also having played a role.In conclusion, loan developments in 2008appeared to reflect a robust yet decliningflow of financing from banks to non-financialcorporations and households, with littleevidence of these sectors’ access to bankloans being significantly impaired, even afterthe intensification of the financial tensions inmid-September. However, a significantweakening of growth in corporate credit wasobserved at the end of the year. Furthermore, theresults of the Eurosystem’s bank lending surveypoint to significant tightening of credit standards.Among the other counterparts of M3, theannual growth rate of MFI longer-term financialliabilities (excluding capital and reserves)held by the money-holding sector declinedsubstantially, reaching 1.0% in the fourth38 ECBAnnual Report2008

quarter of 2008 and -0.1% in December, havingstood at 8.5% at the end of 2007. Developmentsare especially relevant in the case of twosub-components, namely longer-term depositsand MFI debt securities. The reduction observedin the growth rate of holdings of longer-termdeposits may reflect a shift towards shortermaturities given the shape of the yield curve andthe intensification of financial tensions, whiledevelopments in long-term debt securities issuedby MFIs point to the difficulty of obtainingfunding through this source.The net external asset position of the MFI sectordisplayed two different trends in the course of2008. Sizeable capital outflows were observedin the first half of the year, averaging more than€30 billion per month, followed by smallerinflows in the second half. Those outflowswere probably driven to a large extent bynon-euro area residents selling euro area assets(i.e. shifts out of euro area assets), while theinflows reflect the fact that external liabilitiesdeclined more strongly than external assets.As a result, the annual inflows observed inMFIs’ net external asset position in the courseof 2007 became annual outflows at the start of2008. Those annual outflows peaked at almost€300 billion in July, before decreasing thereafter.These continued outflows probably reflect theongoing rebalancing of international portfolios,particularly in relation to the deterioration ofeconomic prospects in the euro area and the needto obtain liquidity. The monetary presentation ofthe balance of payments reveals that the annualoutflows observed in MFIs’ net external assetposition mainly reflect a decline in net portfolioinvestment in equity.MONEY MARKET TENSIONS INTENSIFIED IN THECONTEXT OF THE FINANCIAL MARKET TURMOILEuro money markets continued to exhibitsevere tensions throughout 2008, following theonset of the global financial turmoil in August2007. Interbank trading volumes remained verymodest, particularly at longer maturities, andthe spreads between secured and unsecuredmoney market rates remained very elevated byhistorical standards.Unsecured money market interest rates roseacross the entire maturity spectrum betweenJanuary and the beginning of October, beforedeclining substantially thereafter. Having stoodclose to 4% in January 2008, the three-monthEUREPO rate rose to a peak of around 4.35%at the end of July and the beginning of August.It then stayed around that level until mid-September, before declining to stand at around0.94% at the end of February 2009. This mainlyreflected developments in key ECB interest ratesand market expectations regarding those rates(see Section 1 of this chapter).In addition to developments in policy rates,variations in both the intensity of the ongoingfinancial market tensions and the impact thatthose tensions had on credit and liquidity premiaalso played an important role in determiningunsecured money market interest rates(see Box 2). More specifically, the three-monthEURIBOR increased from a low of 4.29% on29 January to peak at 5.39% on 9 October. Theincrease was particularly steep in the aftermathof Lehman Brothers’ default in mid-September(see Chart 9). The three-month EURIBOR thenfell to stand at 2.89% at the end of 2008 – aresult not only of expectations of policy ratecuts, but also of Member States’ announcementof government packages to support financialinstitutions. At the end of February 2009 thethree-month EURIBOR stood at 1.83%.The slope of the money market yield curve –as measured by the spread between thetwelve-month and one-month EURIBOR rates –showed some volatility in the course of 2008,with that spread rising from a low of 12 basispoints at the end of January 2008 to peak at97 basis points in June, before declining andstabilising at around 50 basis points at the endof February 2009.The spread between secured and unsecuredmoney market rates was also very volatile in2008, remaining elevated by historical standardsand exceeding the levels observed in the secondhalf of 2007 in the initial phases of the financialturmoil. The spread between the three-monthECBAnnual Report200839

Chart 9 Unsecured money marketinterest ratesChart 10 Three-month EUREPO, EURIBOR andovernight index swap(percentages per annum; daily data)6.15.85.55.24.94.64.34.03.73.43.12.82.52.21.91.6one-month EURIBOR (left-hand scale)three-month EURIBOR (left-hand scale)twelve-month EURIBOR (left-hand scale)spread between the twelve-month and one-monthEURIBOR (right-hand scale)1.3Oct. Dec. Feb. Apr. June Aug. Oct. Dec. Feb.2007 2008 2009Sources: ECB and Reuters.3.22.92.62.32.01.71.41.10.80.50.2-0.1-0.4-0.7-1.0-1.3(percentages per annum; daily data)6.05.55.04.54.03.53.02.52.01.51.0three-month EUREPO (left-hand scale)three-month EURIBOR (left-hand scale)three-month overnight index swap (left-hand scale)spread between the three-month EURIBOR andEUREPO (right-hand scale)0.50.0Oct. Dec. Feb. Apr. June Aug. Oct. Dec. Feb.2007 20082009Sources: ECB, Bloomberg and Reuters.2.22.01.81.61.41.21.00.80.60.40.2EURIBOR and EUREPO rates increased fromaround 40 basis points in mid-January 2008 toaround 70 basis points in March following thetakeover of Bear Stearns by JPMorgan Chase.It peaked at 184 basis points in early October,before declining to around 90 basis points at theend of February 2009 (see Chart 10).Implied volatilities derived from options onthree-month EURIBOR futures contracts alsofluctuated significantly in 2008, reflecting thevolatility of money market conditions and theuncertainty surrounding the macroeconomicoutlook and thus the course of monetary policy.Driven by the high levels of uncertainty thatfollowed Lehman Brothers’ default, this measureof interest rate volatility (i.e. the impliedvolatility derived from three-month EURIBORfutures contracts maturing in March 2009)peaked on 10 October.GOVERNMENT BOND YIELDS DECREASED AMIDHIGH VOLATILITY IN 2008In 2008 government bond markets in the euroarea as well as in the rest of the world werecharacterised by large yield swings drivenmainly by direct and indirect consequencesof the intensified financial crisis. Amid highday-to-day volatility, long-term governmentbond yields in the euro area and the United Statesdeclined markedly overall in 2008, reflectinglargely investors’ ongoing preference for highlyliquid and safe securities, strong reductionsin monetary policy rates, and eventually sharpdownward revisions in the market’s outlook foreconomic activity and inflation. The extraordinaryuncertainty as to the eventual impacts of thefinancial crisis on the future state of the globaleconomy and the consequent monetary policyreactions was reflected in heightened levels ofactual and expected bond market volatility,40 ECBAnnual Report2008

whereby investors’ uncertainty surged especiallytowards the end of the year in the context ofintensified financial strains after the bankruptcyof Lehman Brothers. Moreover, the spreadsbetween the yields on long-term euro areagovernment bonds and those on long-termGerman government bonds continued to widenin 2008, reflecting differences in credit risk andliquidity premia (for further details, see Box 6).At the end of 2008 euro area and US ten-yeargovernment bond yields stood at around 3.6%and 2.2% respectively, which was 75 and184 basis points lower than the levels prevailingone year earlier (see Chart 11).The events related to the ongoing financialturmoil, its further escalation since September2008, and its impacts on the real economycan, at least partly, explain the developmentsin major bond markets. Throughout 2008 thefinancial landscape underwent a dramaticreshaping amid a number of staggering events.As a consequence, governments both in theUnited States and in the euro area announceda number of measures aimed at supportingthe financial system, strengthening consumerconfidence, sustaining economic activity andensuring credit availability for households andcorporations. In the United States, starting withthe takeover of Bear Stearns by JPMorgan Chasein March, the investment bank stand-alonebusiness model disappeared. The financial crisisescalated in late summer/autumn when, interalia, the US government-sponsored enterprisesFannie Mae and Freddie Mac were taken intopublic ownership, Lehman Brothers filed forbankruptcy, and the Federal Reserve extendedan extraordinary loan to the insurance groupAIG in exchange for an 80% stake. By the endof September severe financial distress had spreadto the euro area as well, putting under strainseveral financial institutions. As a consequence,in the euro area, there were a number ofinterventions aimed at bringing relief to thebanking system. As reported by the EuropeanCommission in relation to the declaration on aconcerted European action plan of the euro areacountries made at the 12 October summit, theseChart 11 Long-term government bond yields(percentages per annum; daily data)5.55.04.54.03.53.02.52.0euro areaUnited States2004 2005 2006 2007 2008Sources: Bloomberg, EuroMTS, Reuters and ECB.Note: Before January 2007, long-term government bond yieldsfor the euro area refer to ten-year bonds or to the closest availablebond maturity. Starting from January 2007, the euro areaten-year bond yield is represented by the ten-year par yieldderived from euro area sovereign triple-A bonds.interventions were meant “to coordinate nationalefforts to prop up banks and protect depositorsand to increase the flow of credit. Under theplan, national governments would buy intobanks to boost their finances and temporarilyguarantee bank refinancing to ease the creditcrunch”. Against this background and facedwith the deterioration of the macroeconomicoutlook, both the Federal Reserve and the ECBundertook a series of initiatives to enhance theirliquidity facilities and to provide support tofinancial markets. In addition, the two centralbanks repeatedly reduced their policy rates,thereby affecting bond yields. In particular, on16 December 2008 the Federal Reserve’s actionsculminated with a reduction in policy rates to arecord low. The target for the federal funds ratewas kept within a range, rather than at a point,between zero and 0.25%. Moreover, amongother things, the Federal Reserve announced thepossibility of purchasing longer-term Treasurysecurities, which might have also contributed topushing down bond yields.Against this backdrop, until the beginning ofspring 2008, on both sides of the Atlantic longtermgovernment bond yields continued on adeclining trend that started in mid-2007, when5.55.04.54.03.53.02.52.0ECBAnnual Report200841

concerns over the state of the US real estatemarket began to mount. This episode broughtabout a pronounced decline in risk appetite, whichresulted in portfolio shifts from stocks and otherrisky assets to sovereign bonds and a consequentdecrease in yields. Ten-year government bondyields increased between the spring and the endof the summer and declined sharply thereafter.While the increase in yields can be attributed tothe perceptions of heightened global inflationrisks amid the strong upward pressure oncommodity and food prices, their subsequentdecline can be explained by flight-to-qualityand flight-to-liquidity episodes on account ofrenewed concerns regarding the financial sectorand more specifically the further escalation ofthe financial turmoil. Moreover, in the autumnincoming macroeconomic data pointing towardsa marked slowdown in global growth and achange in the perception of inflation risks, whichwere revised downwards, must have contributedto this decline in bond yields. Not surprisingly,in the United States, where the financial crisisbecame quite severe, the decline in bond yieldswas more pronounced than in the euro area.More generally, US government bonds were alsoviewed on average as being more liquid than euroarea government bonds, which also contributedto a further decline in government bond yields inthe United States.In the euro area, from the beginning of theyear until approximately mid-September, realgovernment bond yields hovered around 2%.Subsequently, until about end-October realyields increased. After reaching a peak of about3% in October, the five-year forward real yieldfive years ahead went down and, at the end ofthe year, stood just below 2%. While betweenSeptember and October real yields increasedowing to low liquidity and technical factorscausing dislocations in the inflation-linked bondmarket, the trend was subsequently reversedamid concerns over the macroeconomicoutlook.During 2008 the evolution over time of thefive-year forward break-even inflation ratefive years ahead, which measures marketparticipants’ long-term inflation expectationsand the related risk premia, was also affectedby developments in financial markets and themacroeconomic outlook. While this measureof market participants’ long-term inflationexpectations and the related risk premia in theeuro area edged up and stood at around 2.5%until the summer, reflecting mounting pressuresin commodity and food prices, it declinedsignificantly in the autumn (see Chart 12). Atthe end of 2008 this rate stood at around 2%.Both moderating inflation expectations in thecontext of the weakening economic outlookand technical factors distorting the relativepricing of conventional nominal bonds vis-à-visthe typically much less liquid inflation-linkedgovernment bonds contributed to this decline.Hence, the interpretation of break-even inflationrates as indicators of market participants’inflation expectations and related risk premiahas been severely hampered by special marketfactors, in particular since the intensification ofthe financial crisis in September.Market participants’ perception of governmentbond uncertainty in the euro area and the UnitedStates, as measured by implied volatility, kepton increasing throughout the year, surging fromChart 12 Euro area zero coupon break-eveninflation rates(percentages per annum; five-day moving averages of daily data;seasonally adjusted)3.02.52.01.51.00.50.02004five-year forward break-even inflation ratefive years aheadfive-year spot break-even inflation rateten-year spot break-even inflation rate2005 2006 2007 2008Sources: Reuters and ECB calculations.3.02.52.01.51.00.50.042 ECBAnnual Report2008

September onwards, amid the great unrest onglobal financial markets. At this time of the year,following the unravelling of a number of largeactors in the financial system and the consequentflight to safety and to liquidity, bond marketvolatility reached particularly pronouncedlevels in the United States. However, by the endof September, when financial instability becamemore severe in Europe as well, bond marketvolatility rose also on this side of the Atlantic(for further details, see Box 3).In the first two months of 2009 euro arealong-term government bond yields increasedmoderately by about 10 basis points, whilethe increase in US bond yields was morepronounced and equal to around 80 basispoints. On 27 February euro area and US tenyeargovernment bond yields stood at around3.7% and 3.0% respectively. Developmentsin long-term bond yields on both sides of theAtlantic were influenced by the weakeningeconomic outlook, heightened risk aversion andthe associated flight-to-safety flows, as well asincreasing concerns about the financing needsof sovereign issuers. While the first two factorswould tend to push yields down, the third one,which apparently dominated the other two,especially for the United States, would tend topush yields up. Over the same period, in theeuro area, yields on long-term inflation-linkedbonds increased as well, probably reflectingcontinued strains in the inflation-linkedbond market.Box 3VOLATILITY AND LIQUIDITY IN EQUITY AND GOVERNMENT BOND MARKETSStock and bond markets have become increasingly volatile in the course of the financial crisis,as can be seen from Chart A. 1 This high degree of market volatility stems from a combinationof the unwinding of leveraged positions, the large number of information shocks impactingmarkets, great uncertainty and elevated levels of risk aversion among market participants. Thisheightened risk aversion is likely to have compounded the impact that the information shocksand the uncertainty have had on price developments, with the result that price fluctuations havebeen larger than would have been the case given lower levels of risk aversion.For long periods during the crisis there has been a strong negative correlation between stockand bond returns (see Chart B). This negative correlation may be interpreted as evidence ofsafe-haven flows from stock markets to the most liquid segments of the government bond markets.Such a pronounced negative correlation was last observed around the time that the stock marketbottomed out in 2003. During the final months of 2008 the negative correlation between thesemarkets became less pronounced as the bond markets also became more volatile. This followedincreasingly clear evidence of significant spillovers from developments in financial markets to thereal economy. In addition to the increased variability of inflation expectations and risk premia,large revisions to market participants’ expectations regarding future developments in monetarypolicy rates are likely to have contributed to the increased volatility of long-term bond yields.The increased volatility in the government bond market has generally made market participantsless inclined to provide continuous liquidity to each other by posting tradable quotes for largeamounts in limit order markets. Although the most liquid government bonds, such as those issued1 See the box entitled “Abnormal volatility in global stock markets” in the November 2008 issue of the ECB’s Monthly Bulletin.ECBAnnual Report200843

Chart A Realised volatility of weekly stockand bond returns(percentages per annum; weekly data)Chart B Correlation between weekly stockand bond returns(weekly data)euro area stockseuro area bondsUS stocksUS bondseuro areaUnited States60601.01.050500.80.60.80.640400.40.20.40.230300.00.02020-0.2-0.4-0.2-0.41001999 2000 2001 2002 2003 2004 2005 2006 2007 2008Sources: Bloomberg and ECB calculations.Notes: Equity returns were calculated using the Dow JonesEURO STOXX index for the euro area and the Standard &Poor’s 500 index for the United States. Bond returns werecalculated from US and German zero coupon yields obtainedfrom Bloomberg. Volatilities were calculated using exponentiallyweighted moving averages.100-0.6-0.8-1.01999 2000 2001 2002 2003 2004 2005 2006 2007 2008-0.6-0.8-1.0Sources: Bloomberg and ECB calculations.Notes: Returns were obtained as indicated in Chart A. Correlationswere calculated using exponentially weighted moving averages.by the US and German governments, have acted as a safe haven for investors during the financialcrisis, liquidity has been under pressure even for this asset class. 2 Government bonds, unlikestocks, are largely traded outside exchanges, which inevitably means that the picture of tradingactivity in these markets is more fragmented. Available evidence from electronic platforms usedfor the trading of European government bonds points to sizeable declines in both volumes tradedand depths quoted, even for the most liquid securities. Signs of deterioration in market liquidityare also evident in quoted bid-ask spreads, which have widened significantly. As in previousepisodes of liquidity stress, such as the 1998 turmoil, the deterioration of liquidity has beenmost severe for securities, which were already relatively illiquid before the onset of the financialcrisis. For example, the yields of inflation-linked bonds appear to have been strongly affected byliquidity premia in some markets. 3According to market participants, larger trades in particular are increasingly being executed byinter-dealer brokers, with the result that the decline in trading volumes on electronic platforms islikely to overstate the decline in overall trading activity. However, the level of trading activity inthe euro area government bond market can also be gauged from the futures market. Governmentbond futures are among the most heavily traded instruments in the world and represent one of thefew markets where liquidity is relatively intact. When it comes to measuring market activity, aclear advantage of futures is that they are exchange-traded instruments for which data on overallactivity are readily available.2 See Box 6 for further analysis of the impact of flight-to-safety flows on euro area government bond markets.3 See the box entitled “Recent increases in real yields and their implications for the analysis of inflation expectations” in the November2008 issue of the ECB’s Monthly Bulletin.44 ECBAnnual Report2008

Chart C Trading volumes for governmentbond futuresChart D Trading volumes in equity markets(millions of contracts; three-month moving averages of dailydata)(index: July 2007 = 100; three-month moving averages ofmonthly data)German ten-year Euro-Bund futuresGerman five-year Euro-Bobl futuresUS ten-year Treasury note futuresUS five-year Treasury note futuresDow Jones EURO STOXX indexStandard & Poor’s 500 index1.81.81601601.61.61401401.41.41201201.21.00.80.60.41.21.00.80.60.41008060401008060400.20.220200.02000 2001 2002 2003 2004 2005 2006 2007 2008Sources: Chicago Mercantile Exchange/Chicago Board of Tradeand Eurex Deutschland.Note: The notional size of each contract is €100,000 for theEuro-Bobl and Euro-Bund futures and USD 100,000 for thefive-year and ten-year Treasury note futures.0.002000 2001 2002 2003 2004 2005 2006 2007 2008Sources: Bloomberg and ECB calculations.Note: Volumes are measured as the total number of traded sharesfor the indices’ constituent firms.0Anecdotal evidence suggests that bond dealers have significantly reduced the size of their balancesheets in response to the increased volatility in yields and the higher funding costs. Since futurescontracts are very often used for the hedging of interest rate risk on dealers’ bond portfolios, thenumber of futures traded for this purpose may have declined. Chart C shows that the tradingvolume for futures contracts has indeed declined since the onset of the financial turmoil inmid-2007. In particular, the number of contracts traded for the most frequently used instrument,the ten-year government bond future, has declined by more than two-thirds in the United Statesand by more than half in Germany since mid-2007. Slightly smaller declines have been observedin the trading volumes for five-year government bond futures.Chart D shows that for stock markets, volumes – measured as the average number of stockstraded per month – have remained relatively resilient in both the euro area and the United States,despite declining somewhat at the beginning of 2009, particularly in the euro area. As notedabove, the relatively robust trading volumes observed on stock markets may reflect the manyinformation shocks affecting markets. All other things being equal, market prices should adjustwhen new information becomes available. Thus, when information shocks hit markets with agreater frequency than normal, the frequency of trading will also increase. For stock markets,these information shocks can reflect both revised expectations of future dividends and changesin the discount factor. By contrast, cash flows from standard government bonds are fixed innominal terms, and so valuations respond only to changes in the discount factor.The considerable increase in macroeconomic uncertainty in the course of 2008, combined withmarket participants’ downsizing of balance sheets, has generated spikes in volatility and a severedeterioration in market liquidity in many financial market segments. This has even affectedECBAnnual Report200845

markets which are normally considered to be highly liquid and are typically characterisedby minimal levels of risk, such as the euro area government bond markets. Volatility shouldeventually moderate once the macroeconomic uncertainty has subsided and the period ofdeleveraging has run its course, leading to some normalisation of market liquidity.STOCK PRICES DECREASED SHARPLY IN 2008The year 2008 was characterised by high volatilityand sharp declines in stock prices around theworld, amid a number of events that havereshaped the financial landscape, especially inthe United States, as well as deteriorating globalmacroeconomic conditions. All in all, at the endof 2008 equity prices in the euro area, the UnitedStates and Japan, as measured by the Dow JonesEURO STOXX, the Standard & Poor’s 500,and the Nikkei 225 indices respectively, werelower by around 46%, 39% and 42% comparedwith the end of 2007 (see Chart 13). Stock pricefluctuations became particularly pronouncedin March, and from September, reflectingunrest in global financial markets. Moreover,declining actual and expected earnings growthon both sides of the Atlantic also contributedto the negative performance of stock markets.These price developments took place amid highvolatility, which in October and Novembersurged to exceptional levels.From the beginning of the year until mid-March2008, equity prices in the euro area, the UnitedStates and Japan followed a declining trend.This trend was partly reversed when JPMorganChase took over Bear Stearns after receiving aloan in non-recourse financing from the FederalReserve. The Bear Stearns rescue package wasfavourably perceived by market participants,who changed their risk perceptions, therebycontributing to sustaining equity markets.Against this background, from mid-March tothe beginning of June the Dow Jones EUROSTOXX increased by almost 10%, the Standard& Poor’s 500 by around 8.5%, and the Nikkei225 by 22.5%.However, during the summer stock pricesdeclined significantly on account of renewedconcerns regarding the financial sector and theoutlook for the world economy. Over this periodpressure mounted on the US governmentsponsoredenterprises (GSEs), Fannie Maeand Freddie Mac, as well as on bond insurers.Furthermore, in the first half of the summercommodity prices rose rapidly, darkening theworld economic outlook. In September eventsin financial markets escalated further, whenin the United States the aforementioned GSEswere taken into public ownership, the FederalReserve together with the US Treasury arrangedthe rescue of the insurance group AIG, and thestand-alone investment bank business modelceased to exist after the bankruptcy of LehmanBrothers, the takeover of Merrill Lynch by Bankof America, and the conversion of GoldmanSachs and Morgan Stanley into bank holdingcompanies. Following these extraordinary eventsand in response to the spreading of the turmoilbeyond the US financial system, government-Chart 13 Major stock market indices(indices rebased to 100 on 31 December 2007; daily data)120110100908070605040euro areaUnited StatesJapan2004 2005 2006 2007 2008120110100Sources: Reuters and Thomson Financial Datastream.Note: The indices used are the Dow Jones EURO STOXX broadindex for the euro area, the Standard & Poor’s 500 index for theUnited States and the Nikkei 225 index for Japan.90807060504046 ECBAnnual Report2008

sponsored rescue plans were initiated for anumber of European financial institutions aswell. On both sides of the Atlantic governmentsand public institutions alike undertook anumber of measures aimed at stabilising thefinancial system. These measures includeddeposit guarantees to private account holders,bank recapitalisation measures and actions tostrengthen bank liquidity. In addition, majorcentral banks cut their policy rates amid theintensification of the financial turmoil and thedeterioration of the macroeconomic outlook.The decline in stock markets was compoundedby a decrease in actual and expected earningsgrowth on both sides of the Atlantic. BetweenDecember 2007 and December 2008, actualearnings growth, computed in terms of earningsper share of corporations listed in the DowJones EURO STOXX index, turned negative toaround -16%. Similarly, earnings expectationswere also sharply revised downwards. Theforecast annual growth rate of earnings pershare 12 months ahead fell from about 9% atthe end of December 2007 to around 1.6% atthe end of December 2008. The decrease in euroarea corporations’ profitability, together withnegative news from macroeconomic indicators,have weighed negatively on stock marketvaluations.Against a background of continued unrestin financial markets and deterioratingmacroeconomic conditions, stock markets werecharacterised by a high degree of uncertainty,as measured by the implied volatility extractedfrom stock options. Stock volatility wasespecially elevated during the major episodesshaking financial markets, i.e. in March andsince September (see Chart 14). Against thisbackdrop, it is likely that equity risk premia haveincreased both in the euro area and the UnitedStates, thereby contributing to depressing stockmarket prices.From a sectoral perspective, in both the euroarea and the United States stock prices in thefinancial industry suffered the heaviest lossesbetween December 2007 and December 2008,Chart 14 Implied stock market volatility(percentages per annum; five-day moving average of daily data)1009080706050403020100euro areaUnited StatesJapan2004 2005 2006 2007 2008100Source: Bloomberg.Notes: The implied volatility series reflects the expected standarddeviation of percentage changes in stock prices over a period ofup to three months, as implied in the prices of options on stockprice indices. The equity indices to which the implied volatilitiesrefer are the Dow Jones EURO STOXX 50 for the euro area, theStandard & Poor’s 500 for the United States and the Nikkei 225for Japan.declining by about 57% and 51% respectively.Stock prices in the non-financial sector also fellsignificantly, decreasing by around 41% in theeuro area and 36% in the United States.In early 2009 the deteriorating global economicoutlook as well as renewed concerns about thehealth of the financial system pushed stockprices further down. Between the end of 2008and 27 February 2009, the Dow Jones EUROSTOXX and the Standard & Poor’s 500 indicesdeclined by around 17% and 19% respectively.HOUSEHOLD BORROWING MODERATED FURTHERThe dynamics of household borrowing continuedto slow in the course of 2008, reflecting theimpact of factors such as tighter financingconditions, the weakening of economic prospectsand the ongoing moderation of housing marketdynamics.The annual growth rate of MFI loans tohouseholds, which were the main source of9080706050403020100ECBAnnual Report200847

Chart 15 MFI loans to households(annual percentage changes)Chart 16 Interest rates for lending tohouseholds and non-financial corporations(percentages per annum; excluding charges; rates on newbusiness)totallending for house purchaseconsumer creditother lendingshort-term rates for lending to non-financial corporationslong-term rates for lending to non-financial corporationsrates for loans to households for house purchaserates for loans to households for consumer credit1414101012129910108888776666445522440033-22001 2002 2003 2004 2005 2006 2007-2200822003 2004 2005 2006 2007 20082Source: ECB.Source: ECB.household borrowing in 2008, declined tostand at 1.8% in December, down from 6.2% atthe end of 2007. At the same time, the annualgrowth rate of loans to households by non-MFIs(i.e. OFIs, insurance corporations and pensionfunds) continued to exceed that of MFI loans tohouseholds, which stood at 10.4% in the thirdquarter of 2008. This partly reflects the effectof true-sale securitisation activities, whereloans are derecognised and thereby removedfrom MFI balance sheets, subsequently beingrecorded as loans from OFIs.A breakdown of MFI loans to householdsby purpose indicates that the main driver ofthat moderation was the declining growthrate of borrowing for house purchase. Theannual growth rate of loans to households forhouse purchase was 1.7% in December 2008,having stood at 7.1% in December 2007(see Chart 15). This decline was consistent withthe slowdowns observed in house price growthand housing market activity in a number of euroarea economies. The results of the Eurosystem’sbank lending survey support this assessment, asin the course of 2008 banks identified worseninghousing market prospects and deterioratingconsumer confidence as the main factorscontributing to the dampening of households’demand for loans for house purchase. Moreover,the worsening housing market prospects werealso partly responsible for the tightening ofbanks’ credit standards, which played animportant role in the moderation of loan growth.The moderation of the annual growth rate ofloans for house purchase also reflected thedampening impact of the increases in key ECBinterest rates as of December 2005. Continuingthe trend observed in 2006 and 2007, althoughat a slower pace, MFI interest rates on loans forhouse purchase rose by 31 basis points betweenDecember 2007 and September/October 2008,before declining by 10 basis points in the fourthquarter (see Chart 16). The increase observedin the first three quarters of the year was broadlybased across the maturity spectrum, althoughit was slightly larger for loans with initial ratefixation periods of up to one year and betweenone and five years.48 ECBAnnual Report2008

The annual growth rate of consumer credit alsodeclined, falling to 1.5% in December 2008,around 4 percentage points lower than at the endof 2007. Over recent quarters the annual growthrate of consumer credit has declined in line withfalling consumer confidence and the gradualmoderation in private consumption in the euroarea. Moreover, the results of the Eurosystem’sbank lending survey indicate that creditstandards applied to loans for consumptioncontinued to tighten in 2008, in line withdevelopments in the fourth quarter of 2007,owing to the worsening expectations regardinggeneral economic activity and the deteriorationobserved in the creditworthiness of borrowers.MFI interest rates on consumer credit, whichremained well above those on loans for housepurchase in 2008, increased by 56 basis pointsbetween December 2007 and November 2008,thereby dampening demand for consumer credit.They then declined, with the rates observed inDecember 2008 standing 15 basis points abovethose of December 2007.HOUSEHOLD INDEBTEDNESS STABILISEDIn the second half of 2008 the protractedmoderation observed in the growth rate oflending to households and the ongoing increasein disposable income led to a slight decline inthe ratio of household debt to disposable income,which was estimated at around 92% in thefourth quarter (see Chart 17). The same patterncan be observed for the ratio of debt to GDP,which, according to data from the euro areaintegrated accounts, declined to around 60% inthe fourth quarter of 2008. That being said, thelevel of indebtedness of euro area households isrelatively modest compared with countries suchas the United States or the United Kingdom.The moderation of euro area households’indebtedness has helped to stabilise theirexposure to changes in interest rates, incomeand asset prices. It is also worth mentioningthat there is a large degree of heterogeneity inthe indebtedness of households across the euroarea. In particular, higher levels of risk apply tohouseholds in those parts of the euro area wherethe economic slowdown is more marked orChart 17 Household debt and interestpayments(percentages)9585756555452001interest payment burden as a percentage of grossdisposable income (right-hand scale)ratio of household debt to gross disposable income(left-hand scale)ratio of household debt to GDP (left-hand scale)1.52002 2003 2004 2005 2006 2007 2008Sources: ECB and Eurostat.Notes: Household debt comprises total loans to householdsfrom all institutional sectors, including the rest of the world.Interest payments do not include the full financing costs paid byhouseholds, as they exclude the fees for financial services. Datafor the last quarter shown have been partly estimated.there are still signs of overvaluation in housingmarkets.At the same time, although the level ofhousehold indebtedness stabilised in 2008,past increases in lending rates for householdsled to a further increase in households’ debtservicing burden, measured as interest paymentsplus principal repayments as a percentage ofdisposable income. Indeed, the interest paymentburden is estimated to have reached 3.8% in thesecond half of 2008, up from 3.6% at the endof 2007. This also exceeds the previous peakobserved in 2001.THE COST OF EXTERNAL FINANCING FORNON-FINANCIAL CORPORATIONS INCREASEDCONSIDERABLY IN 2008In 2008, amid the financial market turmoil,the real cost of external financing fornon-financial corporations in the euro areaincreased considerably compared with recent4.03.53.02.52.0ECBAnnual Report200849

years. Although corporate profitability remainedresilient in the first part of 2008, it displayedsigns of rapid deterioration in the remainderof the year, markedly so in the last quarter.Following a spike in the first quarter mainlydue to the strong dynamics of MFI loans, thegrowth of external financing to non-financialcorporations moderated. However, the leverageof the non-financial corporate sector is expectedto have increased further in 2008.Amid intensifying tensions in financial andcredit markets, the overall real cost of externalfinancing for euro area non-financial corporationsrose sharply in 2008 (see Chart 18). In thelast quarter of 2008 the evident deteriorationin both macroeconomic conditions and themacroeconomic outlook contributed to a sharpincrease in the cost of external corporate financeas increased default expectations and downwardearnings revisions weighed on investors’ appraisalof credit and market risk. Throughout the yearthe increase was mostly driven by a sharp risein the real cost of market-based debt and equityfinancing.Turning to the components of the cost of externalcorporate financing, interest rates on MFI loansto non-financial corporations declined in realterms (see Chart 18) when compared with theend of 2007. The point-to-point comparisonbetween year-ends conceals pronounced intrayeardynamics. Nominal short-term interestrates broadly increased for most of the year,closely tracking the upward trend of the threemonthEURIBOR, although the effect wasdampened in real terms by the pick-up in shortterminflation expectations until September.In November and December short-term ratesdeclined considerably, reflecting the cuts inpolicy rates and the decrease in money marketrates. As a result, the nominal rates on loanswith a floating rate and an initial rate fixationperiod of up to one year fell by 70 and 106 basispoints on small and large loans respectively.Long-term MFI lending interest rates, afterincreasing up to September 2008, declined in thelast quarter of the year, with the decline beingChart 18 Real cost of the external financingof euro area non-financial corporations(percentages per annum)9876543210overall cost of financingreal short-term MFI lending ratesreal long-term MFI lending ratesreal cost of market-based debtreal cost of quoted equity01999 2000 2001 2002 2003 2004 2005 2006 2007 2008Sources: ECB, Thomson Financial Datastream, Merrill Lynchand Consensus Economics forecasts.Notes: The real cost of the external financing of non-financialcorporations is calculated as a weighted average of the cost ofbank lending, the cost of debt securities and the cost of equity,based on their respective amounts outstanding and deflated byinflation expectations (see Box 4 in the March 2005 issue of theECB’s Monthly Bulletin). The introduction of the harmonisedMFI lending rates at the beginning of 2003 led to a break in thestatistical series.more marked for large loans. Compared withthe end of 2007, long-term MFI rates for smallloans remained broadly unchanged, while thoseon large loans fell by 72 basis points. Yieldson government bonds of comparable maturityalso displayed a mixed trend over the year,first increasing and later decreasing sharply.Overall, yields on five-year government bondswere 85 basis points lower in December 2008compared with end-2007. As a result of thesedevelopments, the spreads between long-termbank lending rates and comparable market rateson average tended to widen during the secondhalf of the year. The widening of the spreadscame along with the soaring cost of capitalmarket funding for banks.The real cost of market-based debt for nonfinancialcorporations surged during 2008,reinforcing the upward trend that started at the98765432150 ECBAnnual Report2008

end of 2007. By December 2008 this cost was200 basis points above the level of the previousyear and 420 basis points above the historicallow reached in 2005. The level attained at theend of 2008 represents an all-time high since thestart of EMU and was well above that recordedin 2000. By contrast, as mentioned above, yieldson government bonds of comparable maturitydeclined. As a result, corporate bond spreadswidened significantly during the second half of2008. The increase in spreads also reflects thetightening of credit standards and higher creditrisk perceptions among investors.The real cost of quoted equity of non-financialcorporations increased markedly during the year.An evident deterioration took place in the secondhalf of 2008, when stock market prices (measuredfor instance by the Dow Jones EURO STOXX,a broad euro area index) plummeted and riskaversion reached exceptionally high levels. Aftershowing noteworthy resilience in the first halfof the year, earnings growth of listed enterprisesalso deteriorated sharply, turning negative byNovember on an annual basis.THE PACE OF EXTERNAL FINANCING BY NON-FINANCIAL CORPORATIONS MODERATEDNon-financial corporations’ external financingmoderated progressively in the course of 2008.In the fourth quarter of 2008 the real annualgrowth rate of financing of non-financialcorporations was 2.7%, down from 4.9% inthe fourth quarter of 2007 and 5.1% in thefirst quarter of 2008. This development wasmainly driven by the slowdown, albeit fromhigh levels, in the contribution of loans grantedby MFIs, and, to a lesser extent, by the declinein the issuance of quoted equity, while thecontribution of debt securities remained broadlystable (see Chart 19).According to aggregated firm-level data fromcorporate financial statements of listed firms,profits remained resilient during the first halfof 2008 (see Chart 20). However, measures ofcorporate profitability dropped considerably inthe second half of 2008. In parallel, earningsexpectations in the euro area were abruptlyChart 19 Breakdown of the real annualgrowth rate of external financing tonon-financial corporations 1)(annual percentage changes)6.05.04.03.02.01.00.0-1.0-2.0quoted sharesdebt securitiesMFI loans-1.0-2.02001 2002 2003 2004 2005 2006 2007 2008Source: ECB.1) The real annual growth rate is defined as the differencebetween the actual annual growth rate and the growth rate of theGDP deflator.revised downwards in the last quarter of 2008.The number of downward revisions to earningsexpectations for listed euro area firms reached anunprecedented peak around the end of the year.The rate of growth in MFI loans to non-financialcorporations slowed down in 2008. Followinga peak in nominal terms of 15.0% in March2008, this rate of growth moderated to 9.4%in December. This still robust year-on-yeargrowth rate somewhat conceals the underlyingweakening dynamics of the growth of MFIloans to the corporate sector, through a carryovereffect from strong growth in the first halfof 2008. Indeed, as shown by short-term growthrates, an acceleration in the slowdown took placetowards the end of the year, more markedlyin December, as a result of the deteriorationin financing conditions. The deceleration isbroadly in line with the tightening of financingconditions reported in the Eurosystem’s banklending surveys throughout the year, reducedmerger and acquisition (M&A) activities andthe moderation of economic activity. Theremight be a number of possible explanations6.05.04.03.02.01.00.0ECBAnnual Report200851

Chart 20 Profit ratios of listed euro areanon-financial corporations(quarterly data; percentages)14121086420-2-4net income to sales (left-hand scale)operating income to sales (left-hand scale)operating expenses to sales (right-hand scale)-62002 2003 2004 2005 2006 20072008100Sources: Thomson Financial Datastream and ECB calculations.Notes: The calculation is based on aggregated quarterly financialstatements of listed non-financial corporations in the euro area.Outliers have been removed from the sample. Compared withthe operating income, which is defined as sales minus operatingexpenses, the net income refers to operating and non-operatingincome after taxation and extraordinary items.9896949290888684Chart 21 Non-financial corporations’financing gap and its main components(as a percentage of GDP; four-quarter moving average)15131197531-1-3-5financing gap (left-hand scale)non-financial investment 1) (right-hand scale)corporate savings 2) (right-hand scale)2000 2001 2002 2003 200452005 2006 2007 2008Source: ECB.1) Includes inventories and accumulation of non-financial assets.2) Includes net capital transfers.1514131211109876why MFI loan growth, while decelerating,continued to be relatively robust, at least up toNovember. Corporate developments in the euroarea remained relatively resilient in the first partof 2008, thereby sustaining loan demand forfinancing activities. Another contributing factormay have been the drawing-down of creditfacilities negotiated in more benign times. Thedemand for bank loans could have also beensupported by a substitution effect stemming fromhampered capital market funding, a reductionin internally generated funds and a contractionin trade credit. Furthermore, obstacles to theprompt adjustment of productive capacity andthe implementation of cost-cutting programmesoften inhibit corporate spending from adjustingin the short term. This may partly explain theresilience of credit demand in the second half ofthe year, despite weakening growth prospects.Growth in market-based financing (through bothdebt and equity) slowed down, in parallel to thesurge in the cost of these sources of funding.The annual growth rate of debt securities issuedby non-financial corporations declined fromaround 9.0% at the beginning of the year to6.6% in December 2008. The issuance of shorttermdebt securities, which picked up after theonset of the financial turmoil in the summerof 2007, also progressively moderated. Thispattern is confirmed by short-term developmentsin seasonally adjusted data. Adding to the risein corporate spreads, these developments mayfurther reflect the decline in M&A activity. Theannual growth rate of quoted shares issued bynon-financial corporations fell considerablythroughout 2008, reaching zero in December.The negligible contribution of the net issuanceof quoted shares to the net financing of theeuro area corporate sector is attributable to thesoaring real cost of equity and to highly volatileequity market conditions.The growth of external financing to non-financialcorporations, albeit moderating, may be relatedto a wider financing gap or net borrowing –52 ECBAnnual Report2008

calculated as the balance between gross savingand gross capital formation (see Chart 21). Thefinancing gap experienced by non-financialcorporations in the euro area in 2007 and up tothe third quarter of 2008 resulted from decreasesin corporate saving and, to a lesser extent,increases in real investment in relation to GDP.During the first part of 2008 falling corporatesaving was mainly the result of rising interestpayments.A FURTHER RISE IN CORPORATE DEBTWith regard to developments in the balancesheet position of non-financial corporationsin the euro area, the protracted rise in debtfinancing led to a further increase in debt ratios(see Chart 22). In the fourth quarter of 2008the debt-to-GDP and debt-to-gross operatingsurplus ratios rose to 80.5% and 403%respectively. After a period of consolidationbetween 2002 and 2004, the debt ratios ofnon-financial corporations have continuouslyincreased over the last four years. The ratioof debt to financial assets of non-financialcorporations edged upwards in most of 2008,Chart 22 Debt ratios of non-financialcorporations(percentages)410390370350330310290ratio of debt to gross operating surplus (left-hand scale)ratio of debt to GDP (right-hand scale)270501999 2000 2001 2002 2003 2004 2005 2006 2007 2008Sources: ECB, Eurostat and ECB calculations.Notes: Debt is reported on the basis of the quarterly Europeansector accounts. It includes loans, debt securities issued andpension fund reserves. Included is information up to the fourthquarter of 2008.85807570656055interrupting the declining trend observed sincethe first quarter of 2003. The combination ofhigher debt and rising interest rates translatedinto a significant increase in the net interestburdens of non-financial corporations in thecourse of 2008.2.3 PRICE AND COST DEVELOPMENTSOverall HICP inflation averaged 3.3% in 2008,which was a sharp increase by comparisonwith previous years – when annual inflationrates clustered around 2.2% – and well abovethe ECB’s definition of price stability overthe medium term (see Table 1). The increasefor 2008 as a whole resulted from two sharplydistinct patterns in HICP developments over thecourse of the year: starting from an already highlevel at the end of 2007 of 3.1%, annual inflationrates grew further to reach a peak of 4.0% inJune and July 2008, but receded thereafter, at arapid pace in the last few months of the year, tostand at 1.6% in December.The sharply contrasting overall HICP inflationdevelopments in 2008 were dominated bypatterns in global commodity prices (energyprices, as well as the prices of other commodities,including food) (see Chart 23). In the first partof the year, booming world demand continuedto push up commodity prices, which reachedextremely high levels, while the rapid slowdownin activity in the second part of the year, whichdeveloped into a pronounced contraction by theyear-end, abruptly pushed them down again.Most prominently, oil prices continued to surgein the first half of 2008, following rapid increasesin 2007, and reached a historical high in earlyJuly against the background of tight supply anddemand conditions. During the second half ofthe year oil prices fell precipitously, ending atlevels well below those seen at the beginning ofthe year. In a parallel development, processedfood price inflation, which began from alreadyelevated levels at the end of 2007, increasedsharply during the first part of the year as a resultof a worldwide tightening in food commodityinventories, before receding rapidly towardsECBAnnual Report200853

Table 1 Price developments(annual percentage changes, unless otherwise indicated)2006 2007 2008 2007 2008 2008 2008 2008 2008 2009Q4 Q1 Q2 Q3 Q4 Dec. Jan.HICP and its componentsOverall index 2.2 2.1 3.3 2.9 3.4 3.6 3.8 2.3 1.6 1.1Energy 7.7 2.6 10.3 8.1 10.7 13.6 15.1 2.1 -3.7 -5.3Unprocessed food 2.8 3.0 3.5 3.1 3.5 3.7 3.9 3.0 2.8 2.6Processed food 2.1 2.8 6.1 4.5 6.4 6.9 6.7 4.3 3.5 2.7Non-energy industrial goods 0.6 1.0 0.8 1.0 0.8 0.8 0.7 0.9 0.8 0.5Services 2.0 2.5 2.6 2.5 2.6 2.4 2.6 2.6 2.6 2.4Other price and cost indicatorsIndustrial producer prices 1) 5.1 2.8 6.2 4.0 5.4 7.1 8.5 3.7 1.6 .Oil prices (EUR per barrel) 2) 52.9 52.8 65.9 61.0 64.2 78.5 77.6 43.5 32.1 34.3Commodity prices 3) 24.8 9.2 4.4 1.6 11.9 7.1 8.6 -10.7 -17.1 -20.7Sources: Eurostat, Thomson Financial Datastream, Hamburg Institute of International Economics and ECB calculations.Note: Data on industrial producer prices refer to the euro area including Slovakia.1) Excluding construction.2) Brent Blend (for one-month forward delivery).3) Excluding energy; in euro.the end of the year. By contrast, HICP inflationexcluding energy and food (processed andunprocessed) remained broadly stable (at 1.9%in 2008 as compared with 1.8% in 2007).Labour costs accelerated during the first halfof 2008, with substantial upward pressure onunit labour costs in the context of a markedcyclical decline in labour productivity growth.This raised serious and growing concern aboutthe risk of significant second-round effectsemerging in the euro area, which peaked aroundthe middle of the year. These concerns recededin the autumn as the economy entered a phase ofpronounced contraction.Chart 23 Breakdown of HICP inflation: maincomponents(annual percentage changes; monthly data)6420-2total HICP (left-hand scale)unprocessed food (right-hand scale)energy (right-hand scale)2003 2004 2005 2006 200720081815129630-3-6Accordingly, consumer inflation perceptions andexpectations, which had risen markedly duringthe first part of the year, reaching their highestlevels since the introduction of the euro, startedto moderate towards the end of the year.86total HICP excluding energy and unprocessed foodprocessed foodnon-energy industrial goodsservices86HICP INFLATION WAS SIGNIFICANTLY INFLUENCEDBY ENERGY AND FOOD PRICE DEVELOPMENTSThe volatility in commodity prices was themain factor driving the pronounced movementsin euro area HICP inflation during 2008. Thesteady increase in the annual rate, to a peak of4.0% in June and July, followed unprecedentedincreases in energy, industrial and food420-22003 2004 2005 2006 2007Source: Eurostat.2008420-254 ECBAnnual Report2008

commodity prices (see Box 4). Conversely, thesubsequent rapid decline in HICP inflation, to1.6% by the end of the year, resulted from thestrong decline in crude oil prices and reductionsin the prices of a broad range of other globalcommodities, including food, plus a favourablebase effect, in a context of rapidly deterioratingeconomic activity.Box 4COMMODITY PRICES AND HICP INFLATIONThe prices of a broad range of commoditiesrose sharply in the period between the start of2005 and July 2008 (see Chart A). They havedeclined rapidly since then, amid the markeddeterioration in global economic activity.These developments – in particular those in oiland food prices – have had a major bearing onconsumer prices in the euro area and largelyexplain the spike in overall HICP inflationin 2008. This box reviews the effects ofcommodity prices on euro area inflation. 1Direct and indirect effectsChart A Commodity prices(monthly data in euro; index: 2000 = 100)300250200150100food and tropical beveragesmetalsoil300250200150100Commodity price increases affect HICPinflation directly through their immediateeffect on the consumer prices of energy andfood, which represent almost 30% of theoverall HICP. They may also have an indirect effect on consumer prices through producer prices,as firms facing higher input costs pass these cost increases on to sales prices in order to maintainor restore their profit margins.The extent to which cost increases are passed on to further stages of production and to consumersdepends on several factors, including competitive pressures in the market and business cycleconditions. As cost shocks take time to work through the supply chain, indirect effects aregenerally thought to materialise with longer time lags and to last longer than direct effects.Turning to the data, most of the increase in headline HICP inflation from August 2007 was dueto the direct and indirect effects of the commodity price shock. In line with this, processed andunprocessed food and energy prices – the HICP components more directly exposed to the shock –rose substantially up to July 2008, whereas measures of inflation excluding food and energyremained largely unchanged over the period (see Chart B).Indirect effects also appeared to emerge in other HICP components that use oil and raw food asa production input. For example, within the services component, the prices of transport-relatedservices, package holidays and restaurants – which use oil and food as production inputs – rose502000 2001 2002 2003 2004 2005 2006 20072008Sources: Hamburg Institute of International Economics and ECBcalculations.501 See the article entitled “Oil prices and the euro area economy” and the box entitled “Recent oil price developments and their impact oneuro area prices” in the November 2004 and July 2004 issues of the ECB’s Monthly Bulletin respectively.ECBAnnual Report200855

significantly in 2008, as commodity prices spiked (see Chart C). However, these rises may alsoreflect other factors in addition to the increases in oil and food prices, such as wage developmentsand the strength of consumer demand, in particular in the first half of the year.Second-round effectsIn addition to direct and indirect effects, usually described as first-round effects, a commodity priceshock also entails the risk of what are known as second-round effects, which may put further upwardpressure on consumer prices. Second-round effects typically refer to the increase in consumer pricesover and above first-round effects owing to the impact of the shock on wage bargaining and pricesettingbehaviour. An increase in inflation owing to the direct and indirect effects of a commodityprice shock may lead to second-round effects if economic agents (in particular price and wage-setters)attempt to compensate for the loss of real income caused by past inflation shocks. This may, in turn,affect inflation expectations and further influence price and wage-setting behaviour. In this way, atransitory inflation shock may become entrenched and thus more costly to eradicate.The likelihood of a commodity price shock leading to second-round effects depends on severalfactors, including the cyclical position of the economy, the flexibility of goods and labour markets(in particular the presence of automatic indexation mechanisms affecting wage bargaining and pricesettingprocesses), the formation mechanism of inflation expectations and, most importantly, thecredibility of the central bank.Inflation expectations and labour cost developments may be used to monitor the risk of secondroundeffects. Inflation expectations derived from surveys of professional forecasters rosesomewhat between mid-2007 and mid-2008. Expectations implied by break-even inflation ratesderived from bond yields followed a clear upward trend over the same period, but, with theintensification of the financial turmoil and the subsequent fall in oil prices, there has been aChart B HICP inflation(annual percentage changes; monthly data)Chart C Selected sub-components of theHICP services component(annual percentage changes; monthly data)HICPHICP excluding food and energytransport services (left-hand scale)package holidays (left-hand scale)restaurants and cafés (right-hand scale)5.05.010.04.54.04.08.04.06.03.03.04.03.52.02.02.03.00.01.01.0-2.02.50.02000 2001 2002 2003 2004 2005 2006 2007 20080.0-4.02003 2004 2005 2006 2007 20082.0Sources: Eurostat and ECB calculations.Source: Eurostat.56 ECBAnnual Report2008

Chart D Longer-term inflation expectationsfrom surveys and the break-even inflationrate(annual percentage changes)2.6Survey of Professional ForecastersConsensus Economics (for 2013)Euro Zone Barometer (for 2012)five-year forward break-even inflation rate five yearsahead (seasonally adjusted)2.6subsequent reversal of this trend (see Chart D).Evidence from wage bargaining developmentsin the course of 2008 also points to strongwage growth in various euro area countries,although it is difficult to pinpoint how much ofthe rise is attributable to second-round effects(more details on recent wage developments inthe euro area can be found in Box 5).2.42.22.01.81.62001 2002 2003 2004 2005 2006 2007 2008Sources: Consensus Economics, Euro Zone Barometer, ECB,Reuters and ECB calculations.Note: Longer-term inflation expectations are normally surveyedon a half-yearly basis by Consensus Economics and on aquarterly basis in the ECB Survey of Professional Forecastersand Euro Zone Barometer.Latest observations: break-even inflation rate: 27 February 2009;Survey of Professional Forecasters and Euro Zone Barometer:January 2009; Consensus Economics: October 2008.2.42.22.01.81.6While the direct, “mechanical” effects ofa commodity price shock on consumerprices are unavoidable and indirect effectsare, depending on the transmission of theshock through the price chain, possible, itis imperative that widespread inflationarypressures related to second-round effectsbe avoided. The role of a monetary policygeared towards maintaining price stabilityover the medium term is to ensure that acommodity price shock does not affectlonger-term inflation expectations and triggerbroader price pressures. Consequently, in acontext of intensifying inflationary pressures,the ECB decided to raise its key interest ratesin July 2008 in order to stabilise inflationexpectations. However, interest rates werelowered later in the year, when it became clearthat the inflationary pressures would be significantly alleviated by the sharp fall in commodityprices and the economic downturn.The pronounced movement in the energycomponent of the HICP – which has a weightof 9.8% in the overall HICP – reflected theabrupt changes in the prices of liquid fuel(such as petrol, diesel and heating fuel) drivenby global oil prices, combined with the laggedresponse of non-oil energy components (suchas electricity and gas) that tend to followcrude oil prices with a lag (see Chart 24). InJune 2008 oil prices in euro were around63% higher than a year earlier. By December2008 they were 49% lower than a year earlier,having fallen by around 63% from their June2008 peak. This marked variation in the annualprofile was also amplified by a pronouncedmovement in refining margins. The year-onyearchange in HICP energy prices peaked at17.0% in July 2008, compared with 9.1% inDecember 2007, before retreating rapidly andeven turning negative in December, when itstood at -3.6%.The annual growth rate of the processed foodcomponent of the euro area HICP followed asimilar profile to that of the energy component,rising considerably in the autumn of 2007 beforedeclining strongly from the middle of 2008onwards. The annual rate of change in processedfood prices reached a peak of 7.2% in July 2008,up from 2.0% in July 2007, before falling backto 3.6% in December 2008. Much of the spikein processed food prices and of the subsequenteasing was related to components that are stronglyaffected by global agricultural commodity prices,such as bread and cereals, dairy products, and oilsand fats. For the year as a whole, processed foodECBAnnual Report200857

Chart 24 Contributions to HICP inflationfrom main components(annual percentage point contributions; monthly data)4.54.03.53.02.52.01.51.00.50.0-0.5servicesnon-energy industrial goodsprocessed foodunprocessed foodenergyoverall index2004 2005 2006 20072008-0.5Source: Eurostat.Note: Due to rounding errors, the contributions do not add upexactly to the overall index.price inflation reached 6.1% on average in 2008,as compared with 2.8% in 2007. By contrast,unprocessed food prices rose by 3.5% in 2008compared with 3.0% in 2007.Excluding energy and food (processed andunprocessed), HICP inflation was largelystable over 2008. The impact of notably higherinput prices arising from high commodityprices (energy and non-energy) was offset bythe dampening effect of lower import pricepressures, in the context of an appreciation ofthe euro until the middle of the year and stronginternational competition, as well as by thefavourable base effect relating to the fact that the3 percentage point increase in VAT introducedin Germany on 1 January 2007 started to dropout of the annual inflation rates at the beginningof 2008.4.54.03.53.02.52.01.51.00.50.0Non-energy industrial goods prices rose by0.8% in 2008, showing a slight decelerationcompared with the rate of 1.0% recorded in2007. Despite the input cost pressures signalledby domestic producers and the high utilisationrate of manufacturing capacity, non-energyindustrial goods price inflation moderated inthe first half of 2008. It rebounded somewhatfrom July, on account of, among other things,the impact of the abrupt appreciation of theUS dollar observed in the second half of the yearand of some exceptional seasonal discountingwhich affected textile prices in the summer.Services price inflation was broadly stablethroughout much of 2008, although remainingat relatively elevated levels of around 2.5%,following a marked increase in 2007. Whilethe indirect impact of price increases in globalcommodities, especially oil and food, may havecontributed to a persistent upward effect onsome services components, such as transportservices and restaurants and cafés, this wascounterbalanced to a large extent by pronounceddeclines in other services components, such ascommunications.HIGHER AVERAGE PRODUCER PRICE INFLATION IN2008 BUT PRONOUNCED DOWNWARD PRESSURESTOWARDS THE END OF THE YEARSupply chain price pressures reached extremelyelevated levels in late spring, against thebackground of the high commodity priceinflation, exacerbating concerns about inflation.However, these pressures receded steadily inthe course of the summer, and then at a morepronounced pace in the last few months of theyear – with falls in index prices (excludingenergy and construction) from October – ascommodity prices started falling rapidly andpressures on factors of production (both capitaland labour) abated.The annual rate of change in industrial producerprices (excluding construction) in the euro areawas 6.2% on average in 2008, considerablyhigher than in 2007 (2.8%). After reaching ahistorical peak of 9.2% in July 2008, the yearon-yearrate of producer price inflation declined58 ECBAnnual Report2008

apidly to 1.7% in December, mainly on accountof energy and food price developments. Theannual rate of change in energy producer pricesreached a peak of 24.9% in July 2008, but hadfallen back to 1.6% by December.Excluding construction and energy, the annualgrowth rate of industrial producer prices reachedits 2008 peak of 4.4% in July, before decliningto 1.6% in December. This marked moveaffected intermediate and consumer goods,although to varying degrees and at differenttimes, but had less of an impact on capital goods(see Chart 25).Intermediate goods price inflation acceleratedduring the first eight months of the year, peakingat 6.0% in August. In the first half of the year,intermediate goods prices were still affectedby upward pressure from increasingly higherindustrial raw materials and energy prices.During the second half of the year, the latter’sdecline in world markets and the slowdown inactivity dampened output price developmentsin many parts of the intermediate goods sector.By the end of the year, many output prices werefalling in the context of a sharp contraction inactivity.Movements in the annual growth rate of capitalgoods prices were delayed and more subdued,with a slight acceleration to 2.2% in September(reversing the downward trend observed in2007) which levelled off towards the end of theyear as competition intensified in the context ofa rapid fall in demand.Further down the production chain, the sharpacceleration in consumer goods prices observedin the last few months of 2007 continued in thefirst half of 2008. The annual rate of change inoverall consumer goods prices rose to 4.7% inMarch 2008, the highest rate since the beginningof Monetary Union in 1999, mainly driven bynon-durable consumer goods prices, whichreflected global food price pressures. Excludingtobacco and food prices, the annual rate ofchange in consumer goods prices remained flatthroughout the year.Chart 25 Breakdown of industrial producerprices(annual percentage changes; monthly data)2824201612840-4energy (left-hand scale)industry excluding construction (right-hand scale)intermediate goods (right-hand scale)capital goods (right-hand scale)consumer goods (right-hand scale)2003 2004 2005 2006 2007Source: Eurostat.Note: Data refer to the euro area including Slovakia.2008Overall, by the end of the year, the generalweakening in euro area demand had resultedin considerably more competitive marketconditions at various stages of production. Thismore competitive environment, combined withfalling world commodity prices, was reflectedin widespread reports of price falls (or pricestabilisation), in input as well as output prices,for both manufacturing and services.LABOUR COSTS ACCELERATED MARKEDLYAvailable labour cost indicators for the euro areasuggest a substantial acceleration around the endof 2007 and the beginning of 2008, followingyears of wage moderation. The average annualgrowth rate of compensation per employee inthe first three quarters of the year was 3.3%,notably higher than the average annual growthrates recorded in the period 2005-07, whichranged from 1.8% to 2.5% (see Table 2).Hourly compensation provides a similar picture,although the first quarter was affected by theearly timing of Easter in 2008, thus resulting ina spike in the series in that quarter. Negotiatedwages also accelerated in the course of 2008from the band of between 2.1% and 2.3% within14121086420-2ECBAnnual Report200859

Table 2 Labour cost indicators(annual percentage changes, unless otherwise indicated)2006 2007 2008 2007Q4Negotiated wages 2.3 2.1 3.2 2.1 2.8 2.9 3.4 3.5Total hourly labour costs 2.5 2.6 . 2.9 3.5 2.8 4.0 .Compensation per employee 2.2 2.5 . 2.9 3.1 3.4 3.5 .Memo itemsLabour productivity 1.3 0.8 . 0.4 0.5 0.2 -0.1 .Unit labour costs 0.9 1.7 . 2.5 2.6 3.2 3.6 .Sources: Eurostat, national data and ECB calculations.2008Q12008Q22008Q32008Q4which they had fluctuated in past years, risingto 2.9% in the first half of the year, 3.4% in thethird quarter and 3.5% in the fourth quarter.The acceleration in wage growth in the firsthalf of the year may have reflected, aside fromsome differences in employment growth ratesacross wage levels, the prevailing tightnessin the labour market and the direct or indirectimpact of past HICP developments. Given thesizeable hike in global commodity prices, thevery tight labour market conditions and the longlag required for movements in economic activityto have a decisive impact on labour costs,there was a significant risk by mid-2008 thatsecond-round effects, stemming in particularfrom the indexation of wages to high inflationoutcomes (even if temporary), might outweighany possible dampening impact on wage costsstemming from the gradual slowdown in activityforeseen at that time.The rapid alleviation of global inflation pressures,which saw headline HICP inflation fall backbelow 2% by December 2008, and the sudden andstronger than expected contraction in euro areaactivity considerably weakened the risk of broadbasedsecond-round effects materialising. Firmswere expected to implement measures to containlabour costs in view of the uncertainty surroundingthe euro area outlook, and the rapid deteriorationin labour market conditions also contributed to themoderation of wage cost pressures.Sectoral data indicate some heterogeneousbehaviour across sectors. Growth rates in alllabour cost indicators were particularly highfor the construction sector in 2008, perhapsreflecting some composition effects, with lay-offsconcentrated among lower-paid workers amidpronounced regional differences. Compensationper employee in the services sector also increasedstrongly, particularly with regard to non-marketservices (see Chart 26). By contrast, labour costinflation in the industrial sector increased onlymoderately on average and displayed a highdegree of volatility in the course of 2008.Given the slowdown in activity and the expectedadverse cyclical impact on labour productivity,unit labour costs accelerated rapidly, reducingbusiness margins. Annual growth in labourChart 26 Sectoral compensation per employee(annual percentage changes; quarterly data)6543210industry excluding constructionconstructionservices2003 2004 2005 2006 2007Sources: Eurostat and ECB calculations.Note: Data refer to the euro area including Slovakia.6543210200860 ECBAnnual Report2008

productivity slowed to 0.2% in the first threequarters of 2008 on average, even turningnegative in the third quarter, compared withannual growth rates of around 1% on average in2006-07. Unit labour costs thus surged from anannual growth rate of 1.6% in the third quarterof 2007 to 3.6% by the third quarter of 2008. Inthe first three quarters of 2008, unit labour costsgrew at an annual rate of 3.2%, compared withaverage growth rates of 1.7% and 0.9% in 2007and 2006 respectively. The rapid increase in unitlabour costs compressed profits in the courseof 2008, as companies were unable to pass onthese higher costs in full. An indicator of overallprofit mark-up, measured as the difference inthe rates of growth of the GDP deflator and unitlabour costs, points to a fall in profit marginsafter several years of increases. Mark-upsfell on average by 0.9 percentage point in thefirst three quarters of 2008 compared with thecorresponding period of the previous year, afterincreasing by 0.9 percentage point in 2007.RESIDENTIAL PROPERTY PRICE INCREASESSLOWED DOWN FURTHERResidential property prices, which are notincluded in the measurement of the HICP,decelerated in the first half of 2008, continuingthe slowing trend observed since the second halfof 2005. According to the latest estimates, theannual growth rate of residential property pricesfor the euro area as a whole declined to 2.7% inthe first half of 2008, from 3.9% in the secondhalf of 2007 (see Chart 27). Country data confirmthat the gradual moderation in house priceinflation in the euro area was relatively broadbasedin the first half of 2008, notwithstanding acertain degree of heterogeneity across countries.House price increases slowed down significantlyin Belgium, Spain and France compared with theperiod 2006-07. House prices started falling inIreland in the second half of 2007, and in Maltain the first half of 2008. However, in Italy, theNetherlands, Portugal and Austria, house priceincreases in the first half of 2008 were roughlycomparable with those observed in 2007. InGermany, data showed small increases in houseprices in 2008, following a period of subdueddevelopments.Chart 27 Residential property pricedevelopments in the euro area(annual percentage changes; annual data)108642in nominal terms01991 1993 1995 1997 1999 2001 2003 2005 2007Source: ECB calculations, based on non-harmonised national data.Note: Data for 2008 refer to the first half of the year.DEVELOPMENTS IN INFLATION PERCEPTIONS ANDEXPECTATIONSThe sharp rise in headline inflation during thefirst half of 2008 increased the focus on inflationperceptions and expectations for the assessmentof future inflation developments. The EuropeanCommission’s measure of consumers’qualitative perceptions of inflation over theprevious 12 months continued to increase, bymid-2008 reaching levels far beyond thoseseen in the wake of the euro cash changeover inJanuary 2002 (see Chart 28).By the end of the year, these perceptions hadreceded somewhat. Similarly, consumers’inflation expectations for the next 12 monthstended to increase (expectations reported inthe survey are to be judged by reference tothe perceptions reported) in the early monthsof 2008 until the summer, before convergingtowards lower levels by the end of the year.However, the European Commission surveyprovides a measure of short-term expectationswhich is closely in line with observed inflation.It does not gauge long-term expectations,which are more important for monetary policy-1086420ECBAnnual Report200861

Chart 28 Euro area consumers’ qualitativeinflation perceptions and expectations(percentage balance; seasonally adjusted)80706050403020100inflation expectationsinflation perceptionsJan. 2002: euro cashchangeover-101995 1997 1999 2001 2003 2005 2007-102009Source: European Commission Business and Consumer Surveys.Note: Data refer to the euro area including Slovakia.making. Information derived from professionalforecasters indicates that survey-based longterminflation expectations (five years ahead)remained anchored around 2.0%, although therewere, in the middle of the year, indications ofsome upward movements and increased risks.These were reversed later in the year, accordingto survey data from Consensus Economics,Euro Zone Barometer and the ECB Survey ofProfessional Forecasters. Break-even inflationrates derived from inflation-linked bonds andswaps in the euro area (using the implied oneyearforward break-even inflation rate four yearsahead) increased gradually to more than 2.5% bymid-2008, before receding in the autumn, fallingto around 1.8% by the year-end. However, thesemarket-based measures (in particular bondbasedmeasures) were distorted at the time bysudden movements in investors’ preferencesand portfolio shifts. All in all, by mid-2008 anumber of survey and market-based indicatorspointed to a clear risk of inflation expectationsbecoming unanchored, which required a clearbut balanced signal on the part of the ECB, andby the end of the year, inflation expectations hadfallen back to more satisfactory levels.807060504030201002.4 OUTPUT, DEMAND AND LABOUR MARKETDEVELOPMENTSSHARP SLOWDOWN IN ECONOMIC ACTIVITYReal GDP growth in the euro area slowed to 0.8%in 2008, following solid growth rates of 2.7%in 2007 and 3.0% in 2006 (see Table 3). Whilethe year started on a relatively resilient note,there was a rapid deterioration in activity fromthe middle of the year in the face of weakeningdomestic demand and a pronounced slowdown inthe world economy. The year ended with a sharpcontraction in activity amid renewed financialturmoil and a virtually unprecedented downturnin global activity and demand.Quarterly growth rates were affected by certaintechnical factors. The strong GDP growth rateof 0.7% in the first quarter partly reflected anunusually mild winter in many parts of Europe,which boosted construction and thus investment,and a positive contribution to growth frominventories at the start of the year. The unwindingof these factors contributed to the quarteron-quartercontraction in GDP of 0.2% in thesecond quarter of 2008. Notwithstanding thesetechnical factors, the first half of 2008 taken asa whole pointed to a continuation of the mildslowdown in activity observed in the course of2007, with quarterly GDP trend growth slowingdown from ½% to ¼%. Only half of the quarteron-quartergrowth in the first part of the yeararose from internal demand, amid particularlysubdued consumption and weakening residentialinvestment, while the other half resulted fromnet exports.However, external demand started to showsignificant signs of contraction in the summer,as renewed weaknesses emerged in the USeconomy and activity in emerging markets –which had previously been perceived tobe shielded from the effects of the globalslowdown – decelerated (see Chart 29).62 ECBAnnual Report2008

Table 3 Composition of real GDP growth(percentage changes, unless otherwise indicated; seasonally adjusted)Annual rates 1) Quarterly rates 2)2006 2007 2008 2007 2008 2008 2008 2008 2007 2008 2008 2008 2008Q4 Q1 Q2 Q3 Q4 Q4 Q1 Q2 Q3 Q4Real gross domestic product 3.0 2.7 0.8 2.2 2.1 1.5 0.7 -1.2 0.3 0.7 -0.2 -0.2 -1.5of which:Domestic demand 3) 2.9 2.4 . 2.1 1.7 1.1 0.8 . 0.1 0.6 -0.3 0.4 .Private consumption 2.1 1.7 . 1.3 1.3 0.4 0.1 . 0.2 0.0 -0.2 0.1 .Government consumption 1.9 2.2 . 2.0 1.4 2.0 2.2 . 0.3 0.3 0.8 0.7 .Gross fixed capital formation 5.8 4.2 . 3.2 3.7 2.6 0.9 . 1.0 1.4 -0.9 -0.6 .Changes in inventories 4) 0.0 0.0 . 0.2 -0.1 -0.2 0.1 . -0.3 0.2 -0.2 0.4 .Net exports 3) 0.2 0.3 . 0.1 0.4 0.4 -0.1 . 0.3 0.1 0.1 -0.6 .Exports 5) 8.6 6.0 . 4.0 5.3 3.9 2.0 . 0.5 1.7 -0.1 0.0 .Imports 5) 8.4 5.4 . 3.9 4.4 3.1 2.2 . -0.2 1.6 -0.5 1.4 .Real gross value addedof which:Industry excluding construction 3.9 3.6 . 3.3 2.7 1.3 -1.1 . 0.5 0.2 -0.6 -1.3 .Construction 3.0 3.2 . 1.7 2.8 1.6 0.4 . 0.9 2.6 -1.8 -1.2 .Purely market-related services 6) 3.6 3.2 . 2.7 2.6 1.9 1.2 . 0.4 0.6 0.2 0.0 .Sources: Eurostat and ECB calculations.Notes: The figures reported are seasonally and partly working day-adjusted, as not all euro area countries report quarterly national accountseries adjusted for the number of working days. Data refer to the euro area including Slovakia.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 trade is notcancelled out in import and export figures used in national accounts, these data are not fully comparable with balance of payments data.6) Includes trade and repairs, hotels and restaurants, transport and communication, financial intermediation, real estate, renting andbusiness activities.From September 2008 the sudden andextraordinary intensification and broadening ofthe financial turmoil and the ensuing heighteneduncertainties led to a rapid contraction of euroarea GDP (-1.5% quarter on quarter). Firmsstarted to react forcefully to the rapid depletionof order books, postponing expansion plans andcutting inventories in the face of costlier andreduced access to financing, while householdsincreased their savings in reaction to theincreased uncertainty about short-term jobprospects and to negative wealth effects.THE SLOWDOWN IN GDP GROWTH WASBROAD-BASEDThe weakening in demand during 2008 wasbroadly based across GDP components. Externaldemand slowed as activity in advanced economiesdecelerated and emerging markets becameincreasingly affected by the financial turmoil.Domestic demand also softened considerably.Rising commodity prices strongly affectedhouseholds’ real income in the first half of theyear, while cooling housing markets led to arapid decline in residential investment. Waningcapacity pressures, renewed uncertainty andtighter financing conditions led to cuts in corporateinvestment.Faced with subdued real income growth, fallingfinancial wealth, tightening credit conditions andworsening labour market prospects, householdspending moderated considerably in the courseof the year, with private consumption growingby around 0.6% in 2008 as a whole – fully onaccount of the carry-over effect from 2007 on theyearly growth rate, as during 2008 consumptionincreased in only one quarter – compared with1.7% in 2007. Although nominal householdincome growth was reasonably robust duringmost of the year, owing to the solid growth incompensation of employees (resulting from theacceleration in compensation per employee andstill resilient employment), the real disposableincome of households came under significantdownward pressure from accelerating HICPinflation. Large increases in commodityprices raised the cost of households’ typicalECBAnnual Report200863

Chart 29 Contributions to quarterly realGDP growthChart 30 Confidence indicators(quarterly percentage point contributions; seasonally adjusted)1.51.00.50.0-0.5-1.0-1.5-2.0real GDP 1)final domestic demand 2)net exports2002 2003 2004 2005 2006 20072008-0.5-1.0-1.5-2.0Sources: Eurostat and ECB calculations.1) Percentage change compared with the previous quarter.2) Defined as domestic demand excluding changes in inventories.consumption basket, and year-on-year growth inreal household disposable income fell to its lowestrate since 2003 (to around 0.7% on average in thefirst three quarters of 2008). Households reactedcautiously, choosing to retrench spending ratherthan to smooth consumption and reduce savings.While the recent cycle has generally beencharacterised by relatively subdued householdspending, the ongoing financial turmoil islikely to have been an additional factor behindhouseholds’ reluctance to spend. Large fallsin financial wealth as stock markets slumpedcaused households – either because some ofthe losses were perceived to be permanentor because uncertainty about the economicoutlook was heightened – to reduce expenditureand build up precautionary savings. Thedeteriorating outlook for the labour market alsocontributed to a decline in consumer sentiment.Consumer confidence indicators, which hadpeaked in mid-2007, fell to their long-termaverage levels in the early months of 2008,sharply deteriorating further to reach very lowlevels by the end of the year (see Chart 30).1.51.00.50.0(percentage balances; seasonally adjusted)151050-5-10-15-20-25-30-35-40consumer confidenceindustrial confidenceservices confidence2002 2003 2004 2005 2006 2007 2008Source: European Commission Business and Consumer Surveys.Note: Data shown are calculated as deviations from the averageover the period since January 1985 for consumer and industrialconfidence, and since April 1995 for services confidence.Total investment growth declined sharply toaround 0.6% in 2008 following two years ofelevated growth (5.8% in 2006 and 4.2% in2007), with quarter-on-quarter contractions inthe last three quarters offsetting the positivecarry-over effects from 2007 and a strong firstquarter that benefited from unusually goodweather (with the latter mechanically depressingthe figures for the second quarter). Thisdeceleration was more marked for residentialinvestment than for other private investment.Indeed, housing investment contracted in 2008,following the end of the expansionary phaseof the residential construction cycle in 2007 inthe context of slowing house price growth. Thedeceleration was generally more pronounced incountries that had experienced very fast growthin previous years. The Eurosystem’s banklending survey also indicated a considerabledrop in demand for loans for house purchasesince the start of the financial turmoil insummer 2007, reflecting the downturn in thehousing market. At the same time, there was asubstantial tightening in credit conditions.151050-5-10-15-20-25-30-35-4064 ECBAnnual Report2008

Corporate investment, which had expanded at abrisk pace in 2007, reflecting strong profitabilityand high capacity utilisation rates, also slowedmarkedly in 2008, contracting in the secondhalf of the year after a dynamic first half. Thisreversal in corporate investment resulted tovarying degrees from weakening demand andthe ensuing waning capacity pressures, fromreduced profitability owing to the incompletepass-through of the commodity price shock inthe first part of the year and to the surge in unitlabour costs over the course of the year, andfrom tighter lending standards.The tightening of financing conditions,which had been ongoing since the start ofthe financial turmoil, accelerated abruptly inSeptember 2008, pushing the cost of marketbasedfinance considerably higher, as well asthe overall real cost of finance (an aggregatemeasure combining the costs of market debt,equity and bank-based finance). Nonetheless,the proportion of firms citing financing asa factor limiting production remained lowin 2008. This was largely due to the factthat the impact of tighter credit conditionstends to appear with a lag, because firmscan rely on previously committed creditlines, and that internally generated fundsremained at a high level. In addition, theproportion of industrial firms identifying alack of equipment or space as a factor limitingproduction decreased sharply after peaking inthe third quarter of 2007, while the utilisationrate of industrial capacity returned to itslong-term average in October 2008. Firmsalso faced heightened uncertainty concerningthe economic outlook, as evidenced by theexceptional volatility of financial markets,particularly in the last few months of 2008,and by the unusually wide dispersion of GDPforecasts in the ECB Survey of ProfessionalForecasters for the fourth quarter of 2008.Growth in euro area exports slowed downmarkedly in 2008, to an annual rate of around1.8%, compared with 6.0% in 2007, and turnednegative over the last three quarters of theyear. The external environment deterioratedsignificantly in 2008, aggravated by the financialcrisis, with growth slowing in advancedeconomies and emerging markets becomingincreasingly affected. During the last few monthsof the year, various survey indices on industrialexport orders or order books fell to historicallylow levels. Euro area imports also slowed in2008, reflecting sluggish domestic demand. Nettrade had a neutral impact on growth in 2008,following two years of positive contributions,with the strongly negative figures in the secondhalf of the year offsetting the positive figuresrecorded in the first half and carry-over effectsfrom 2007.From a sectoral perspective, the slowdownin activity was broadly based, although moremarked in the industrial sector, which tendsto display greater sensitivity to economiccycles. Manufacturing activity fell abruptly inthe second half of the year, in particular withregard to capital goods, which suffered fromweaker external demand, a rapid depletion oforder backlogs and sharp cuts in activity in thecar industry. Construction continued to be veryweak, despite a temporary boost in the firstquarter owing to good weather conditions, witha steady deterioration in the residential sectorwhich was particularly severe in some countries.Although more resilient, services grew at theirslowest pace since 2004, against the backgroundof weak private consumption and slackeningbusiness activity.DECLINE IN THE LABOUR MARKETConditions in the euro area labour marketworsened in 2008, after two years of substantialimprovements.Over the previous few years, euro area labourmarkets had performed very positively,with strong increases in employment, risingparticipation levels and low unemployment rates,the latter reaching in early 2008 the lowest levelsince the 1980s (7.3%). Thus, by the end of 2007labour markets were particularly tight and wagepressures were beginning to rise. However, thesetrends were reversed in the course of 2008, withemployment contracting in the second half ofECBAnnual Report200865

Table 4 Labour market developments(percentage changes compared with the previous period; percentages)2005 2006 2007 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3Labour force 1.0 1.0 0.9 0.3 -0.0 0.2 0.2 0.3 0.4 0.2 0.3 0.3 0.1Employment 1.0 1.6 1.8 0.6 0.3 0.4 0.5 0.5 0.5 0.3 0.4 0.2 -0.0Agriculture 1) -0.7 -1.9 -1.2 0.8 -1.3 -0.3 0.4 -0.5 -1.0 -0.4 0.5 -1.2 -0.8Industry 2) -0.0 0.6 1.4 0.2 0.3 0.5 0.6 0.3 0.0 0.1 0.2 -0.3 -0.7– excluding construction -1.1 -0.3 0.3 0.1 0.1 0.1 0.0 0.1 0.0 0.1 0.3 0.1 -0.3– construction 2.7 2.7 3.9 0.5 0.8 1.5 1.8 0.6 -0.1 0.0 0.0 -1.2 -1.5Services 3) 1.4 2.2 2.1 0.7 0.3 0.4 0.5 0.7 0.7 0.4 0.4 0.4 0.2Rates of unemployment 4)Total 9.0 8.4 7.5 8.5 8.2 8.0 7.7 7.5 7.4 7.3 7.3 7.4 7.6Under 25 years 17.5 16.3 14.9 16.5 15.9 15.9 15.2 14.8 14.8 14.7 14.6 15.1 15.525 years and over 7.9 7.4 6.6 7.5 7.2 7.0 6.8 6.6 6.5 6.4 6.4 6.5 6.6Sources: Eurostat and ECB calculations.Note: Data refer to the euro area including Slovakia.1) Includes fishing, 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.the year and the unemployment rate rising fromthe second quarter and accelerating towards theend of the year (see Box 5 for more details).Taking a sectoral perspective, employment inthe construction sector was contracting at anannual rate of 2.7% by the third quarter of 2008,after having grown at a very strong rate of 3.9%in 2007 (see Table 4). Employment in industryexcluding construction increased in the firsthalf of the year, continuing an unusual patternthat began in 2007 after years of job losses, butreverted to its historical downward trend in thesecond half of the year. Employment growthin the services sector was relatively resilient,recording an annualised quarter-on-quarter rateof change of 1.6% in the first half of the year.The average monthly increase in the number ofunemployed persons during 2008 stood at around170,000. The unemployment rate was 8.1% inDecember 2008 (see Chart 31).Labour productivity growth, measured as GDPdivided by total employment, slowed to almostzero in 2008 on average (with falls during thesecond half of the year), down from 1% in 2007.This sharp deceleration in labour productivitygrowth was mainly due to the business cycle. Itis costly for firms to recruit and dismiss staff,particularly those with permanent contracts, asthis often involves large losses in firm-specifichuman capital. Companies may thus initiallyretain staff at the beginning of a slowdown ifthey expect it to be mild or relatively short-lived,or if they wish to wait to assess its magnitude.Chart 31 Unemployment(monthly data; seasonally adjusted)2.52.01.51.00.50.0-0.5-1.0-1.5-2.0annual change in millions (left-hand scale) 1)percentage of the labour force (right-hand scale)2002 2003 2004 2005 2006 2007Source: Eurostat.1) Annual changes are not seasonally adjusted.200810.09.59.08.58.07.57.06.56.066 ECBAnnual Report2008

Box 5LABOUR MARKET DEVELOPMENTS IN THE EURO AREA IN 2008After three years of buoyant employment growth and rapidly declining unemployment, euroarea labour markets experienced a clear slowdown in 2008. Unemployment started to risein the second quarter of the year, reaching 8.1% by the end of 2008, while the annual rate ofemployment growth slowed to 0.8% in the third quarter, more than 1 percentage point below theaverage rate for the previous year. This box examines the factors behind the downturn in euroarea labour market developments.In general, developments in labour market variables tend to lag those in economic activity.Chart A shows employment growth clearly lagging economic growth. When a fall in demandfirst occurs, firms do not know whether this fall is temporary or likely to be more persistent.They therefore tend to react by maintaining production and employment levels, leading to abuild-up of inventories of unsold goods. If, over time, the fall in demand becomes more persistent,firms need to stop the excessive accumulation of inventories and start reducing production.However, they still generally maintain employment levels. When employers are uncertain aboutthe probable depth or duration of a downturn, they are likely to adjust labour input by varyingworking hours rather than the number of people employed. The reasons for this are clear: giventhe significant costs involved in recruiting, training and dismissing staff, employers are reluctantsimply to “write off” their investment in staff until they are convinced that a downturn in productmarkets is likely to persist. Consequently, firms prefer to maintain employment levels and cutproduction via a reduction in capacity utilisation (e.g. a shortening of hours worked or a declinein output per worker). While it is not immediately apparent from recent quarterly data (owingto the distortionary effect of the early timing of Easter in 2008), some slowdown in the rate ofgrowth of hours worked seems to have occurred in the course of 2008 (see Chart B). Averaginghours worked in the first half of 2007 and those worked in the first half of 2008 shows a sharpdecline in the growth rate of total hours worked (down from around 1.7%, on an annualisedbasis, in the first half of 2007 to just over 1.2% in the first half of 2008; see the dotted line).Moreover, in 2008 working hours, rather than the level of employment, seem to have played anincreasingly important role in determining developments in the growth of total hours worked incomparison with previous years.It is only when the fall in demand and the required cutback in production are expected to bepersistent and large that a significant reduction in employment levels is observed, as firmsseek to cut labour costs. A marked deterioration in labour demand is likely to hit first thosecategories of workers with more flexible working conditions, such as temporary workers, whoare less costly to lay off. There is now considerable empirical evidence that developments intemporary employment exhibit different patterns to those in permanent employment in periodsof weakening activity and economic downturn. 1 As is often the case in the early stages of aneconomic slowdown, in 2008 temporary employment growth declined more rapidly thanpermanent employment growth (see Chart C).1 See, for example, S. Bentolila and G. Saint-Paul, “The macroeconomic impact of flexible labor contracts, with an application to Spain”,European Economic Review, Vol. 36, 1992, pp. 1013-1047; B. Holmlund and D. Storrie, “Temporary work in turbulent times: theSwedish experience”, Economic Journal, Vol. 112, June 2002, pp. F245-F269.ECBAnnual Report200867

Chart A Euro area real GDP and totalemployment growth(annual percentage changes)5.03.04.02.53.02.02.01.51.01.00.0-1.00.5-2.0 0.01996 1998 2000 2002 2004 2006 2008Source: Eurostat.real GDP (left-hand scale)total employment (right-hand scale)Chart B Breakdown of growth in hoursworked(in percentage points, unless otherwise indicated)43210-1-2-3part-time employmentfull-time employmentpart-time hoursfull-time hourshours worked (annual percentage changes)-32002 2003 2004 2005 2006 2007 2008Source: Eurostat.43210-1-2An increase in part-time work is also likely to be observed during a downturn, for a number ofreasons. First, the weakening of economic activity may lead to changes in the structure of theeconomy, including a shift towards those sectors that are typically more reliant on part-time jobs.Second, employers may modify the hours worked in line with changes in output demand, to theextent that previously full-time positions are transformed into part-time jobs. 2 Third, workerswho would prefer to work full time may be forced to consider part-time work because they cannotfind a full-time position. Finally, additional workers may enter the labour market as householdmembers take up part-time jobs to compensate for the unemployment or under-employmentof the main worker in the household. 3 However, these cyclical effects are not always easy toidentify in the data, since part-time employment growth has followed a clear long-term upwardtrend in the euro area, in large part owing to labour market reforms aimed at fostering increasedlabour force participation (see Chart D).Meanwhile, the potential supply of labour is likely to grow less rapidly as a result of an economicslowdown. It is a well-known phenomenon that some workers become discouraged from seekingwork as they see the number of available jobs fall. The nature of the current slowdown mayresult in some reallocation of workers away from those sectors worst affected by the downturn(e.g. financial services, real estate and construction, as well as the car industry), while theresulting mismatch – as people take time to retrain and relocate – may result in a slowdownin labour supply. Looking ahead, cyclical downturns can have a negative long-term effect onlabour supply growth through the atrophy of skills. This problem becomes particularly acute ifindividuals remain unemployed for a long period of time: the longer they remain unemployed,2 For the most part, Eurostat’s Labour Force Survey distinguishes between full-time and part-time employment on the basis ofrespondents’ assessments.3 See, for example, H. Buddelmeyer et al., “Why do Europeans work part-time? A cross-country panel analysis”, Working Paper Series,No 872, ECB, February 2008.68 ECBAnnual Report2008

Chart C Breakdown of employment growthby type of contractChart D Part-time work in the euro area(in percentage points, unless otherwise indicated)(as a percentage of total employment)self-employmentpermanent worktemporary worktotal employment (annual percentage changes)2.52.520202.02.019191.51.518181.01.0171617160.50.515150.00.01414-0.5-0.52001 2002 2003 2004 2005 2006 2007 2008Source: Eurostat.13132000 2001 2002 2003 2004 2005 2006 2007 2008Source: Eurostat.the more detached they become from the labour market. As it becomes increasingly difficult forthese people to find work, long-term unemployment is likely to increase.Under such circumstances, labour market measures need to avoid a structural deterioration inunemployment levels and a reduction in long-term labour force participation. Such measuresshould include policies to support wage flexibility and foster wage moderation, not leastthrough the abolition or overhaul of wage indexation schemes. Such policies would reducecost pressures on firms, enhance competitiveness and support employment. Reforms whichenhance the effectiveness and efficiency of active labour market policies would make it easierfor the unemployed to (re)train and find new jobs. With regard to those in employment, policiespermitting greater flexibility in fine-tuning working hours could give firms some leeway toreduce working hours without losing human capital through lay-offs. Labour market reformsmust be implemented with a view to improving the resilience of the euro area economy to thecrisis and creating a favourable environment for recovery and long-term economic growth andjob creation.2.5 FISCAL DEVELOPMENTSREVERSAL IN BUDGETARY POSITIONS IN 2008The relatively favourable fiscal outcomesachieved in recent years were partly reversedin 2008 as the financial crisis unfolded and themacroeconomic environment deteriorated rapidly.According to the European Commission’s interimforecast of January 2009, the average generalgovernment balance in the euro area worsenedfrom -0.6% of GDP in 2007 to -1.7% in 2008(see Table 5). The deficit increase is accountedfor by lower revenue, also owing to tax cuts, andhigher primary expenditure, in the context of aslowdown in economic activity. The impact ofgovernment interventions to stabilise the financialsystem on the 2008 deficit was negligible.In Ireland, Greece, Spain, France and Malta, thegovernment deficit rose above the 3% of GDPreference value in 2008, whereas in 2007 onlyGreece had a deficit higher than 3% of GDP. TheECBAnnual Report200869

Table 5 Fiscal positions in the euro area and euro area countries(as a percentage of GDP)General government surplus (+) / deficit (-)2006 2007 2008Belgium 0.3 -0.3 -0.9Germany -1.5 -0.2 -0.1Ireland 3.0 0.2 -6.3Greece -2.8 -3.5 -3.4Spain 2.0 2.2 -3.4France -2.4 -2.7 -3.2Italy -3.4 -1.6 -2.8Cyprus -1.2 3.4 1.0Luxembourg 1.3 3.2 3.0Malta -2.3 -1.8 -3.5Netherlands 0.6 0.3 1.1Austria -1.5 -0.4 -0.6Portugal -3.9 -2.6 -2.2Slovakia -3.5 -1.9 -2.2Slovenia -1.2 0.5 -0.9Finland 4.1 5.3 4.5Euro area -1.3 -0.6 -1.7General government gross debt2006 2007 2008Belgium 87.8 83.9 88.3Germany 67.6 65.1 65.6Ireland 24.7 24.8 40.8Greece 95.9 94.8 94.0Spain 39.6 36.2 39.8France 63.6 63.9 67.1Italy 106.9 104.1 105.7Cyprus 64.6 59.4 48.1Luxembourg 6.6 7.0 14.4Malta 63.8 61.9 63.3Netherlands 47.4 45.7 57.3Austria 62.0 59.5 59.4Portugal 64.7 63.6 64.6Slovakia 30.4 29.4 28.6Slovenia 26.7 23.4 22.1Finland 39.2 35.1 32.8Euro area 68.3 66.1 68.7Source: European Commission.Notes: Data are based on ESA 95 definitions. In the Commission’s forecast, the euro area average includes Slovakia, which joined theeuro area on 1 January 2009.2007 Greek deficit was revised upwards to 3.5%of GDP in Eurostat’s validation of the autumn2008 notification, from 2.8% in the spring 2008notification. The revision resulted from thecorrection of the recording of EU grants andthe improved coverage of extra-budgetary, localgovernment and social security funds. Comparingthe 2008 figures with the targets set in the stabilityprogramme updates released at the end of 2007and in early 2008, the euro area average balancefell short by 0.8 percentage point of GDP.As a result of the economic and fiscal deteriorationand the interventions by governments to stabilisethe financial system, the average governmentdebt ratio in the euro area rose from 66.1% ofGDP in 2007 to 68.7% of GDP in 2008. The debtincrease could end up being even more sizeable,depending on the statistical classification offinancial rescue operations by Eurostat, whichhas yet to be finalised (see Box 7). In particular,government debt increased significantly incountries which undertook sizeable interventionsin financial institutions or which experienced asharp macroeconomic slowdown. The annualgrowth rate of debt securities issued by euroarea governments in 2008 increased noticeablycompared with 2007, while sovereign spreadsvis-à-vis Germany widened considerably forsome countries (see Box 6).70 ECBAnnual Report2008

Box 6DEVELOPMENTS IN THE ISSUANCE AND YIELD SPREADS OF EURO AREA GOVERNMENT DEBTSECURITIESThe annual growth rate of the outstandingamount of euro area general government debtsecurities stood at 8.0% in 2008. Althoughsignificantly higher than the 2.8% recordedin 2007 (see Table A) 1 , it is comparable tothe figures recorded in previous periods ofslowing economic growth. This growth in thenet issuance of government debt securities,together with the sharp slowdown in GDPgrowth observed in 2008, was also reflectedin the deterioration in the government debt-to-GDP ratio for the euro area, which rose from66.1% in 2007 to 68.7% in 2008. 2Chart A Breakdown of the change in interestpayments for the period 1999-2008(as a percentage of GDP; annual data)change in debtchange in interest ratecross effect0.20.10.0-0.1-0.20.20.10.0-0.1-0.2Looking at the composition of net issuancein 2008, the activity of the euro areashort-term debt securities primary market was-0.3-0.4-0.3-0.4remarkably strong. This partly reflects the fact-0.5that the yield curve became steeper during 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008-0.52008, making short-term financing relatively Source: European Commission (AMECO database).cheaper. This is a feature common to otherepisodes of slower economic growth with declining short-term interest rates. As a result, longtermdebt accounted for around 88.7% of outstanding debt securities in 2008, the lowest levelsince the start of Stage Three of EMU (see Table B).1 Growth rates are calculated on the basis of financial transactions and therefore exclude reclassifications, revaluations, exchange ratevariations and other changes that do not arise from transactions. For details, see the technical notes relating to Sections 4.3 and 4.4 ofthe “Euro area statistics” section of the ECB’s Monthly Bulletin.2 As at January 2009 the potential direct impact of announced government support to the banking sector on euro area general governmentdebt was estimated at €284.6 billion (around 3% of euro area GDP).Table A Annual growth rates of debt securities issued by euro area governments(percentages; end of period)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Total general government 3.4 2.7 3.3 5.0 5.5 5.8 4.7 2.4 2.8 8.0Long-term 5.6 3.6 2.8 3.9 4.8 6.2 5.5 3.4 2.3 3.6Fixed rate 5.2 5.6 4.6 5.7 6.4 5.4 3.4 2.0 3.6Floating rate -2.5 -13.4 -4.5 -1.6 7.0 8.3 3.0 5.4 3.5Short-term -16.5 -7.1 8.7 18.5 13.6 2.1 -4.0 -8.8 9.5 62.6Source: ECB.ECBAnnual Report200871

Table B Structure of amounts outstanding of debt securities issued by euro area governments(percentages of total debt securities issued by general government; end of period)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Central government 96.9 96.7 96.3 95.5 94.7 94.3 93.8 93.4 93.2 93.5Long-term securities 89.3 89.8 89.0 87.3 85.9 85.8 86.0 86.5 86.1 82.7Short-term securities 7.6 6.9 7.2 8.2 8.9 8.5 7.8 6.8 7.1 10.8Other general government 3.1 3.3 3.7 4.5 5.3 5.7 6.2 6.6 6.8 6.5Long-term securities 3.0 3.2 3.6 4.4 5.2 5.6 6.0 6.4 6.4 6.0Short-term securities 0.2 0.1 0.1 0.1 0.1 0.1 0.2 0.2 0.4 0.5Total general governmentLong-term 92.3 93.0 92.6 91.7 91.0 91.4 92.1 92.9 92.5 88.7Fixed rate 79.2 81.1 82.5 82.1 82.2 82.7 83.2 84.0 83.3 79.9Floating rate 10.6 10.0 8.8 8.1 7.5 7.6 7.9 8.0 8.2 7.8Short-term 7.7 7.0 7.4 8.3 9.0 8.6 7.9 7.1 7.5 11.3Total general governmentin EUR billions 3,453.4 3,549.1 3,775.5 3,949.4 4,151.7 4,386.7 4,604.8 4,706.6 4,836.7 5,239.6Source: ECB.Chart A breaks down changes in interest payments into: i) an effect stemming fromchanges in government debt, ii) an effect resulting from changes in interest rates andiii) a residual cross effect. 3 Interest expenditure increased by around 0.2 percentage point of GDPin 2008. This was mostly a reflection of the increase in the level of debt, whereas the impact ofthe decline in interest rates and cross effects was marginal.Following the developments triggered by the onset of the financial turmoil in August 2007, thespreads between the yields on long-term euro area government bonds and those on German bondswidened significantly in 2008, particularly over the second half of the year. This is illustratedin Chart B, which shows the spreads against Germany for eight euro area countries (Belgium,Ireland, Greece, Spain, France, Italy, the Netherlands and Portugal). The differences betweengovernment bond yields across euro area countries ultimately reflect differences in credit riskand liquidity premia.First, in response to the intensification of the financial turmoil in the second half of 2008, thesummit of euro area countries in Paris on 12 October announced coordinated rescue packages,including guarantees for bank debt, capital injections for banks and outright purchases of banks’risky assets. The expected fiscal burden of such measures may have increased the perceivedprobability of defaults on sovereign bonds. Credit risk premia increased in all euro area countries,albeit to varying degrees, as illustrated in Chart C, which shows sovereign credit default swapspreads. 4Second, for most of 2008 the changes in euro area government bond yields also reflected flightto-qualitybehaviour on the part of investors. This process was also characterised by increaseddiscrimination among investors with regard to their flight-to-quality destinations. German3 The change in the nominal interest payments, I, can be broken down as follows:Δ I = Δ B × i + Δ i × B + Δ B × Δ iEffect via{ {change indebtEffect viachange ininterest rateCross effect(residual)where B is the nominal general government debt and i is the average implicit interest rate (I/B).4 Sovereign credit default swap spreads have the advantage of not being distorted by changes in the benchmark bonds of the countriesconcerned, of not being affected by any maturity mismatches, and of tending to be more responsive to market changes.72 ECBAnnual Report2008

Chart B Government bond yield spreadsagainst German government bondsChart C Sovereign credit default swaps(daily data; basis points)(daily data; basis points)FranceGreeceItalyPortugalNetherlandsSpainBelgiumIrelandGermanyFranceGreeceItalyPortugalNetherlandsSpainBelgiumIreland350350450450300300400400250250350300350300200200250250150150200200100501005015010050150100500July2007Jan.2008July2008Jan.200900JulyJan.July2007 2008 2008Jan.20090Source: Thomson Financial Datastream.Note: Government bonds with a ten-year maturity.Source: Thomson Financial Datastream.Note: Credit default swaps with a five-year maturity.bonds are generally regarded as the most liquid of all the euro area government bonds, with theresult that these attracted most of the flight-to-quality flows, partly explaining the widening ofsovereign spreads vis-à-vis Germany even where countries were perceived as having an identicalor even a better fiscal outlook. 55 See the box entitled “Recent widening in euro area sovereign bond yield spreads” in the November 2008 issue of the ECB’s MonthlyBulletin.According to the European Commission’sestimates, the average structural budget balance(the cyclically adjusted balance excluding oneoffand other temporary measures) in the euroarea worsened in 2008 by 0.7 percentage pointto -2.3% of GDP. The deterioration in structuralbalances amounted to more than half of therise in the average government deficit, whichsuggests that cyclical conditions (on average)had a more limited impact. Moreover, there wasa favourable “composition effect”. The growthin tax-rich wages, salaries and (nominal) privateconsumption continued to support tax receiptsin some countries, despite the overall worseningeconomic situation. However, it should be notedthat structural balance estimates are subject toconsiderable uncertainty in the current situationand, in particular, may be revised at a later stage.Looking at individual countries, among the euroarea countries, only Cyprus, Luxembourg, theNetherlands and Finland met their medium-termbudgetary objective, while Spain and Sloveniamoved away from theirs.MEASURES IN RESPONSE TO THE FINANCIALCRISIS AND ECONOMIC DOWNTURNIn October 2008 the euro area countries andthe United Kingdom agreed on coordinatedaction to stabilise the financial sector, includingthe recapitalisation of financial institutionsand guarantees for loans and deposits, whichwas subsequently approved by the EuropeanECBAnnual Report200873

Council. The effects of these interventions onpublic finances in the euro area are difficultto assess (see also Box 7). As at 1 January2009 the potential direct impact of announcedgovernment support to the banking sector oneuro area general government debt was estimatedat €284.6 billion (around 3% of euro area GDP),and on government contingent liabilities ataround 19%. The impact of these interventionson the euro area government deficit in 2008 wasestimated to be negligible.In response to the severe economic downturn,the European Council approved a EuropeanEconomic Recovery Plan in its meeting on11 and 12 December 2008. According to this plan,individual EU Member States will contribute€170 billion to a total fiscal stimulus of€200 billion (1.5% of EU GDP), with theremainder coming from the EU budget and theEuropean Investment Bank. This coordinatedeffort by the Member States is intended tosupport economic recovery by strengtheningaggregate demand and increasing efforts toimplement the structural reforms envisaged in theLisbon strategy. Depending on national circumstances,measures can take the form of increasedpublic spending, a reduction in tax burdens orsocial security contributions and aid to certaincategories of enterprises or households. At thesame time, the European Council confirmed itsfull commitment to the implementation of theStability and Growth Pact and to sustainablepublic finances. Member States were called onto return as soon as possible to their mediumtermbudgetary targets.Many euro area countries adopted fiscalmeasures to stimulate aggregate demand. Inthe autumn of 2008, the German governmentadopted a package of measures, mostly on therevenue side of the budget, amounting to 1.3%of GDP in 2009 and 2010. At the beginningof 2009, the government announced a secondstimulus package, accounting for about 2% ofGDP and consisting of additional measures inthe same two years. In France, measures worthsome 1.5% of GDP were announced at theend of 2008 for the period 2009-11, includingaccelerated public investment and support forsmall businesses and specific industries. In 2008the Italian government adopted expansionarymeasures, mostly focusing on the expenditureside, amounting to half a percentage pointof GDP for 2009 and 2010. Their impacton net borrowing is planned to be largelyoffset by compensating measures. In Spain, anumber of revenue measures to stimulate theeconomy were taken in the first half of 2008,and additional public investment plans wereannounced in November, representing morethan 3% of GDP in the period 2008-10. Mostother countries also adopted sizeable fiscalstimulus measures.While a deeper assessment of the stimuluspolicies will have to wait until the exact measuresand their implementation are known, it is clear thatcurrent government intentions pose some risks(see also Box 8). Rising deficits can undermineconfidence in fiscal sustainability, especiallysince the reversibility of the stimulus measuresis in many cases not addressed and may prove tobe very difficult. The sharp rise in governmentbond spreads vis-à-vis Germany is a warningsign that financial markets are watching theevolution of the potential risks very carefully.The effectiveness of the stimulus measuresis sometimes doubtful, as a wide range ofmeasures has been envisaged. Not all measuresare clearly linked to the root of the currenteconomic problems and some may reflectpolitical compromises rather than economicconsiderations. Government intervention alsocarries the risk of distorting the behaviour ofeconomic agents.74 ECBAnnual Report2008

Box 7STATISTICAL ACCOUNTING CONSEQUENCES OF THE FINANCIAL CRISIS ON GOVERNMENT DEFICIT ANDDEBTIn response to the global financial crisis and its consequences for European financial institutions,European governments, central banks and other public authorities are implementing measures tostabilise the financial markets and the economy in general. These government operations include(partial) nationalisations, capital injections (recapitalisations), the purchase and/or exchange offinancial assets and the provision of guarantees (on deposits and new debt issuances by banks, aswell as on interbank lending).The government deficit and debt, which are the key fiscal variables monitored under the Stabilityand Growth Pact, are recorded in accordance with the European statistical accounting rules knownas the European System of Accounts 1995 (“ESA 95”) and the ESA 95 Manual on deficit and debt.The European Commission (Eurostat) has further developed methodological guidance on recordingthe above-mentioned government operations, on the basis of the ESA 95 and the Manual, in order toensure that the compilation of government deficit and debt statistics is carried out consistently andhomogeneously across Member States. In this process, Eurostat has consulted the Committee onMonetary, Financial and Balance of Payments Statistics (in which the national statistical institutesand the national central banks of the EU Member States, as well as the European Commission and theECB, are represented) to determine how the accounting rules should be applied. In each individualcase a number of questions will need to be answered, to decide on the appropriate recording:––––––Do the entities created to recapitalise financial institutions or provide guarantees to financialinstitutions belong to the government sector in national accounts? If so, their deficit and debtwill augment the government deficit and debt.Have governments bought shares in financial institutions at market prices, which indicatethat a financial asset has been acquired (without an impact on the deficit), or should part ofthe amount injected into financial institutions be considered as a capital transfer (a subsidy)?If the government lends money to a financial institution, does the financial institution havean obligation to pay interest and to repay the loan? If not, it should be recorded as a capitaltransfer and not as a financial transaction.If the government takes over part of a financial institution’s liabilities and obtains a stake inthe financial institution in return, is the stake worth the same as the liabilities? If not, (partof) the takeover of liabilities is considered a capital transfer with a negative impact on thegovernment budget balance.At what point are government guarantees very likely to be called, so that they may have animpact on the deficit and debt at the moment they are granted? Normally guarantees have animpact on the deficit and debt only at the time when they are called.If a financial institution is fully nationalised, should it be reclassified to the governmentsector? As a general rule, it will become a public corporation, but not a governmental body.However, if a special unit is set up by government to acquire shares in a financial institution,this unit may need to be classified within the government sector if it is not autonomous or if itis not deemed to be engaged in a market activity.Eurostat will publish the preliminary statistics on the government deficit and debt of the EUMember States for 2008 in the second half of April 2009.ECBAnnual Report200875

Chart 32 Fiscal developments, 1999-2009(as a percentage of GDP)gross debt (left-hand scale)deficit (right-hand scale)80570460503403022011001999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 0Source: European Commission (AMECO database).Notes: The euro area average includes 16 countries as of1 January 2009; ESA 95 definition; deficit excludes UMTSreceipts.FURTHER FISCAL DETERIORATION EXPECTEDIN 2009The fiscal outlook in euro area countriesis set to deteriorate further in 2009.According to the interim forecast of theEuropean Commission, which includes theavailable stability programme updates at theend of 2008 and the beginning of 2009, theaverage general government deficit in the euroarea is expected to increase by 2.3 percentagepoints to 4.0% of GDP (see Chart 32).Government expenditure is set to increase by2.1 percentage points of GDP, and revenuesto decrease by 0.1 percentage point of GDP.The average government debt ratio in theeuro area is expected to increase in 2009, by4.0 percentage points, to 72.7% of GDP.In all euro area countries except Malta, thegeneral government balance is expected todecline, according to the Commission’s interimforecast. Ireland, Greece, Spain, France, Italy,Portugal and Slovenia are expected to breachor remain above the 3% of GDP referencevalue in 2009, in some cases by a wide margin.Deficits in Belgium and Austria are expected tobe at the 3% reference value and in Germanyand Slovakia to be just below it. There areclear risks that actual outcomes could be evenworse than expected.FOCUS ON FISCAL SUSTAINABILITY ESSENTIALThe reversal in fiscal outcomes and thehighly uncertain outlook pose considerablechallenges to fiscal policy in the euro area.Public finances are coming under pressurefrom four developments. First, deficits arerising significantly as a result of the operationof automatic stabilisers in the macroeconomicslowdown. Second, on top of the unwinding ofrevenue windfalls of recent years, additionalrevenue shortfalls may materialise owing to,among other factors, sharp falls in financialasset prices, as well as a housing slumpin some countries. Third, the governmentinterventions in the financial sector to prevent asystemic banking crisis and much more severemacroeconomic disruption carry substantialfiscal risks. Fourth, stimulus measures tocounter the economic slowdown put the fiscaloutlook under pressure.In this challenging environment, it is crucialthat fiscal discipline and a medium-termperspective are maintained. A preconditionfor maintaining the public’s trust in thesustainability of public finances is to safeguardthe integrity of the rules-based EU fiscalframework. It is therefore essential that allparties involved adhere to their commitmentto fully apply the provisions of the Stabilityand Growth Pact, which provide the necessaryflexibility to deal with adverse economiccircumstances.The substantial stimulus packages adopted in2008 and early 2009 add to fiscal imbalances inthe euro area. To prevent a loss of confidence inthe sustainability of public finances, a crediblecommitment to undo stimulus measures as soonas possible is required. In the implementationof the stimulus packages, careful considerationshould be given to the quality of the measuresto ensure their effectiveness. Determinedefforts in euro area countries to achieveand maintain sound public finances are also76 ECBAnnual Report2008

warranted because of the need to cope with theexpenditure pressure resulting from an ageingpopulation in the decades ahead. A bindingmedium-term fiscal framework at the nationallevel, if properly designed and rigorouslyimplemented, can complement the Europeanfiscal framework enshrined in the Stability andGrowth Pact in assisting a quick return to themedium-term budgetary objectives (see alsoBox 8).Box 8THE FINANCIAL CRISIS AND FISCAL POLICYA key policy challenge is to prevent the financial crisis and the subsequent economic downturn fromundermining the credibility and sustainability of public finances. In the EU, the Stability and GrowthPact provides the appropriate framework for the conduct and coordination of fiscal policies, in goodas well as bad times. While compliance with the Pact in the initial ten years was somewhat uneven,the EU’s overall fiscal performance in terms of avoiding high budget deficits and the build-up ofgovernment debt was much better than in the decades preceding the Pact. 1A missed opportunity making the fiscal challenge unnecessarily onerousMany euro area countries entered the financial crisis and the economic downturn with weakfiscal positions. Governments had not used the opportunity presented by past years’ revenuewindfalls to consolidate their budgets. In this regard, the arguments set out in the ECB’s AnnualReport 2007 still hold and, indeed, their relevance is now magnified. 2 At the time, the ECBemphasised an important fiscal lesson to be learnt from the period 2000-01, namely that therevenue outlook can change dramatically in a short period of time. Indeed, experience shows thatthe volatility of government revenues is greater than that of the spending side and also exceedsthat of the business cycle. Taken together with the difficulty of predicting turning points forGDP growth, this presents a strong reason to increase caution in good times, i.e. to use revenuewindfalls for faster deficit and debt reduction rather than for extra spending. 3 This would allowcountries to create budgetary room for manoeuvre to absorb revenue shortfalls and deal withextra spending should conditions change. One of the fiscal policy errors prior to and during2000-01 was to mistakenly interpret budgetary improvements in good times as evidence ofstructural improvements, which were often used to motivate spending increases or tax cuts.The role of automatic stabilisersThe fiscal adjustment in response to the economic downturn reflects to a large extent the operation ofautomatic fiscal stabilisers, which contribute to smoothing economic fluctuations. This is appropriate,since this type of fiscal reaction is timely and shielded from political economy risks that can underminethe effectiveness of discretionary fiscal measures. In particular, automatic stabilisers are not subjectto time lags in the identification of measures or in the political decision-making and implemenationprocesses. Moreover, the automatic reaction of revenues and, to a lesser extent, expenditures to thecycle makes automatic stabilisers self-reversing. Finally, the impact of particular interest groups in1 See the article “Ten years of the Stability and Growth Pact” in the October 2008 issue of the ECB’s Monthly Bulletin.2 See in particular the box entitled “Learning from the fiscal policy experience of 2000-01” in the ECB’s Annual Report 2007.3 For a review of forecasting accuracy and the difficulties with turning points, see M. Blix, J. Wadefjord, U. Wienecke and M. Ådahl,“How good is the forecasting performance of major institutions?”, Economic Review, 2001:3, Sveriges Riksbank, pp. 38-68.ECBAnnual Report200877

achieving group-specific benefits is low. Countries in the euro area that comply with the Stability andGrowth Pact can take advantage of their relatively large automatic stabilisers.The risks of fiscal activism in times of financial crisisRegarding the use of discretionary fiscal policy measures to stimulate demand, a consensus hasemerged that such measures should be timely and targeted to ensure effectiveness, and temporary toavoid additional risks for fiscal sustainability. In particular, unless a reversal of deficit-increasing fiscalmeasures is expected, such measures may undermine public confidence in the sustainability of publicfinances and lead to higher precautionary savings or negative financial market reactions and higherinterest rates – thus counteracting the intended expansionary effect. In this regard, the experience offiscal activism during the oil crisis of the 1970s stands out as a warning: instead of boosting demand,it ultimately contributed towards destabilising the real economy and increasing inflationary pressuresand government debt – with little, if any, net gain.Regarding targeting, actions should be taken where elasticities are the highest and where thedistortions to incentives are the least onerous. In this regard, consideration should be given tothe quality of the fiscal stimulus so that action can be taken that is most conducive to a soundfoundation for recovery and long-term growth. Timeliness is essential, since past experienceshows that discretionary policy measures frequently end up being pro-cyclical, because theybecome effective only after a considerable time lag.The quality of fiscal policy is important in many ways. While the issue of the optimal size ofgovernment is a matter for debate, 4 the citizens of euro area countries could be at least as well offas they are today, but pay less in taxes, if the quality of public spending were better. Moreover,there is some evidence that past increases in government size have come at the cost of lowereconomic growth. 5 If euro area governments comply with the Stability and Growth Pact, theireconomies are more likely to reap long-term benefits and their citizens to enjoy greater welfare. 64 There is evidence to suggest that, in many industrialised countries, governments have grown in size beyond what is warranted to attaincore objectives. See, for example, A. Afonso, L. Schuknecht and V. Tanzi, “Public sector efficiency: an international comparison”,Public Choice, Vol. 123 (No 3-4), 2005, pp. 321-347, and A. Afonso and D. Furceri, “Government size, composition, volatility andeconomic growth”, Working Paper Series, No 849, ECB, 2008.5 See A. Afonso, W. Ebert, L. Schuknecht and M. Thöne, “Quality of public finances and growth”, Working Paper Series, No 438, ECB, 2005.6 The costs of downsizing governments may be rather limited if appropriately designed and implemented; see for example S. Hauptmeier,M. Heipertz and L. Schuknecht, “Expenditure reform in industrialised countries: a case study approach”, Working Paper Series,No 364, ECB, 2006.2.6 EXCHANGE RATES AND BALANCE OFPAYMENTS DEVELOPMENTSTHE EURO APPRECIATED MODERATELY IN 2008 INEFFECTIVE TERMSThe financial turmoil in money andcredit markets which started in August 2007and its ensuing spillovers into the realeconomy worldwide significantly influenceddevelopments in foreign exchange markets in2008. More precisely, the first four months of2008 saw the euro continue its strengtheningtrend established in late 2000, supported byfairly upbeat market expectations about therelative economic prospects of the euro area.After reaching a historical peak in April, thenominal EER broadly stabilised until August.Thereafter the euro experienced a sharpdepreciation which, in just three months, broughtit to the level prevailing around mid-2007. The78 ECBAnnual Report2008

sharp depreciation of the euro was associatedprimarily with a revision of market expectationsabout the euro area economic outlook – as thefinancial crisis continued to unfold and its globalreach gradually began to be realised – and tookplace within an environment of heightenedmarket uncertainty and global risk aversion.Towards the end of the year, the euro reboundedstrongly, reaching another historical peak on18 December 2008. By the end of 2008 theeuro was, in nominal effective terms, about2.5% higher than at the beginning of the yearand about 7% above the average level in 2007.Much of the nominal effective appreciationof the euro in 2008 can be accounted for byits sizeable strengthening against the poundsterling, which was only partly counterbalancedby the euro’s weakening against the US dollarand the Japanese yen.Against the US dollar, the euro underwent astrong appreciation in the first eight months ofthe year, peaking in mid-July at USD 1.60. Thisappreciation was driven largely by expectationsof a widening interest rate differential in favourof euro area assets, reflecting market beliefsthat the euro area was going to be affected bythe ongoing financial turmoil to a significantlylesser extent than the United States. From thatperiod on, however, data releases began to showthat the financial turmoil that originated in thesub-prime US mortgage market in August 2007was unfolding into a synchronous economicslowdown across all main economic areas. As aresult, the euro began to depreciate sharply againstthe US currency in August. In the course of theautumn, renewed strains in global money andcredit markets intensified the downward pressureon the euro, with the single currency reachingUSD 1.25 in October. This sizeable depreciationwas associated partly with a worldwide dollarliquidity shortage which commanded a sizeablerepatriation of foreign investments and concertedcentral bank policy actions. In this environment ofextremely heightened risk aversion and financialdeleveraging, the US dollar found support in itsinternational status. Other technical, and possiblytransitory, factors in foreign exchange marketsalso appear to have lent support to the US dollar,as can also be deduced from the weakening ofthe link between interest rate differentials andmovements in the EUR/USD exchange rateduring this period. In December, however, theeuro experienced a strong rebound as the strengthof the above-mentioned non-cyclical factors thatsupported the dollar in the autumn waned andforeign exchange markets refocused attention onthe growth outlook and interest rate differentialsacross major economic areas. On 31 Decemberthe euro was trading at USD 1.39, i.e. about 5%weaker than at the beginning of 2008 and about6% stronger than its 2007 average.Following a similar pattern to the EUR/USDexchange rate, the euro also fluctuated widelyagainst the Japanese yen in the course of 2008,trading within an unusually wide range ofJPY 115.75 and JPY 169.75. The volatilityin the EUR/JPY exchange rate seems to havereflected not only a changing market assessmentof relative economic prospects, but mostimportantly market expectations relating to assetprice volatility. As a consequence, the latter hadan impact on the expected profitability of carrytrades, i.e. trades that consist of borrowing ina low-yielding currency (such as the yen) andinvesting in a high-yielding currency. In general,an increase in the expected volatility of the yenreduces its attractiveness as a funding currencyfor carry trades, tending to put upward pressureon the yen and downward pressure on highyieldingcurrencies. Indeed, implied volatilityin the EUR/JPY exchange rate – as measuredthrough indicators based on option prices – sawwide gyrations in the course of 2008, peakingin October and subsiding thereafter. Theseextremely volatile conditions in the foreignexchange market accounted mostly for the initialappreciation and subsequent sharp depreciationof the euro against the yen in 2008. On31 December 2008 the euro traded at JPY 126.14,i.e. 23% weaker than at the beginning of the yearand about 22% lower than its 2007 average.The euro also continued to appreciate againstthe pound sterling in 2008, strengthening bya sizeable 28.5% by the end of the year, afterthe 9% appreciation witnessed in 2007. OnECBAnnual Report200879

Chart 33 Current account balance and itscomponents(annual data; EUR billions)100806040200-20-40-60-80-1002005200620072008CurrentaccountGoods Services Income CurrenttransfersSource: ECB.Note: Data for 2008 refer to the year to October.100806040200-20-40-60-80-10029 December the euro traded at GBP 0.98,the highest level since the launch of the singlecurrency in 1999. The noticeable weakeningof the pound, particularly in the last monthsof 2008, relates to the significant slowdown ineconomic activity in the United Kingdom, whichtriggered a sizeable easing of monetary policyconditions and an associated fall in longer-termyields.The euro appreciated significantly againstthe currencies of several EU trading partnereconomies between early January and31 December, for example by 15.3% againstthe Swedish krona, 15.3% against the Polishzloty, 12.3% against the Romanian leu, 5.3%against the Hungarian forint and 1.9% againstthe Czech koruna. A sizeable strengtheningwas also witnessed vis-à-vis the Korean won(33.6%), the Norwegian krone (22.1%) andthe Australian and Canadian dollars (21.0%and 17.1% respectively). The appreciationof the euro against these currencies wascounterbalanced partly by its weakeningagainst the currencies of several Asianpartners whose currencies are linked to the USdollar, namely the Chinese renminbi (11.4%)and the Singapore and Hong Kong dollarsChart 34 Euro area export volumes toselected trading partners(indices: Q1 2004 = 100; seasonally adjusted; three-monthmoving average)18016014012010080extra-euro areaUnited StatesUnited KingdomOPECAsiaCEECs2004 2005 2006 2007 2008180160140120100Source: ECB.Notes: Last observation refers to December 2008 except forextra-euro area and the United Kingdom (November). “CEECs”stands for central and eastern European countries.(5.2% and 6% respectively). The euro also lostground against the Swiss franc (10.2%) amidpositioning in and out of carry trades, giventhat the Swiss franc, like the Japanese yen,played the role of funding currency in this formof financial transaction.The real EER, based on different cost and pricemeasures, appreciated in the first four monthsof 2008 and then stabilised until August.After declining until November it reboundedsomewhat in the last month of 2008. In the lastquarter of 2008 the real EER of the euro, basedon consumer prices, was 2% below its averagevalue in 2007 and 4% below its average level inthe corresponding quarter of 2007.CURRENT ACCOUNT SHIFTED INTO DEFICIT IN 2008In 2008 the current account of the euro arearecorded a deficit of €63.2 billion (or 0.7% ofeuro area GDP), compared with a surplus of€36.3 billion in 2007. This resulted largelyfrom the goods balance shifting into deficit.In 2008 the goods balance recorded a deficitof €0.6 billion, compared with a surplus of€56.6 billion in 2007. The weakening ofexports, particularly in the second half of theyear, together with a robust increase in import8080 ECBAnnual Report2008

prices in the first eight months of the year,were the main factors behind this development.The higher deficit in current transfers andthe shift into deficit of the income componentalso contributed to the overall deteriorationin the current account balance. At the sametime the surplus in services, which stood at€50.6 billion in 2008, decreased only marginally(by €2.6 billion) compared with the previousyear (see Chart 33).The contraction of goods exports in the courseof 2008 can be largely explained by the fall inglobal demand and possibly by a deteriorationin trade financing conditions worldwide. Aftera temporary rebound in the first quarter of theyear, euro area exports to the United States andother OECD countries, as well as to China andthe rest of Asia, contracted, while exports to theEU Member States that have joined the EU since2004 also weakened. By contrast, the growth inexports to OPEC countries remained robust overthe entire year, amid strong economic growthin these countries and wealth effects from oilrevenues (see Chart 34).The decline in euro area price and costcompetitiveness observed since 2001 was partlyreversed after mid-2008 owing to the depreciationof the euro. The moderation in the growth ofeuro area export prices in the first half of the yearmay indicate that euro area firms adjusted theirprofit margins to offset the decline in price andcost competitiveness (see also Box 9).Box 9RECENT DEVELOPMENTS IN EURO AREACOMPETITIVENESSAn assessment of the international priceand cost competitiveness of the euro area –which also reflects the competitiveness of theindividual euro area countries – can provideimportant information for monitoring theeuro area economy. This box therefore looksat developments in euro area competitivenessas measured by various real EERs, both at theaggregate and individual Member State levels.In summary, these indicators show a decline inthe euro area’s price and cost competitivenessover the past decade, owing largely to thenominal appreciation of the exchange rate ofthe euro over the same period. Although thisresult holds true irrespective of the deflatorsused, there is considerable heterogeneity incompetitiveness developments across theindividual euro area countries.Chart A Nominal and real effective exchangerates of the euro(index: Q1 1999 = 100; quarterly data)120115110105100959085range of real EERsnominal EER80801999 2000 2001 2002 2003 2004 2005 2006 2007 2008120115110105100Source: ECB calculations.Notes: Last observation refers to the fourth quarter of 2008.The real EER in the last quarter of 2008 is available only on thebasis of the CPI and the PPI.959085Looking at the euro area as a whole,Chart A compares the evolution of the nominal EER of the euro and a range drawn from fivereal EER indices based on different deflators. 1 Overall, the various measures reveal a decrease1 The five deflators are the CPI, producer prices, GDP, unit labour costs in manufacturing and unit labour costs in the total economy.ECBAnnual Report200881

in competitiveness of around 5-10% between1999 and 2008, according to both real andnominal EERs. Thus, there is a high degree ofco-movement between nominal and real EERs,reflecting similarities in price developments inthe euro area and its trading partners. The overalldecline in competitiveness for the euro area istherefore explained primarily by movements inthe nominal exchange rate, which can be splitinto several episodes. The first episode saw anincrease in competitiveness between 1999 and2001, reflecting the depreciation of the euroaround this time. This was followed by decreasesin competitiveness driven primarily by theappreciation of the euro in the period 2002-04and again from 2006. More recently, the euroarea has registered a rise in competitivenessowing to the depreciation of the euro during thesecond half of 2008.The evolution of price competitiveness for theeuro area as a whole can mask quite differentdevelopments across the individual countries.For an analysis of the latter, the ECB employsa consistent methodology by compiling foreach euro area country a set of harmonisedcompetitiveness indicators against the othereuro area countries and a set of extra-euro areatrading partners. 2 There are three harmonisedcompetitiveness indicators that are calculatedas a weighted average of bilateral exchangerates based on trade weights – which reflect therelative importance of the individual country’smajor competitors – deflated by either theCPI, GDP or unit labour cost deflator. Amongthese harmonised competitiveness indicators,the CPI-based indicator seems to be the mostwidely used, partly because of the relativelyhomogeneous definition of the CPI acrosscountries, as well as the absence of significantdata revisions and the relatively short delayin availability. Meanwhile, the GDP deflatorsand unit labour cost-based indicators providealternative measures of competitivenessChart B Changes in harmonised competitivenessindicators 1) across euro area countries(in percentage points; quarterly data)403020100-10CPIGDPULCQ1 1999 to Q4 2008-20-20DE AT FR FI BE IT SI NL PT GRLUCY MT ES IE403020100-10Q1 2006 to Q4 2008-20-20AT NL DE CY PT FR LU FI IT BE ES SI GRMT IESource: ECB calculations.1) Based on the CPI, GDP or total unit labour cost (ULC)deflators, including intra- and extra-euro area trade.Notes: A negative (positive) number signifies a gain (loss) in pricecompetitiveness. The last observation refers to the fourth quarterof 2008 (based on the CPI deflator) and the third quarter of 2008(based on GDP and ULC deflators). For the period from the firstquarter of 2006 to the fourth quarter of 2008 the harmonisedcompetitiveness indicators were rescaled to Q1 2006 = 100. TheGDP deflator-based harmonised competitiveness indicator forMalta is not published by the ECB.403020100-10403020100-102 For a more detailed analysis of the harmonised competitiveness indicators, see F. di Mauro and K. Forster, “Globalisation and thecompetitiveness of the euro area”, Occasional Paper Series, No 97, ECB, September 2008, and the article entitled “Monitoring labourcost developments across euro area countries” in the November 2008 issue of the ECB’s Monthly Bulletin.82 ECBAnnual Report2008

focused more on the production rather than theconsumption side of the economy.Various caveats should be borne in mindwhen interpreting these indicators. Indexbasedcompetitiveness indicators do notaccount for differences in initial price levels,hence it is not possible to draw conclusionsas to which country is more competitive inabsolute terms. Conclusions based on suchindicators are also sensitive to the choiceof the start and end point of the periodconsidered. Furthermore, the harmonisedcompetitiveness indicators capture onlylimited aspects of competitiveness. In orderto obtain a broader picture, other factors, suchas trade specialisation or the general businessenvironment, as well as the degree of pricingto market and the responsiveness of tradeprices to changes in the exchange rate, couldbe considered in a more detailed analysis. 3Moreover, at the current juncture, themethodology used for these indicators doesnot fully recognise cross-country differencesin the productivity of the services sector.(The trade patterns of this sector are notreflected in the weighting of trading partners.)Chart C Developments in intra- and extraeuroarea harmonised competitivenessindicators 1)(cumulated changes in percentage points from Q1 1999 to Q42008)141210x-axis: change in extra-euro area harmonisedcompetitiveness indicatory-axis: change in intra-euro area harmonisedcompetitiveness indicatorES8LUSI6GRMT4ITPTCY2NLBE0EAAT-2FI-4FR-6DE-8-10 0 10 20 30IE-840Source: ECB calculations.1) Based on the CPI.Notes: A positive (negative) number represents a loss (gain) inprice competitiveness. For the euro area, the chart shows thereal EER of the euro vis-à-vis 22 trading partners based only onextra-euro area trade.14121086420-2-4-6Turning to past movements in the harmonised competitiveness indicators, Chart B revealsconsiderable heterogeneity in competitiveness developments across the euro area countries.Using the CPI-based harmonised competitiveness indicator, Ireland has recorded the strongestdeclines in competitiveness since 1999 (above 20%), followed by Cyprus, Malta, Luxembourgand Spain (10-20%). Austria, Germany, Finland and France show the smallest declines or evenslight improvements in competitiveness over the same period. Focusing on the period of themost recent appreciation of the euro, i.e. since the beginning of 2006, the differences appear tobe less pronounced, with all countries recording decreases in price competitiveness. While themagnitude of competitiveness developments across the countries is sometimes sensitive to thechoice of deflator, the qualitative conclusions remain the same across the different measures.The harmonised competitiveness indicators also make it possible to distinguish betweendevelopments in intra-euro area and extra-euro area competitiveness at the country level.This is a useful distinction, as movements in the nominal exchange rate since the launch ofthe euro remain important only for external competitiveness. Hence, price competitivenessbetween the euro area countries is influenced only through differing developments in costsand prices. In general, declines in price competitiveness at the country level are more3 For an analysis of these broader competitiveness issues, see Task Force of the Monetary Policy Committee of the ESCB,“Competitiveness and the export performance of the euro area”, Occasional Paper Series, No 30, ECB, June 2005, and U. Baumann andF. di Mauro, “Globalisation and euro area trade: interactions and challenges”, Occasional Paper Series, No 55, ECB, March 2007.ECBAnnual Report200883

pronounced with respect to extra-euro area trade partners, as shown by the regressionline which captures the relationship between the intra- and extra-euro area indicators(see Chart C). This largely reflects the overall nominal appreciation of the exchange rate of the eurobetween 1999 and 2008. Accordingly, countries such as Ireland, which have a relatively large shareof trade with partners outside the euro area, also exhibit a relatively larger decline in extra-euroarea competitiveness. However, for most countries, the high correlation between intra- and extraeuroarea competitiveness also suggests that the relative competitive positions of the individualeuro area countries are determined mainly by the evolution of domestic costs and prices. Overall,Austria is the only country which improved its competitiveness both inside and outside the euroarea. Finland, France and Germany also recorded increases in their intra-euro area competitiveness,but registered declines vis-à-vis their extra-euro area trade partners. The remaining euro areacountries recorded decreases in competitiveness both inside and outside the euro area.In summary, according to various measures of real EERs, the euro area has experienced a declinein price and cost competitiveness over the past ten years or so, owing largely to the nominalappreciation of the euro. However, there is considerable heterogeneity in competitivenessdevelopments among the euro area countries, reflecting mostly differences in the evolution oftheir domestic costs and prices, as well as the geographical specialisation of their foreign trade.Volumes of imported goods decreased in 2008,particularly those of intermediate goods. At thesame time, import prices increased robustly upto the third quarter of 2008 and moderated in thelast quarter of the year. As price developmentsmore than offset the decline in the volumeof imports, overall import values increasednoticeably over the first three quarters of theyear. Price data by category of goods suggestthat the steady increase in import prices up toChart 35 Extra-euro area import prices(indices: Q1 2003 = 100; seasonally adjusted; three-monthmoving average)200180160140120100802003 2004 2005 2006 2007 2008Source: ECB.non-energy commoditiesmanufacturingtotal goodsBrent crude oil (right-hand scale)350300250200150100500the summer and the subsequent decelerationwere driven largely by developments in oil andnon-energy commodity prices (see Chart 35).Nevertheless, despite the fall in oil pricesfrom the summer onwards, in the 12-monthcumulated period up to November 2008, theoil trade deficit stood at €223.6 billion, wellabove the already high level of more than€170 billion registered at the end of 2007.NET INFLOWS IN COMBINED DIRECT ANDPORTFOLIO INVESTMENT INCREASED IN 2008In the financial account, the euro area experiencednet inflows of €128.5 billion in combined directand portfolio investment in 2008, compared withnet inflows of €47.3 billion a year earlier. Thisincrease reflected a rise in net inflows of debtinstruments and equity portfolio investment.The above developments were offset partly byan increase in net outflows in direct investment(see Chart 36).In 2008 the financial turmoil led to heightenedvolatility in all segments of the financial marketsand, given the financial spillovers to the real sideof the economy, to a high degree of uncertaintyover the global outlook. In this context, globalportfolio allocation decisions were influencedby the ensuing drain of liquidity in key market84 ECBAnnual Report2008

segments and, in turn, affected euro area crossborderportfolio investment flows. Specifically,the equity market witnessed unusually high netsales of both euro area financial instrumentsby global investors and foreign equities byeuro area investors. Global investors seemedto reduce their foreign investments, possiblyreflecting more cautious investment strategiesand the global fall in equity prices.Also in the wake of the financial turmoil, bothforeign direct investment flows into the euroarea and euro area investment flows abroad fellsubstantially in 2008, indicating a preference forhome markets. Disinvestments by non-residentsin the euro area were larger than euro areadisinvestments abroad, leading to overall highernet outflows of direct investment for the euro area.Finally, higher net inflows of debt securities,amounting to €345.6 billion, compared with€122.8 billion in 2007, contributed to theincrease in net inflows in the financial account.Increased risk aversion, heightened liquidityneeds and short-term interest rate differentialsmight have contributed to this development. Inparticular, money market instruments recordedstrong net inflows, reaching in September andOctober 2008 their highest levels since 1999.These developments possibly reflect attemptsto boost liquidity amid the intensification of thefinancial turmoil.INTERNATIONAL INVESTMENT POSITION IN 2008Data on the international investment position(i.i.p.) of the euro area vis-à-vis the rest of theworld, available up to the third quarter of 2008,indicate that the euro area recorded net liabilitiesof €1,158 billion vis-à-vis the rest of the world(representing 12.5% of euro area GDP), comparedwith net liabilities of €1,131 billion (also equalto 12.5% of GDP) at the end of 2007 (seeChart 37). This marginal increase in net liabilitiesin 2008 resulted largely from an increase inthe net liability position in other investment(by €191 billion) and in portfolio investment (by€76 billion), which were almost entirely offsetby an increase in the net asset positions in euroarea direct investment abroad (by €182 billion)and in financial derivatives (by €35 billion).Reserve assets also increased only marginally,with valuation effects resulting from asset pricechanges and movements in the exchange ratecontributing to these developments.Chart 36 Euro area direct and portfolioinvestment(annual data; EUR billions)375300225150750-75-150-225-300-3751234200520062007200812 3 4375300225150750-75-150-225-300-375Net direct investmentNet portfolio investment in equitiesNet portfolio investment in debt instrumentsCombined net direct investment and portfolio investmentSource: ECB.Note: Data for 2008 refer to the year to October 2008.Chart 37 Net international investmentposition(as a percentage of GDP)0-2-4-6-8-10-12-142005 2006 2007 2008Source: ECB.Note: Data refer to the year-end except for 2008 (third quarter).0-2-4-6-8-10-12-14ECBAnnual Report200885

3 ECONOMIC AND MONETARY DEVELOPMENTSIN NON-EURO AREA EU MEMBER STATESECONOMIC ACTIVITYIn most non-euro area EU Member Stateseconomic growth declined in the course of 2008following several years of robust expansion(see Table 6). 1 While this pattern of slowingeconomic activity was observed across almostall of the countries, annual GDP growth ratesand the extent of the slowdown differedconsiderably.The Baltic States experienced the mostpronounced slowdown, with average annualgrowth more than halving in Lithuaniacompared with the previous year and turningnegative in Estonia and Latvia. In all threecountries these developments followed severalyears of very strong growth in economicactivity, accompanied by exceptionally strongincreases in wages, credit and inflation, as wellas very large current account deficits. Indeed,macroeconomic imbalances in the Baltic Statesremained large in 2008, notwithstanding thepartial correction observed in the course of theyear.intensifying financial crisis. Tighter financingconditions and falling asset prices weakenedconsumer and industrial confidence anddampened domestic demand.The deceleration of economic growth in Slovakia,from 10.4% in 2007 to 6.4% in 2008, was inpart a normalisation following exceptionallyhigh growth in the previous year. In Hungary,the very low annual growth of 0.5% in 2008reflects the lagged impact of the sizeable fiscalconsolidation package in 2007, from whichthe economy started to recover slowly in 2008,combined with the subsequent impact of thefinancial crisis on the economy. In the threenon-euro area EU Member States that joinedthe EU before 2004, the impact of the financialcrisis was equally pronounced, resulting inannual GDP growth rates for 2008 of 0.7% in theUnited Kingdom, -0.2% in Sweden and -1.3% inDenmark. Economic activity in Poland and theCzech Republic appears to have been affected toa somewhat lesser extent, decelerating in 2008to 5.4% and 3.2% respectively. While RomaniaThe deceleration in GDP growth in most othernon-euro area EU Member States was drivenmainly by the weakening external environmentand, later in the year, by the direct impact of the1The non-euro area EU Member States referred to in this sectioncomprise the 12 EU Member States outside the euro area in theperiod to the end of December 2008 (i.e. Bulgaria, the CzechRepublic, Denmark, Estonia, Latvia, Lithuania, Hungary, Poland,Romania, Slovakia, Sweden and the United Kingdom).Table 6 Real GDP growth in the non-euro area EU Member States and the euro area(annual percentage changes)2004 2005 2006 2007 2008 2008 2008 2008 2008Q1 Q2 Q3 Q4Bulgaria 6.6 6.2 6.3 6.2 6.0 7.0 7.1 6.8 3.5Czech Republic 4.5 6.3 6.8 6.0 3.2 4.4 4.4 4.0 0.2Denmark 2.3 2.4 3.3 1.6 -1.3 -0.7 0.8 -1.6 -3.9Estonia 7.5 9.2 10.4 6.3 -3.6 0.2 -1.1 -3.5 -9.7Latvia 8.7 10.6 12.2 10.0 -4.6 0.5 -1.9 -5.2 -10.3Lithuania 7.4 7.8 7.8 8.9 3.1 7.0 5.2 2.9 -2.0Hungary 4.8 4.0 4.1 1.1 0.5 1.7 2.0 0.8 -2.3Poland 5.3 3.6 6.2 6.6 5.4 6.2 5.8 5.2 2.3Romania 8.5 4.2 7.9 6.2 7.1 8.2 9.3 9.2 2.9Slovakia 5.2 6.5 8.5 10.4 6.4 9.3 7.9 6.6 2.5Sweden 4.1 3.3 4.2 2.6 -0.2 0.9 3.0 0.3 -4.9United Kingdom 2.8 2.1 2.8 3.0 0.7 2.3 3.2 1.8 .EU9 1) 5.8 4.9 6.7 6.2 4.3 5.7 5.5 4.7 0.9EU12 2) 3.6 2.9 3.9 3.6 1.3 2.7 3.5 2.2 .Euro area 2.1 1.7 2.9 2.6 0.8 1.9 2.0 0.8 -1.4Sources: Eurostat and national sources.Note: Data are non-seasonally adjusted for all countries.1) The EU9 aggregate comprises the nine non-euro area EU Member States that joined the EU on 1 May 2004 or 1 January 2007.2) The EU12 aggregate comprises the 12 non-euro area EU Member States as at 31 December 2008.86 ECBAnnual Report2008

and Bulgaria registered robust growth figures of,respectively, 7.1% and 6.0% in 2008, economicactivity in these countries also slowed morenoticeably towards the end of the year, followinga lengthy period of very high growth fuelled bybuoyant domestic demand and strong credit andwage growth, and supported by sizeable foreigndirect investment inflows.PRICE DEVELOPMENTSAverage annual inflation increased in 2008 inall non-euro area EU Member States (with theexception of Hungary) and, in inflation-targetingcountries, significantly exceeded inflation targets.The increase reflects the initial upward trendin inflation rates in most countries in the firsthalf of the year, which was later reversed. InDecember 2008 inflation was in most countrieslower than at the beginning of the year.The highest inflation rates were recorded inthe Baltic States and Bulgaria, where averageannual HICP inflation ranged between 10.6%and 15.3%. In the Czech Republic, Hungary andRomania, average annual HICP inflation wasbetween 6.0% and 7.9%, while in the remainingcountries – Denmark, Poland, Slovakia, Swedenand the United Kingdom – inflation was between3.3% and 4.2%.One of the main factors behind the broad-basedrise in inflation was common to almost all noneuroarea EU countries, namely a strong increasein the world prices of food and energy. Somecountries also implemented marked increases inadministered prices and indirect taxes, and in anumber of economies currency depreciation alsocontributed to the rise. Finally, in some casesbuoyant domestic demand, increasing capacityconstraints and agricultural supply shocksalso exerted strong upward pressure on wagesand prices.The factors driving the considerablemoderation in inflation later in 2008 werealso common to most countries. First, annualinflation rates started to decline as the effectsof the global commodity price shock of2007 and early 2008 faded and world pricesof oil declined significantly. Second, domesticdemand pressures eased in parallel with thedecline in economic growth in the previouslyfastest-growing economies, and later also inmost other non-euro area EU Member Statesas the financial crisis intensified. Nevertheless,wage pressures remained significant in a numberof countries, where real wage growth continuedto outpace productivity growth, leading tosignificant increases in unit labour costs.Table 7 HICP inflation in the non-euro area EU Member States and the euro area(annual percentage changes)2004 2005 2006 2007 2008 2008Q1Bulgaria 6.1 6.0 7.4 7.6 12.0 12.4 14.0 12.5 9.0Czech Republic 2.6 1.6 2.1 3.0 6.3 7.6 6.7 6.5 4.4Denmark 0.9 1.7 1.9 1.7 3.6 3.2 3.7 4.6 3.0Estonia 3.0 4.1 4.4 6.7 10.6 11.3 11.5 11.0 8.7Latvia 6.2 6.9 6.6 10.1 15.3 16.3 17.5 15.6 11.9Lithuania 1.2 2.7 3.8 5.8 11.1 10.8 12.3 12.0 9.4Hungary 6.8 3.5 4.0 7.9 6.0 6.9 6.8 6.3 4.2Poland 3.6 2.2 1.3 2.6 4.2 4.5 4.3 4.4 3.6Romania 11.9 9.1 6.6 4.9 7.9 8.0 8.6 8.2 6.9Slovakia 7.5 2.8 4.3 1.9 3.9 3.4 4.0 4.5 3.9Sweden 1.0 0.8 1.5 1.7 3.3 3.1 3.6 4.0 2.7United Kingdom 1.3 2.1 2.3 2.3 3.6 2.4 3.4 4.8 3.9EU9 1) 5.3 3.8 3.3 4.2 6.4 6.8 7.0 6.7 5.2EU12 2) 2.6 2.6 2.6 2.9 4.7 4.2 4.9 5.5 4.3Euro area 2.1 2.2 2.2 2.1 3.3 3.4 3.6 3.8 2.3Source: Eurostat.1) The EU9 aggregate comprises the nine non-euro area EU Member States that joined the EU on 1 May 2004 or 1 January 2007.2) The EU12 aggregate comprises the 12 non-euro area EU Member States as at 31 December 2008.2008Q22008Q32008Q4ECBAnnual Report200887

FISCAL POLICIESThe fiscal situation in the non-euro area EUMember States evolved very heterogeneouslyin 2008. Only Bulgaria, Denmark and Swedencontinued to record fiscal surpluses; theremaining countries registered in some caseshigh fiscal deficits (see Table 8). The deficitratio rose to above 3% of GDP in Latvia,Romania and the United Kingdom and wasclose to this level in Lithuania. Hungaryreduced its deficit from 5.0% of GDP in 2007to 3.3% in 2008. In the Baltic States, Romaniaand the United Kingdom, and to a lesser extentin Sweden, budgetary outcomes for 2008 failedto meet the targets contained in the updatedconvergence programmes submitted at theend of 2007 or the beginning of 2008. For theBaltic States as well as for the United Kingdom,this was partly the result of the considerablyworsening macroeconomic conditions, whichrendered planned continued expenditure growthand therefore the 2008 budget unsustainable.Table 8 Fiscal positions in the non-euro area EU Member States and the euro area(as a percentage of GDP)General government surplus (+) / deficit (-)2007 convergenceprogramme updates2009 EuropeanCommission forecast2005 2006 2007 2008 2008Bulgaria 1.9 3.0 0.1 3.0 3.2Czech Republic -3.6 -2.7 -1.0 -2.9 -1.2Denmark 5.2 5.2 4.5 3.0 3.1Estonia 1.5 2.9 2.7 1.3 -2.0Latvia -0.4 -0.2 0.1 0.7 -3.5Lithuania -0.5 -0.4 -1.2 -0.5 -2.9Hungary -7.8 -9.3 -5.0 -4.0 -3.3Poland -4.3 -3.8 -2.0 -2.5 -2.5Romania -1.2 -2.2 -2.5 -2.9 -5.2Slovakia -2.8 -3.5 -1.9 -2.3 -2.2Sweden 2.4 2.3 3.6 2.8 2.3United Kingdom -3.4 -2.7 -2.7 -2.9 -4.6EU9 1) -3.7 -3.5 -2.0 -2.4 -2.6EU12 2) -2.3 -1.8 -1.5 -1.8 -2.8Euro area -2.5 -1.3 -0.6 -0.9 -1.7General government gross debt2007 convergenceprogramme updates2009 EuropeanCommission forecast2005 2006 2007 2008 2008Bulgaria 29.2 22.7 18.2 18.3 13.8Czech Republic 29.8 29.6 28.9 30.3 27.9Denmark 36.4 30.7 26.3 21.6 30.3Estonia 4.5 4.3 3.5 2.3 4.3Latvia 12.4 10.7 9.5 8.3 16.0Lithuania 18.4 18.0 17.0 17.2 17.1Hungary 61.7 65.6 65.8 65.8 71.9Poland 47.1 47.7 44.9 44.2 45.5Romania 15.8 12.4 12.7 13.6 15.2Slovakia 34.2 30.4 29.4 30.8 28.6Sweden 50.9 45.9 40.6 34.8 34.8United Kingdom 42.3 43.4 44.1 44.8 50.1EU9 1) 38.5 37.4 35.5 35.6 36.6EU12 2) 41.9 41.4 40.5 39.6 43.4Euro area 70.0 68.3 66.1 65.1 68.7Sources: European Commission data (for 2005-08), 2007 convergence programme updates and 2009 European Commission interimforecast (for 2008), and ECB calculations.Notes: Data are based on ESA 95 definitions. The 2008 figures in the convergence programmes are estimated by national governments andhence could differ from the final outcomes.1) The EU9 aggregate comprises the nine non-euro area EU Member States that joined the EU on 1 May 2004 or 1 January 2007.2) The EU12 aggregate comprises the 12 non-euro area EU Member States as at 31 December 2008.88 ECBAnnual Report2008

In the remaining non-euro area EU countries(i.e. Bulgaria, the Czech Republic, Denmark,Hungary, Poland and Slovakia), budgetaryoutcomes for 2008 were broadly in line with orbetter than the convergence programme targets.In a generally deteriorating economic andfiscal environment, Slovakia, Sweden andthe United Kingdom planned or implementedfiscal stimulus packages towards the end of2008, whereas several other non-euro area EUMember States announced plans for – in somecases ambitious – fiscal consolidation in 2009.Latvia and Hungary, which received emergencyfinancial support from, among others, the EUand the IMF, committed to sizeable fiscalconsolidation packages for 2009 and beyond.At the end of 2008, Hungary and theUnited Kingdom were subject to excessivedeficit procedures. The ECOFIN Councilabrogated the excessive deficit proceduresfor the Czech Republic and Slovakia in Juneand for Poland in July. In June Romania receivedpolicy advice from the European Commissionin view of the risk that it would breach the3% of GDP deficit ceiling in an environment ofstrong GDP growth.The government debt ratio remainedsubstantially below the 60% of GDP referencevalue in 2008 in most non-euro area EU MemberStates, with only Hungary recording a debt ratioabove 60%. However, developments differedsignificantly across countries. The debt ratioincreased in Denmark, Estonia, Latvia, Hungary,Poland, Romania and the United Kingdom,while it declined or was broadly unchanged inthe other countries. Increases in the debt ratio inmost countries reflect mainly the deteriorationin GDP growth and in the budget balance. Forthe United Kingdom the increase in the debtratio relates to some extent also to the budgetaryimpact of emergency support provided tofinancial institutions. In the case of Denmark,the increase reflects bond issuance in excess ofthe funding requirement.BALANCE OF PAYMENTS DEVELOPMENTSThe combined current and capital accounts ofthe non-euro area EU Member States continuedto vary considerably across countries in 2008Table 9 Balance of payments of the non-euro area EU Member States and the euro area(as a percentage of GDP)Current andcapital account balance Net direct investment Net portfolio investment2005 2006 2007 2008 2005 2006 2007 2008 2005 2006 2007 2008Bulgaria -11.3 -17.1 -20.6 -22.7 14.7 23.3 21.8 18.0 -4.7 1.3 -1.6 -2.4Czech Republic -1.2 -2.3 -1.2 -1.4 9.4 2.8 4.5 4.9 -2.7 -0.8 -1.5 1.3Denmark 4.5 2.9 0.7 1.6 -1.3 -2.1 -2.8 -3.6 -4.5 -6.3 -2.0 -6.2Estonia -9.2 -14.6 -16.9 -10.5 15.7 4.2 5.3 5.5 -16.0 -8.0 -2.4 0.5Latvia -11.2 -21.3 -20.6 -13.0 3.6 7.5 6.7 4.4 -0.8 0.2 -2.3 1.2Lithuania -5.8 -9.5 -12.8 -12.4 2.6 5.1 3.6 2.5 -1.0 -0.8 -0.8 0.7Hungary -6.7 -7.1 -5.1 -5.7 5.0 1.0 3.2 1.7 3.9 5.5 -1.6 1.7Poland -0.9 -2.1 -3.6 -3.7 2.3 3.1 4.3 2.8 4.1 -0.9 -1.2 0.7Romania -7.9 -10.5 -13.1 -13.2 6.6 8.9 5.8 6.3 1.0 -0.2 0.4 -0.2Slovakia -8.5 -7.8 -4.7 -5.2 4.8 7.5 3.8 2.8 -2.0 2.9 -1.0 1.3Sweden 7.0 7.8 8.4 8.0 -4.5 0.6 -3.7 2.0 -0.1 -5.2 2.2 -2.0United Kingdom -2.5 -3.4 -2.7 -1.3 4.4 2.6 -2.7 -2.8 -1.5 1.1 8.4 20.5EU9 1) -4.1 -5.5 -5.5 -5.6 5.9 4.4 4.9 4.0 0.7 0.7 -1.2 0.9EU12 2) -1.0 -1.8 -1.5 -0.8 3.1 2.4 -1.1 -0.6 -1.0 -0.4 4.5 10.7Euro area 0.3 0.2 0.6 -0.2 -2.6 -1.9 -1.0 -1.9 1.6 3.5 1.5 1.6Source: ECB.Note: Data for 2008 refer to the sum of the four quarters up to the third quarter of 2008.1) The EU9 aggregate comprises the nine non-euro area EU Member States that joined the EU on 1 May 2004 or 1 January 2007.2) The EU12 aggregate comprises the 12 non-euro area EU Member States as at 31 December 2008.ECBAnnual Report200889

(see Table 9). While Denmark and Swedenreported surpluses, all other countries recordeddeficits. For many of the countries that joinedthe EU in 2004 or later, deficits are a normalfeature of the catching-up process, to theextent that they reflect favourable investmentopportunities and inter-temporal consumptionsmoothing. However, the very large current andcapital account deficits in some non-euro areaEU Member States were also driven by buoyantdomestic demand, benign global financingconditions and strong credit growth. The globalfinancial turmoil in 2008 and its spillover tothe real economy led to cooling or contractingdomestic demand, thereby contributing to anarrowing of the deficit in several non-euro areaEU countries.Looking at the high-deficit countries, thecontraction in the current and capital accountdeficit was the most pronounced in Estoniaand Latvia, even though the deficits recordedby those countries remained very large at theend of 2008. In Lithuania the deficit narrowedto a significantly lesser extent and in Romaniait remained broadly unchanged, while Bulgariarecorded a further increase. In all the abovecountries the deficit continued to exceed 10% ofGDP, with the Bulgarian deficit at over 20%.As regards countries with lower external deficits,only the United Kingdom witnessed a contractionin its deficit in 2008. In the Czech Republic andPoland the deficit was broadly unchanged, whilein Hungary and Slovakia it increased somewhat.The external imbalances in most countriesoriginated from a deficit in goods trade, exceptin the Czech Republic, Hungary and Slovakia,where the deficit in the income balance wasthe most important factor. In comparison with2007, net direct investment inflows decreased insome countries in 2008. Most non-euro area EUMember States recorded a deficit in the basicbalance, i.e. the sum of the combined currentand capital account and the direct investmentbalance, which exceeded 4% of GDP in severaleconomies. Net portfolio investment flows werenegative or broadly neutral in all non-euro areaEU Member States in 2008, with the exceptionof the United Kingdom. Net “other investment”flows continued to be largely positive in mostcountries that joined the EU in 2004 or later,reflecting mainly loans from foreign-ownedparent banks to their subsidiaries in the region.EXCHANGE RATE DEVELOPMENTSExchange rate developments in the non-euroarea EU Member States in 2008 were stronglyinfluenced by the exchange rate regimes of theindividual countries.The currencies of Denmark, Estonia, Latvia,Lithuania and Slovakia participated in ERM II.They were subject to a standard fluctuationband of ±15% around their central rates againstthe euro, except for the Danish krone, witha narrower band of ±2.25% (see Chart 38).ERM II participation is, in some cases,accompanied by unilateral commitments onthe part of the countries concerned to maintainnarrower fluctuation bands. These unilateralcommitments place no additional obligationson the ECB. In particular, it was agreed that theChart 38 Developments in ERM II(daily data; deviation from the central rate in percentage points)30-3-6-9-12DKKLVLLTLSKKEEK-15-15Jan. Apr. July Oct. Jan. Apr. July Oct. Jan.2007 2008 2009Source: ECB.Notes: A positive (negative) deviation from the central rateagainst the euro implies that the currency is on the weak (strong)side of the band. For the Danish krone, the fluctuation band is±2.25%; for all other currencies, the standard fluctuation band of±15% applies. However, on the basis of unilateral commitments,the fluctuation band for the Latvian lats is ±1%, and for boththe Lithuanian litas and the Estonian kroon a currency boardarrangement is maintained. The central rate of the Slovak korunawas revalued by 8.5% on 16 March 2007 and by 17.6472% on29 May 2008.30-3-6-9-1290 ECBAnnual Report2008

Estonian kroon and the Lithuanian litas couldjoin ERM II with their existing currency boardarrangements in place. The Latvian authoritiesdecided to maintain the exchange rate of the lats atits central rate against the euro with a fluctuationband of ±1%. The agreements on participationfor the countries whose currencies joinedERM II in 2004 or later (i.e. all the countrieslisted above except Denmark) are also all basedon a number of other policy commitmentsby the respective authorities. These relate to,among other things, the pursuit of sound fiscalpolicies, the promotion of wage moderation andwage developments in line with productivitygrowth, the pursuit of prudent credit policiesand the implementation of further structuralreforms.Prior to the collapse of Lehman Brothers inSeptember 2008, money market spreads wererelatively stable in most of the above-mentionedcountries, some volatility in the Latvian marketnotwithstanding. In the fourth quarter of 2008,while exchange rate developments continuedto reflect the official exchange rate regimes,the intensification of the global financial crisis,the deteriorating economic outlook, investors’concerns about external vulnerabilities in somecountries, together with credit rating downgradesfor Latvia and Lithuania and decisions on thepart of credit rating agencies to place Estoniaunder review for a rating downgrade, contributedto a rapid and pronounced widening of bond andmoney market spreads vis-à-vis the euro area inall ERM II countries except Slovakia. In Latvia,where the money market spread widening wasparticularly pronounced, and in Denmark, thecentral banks supported their currencies withforeign exchange intervention and by increasingthe official interest rate spreads vis-à-vis theeuro area. Against the background of a sharpdeceleration in economic activity and tensionsin the financial system, Latvia nationalisedits largest domestically owned bank and inDecember 2008 arranged a €7.5 billion jointinternational financial support programme. Theprogramme includes measures to stabilise thefinancial sector, substantial domestic economicreforms, fiscal consolidation and significantpublic wage reductions, and is based onmaintaining the current narrow-band exchangerate peg with a view to achieving Latvia’s policygoal of entering the euro area at the earliestpossible date.By contrast, the prospect of Slovakia joining theeuro area appears to have shielded the Slovakkoruna from the negative impact of the globalfinancial crisis. In the first half of 2008 thekoruna strengthened considerably against theeuro. On 29 May the currency’s central rate wasrevalued by 17.6472% to SKK 30.1260 againstthe euro. After the decision of the EU Council inJuly 2008 allowing Slovakia to adopt the euro,the Slovak koruna remained close to its newcentral rate, which was also the rate at which itwas converted to the euro when the latter wasintroduced in Slovakia on 1 January 2009.Turning to the currencies of the non-euro areaEU Member States that did not participate inERM II, developments varied considerablyacross countries (see Chart 39). Most currencieswere broadly stable in the first half of 2008,while some, such as the Czech koruna,Chart 39 Developments in non-ERM II EUcurrencies(daily data; index: 2 January 2008 = 100)140130 130120110 110100GBPSEKCZKHUF90 908080Jan. Apr. July Oct. Jan. Apr. July Oct. Jan.2007 2008 2009Source: ECB.PLNBGNRON140120100ECBAnnual Report200891

the Hungarian forint and the Polish zlotyappreciated and reached record levels againstthe euro. From September, however, thedeepening of the financial crisis, amid markedglobal deleveraging and severe problems in thefunctioning of interbank markets worldwide,resulted in a rapid and pronounced depreciationof several currencies, in particular the Polishzloty, the Hungarian forint, the Romanian leuand, to a lesser extent, the Czech koruna.The joint international financial supportprogramme for Hungary, which was aimedat alleviating the tensions in the financialmarket, helped initially (in late October andNovember 2008) to ease the downward pressureon both the forint and other currencies in theregion. However, the deteriorating economicoutlook and investors’ concerns about externalvulnerabilities in some countries, together withcredit rating downgrades for Bulgaria, Hungaryand Romania in October and November, resultedin a further sharp depreciation of the zloty,the forint, the leu and, to a lesser extent, thekoruna. Reflecting its euro-based currency boardarrangement, the Bulgarian lev remained fixedagainst the euro, notwithstanding an increasein interest rate spreads vis-à-vis the euro area.The pound sterling weakened sharply againstthe euro in the fourth quarter of 2008, withmounting recession fears in the United Kingdomand decreasing interest rate differentials visà-visthe euro area. In the first two months of2009 the pound appreciated somewhat againstthe euro amid high volatility. The Swedish kronadepreciated substantially against the euro in thecourse of 2008.FINANCIAL DEVELOPMENTSBetween January and December 2008 longtermgovernment bond yields in the non-euroarea EU Member States (other than Estonia,for which no comparable long-term interestrate is available) were strongly affected by theglobal financial crisis. Portfolio changes dueto a general increase in investor risk aversionwere an important factor driving bond marketdevelopments in these countries. In the firstpart of 2008, developments in governmentbond yields in most non-euro area EU countrieswere similar to those in the euro area, whereyields were relatively stable. This was followedby a period of increased divergence across thenon-euro area EU countries, with somecountries showing declining yields, as in theeuro area, and others experiencing abruptincreases. In December 2008 long-term interestrates in the non-euro area EU Member Stateswere, on average, around 85 basis points higherthan at the beginning of 2008, compared witha decrease of 34 basis points in the euro area.The largest increases took place in Lithuaniaand Latvia (by 430 and 330 basis pointsrespectively), mainly reflecting the increaseddifficulties encountered by those governmentsin meeting their financing requirements in thecontext of a sharp deterioration in economicgrowth.Between January and December 2008,government bond yield spreads against the euroarea increased on average in the non-euro areaEU Member States. In Lithuania and Latvia theyreached historical peaks, standing in Decemberat around 500 basis points.As in the bond markets, stock exchange indiceswere negatively affected in all non-euro areaEU countries in 2008 by higher uncertainty,negative sentiment as regards future economicdevelopments and news of continued lossesin the financial sector. Stock markets weregenerally characterised by high volatility andmarked declines – on average by 50% betweenDecember 2007 and December 2008. Stockprices fell most in Bulgaria and Romania, wherethey decreased by more than 70%, mainlyreflecting the higher risk assigned by investorsto the capital markets of these countries.MONETARY POLICYThe primary objective for monetary policy inall non-euro area EU Member States is pricestability. Monetary policy strategies, however,differ considerably from country to country(see Table 10).92 ECBAnnual Report2008

Table 10 Official monetary policy strategies of the non-euro area EU Member StatesMonetary policy strategy Currency FeaturesBulgaria Exchange rate target Bulgarian lev Exchange rate target: peg to the euro at BGN 1.95583 per eurowithin the framework of a currency board arrangement.Czech Republic Inflation target Czech koruna Inflation target: 3% ±1 percentage point until end-2009; thereafter2% ±1 percentage point. Managed floating exchange rate.Denmark Exchange rate target Danish krone Participates in ERM II with a ±2.25% fluctuation band around acentral rate of DKK 7.46038 per euro.Estonia Exchange rate target Estonian kroon Participates in ERM II with a ±15% fluctuation band around acentral rate of EEK 15.6466 per euro. Estonia continues with itscurrency board arrangement as a unilateral commitment.Latvia Exchange rate target Latvian lats Participates in ERM II with a ±15% fluctuation band around acentral rate of LVL 0.702804 per euro. Latvia continues with afluctuation band of ±1% as a unilateral commitment.Lithuania Exchange rate target Lithuanian litas Participates in ERM II with a ±15% fluctuation band around acentral rate of LTL 3.45280 per euro. Lithuania continues with itscurrency board arrangement as a unilateral commitment.Hungary Inflation target Hungarian forint Inflation target: 3% ±1 percentage point medium-term targetsince 2007. Free-floating exchange rate.Poland Inflation target Polish zloty Inflation target: 2.5% ±1 percentage point (12-month increase inthe CPI). Free-floating exchange rate.Romania Inflation target Romanian leu Inflation target: 3.8% and 3.5% ±1 percentage point for end-2008and end-2009 respectively. Managed floating exchange rate.SlovakiaInflation targeting underthe conditions of ERM IISlovak korunaParticipated in ERM II with a ±15% fluctuation band around acentral rate of SKK 35.4424 per euro, and from 29 May a centralrate of SKK 30.1260 per euro. The inflation target was set at below2% for end-2008. Adopted the euro as of 1 January 2009.Sweden Inflation target Swedish krona Inflation target: 2% increase in the CPI with a tolerance marginof ±1 percentage point. Free-floating exchange rate.United Kingdom Inflation target Pound sterling Inflation target: 2% (12-month increase in the CPI). 1 In the eventof a deviation of more than 1 percentage point, the MonetaryPolicy Committee is expected to write an open letter to theChancellor of the Exchequer. Free-floating exchange rate.Source: ESCB.1) The CPI is identical to the HICP.In 2008 the monetary policy and exchangerate regimes of most non-euro area EUMember States remained largely unchanged.However, in February Hungary replacedits exchange rate band vis-à-vis the eurowith a free-floating exchange rate andfreed its existing inflation-targeting regime.Some refinements were made to monetarypolicy frameworks in a few other countrieswith a view to future monetary integration in theeuro area.The intensification of the global financialturmoil in autumn 2008 brought about severalchallenges for monetary policy in most non-euroarea EU countries, with a number of countriesexperiencing liquidity constraints in theirinterbank markets, as well as tensions in theirforeign exchange markets. The responses by theNCBs to these challenges varied depending onthe economic conditions and the monetary policyframework in place.With regard to monetary policy decisions takenin 2008, most central banks participating inERM II adopted monetary policy measureswhich often mirrored moves by the ECB.In July, the ECB raised the minimum bid rateECBAnnual Report200893

on the main refinancing operations of theEurosystem by 25 basis points, before cutting itsmain policy rate in the last quarter of the yearin three steps by a total of 175 basis points.Given their currency board arrangements,Българска народна банка (Bulgarian NationalBank), Lietuvos bankas and Eesti Pank have noofficial policy rates; they automatically adjust tothe rates set by the ECB. In addition, in view ofdiminishing confidence among domestic banksand liquidity pressures in the interbank markets,the former two central banks lowered theirminimum reserve requirements to ease liquidityconstraints.Turning to the countries participating inERM II and not operating under a currency boardarrangement, Latvijas Banka, which maintainsa ±1% fluctuation band around the central rateof the lats as a unilateral commitment, kept itsmain interest rate at 6% throughout the year.However, it increased the deposit facility rateby 100 basis points to 3% and applied differentmarginal lending facility rates depending on thenumber of days the lending facility had beenused within the previous 30-day period. LatvijasBanka also reduced its minimum reserve ratiofor bank liabilities of over two years in five stepsby a total of 500 basis points to 3%, and for otherliabilities by a total of 300 basis points to 5%,in order to ease the liquidity constraints in thebanking sector. In December it entered into aswap agreement with Sveriges Riksbank andDanmarks Nationalbank, enabling it to borrowup to €500 million as short-term funding topreserve macroeconomic and financial stability.Danmarks Nationalbank increased its mainpolicy interest rate in four steps by a total of 125basis points between May and October 2008.While one decision (in July) followed a25 basis point rate increase by the ECB, theother measures were taken when the interestrate on the main refinancing operations ofthe Eurosystem was left unchanged or evendecreased, and were aimed at increasing thespread in policy rates vis-à-vis the euro area.The interest rate increases by DanmarksNationalbank were intended to support theweakening krone in periods of tension inthe foreign exchange markets. In October,Danmarks Nationalbank and the ECB announcedthe establishment of a swap line amounting to€12 billion to improve liquidity in short-termeuro markets. This followed the conclusion of asimilar arrangement by Danmarks Nationalbankwith the Federal Reserve System in September.Following some easing of tensions in Danishfinancial markets, Danmarks Nationalbankfollowed the ECB in November and December2008 and decreased its main policy interest ratein two steps by a total of 125 basis points.In light of Slovakia’s coming adoption of theeuro, Národná banka Slovenska followed themonetary policy decisions of the ECB fromOctober 2008 and reduced its repo rate in threesteps by a total of 175 basis points to 2.5%. Italso narrowed the corridor of overnight ratesaround the repo rate to 100 basis points.Most NCBs with inflation targets and notparticipating in ERM II tightened their monetarypolicy stance at the beginning of 2008, withthe aim of containing inflationary pressuresstemming in large part from food and energyprice increases, and in some countries also fromrobust wage growth. In the first three quarters of2008 Sveriges Riksbank, the Magyar NemzetiBank and Narodowy Bank Polski each increasedtheir main policy rates by a total of 100 basispoints in several steps, while Banca Naţionalăa României increased its key interest rate insix steps by 275 basis points. Česká národníbanka increased its main policy rate only once,by 25 basis points in February, a move whichwas reversed in August. Having already startedto lower policy rates in December 2007, theBank of England continued to cut interest ratesthroughout the first three quarters of 2008.As inflationary pressures diminished on the backof declining commodity prices, a weakeningeconomic outlook and an intensification ofthe global financial crisis, most NCBs with aninflation target decreased their policy interestrates in the fourth quarter of 2008. On 8 October94 ECBAnnual Report2008

the Bank of England and Sveriges Riksbank cutinterest rates by 50 basis points in a concertedaction with the ECB and other, non-EU centralbanks. On 22 October, however, the MagyarNemzeti Bank raised its key policy rate by300 basis points in response to financial marketdevelopments. In contrast, the Bank of Englandand Sveriges Riksbank continued to reducerates in several steps, by a total of 300 basispoints and 275 basis points respectively in thefourth quarter. The central banks of the CzechRepublic, Poland and Hungary also made aseries of policy rate decreases, reducing rates bya total of, respectively, 125, 100 and 150 basispoints in November and December.ECBAnnual Report200895

Former ECB President Willem F. Duisenberg with his wife Gretta and German Chancellor Helmut Kohl arriving at the ceremony tocelebrate the inauguration of the ECB on 30 June 1998

CHAPTER 2CENTRAL BANKOPERATIONSAND ACTIVITIES

1 MONETARY POLICY OPERATIONS, FOREIGNEXCHANGE OPERATIONS AND INVESTMENTACTIVITIES1.1 MONETARY POLICY OPERATIONSThe monetary policy operations of theEurosystem comprise on the one hand openmarket operations, such as main refinancingoperations (MROs), longer-term refinancingoperations (LTROs) and fine-tuning operations,and on the other hand standing facilities.Within the operational framework for theimplementation of monetary policy, whichis based on a system of minimum reserverequirements, these instruments are used tomanage liquidity conditions in the interbankmoney market with a view to steering veryshort-term interest rates close to the ECB’s keypolicy rate.During 2008 Governing Council decisionsaffecting the key ECB interest rates were takenon four occasions. On 3 July the GoverningCouncil decided to increase the key ECB interestrates by 25 basis points to 4.25%. On 8 October,6 November and 4 December it decided to lowerthe key ECB interest rates to 3.75%, 3.25% and2.50% respectively. In addition, on 8 Octoberthe Governing Council decided to narrow thecorridor around the MRO interest rate formedby the rates on the standing facilities, from200 to 100 basis points, as of 9 October. As aconsequence, the marginal lending facility ratewas set at 50 basis points above the MRO interestrate, and the deposit facility rate at 50 basispoints below the MRO rate. On 18 December theGoverning Council decided to restore the widthof the corridor to its pre-October levels witheffect from 21 January 2009.The implementation of monetary policy during2008 was driven by the Eurosystem’s effortsto address the tensions in the money marketsrelated to the financial turmoil. In a first waveof measures, in the period up to September, theEurosystem frontloaded the supply of liquidityat the beginning of the reserve maintenanceperiod, allowing the banks to fulfil theirminimum reserve requirements somewhatearlier in the maintenance period, and reducedit later, thus leaving the total supply of liquidityChart 40 Key ECB interest rates and theEONIA5.505.255.004.754.504.254.003.753.503.253.002.752.502.252.001.751.50deposit ratemarginal lending rateinterest rate on main refinancing operations 1)EONIAJan. Feb.Mar.Apr.MayJuneJulyAug.Sep. Oct.Nov.Dec.20085.505.255.004.754.504.254.003.753.503.253.002.752.502.252.001.751.50Source: ECB.1) Minimum bid rate until 14 October 2008; fixed rate from15 October 2008.over the entire maintenance period unchanged.At the same time, the average maturity of openmarket operations was lengthened by increasingthe share of liquidity provided via longer-termoperations.In October 2008, following a markeddeterioration in financial market conditionsafter the failure of Lehman Brothers, the ECBlaunched a second wave of measures. Thesemeasures included a move to a fixed rate tenderprocedure with full allotment for open marketoperations, the reduction of the corridor ofstanding facility rates from 200 to 100 basispoints and the expansion of the list of assetseligible to be used as collateral in Eurosystemcredit operations.All these measures aimed to ensure the continuedaccess of solvent banks to liquidity, thus helpingto improve the impaired functioning of themoney market, while at the same time alsosteering short-term interest rates (see Box 10 formore details).98 ECBAnnual Report2008

Box 10MONETARY POLICY OPERATIONS DURING THE RECENT FINANCIAL MARKET VOLATILITYThe financial market turmoil affected the conduct of monetary policy operations throughout2008. This box describes the monetary policy operations conducted by the ECB in relation tothe turmoil. It focuses on liquidity management measures, with regard to both euro operationsand operations in foreign currencies, and describes how the collateral framework supported theimplementation of monetary policy during this period.Two phases of liquidity management can be identified in 2008. The first was the period fromJanuary to September, when the ECB broadly continued with the measures it had adoptedduring the second half of 2007. The second phase began with the failure of Lehman Brothers inSeptember, which led to intensified money market tensions and triggered a new wave of liquiditymanagement measures.Liquidity management from January to September 2008The ECB’s measures to address the tensions in the money market in the period from January toSeptember 2008 can be grouped under three headings:1 Provision of liquidity earlier in the maintenance periodDuring this period the ECB increased the supply of liquidity at the beginning of themaintenance period and reduced it towards the end. This “frontloading” of liquidity enabledcounterparties to fulfil their reserve requirements somewhat earlier in the maintenance period,but did not change the average supply of liquidity over the entire maintenance period. Creditinstitutions appeared to develop a preference for the early fulfilment of reserve requirementsin an environment of high uncertainty and decreasing turnover, especially in longer-termsegments of the money market. On some occasions, the ECB conducted fine-tuning operationson days within a maintenance period with the aim of steering short-term interest rates close tothe policy rate.2 Supplementary longer-term refinancing operationsIn this period the outstanding amount of refinancing provided via longer-term operations,which had increased from roughly 30% before the start of the turmoil in July 2007 to around60% in January 2008, was kept broadly unchanged. On 7 February 2008 the GoverningCouncil decided 1 to renew the two additional three-month operations that had been introducedin 2007 with the aim of supporting the normalisation of the money market (initially for anamount of €60 billion and then for the reduced amount of €50 billion). At the same time,the average maturity of outstanding refinancing was further increased with the introductionof supplementary LTROs with maturities of three and six months. On 28 March 2008 theGoverning Council decided to introduce additional three-month operations of €50 billion aswell as six-month operations. The first such six-month operations were settled on 3 April and1 The full list of statements communicated by the ECB can be found at http://www.ecb.europa.eu/mopo/implement/omo/html/communication.en.html.ECBAnnual Report200899

10 July for amounts of €25 billion each. During 2008 these operations were all renewed whenthey matured.3 Operations in connection with the US dollar Term Auction FacilityIn order to address disruptions in the European US dollar funding markets triggered by thefinancial market turmoil, in 2007 the ECB established a reciprocal currency arrangement (swapline) with the Federal Reserve System. In connection with the US dollar Term Auction Facilityof the Federal Reserve System, and in close cooperation with other central banks, the Eurosystemprovided the US dollar funding received via this swap line to its counterparties against collateraleligible for Eurosystem credit operations.The Eurosystem provided US dollar liquidity for the first time in December 2007, in two operationswhich were renewed in January 2008. In view of the reduced demand for US dollars followingthese operations, the Eurosystem temporarily discontinued its US dollar-providing operations inFebruary. However, liquidity pressures in funding markets increased again in February and atthe beginning of March and prompted coordinated action by several central banks to address therenewed tension. As part of this coordinated action, the Governing Council decided on 11 Marchto reactivate the provision of US dollar funding to Eurosystem counterparties.US dollar funding was provided on a bi-weekly basis with a maturity of 28 days and for anamount of USD 15 billion in each auction. However, in view of persisting money market strainsin some funding markets, evidenced by the high deposit rates for terms longer than overnight(e.g. one week) in various currencies, the unusually high US dollar rates implied by foreignexchange swap rates and the strong levels of demand in the Eurosystem’s US dollar operations,the amount in each bi-weekly auction was raised to USD 25 billion on 2 May.In order to better accommodate banks’ US dollar funding needs, the existing EurosystemUS dollar funding facilities were further enhanced on 30 July. The ECB, in coordination withthe Federal Reserve System, announced the introduction of an 84-day Term Auction Facility tocomplement the existing 28-day US dollar funding. However, the total outstanding amount wasleft unchanged at USD 50 billion.Liquidity management from October to December 2008As tensions across all segments of the money market intensified in mid-September 2008, theECB adopted five additional liquidity management measures.1 Fixed rate tenders with full allotmentHeightened pressure in financial markets in the second half of September and early October2008 led to additional disruption in money markets, making it increasingly difficult for creditinstitutions to obtain funding on the money market. In response to these developments, theGoverning Council decided on 8 October that as of 15 October, and at least until the end ofthe maintenance period ending on 20 January 2009, all MROs would be conducted as fixedrate tenders with full allotment. This measure was aimed at signalling to market participantsthat the ECB was willing to supply as much liquidity as needed to avoid a liquidity crisis.100 ECBAnnual Report2008

Chart A Liquidity supply through openmarket operations and use of standingfacilities(EUR billions)950850marginal lending facilitylonger-term refinancing operationsmain refinancing operationsfine-tuning operationsdeposit facility950850The measure led to a significant increasein the total volume of outstanding eurodenominatedopen market operations, asthe liquidity supply was now determined bythe aggregate amount bid by counterparties(see Chart A). The full allotment policy wasde facto implemented on 9 October by meansof a liquidity-providing fine-tuning operationin which all bids were satisfied.75065055045035025015050-50-150-250-350Jan. Feb. Mar. Apr. MayJuneJulyAug. Sep. Oct. Nov.Dec.2008Source: ECB.Chart B Spread between the EONIA and theMRO rate75065055045035025015050-50-150-250-350(until 14 October: minimum bid rate; from 15 October: fixed rate)EONIA spread80806040200-20-40-60-80Jan. Feb.Mar.Apr.MayJune JulyAug.Sep. Oct.Nov.Dec.2008Source: ECB.6040200-20-40-60-80Moreover, on 15 October the GoverningCouncil decided to apply fixed rate tenderswith full allotment also to LTROs (andsupplementary LTROs), with effect from30 October and at least until the end of the firstquarter of 2009.This enhanced liquidity provision significantlyalleviated tensions at the short end of themoney market and led to a general declinein the EONIA, starting from the date of theannouncements (see Chart B). Between mid-October and the end of 2008, the EONIA wasconsistently below the MRO rate. Moreover,the EONIA declined within each maintenanceperiod, in line with counterparties’ gradualfulfilment of reserve requirements andincreasing overall use of the deposit facility.2 Reduction of the corridor formed by thestanding facility ratesOn 8 October the Governing Council alsodecided to reduce the width of the corridorformed by the two standing facilities(i.e. the marginal lending facility and the depositfacility) from 200 to 100 basis points. The rateon the marginal lending facility was set at50 basis points above the MRO rate, and therate on the deposit facility was set at 50 basispoints below the MRO rate. The reductionof the corridor aimed to further ease banks’liquidity management by offering cheapercentral bank intermediation to the bankingsector. This measure became effectiveon 9 October and remained in place until20 January 2009, when the width of the corridorwas widened again to 200 basis points.ECBAnnual Report2008101

3 Supplementary longer-term refinancing operationsFollowing a decision by the Governing Council on 15 October, the provision of longer-termrefinancing was enhanced by rolling over existing operations and launching new operations. Asa result, during each maintenance period four longer-term operations were conducted: one forthe length of the maintenance period (a special-term refinancing operation), two with a maturityof three months, and one with a maturity of six months. Consequently, by the end of 2008the share of MROs in the total refinancing volume had declined to about 28%, while LTROs,supplementary LTROs and the special-term refinancing operation accounted for the remaining72% (see Chart A).4 Additional US dollar and Swiss franc-providing operationsThe Eurosystem’s US dollar-providing operationsFrom mid-September 2008 strains in the US dollar money markets worsened significantly. Inparticular, the rates quoted for US dollar deposits during Asian, European and early US tradinghours were very high, at times reaching levels above 10%. Market liquidity in the foreignexchange swap market was also unusually low amid signs of increased stress and marketsegmentation, whereby access to US dollar funding became extremely difficult for institutionsoutside the United States. In response, the Eurosystem further reinforced its provision ofUS dollar liquidity to Eurosystem counterparties by adding operations with a 7-day and thereafteran overnight maturity to the existing 28-day and 84-day operations. It also further increased theamounts offered to counterparties in these US dollar-providing operations in two steps, each timealso increasing the swap line with the Federal Reserve System. In early October the maximumamounts in the Eurosystem’s US dollar liquidity-providing operations reached USD 50 billionin the overnight operations, USD 40 billion in the 28-day operations and USD 20 billion in the84-day operations.On 15 October, given the high levels of uncertainty prevailing in the banking system, the ECB,in coordination with the Federal Reserve System, committed to fulfil all bids at a fixed rate forthe 7-day, 28-day and 84-day operations, while the overnight operations were discontinued.In order to mitigate the potential problem of insufficient availability of eligible collateral, giventhe full allotment procedure in both euro and US dollar liquidity-providing operations, the ECBannounced on 15 October 2008 that the Eurosystem would also conduct US dollar liquidityprovidingoperations in the form of EUR/USD foreign exchange swaps. These foreign exchangeswap operations, conducted in parallel with the existing US dollar collateralised repurchaseoperations, were also financed through the swap agreement with the Federal Reserve System,which had been extended until 30 April 2009.The Eurosystem’s US dollar repurchase operations continued to meet with fairly high demand,with large bid amounts and a large number of bidders, whereas participation in the US dollarforeign exchange swap operations generally remained very limited in terms of both biddingvolumes and the number of participants.The Eurosystem’s Swiss franc-providing operationsThe increased tensions in international money markets observed in October 2008 also led toupward pressure on short-term Swiss franc money market rates. At the same time, the Swiss102 ECBAnnual Report2008

franc funding needs of banks with no direct access to the Swiss National Bank’s operations,notably in the euro area, increased. Therefore, on 15 October the Swiss National Bank and theECB jointly announced measures to improve liquidity in short-term Swiss franc money markets,whereby the Eurosystem would provide its counterparties with Swiss franc funding received viaa swap line with the Swiss National Bank.The provision of Swiss franc liquidity by the Eurosystem took the form of EUR/CHF foreignexchange swaps at a fixed price and with a maximum allotment amount determined by the ECBin coordination with the Swiss National Bank. These swaps were initially introduced with aseven-day maturity only, but were later complemented by swaps with a three-month maturity,which were aimed at reducing tensions in this segment of the Swiss franc money markets.The maximum amount for each of these tenders was set at €20 billon in the 7-day and€5 billion in the 84-day operations. The EUR/CHF foreign exchange swaps met with fairlymoderate demand, with bidding volumes below the maximum amount in all operations. Thebid-to-cover ratio was stable at around 0.6 in the 7-day swaps and around 0.1 in the 84-dayoperations.The ECB’s euro liquidity provision to some EU central banksIn October and November 2008 the ECB signed agreements to provide euro liquidity to a numberof EU central banks outside the euro area. The ECB’s intention in establishing these agreementswas to support various measures taken by these central banks, all of which were aimed at improvingeuro liquidity in their respective domestic financial markets.This support took the form of repurchase agreements for an amount of up to €5 billion withthe Magyar Nemzeti Bank and for up to €10 billion with Narodowy Bank Polski. The ECBand Danmarks Nationalbank established a reciprocal currency swap arrangement amounting to€12 billion.5 Expansion of the list of collateralOn 15 October the Governing Council decided to expand the list of eligible collateral on atemporary basis until the end of 2009. Availability of collateral was not a constraint throughoutmuch of 2008, owing to the breadth of the Eurosystem’s collateral framework. Nevertheless, inthe light of the extension of liquidity at various maturities in euro and in US dollars and of theintroduction of fixed rate tenders with full allotment, the collateral framework was temporarilyexpanded as follows:• As of 22 October 2008 the credit threshold for marketable and non-marketable assets waslowered from “A-” to “BBB-”, with the exception of asset-backed securities, for whichthe credit quality threshold of “A-” remains in force. In addition, since 22 October 2008the Eurosystem has also accepted debt instruments issued by credit institutions, includingcertificates of deposit, which are not listed on a regulated market, but traded on certain nonregulatedmarkets deemed acceptable by the ECB. Subordinated marketable debt instruments,which are protected by an acceptable guarantee and which fulfil all other eligibility criteria,can also be used as collateral.ECBAnnual Report2008103

• Since 14 November the Eurosystem has also accepted marketable debt instruments issued inthe euro area and denominated in US dollars, pounds sterling and Japanese yen, provided thatthe issuer is established in the EEA.In order to fulfil the Eurosystem’s statutory obligation to ensure that its balance sheet remainsprotected against financial risk, risk control measures are applied to the enlarged set of eligiblecollateral. The expansion of the eligibility criteria is thus combined with vigilant monitoring ofthe use of the framework.LIQUIDITY NEEDS OF THE BANKING SYSTEMWhen supplying liquidity through openmarket operations, the Eurosystem takes intoaccount a daily assessment of the liquidityneeds of the aggregate euro area bankingsystem. These liquidity needs are determinedby the sum of minimum reserve requirements,funds held in excess of these requirements oncredit institutions’ current accounts with theEurosystem (excess reserves) and autonomousfactors. Autonomous factors are those itemson the Eurosystem’s balance sheet, such asbanknotes in circulation and governmentdeposits, which have an impact on creditinstitutions’ current account holdings but arenot under the direct control of the Eurosystem’sliquidity management.In 2008 the average daily liquidity needs ofthe euro area banking system amounted to€487.1 billion, 10.3% higher than in 2007(see Chart 41). One reason for the increase wasthe continued growth in reserve requirements,by 12.5%, to €210.8 billion. Another importantreason was an exceptional increase in thedemand for banknotes which was unrelatedto seasonal factors. Chart 42 shows thatthe amount of banknotes in circulation rosesignificantly, by more than 6% betweenSeptember and early November 2008, whichcontributed to the total increase in liquidityneeds. Overall, in 2008 autonomous factorsincreased by 8.9% to €274.5 billion. Althoughaverage excess reserves for the maintenanceperiods ending in 2008 increased comparedwith 2007, by €0.2 billion to €1.1 billion, theyremained negligible in relative terms at 0.5% ofreserve requirements.Chart 41 Liquidity factors in the euro areain 2008(EUR billions)1,0008006004002000-200-400-600autonomous factorsopen market operations (outstanding volume)minimum reserve requirementscurrent accountsJan. Mar. May July Sep. Nov.2008Source: ECB.Chart 42 Banknotes in circulation(EUR billions)8007507006506005505004502008200720062005400Jan. Mar. May July Sep. Nov.Source: ECB.1,0008006004002000-200-400-600800750700650600550500450400104 ECBAnnual Report2008

MINIMUM RESERVE SYSTEMCredit institutions in the euro area are requiredto hold minimum reserves on current accountswith the Eurosystem. As has been the case since1999, the minimum reserve requirements wereequal to 2% of credit institutions’ reserve base in2008 and amounted to €210.8 billion on average.It is the growth in the reserve base, which isdetermined by certain short-term liabilitieson credit institutions’ balance sheets, whichexplains the above-mentioned 12.5% increasein the total amount of reserve requirementsduring 2008. Since for any maintenance periodthe Eurosystem remunerates reserve holdingsat a rate which is the average of the marginalrates of the MROs (if conducted as variable ratetenders) or at the fixed MRO rate (in the caseof fixed rate tenders), the minimum reservesystem does not impose significant costs onthe banking sector. At the same time, it fulfilstwo important functions in the operationalframework for monetary policy implementation.First, it stabilises short-term money market rates,because the reserve requirements have to befulfilled only on average over the maintenanceperiod, allowing credit institutions to smoothout temporary and unexpected liquidity inflowsand outflows. Second, it enlarges the liquiditydeficit of the banking system, i.e. banks’ overallneed for refinancing from the Eurosystem.OPEN MARKET OPERATIONSThe Eurosystem uses MROs, LTROs andfine-tuning operations to manage the liquiditysituation in the money market. All liquidityprovidingoperations have to be fullycollateralised. MROs are regular operationswith a weekly frequency and normally havea maturity of one week. They are the maininstrument for signalling the ECB’s monetarypolicy stance.Until 8 October 2008 MROs were conducted asvariable rate tenders with a minimum bid rate, andfrom 15 October as fixed rate tenders in whichall bids were satisfied. The number of eligiblecounterparties increased during 2008 from 1,693to 2,099. Most of this increase took place duringthe months of October and November, whensome banks decided to apply for eligibility owingto borrowing constraints in the money market.On average, 443 counterparties participated inMROs in 2008, 31% more than in 2007 (when338 counterparties participated on average).This increase was also related to the intensifiedpressure in the money market, which meant thatmany counterparties had to fulfil their liquidityneeds by borrowing from the ECB instead ofthe market. The number of bidders in the MROsincreased further when the ECB switched to fixedrate tenders with full allotment in October, froman average of 354 in the variable rate tenders to747 in the fixed rate tenders.Up until 8 October the Eurosystem allotted€175 billion on average in the variable ratetender MROs. The allotted amount variedconsiderably during this period owing tothe frontloading policy, which resulted in adeclining pattern of allotment amounts in thecourse of each maintenance period, and to theincreased liquidity provision through LTROs.When fixed rate tenders with full allotmentwere introduced for MROs on 15 October 2008,allotment amounts increased significantly, to€291 billion on average. By the end of 2008 theliquidity provided in MROs represented 28% ofthe total refinancing volume, considerably lessthan in previous years, when it amounted toaround 65-75%.LTROs are monthly liquidity-providingoperations with a three-month maturity. Inaddition to these operations, a number offurther supplementary LTROs were introducedgradually during 2008. By the end of the year,two supplementary LTROs were conductedduring each maintenance period, one with athree-month and one with a six-month maturity,as well as one special-term refinancing operationwith a maturity equal to the length of themaintenance period. Until mid-October LTROsand supplementary LTROs were conductedas pure variable rate tenders (i.e. without aminimum bid rate). The allotment amount inthe LTROs and three-month supplementaryLTROs during this period was €50 billion(with the exception of two supplementaryECBAnnual Report2008105

LTROs settling on 21 February and 13 March,in each of which €60 billion was allotted).Two of the six-month supplementary LTROswere conducted for an amount of €25 billion(on 2 April and 9 July), and one was conductedfor an amount of €50 billion (on 8 October).As of 30 October 2008 longer-term operationswere also conducted as fixed rate tenders withfull allotment. The rate applied in all theseoperations was the MRO rate. The changeto fixed rate tenders led to a general increasein allotment amounts also for longer-termoperations. However, given strong expectationsof a cut in key ECB interest rates, especiallytowards the end of 2008, the fixed rate appliedin these tenders led to only a moderate increasein allotment amounts for supplementary LTROswith a maturity of three or six months. At theend of 2008 the outstanding amount of alllonger-term operations (LTROs, supplementaryLTROs and special-term refinancing operations)stood at €617 billion, which represented thelargest share of ECB refinancing to the bankingsector ever, at roughly 72% of all open marketoperations.LTROs are open to the same set of counterpartiesas MROs, 157 of which participated on averageduring 2008, compared with 145 in 2007.The introduction of fixed rate tenders led toa decrease in the average number of biddersin the LTROs from 161 (in variable ratetenders) to 146 (in fixed rate tenders). In thespecial-term refinancing operations, which arealso open to the same set of counterparties,210 counterparties participated in the variablerate tender settled on 30 September, while anaverage of 97 counterparties participated in thefollowing two fixed rate tenders.The ECB may conduct liquidity-providing andliquidity-absorbing fine-tuning operations onan ad hoc basis to manage liquidity conditionsin the market and to steer interest rates. Until5 October 2008 the Eurosystem selected alimited number of counterparties most active inthe money market for these operations (136 on30 September 2008). Following a decision bythe Governing Council, from 6 October 2008access to fine-tuning operations was widenedby granting eligibility to all counterparties thatare eligible to participate in Eurosystem openmarket operations based on standard tenders,and that additionally fulfil certain selectioncriteria specified by the respective NCBs.In 2008 the ECB conducted 25 fine-tuningoperations. The practice of conducting end-ofperiodfine-tuning operations was maintainedthroughout the year, with 12 of these operationstaking place on the last day of the maintenanceperiods. The remaining 13 were conducted inresponse to prevailing liquidity conditions andshort-term money market interest rates. On2 and 3 January, when tensions related to theyear-end eased, liquidity-absorbing fine-tuningoperations were conducted in an environmentof excess liquidity supply. On 20 and 31 Marchliquidity was provided in fine-tuning operationsas a result of money market tensions related tothe Easter holiday period and the bankruptcyof Bear Stearns. To address the heightenedpressure in money markets in September, theECB conducted nine fine-tuning operationsbetween 15 September and 9 October, five ofwhich were liquidity-providing and four ofwhich were liquidity-absorbing.STANDING FACILITIESCounterparties may use the two standingfacilities on their own initiative to obtainovernight liquidity against eligible collateral orto place overnight deposits with the Eurosystem.At the end of 2008, 2,267 counterparties hadaccess to the marginal lending facility and2,802 counterparties had access to the depositfacility. The rates for these facilities in principleprovide a ceiling and a floor for the overnightrate and therefore perform an important functionfor monetary policy implementation.In October 2008, following a decision by theGoverning Council, the width of the corridorformed by these two rates was reduced from200 to 100 basis points symmetrically aroundthe MRO rate as a measure to alleviate tensionsin the money market. This measure, together106 ECBAnnual Report2008

with the ample allotments in the fixed rate openmarket operations, led to a significant increasein the use of the deposit facility (see Chart A inBox 10). Until 8 October the average daily useof the deposit facility was €2.5 billion (comparedwith €0.5 billion in 2007). In the period from9 October until the end of the year, this figureincreased dramatically to €208.5 billion. Duringthis period, recourse to the deposit facilityfollowed a broadly similar pattern during eachreserve maintenance period: the amounts wererelatively low at the beginning of each period, butincreased subsequently as more counterpartiesfulfilled their reserve requirements.The daily average recourse to the marginallending facility was €0.9 billion until 8 October2008 (compared with €0.2 billion in 2007), andincreased to €6.7 billion thereafter. This risereflects the lower interest rate on this facility,in relative terms, as a result of the reducedcorridor, but to some extent may also be linkedto heightened uncertainty about individual bankliquidity needs.ELIGIBLE ASSETS FOR MONETARY POLICYOPERATIONSIn line with central bank practice worldwide,all credit operations of the Eurosystem arebased on adequate collateral. The concept ofadequacy implies, first, that the Eurosystemis to a large extent protected from incurringlosses in its credit operations and, second, thatsufficient collateral should be available to a wideset of counterparties, so that the Eurosystemcan provide the amount of liquidity it deemsnecessary through its monetary policy andpayment systems operations. To facilitate this,the Eurosystem accepts a broad range of assets ascollateral in all its credit operations. This featureof the Eurosystem’s collateral framework,together with the fact that access to Eurosystemopen market operations is granted to a large poolof counterparties, has been key to supporting theimplementation of monetary policy in times ofstress. The inbuilt flexibility of its operationalframework allowed the Eurosystem to providethe necessary liquidity to address the impairedfunctioning of the money market withoutencountering widespread collateral constraintsthroughout much of 2008. It was only towards theend of the year that, in the light of the extensionof refinancing for terms longer than overnight ineuro and in US dollars as well as the recourseto fixed rate full allotment tender procedures, theGoverning Council decided to expand the list ofeligible collateral on a temporary basis until theend of 2009 (see Box 10).In 2008 the average amount of eligiblecollateral increased by 17.2%, compared with2007, to a total of €11.1 trillion (see Chart 43).General government debt, at €4.9 trillion,accounted for 44% of the total, while theremainder of marketable collateral was in theform of uncovered bank bonds (€2.2 trillion,or 20%), covered bank bonds (€1.2 trillion, or11%), asset-backed securities (€1.1 trillion,or 9%), corporate bonds (€0.9 trillion, or8%), and other bonds, such as those issued bysupranational organisations, (€0.6 trillion, or5%). The overall volume of marketable assetseligible as a result of the temporary measures toChart 43 Eligible collateral by asset type(EUR billions; annual averages)12,00010,0008,0006,0004,0002,0000Source: ECB.non-marketable assetsother marketable assetsasset-backed securitiescorporate bondscovered bank bondsuncovered bank bondsregional government securitiescentral government securities2004 2005 2006 2007 200812,00010,0008,0006,0004,0002,0000ECBAnnual Report2008107

expand the list of eligible collateral amountedto around €870 billion at the end of 2008.The list of eligible collateral also includesnon-marketable assets, mostly credit claims(also referred to as bank loans). In contrastto marketable assets, non-marketable assetsare assessed for eligibility only at the time oftheir acceptance. For this reason, the volumeof potentially eligible non-marketable assetscannot easily be measured. The amount of nonmarketableassets put forward by counterpartiesas collateral in Eurosystem credit operationsreached €0.2 trillion in 2008, representing 2% oftotal eligible collateral in the Eurosystem. Thelower credit threshold temporarily introduced toexpand the list of eligible collateral (see Box 10)was also applied to non-marketable assets.The average value of marketable and nonmarketableassets put forward by counterpartiesas collateral in Eurosystem credit operationsrose significantly, from €1,148 billion in2007 (revised upwards from €1,101 billion)to €1,579 billion in 2008. This increase wasmainly due to the fact that counterparties putforward large additional amounts of collateralwith the Eurosystem in response to thefinancial market turbulence (see Chart 44). Asthe comparison of collateral with outstandingcredit to the Eurosystem’s counterpartiesindicates, the share of deposited collateralthat is not used to cover credit from monetarypolicy operations increased marginally on anaggregate basis. This suggests that sufficiencyof collateral has not been a systemic constrainton the Eurosystem’s counterparties despite theincreasing volume of liquidity received in therefinancing operations.As regards the composition of collateral putforward, the average share of asset-backedsecurities increased from 16% in 2007 to 28%in 2008, overtaking uncovered bank bondsas the largest class of assets put forward ascollateral with the Eurosystem. Uncoveredbank bonds accounted on average for slightlyless than 28% of the collateral put forward in2008. The average share of non-marketableassets increased from 10% in 2007 to 12% inChart 44 Collateral put forward in Eurosystemcredit operations versus outstanding credit inmonetary policy operations(EUR billions)1,8001,6001,4001,2001,0008006004002000total collateral put forwardof which: outstanding creditpeak outstanding credit2004 2005 2006 2007 20081,8001,6001,4001,2001,000800600400200Source: ECB.Note: “Collateral put forward” refers to assets deposited ascollateral in countries operating a pooling system and assets usedas collateral in countries operating an earmarking system.Chart 45 Breakdown of assets (includingcredit claims) put forward as collateral byasset type(percentages; annual averages)10090807060504030201002004Source: ECB.non-marketable assetsother marketable assetsasset-backed securitiescorporate bondscovered bank bondsuncovered bank bondsregional government securitiescentral government securities200520062007200801009080706050403020100108 ECBAnnual Report2008

2008. By contrast, the average share of centralgovernment bonds dropped from 15% in 2007 to10% in 2008. The new asset classes which weretemporarily eligible accounted for around 3% ofthe total marketable collateral put forward.RISK MANAGEMENT ISSUESThe Eurosystem mitigates the risk of acounterparty default in a Eurosystem creditoperation by requiring counterparties to submitadequate collateral. However, the Eurosystem isstill exposed to a number of financial risks if acounterparty defaults, including credit, marketand liquidity risk. In addition, the Eurosystem isexposed to currency risk in the context ofliquidity-providing operations in foreigncurrencies against euro-denominated collateral,such as those conducted in 2008. In order toreduce these risks to acceptable levels, theEurosystem maintains high credit standards forassets accepted as collateral, valuates collateralon a daily basis and applies appropriate riskcontrol measures. As a matter of prudence, theEurosystem has established a buffer againstpotential shortfalls resulting from the eventualresolution of collateral received from fivespecific counterparties that defaulted in 2008,the level of which will be reviewed annually,pending the eventual disposal of the collateraland in line with the prospect of recovery. 1 Moregenerally, financial risks in credit operations arequantified and regularly reported to the ECB’sdecision-making bodies.Every two years a review of the risk controlmeasures for Eurosystem credit operationsis conducted. These risk control measuresare applied to the assets put forward by theEurosystem’s counterparties as collateral for thecredit the Eurosystem provides through its openmarket operations and the marginal lendingfacility, as well as in the form of intradaycredit for payment systems purposes. Whilefully preserving the principle of accepting awide range of collateral, the biennial reviewin 2008 led to some technical refinements ofthe risk control framework for Eurosystemcredit operations. These refinements reflect,among other things, improvements in themethodological framework, the assessmentof market and liquidity risk characteristics ofeligible assets, the actual use of eligible assetsby counterparties and new developments infinancial instruments. They were announcedon 4 September 2008 and entered into force on1 February 2009.In the context of these refinements, valuationhaircuts for asset-backed securities anduncovered bank bonds have been revised. Inaddition, the prohibition to submit collateral thatis issued or guaranteed by entities closely linkedto the submitting counterparty has been extendedto include special forms of close links that mayarise when asset-backed securities are used ascollateral. As of 1 February 2009, enhancedtransparency is required for credit assessmentsof asset-backed securities issued by an eligibleexternal credit assessment institution.Finally, the Eurosystem has the possibilityto limit or exclude the use of certain assets ascollateral for its credit operations if required,also at the level of individual counterparties,to ensure adequate risk protection of theEurosystem in line with Article 18.1 of theStatute of the ESCB.1.2 FOREIGN EXCHANGE OPERATIONSIn 2008 the Eurosystem did not undertake anyinterventions in the foreign exchange marketfor policy reasons. The ECB’s foreign exchangetransactions were exclusively related toinvestment activity. Furthermore, the ECB didnot undertake any foreign exchange operationsin the currencies that participate in ERM II.The standing agreement between the ECB andthe IMF to facilitate the initiation of specialdrawing right (SDR) transactions by the IMF onbehalf of the ECB with other SDR holders wasactivated on 17 occasions in 2008.In the context of the continuing financialmarket volatility in 2008, the Eurosystem also1For further details, see the press release of 5 March 2009.ECBAnnual Report2008109

conducted 73 operations in connection with theUS dollar Term Auction Facility of the FederalReserve System (57 reverse transactions againsteligible collateral and 16 through EUR/USDforeign exchange swaps), providing US dollarliquidity to the Eurosystem’s counterparties,and 15 Swiss franc-providing operations incooperation with the Swiss National Bank(for more details, see Box 10).1.3 INVESTMENT ACTIVITIESThe ECB’s investment activities are organisedin such a way as to ensure that no insiderinformation about central bank policy actionsmay be used when making investmentdecisions. A set of rules and procedures, knownas the Chinese wall, separates the business unitsinvolved in operational investment activitiesfrom other business units.FOREIGN RESERVE MANAGEMENTThe ECB’s foreign reserve portfolio wasoriginally set up through transfers of foreignreserve assets from the euro area NCBs. Overtime, the composition of the portfolio reflectschanges in the market value of the invested assets,as well as foreign exchange and gold operationsof the ECB. The main purpose of the ECB’sforeign reserves is to ensure that, wheneverneeded, the Eurosystem has a sufficient amountof liquid resources for its foreign exchangepolicy operations involving non-EU currencies.The objectives for the management of the ECB’sforeign reserves are, in order of importance,liquidity, security and return.The ECB’s foreign reserve portfolio consists ofUS dollars, Japanese yen, gold and SDRs. TheUS dollar and Japanese yen reserves are activelymanaged by the ECB and the euro area NCBs,as agents for the ECB. Since January 2006 a“currency specialisation model” has been inoperation to increase the efficiency of theEurosystem’s investment operations. Under thisscheme, each NCB is as a rule allocated a sharein either the US dollar or the Japanese yenportfolio, with two NCBs currently managingtwo. 2 During 2008 two arrangements were putin place which enable certain NCBs to pooloperational activities for the management oftheir shares of the ECB’s foreign reserves: theCentral Bank of Cyprus has pooled with theBank of Greece and the Central Bank of Maltahas pooled with the Central Bank and FinancialServices Authority of Ireland since January2008. As of January 2009 Národná bankaSlovenska manages a US dollar portfolio as anagent for the ECB.During 2008 the ECB sold 30 tonnes of goldin total. These sales were in full conformitywith the Central Bank Gold Agreement of27 September 2004, to which the ECB is asignatory. The proceeds of the gold sales wereadded to the US dollar portfolio.The value of the ECB’s net foreign reserveassets 3 at current exchange rates and marketprices increased from €42.8 billion at end-2007 to€49.5 billion at end-2008, of which €38.5 billionwas in foreign currencies – the Japanese yenand the US dollar – and €11 billion was in goldand SDRs. Applying the exchange rates of end-2008, US dollar-denominated assets represented77.5% of the foreign currency reserves, whilethose denominated in Japanese yen accountedfor 22.5%. The increase in value of the foreigncurrency portfolio, of 19.9%, mainly reflectedcapital gains and interest income generated byportfolio management activities, particularlywith regard to US dollar-denominated assets.The appreciation of the Japanese yen (by30.8%) and the US dollar (by 5.8%) versus theeuro also contributed to the increase in valueof the currency portfolio. Finally, the ECB’sforeign currency reserves also rose as a result ofthe investment of the proceeds of the gold salesmentioned above. The value of both the gold2 For more details, see the article entitled “Portfolio managementat the ECB” in the April 2006 issue of the ECB’s MonthlyBulletin.3 Net foreign reserve assets are calculated as official reserve assetsexcluding the net, marked-to-market value of foreign currencyswaps, plus deposits in foreign currency with residents, minusfuture predetermined net drains on foreign currency holdingsowing to repurchase and forward transactions. For detailedinformation on the data sources, see http://www.ecb.europa.eu/stats/external/reserves/templates/html/index.en.html110 ECBAnnual Report2008

and SDR holdings increased by around 2.6%in 2008, despite the sale of 30 tonnes of goldduring the year. This increase was mostly dueto the appreciation of gold by around 9.4% in2008, as measured in euro terms. No losses inthe ECB’s foreign reserves were experienced asa result of defaulting investment counterparties.In 2008 the list of eligible instruments in whichthe ECB’s foreign reserves can be invested waskept unchanged. Interest rate swaps, which wereintroduced in late 2007, were used regularlyin 2008. The preparatory work to establish anautomatic securities lending programme forthe ECB’s US dollar-denominated assets wascompleted in 2008. It is envisaged that theprogramme will start in 2009, although this willdepend on prevailing market conditions.OWN FUNDS MANAGEMENTThe ECB’s own funds portfolio consists ofthe invested counterpart of the ECB’s paid-upcapital, as well as amounts held from time totime in its general reserve fund and its provisionagainst foreign exchange rate, interest rate andgold price risks. The purpose of this portfolio isto provide the ECB with income to help to coverits operating expenses. The objective of itsmanagement is to maximise expected returns,subject to a no-loss constraint at a certainconfidence level. The portfolio is invested ineuro-denominated fixed income assets.The value of the portfolio at current market pricesgrew from €9.3 billion at end-2007 to €10.2 billionat end-2008. The increase in market value wasdue to the investment in the own funds portfolioof the provision against foreign exchange rate,interest rate and gold price risks established by theECB in 2005, as well as to investment returns andthe contributions by the Central Bank of Cyprusand the Central Bank of Malta to the capital andreserves of the ECB following the adoption of theeuro by Cyprus and Malta.The list of eligible issuers of covered bonds andsenior uncovered bonds was extended slightlyin 2008. No losses were experienced as a resultof defaulting investment counterparties.RISK MANAGEMENT ISSUESThe financial risks to which the ECB isexposed in its investment activities are closelymonitored and measured in order to keepthem within the levels specified by the ECB’sdecision-making bodies. For this purpose, adetailed limit structure is in place and limits aremonitored daily. Regular reporting ensures thatall stakeholders are adequately informed of thelevel of such risks.In 2008 the ECB further enhanced the riskmanagement framework for its investmentoperations by upgrading IT systems and finetuningits credit risk methodology. The overallframework proved resilient in the wake of thefinancial crisis and no losses occurred as a resultof a counterparty or issuer default. Moreover,as part of its efforts to support the developmentof state-of-the-art strategic asset allocationmethodologies in central banks, the ECB, incooperation with the World Bank and the BIS,organised the first conference on strategic assetallocation for central banks and sovereign wealthmanagers in Frankfurt on 24 and 25 November2008.One of the indicators used to monitor marketrisk is Value-at-Risk (VaR), which definesthe loss for a portfolio of assets that will notbe exceeded at the end of a specified period oftime with a given probability. The value of thisindicator depends on a series of parameters usedfor the calculation, in particular the confidencelevel, the length of the time horizon and thesample used to estimate asset price volatility.As an illustration, computing this indicator forthe ECB’s investment portfolio on 31 December2008, using as parameters a 95% confidencelevel, a time horizon of one year and a sampleof one year for asset price volatility, would resultin a VaR of €9,185 million. Computing the sameindicator with a five-year instead of a one-yearsample would result in a VaR of €5,823 million.Most of this market risk is due to currency andgold price risk. The low levels of interest rate riskreflect the fact that the modified duration of theECB’s investment portfolios remained relativelylow in 2008.ECBAnnual Report2008111

2 PAYMENT AND SECURITIES SETTLEMENT SYSTEMSThe Eurosystem has the statutory task ofpromoting the smooth operation of paymentsystems. Its main instrument for carrying outthis task – aside from the oversight function(see Section 4 of Chapter 4) – is the provisionof payment and securities settlement facilities.To this end, the Eurosystem created theTrans-European Automated Real-time Grosssettlement Express Transfer system, knownas TARGET, for large-value and urgentpayments in euro. The technically decentralisedfirst-generation system was progressivelyreplaced by a second-generation system(TARGET2), which is based on a single technicalinfrastructure, the Single Shared Platform(SSP). Three Eurosystem central banks – theBanca d’Italia, the Banque de France and theDeutsche Bundesbank – jointly provide the SSPand operate it on behalf of the Eurosystem. Themigration to TARGET2 started in November2007 and was completed in May 2008.With regard to collateral mobilisation,the Eurosystem and the market offer anumber of channels to facilitate the use ofcollateral across national borders. In 2008 theEurosystem, together with market participants,continued to work on the development ofTARGET2-Securities (T2S), with the objectiveof providing securities settlement services incentral bank money through a single Europeantechnical platform with harmonised processesand procedures. The project was approved bythe Governing Council in July 2008, and thetechnical details of the project are now in theprocess of being defined. T2S will harmonisedomestic and cross-border settlements ofsecurities transactions in central bank moneywithin the euro area.2.1 THE TARGET SYSTEMTARGET plays an important role in theexecution of the single monetary policy andthe functioning of the euro money market.TARGET offers a real-time settlement servicein central bank money and broad marketcoverage. It processes large-value and urgenttransactions and has also attracted a varietyof other payments. TARGET is available forpayments in euro between participating banks,without any upper or lower value limit. Suchtransfers are made both between banks in thesame Member State (intra-Member State traffic)and between those in different Member States(inter-Member State traffic).THE MIGRATION TO TARGET2The TARGET system began operations on4 January 1999, following the introduction of theeuro. It was originally made up of 15 nationalreal-time gross settlement (RTGS) systems andthe ECB payment mechanism (EPM). Despite itssuccess, TARGET had a number of shortcomingsthat stemmed from its heterogeneous technicaldesign and decentralised structure. To addressthese issues and to cater for developments suchas the further enlargement of the euro area, theEurosystem launched the TARGET2 project inOctober 2002.The Eurosystem’s aim in developing TARGET2was to create a streamlined version of theoriginal TARGET system which would bettermeet user needs, providing a harmonised servicelevel with a harmonised pricing scheme andensuring cost-efficiency. TARGET2 was alsodesigned to be able to respond flexibly and in atimely manner to future developments, such aseuro area and EU enlargement.The TARGET2 system started operations on19 November 2007, when the first group ofcountries (Germany, Cyprus, Latvia, Lithuania,Luxembourg, Malta, Austria and Slovenia)migrated to the SSP. This first step was verysuccessful and confirmed the reliability of theTARGET2 platform, which, following thisinitial migration, was already settling around50% of the overall TARGET traffic in terms ofvolume and 30% in terms of value.On 18 February 2008 the second migrationgroup (Belgium, Ireland, Spain, France, theNetherlands, Portugal and Finland) successfullyjoined the SSP, followed on 19 May by the finalgroup (Denmark, Estonia, Greece, Italy, Poland112 ECBAnnual Report2008

and the ECB). As a result of careful monitoringby the central banks, all related testing activitieswere completed successfully and on time for alluser communities. Between November 2007 andMay 2008, procedures were in place to ensurethat those user communities which had a latermigration date (and were therefore still operatingin the first-generation TARGET system) couldinteract effectively with the user communitiesalready connected to the SSP of TARGET2. Thesix-month migration process was very smoothand did not cause any operational disruptions.TARGET OPERATIONSThe TARGET system functioned smoothlyin 2008 and continued to settle an increasingnumber of euro payments. The system’s marketshare was stable, with 90% of the total value ofpayments in euro large-value payment systemsbeing executed via TARGET. The averagenumber of payments processed by the TARGETsystem each day increased by 1%, to 369,966,while the average value rose by 10%, to €2,667.On 22 December 2008 TARGET reacheda peak of 576,324 transactions, which is anall-time high for the system. Table 11 providesan overview of the payment traffic in theTARGET system in 2008, comparing it with thetraffic in the previous year.The overall availability of TARGET, i.e. theextent to which participants were able to use theTARGET system during their business hourswithout incident, reached 99.79% in 2008. It isnoteworthy that this is the highest figure sincethe start of TARGET operations in 1999 andthat the migration to TARGET2 did not haveany negative effects on the system’s availability.More than 99.76% of the payments on the SSP ofTARGET2 were processed within five minutes.The feedback from TARGET2 users on thesystem’s performance has been very positive.By December 2008 900 direct participantsmaintained an RTGS account on the SSP ofTARGET2. This figure is lower than the 1,072direct participants which had accounts in the firstgenerationTARGET system at the start of themigration. There are two main reasons for this.Table 11 Payment traffic in TARGET 1Volume (numberof transactions) 2007 2008Change(%)OverallTotal 93,375,701 94,711,380Daily average 366,179 369,966 1.03Intra-Member State 2Total 72,574,446 69,212,880Daily average 284,606 270,363 -5.00Inter-Member StateTotal 20,801,255 25,498,500Daily average 81,574 99,604 22.10Value(EUR billions) 2007 2008Change(%)OverallTotal 616,731 682,780Daily average 2,419 2,667 10.28Intra-Member State 2Total 395,412 466,572Daily average 1,551 1,823 17.54Inter-Member StateTotal 221,319 216,208Daily average 868 845 -2.69Source: ECB.1) There were 255 operating days in 2007 and 256 operatingdays in 2008.2) Includes the traffic of remote participants.First, a number of credit institutions reconsideredtheir direct participation at the time of theirmigration and opted instead to connect indirectlyvia a direct participant. Second, TARGET2created strong incentives for banks to rationalisetheir euro liquidity management and to centraliseit in fewer RTGS accounts. The overall numberof banks (including branches and subsidiaries)that can be addressed worldwide throughTARGET has remained stable at some 52,000.RELATIONS WITH TARGET2 USERSDuring its development, TARGET2 benefitedgreatly from the active cooperation between theEurosystem and the future users of the system.This considerably improved the understandingof market requirements and was instrumental inensuring a smooth migration process and highlevels of acceptance of the system by the users.This cooperation continued beyond themigration phase. The Eurosystem maintainsclose relations with TARGET2 users andregular meetings were held between the euroECBAnnual Report2008113

area NCBs and national TARGET2 usergroups in 2008. In addition, joint meetings ofthe Eurosystem Working Group on TARGET2and the TARGET Working Group of theEuropean banking industry took place regularly,at which TARGET2 operational issues werediscussed. Strategic issues were addressed inthe Contact Group on Euro Payments Strategy,a forum composed of senior representatives ofcommercial and central banks.THE CONNECTION TO TARGET OF NON-EURO AREACOUNTRIESAll euro area countries participate in TARGET,as its use is mandatory for the settlement of anyeuro operations with the Eurosystem. TARGETis also available, on a voluntary basis, to noneuroarea Member States to facilitate thesettlement of euro-denominated transactions inthese countries. 4 When Cyprus and Maltaadopted the euro on 1 January 2008, the CentralBank of Cyprus, the Central Bank of Malta andtheir respective national user communities werealready using the TARGET system. In thecontext of Slovakia’s entry into the euro area on1 January 2009, Národná banka Slovenska alsojoined the system.FORTHCOMING DEVELOPMENTSIt is foreseen that a new release of the SSP willbe made available each year, offering a range ofenhancements and new features to TARGET2users. The content of these annual releases willbe defined following a broad consultation of theuser community. The first annual release of theSSP went live on 17 November 2008. Its contentwas mainly driven by the new SWIFT standardrelease, which went live on the same day. As anexception, two releases are scheduled for 2009.The first one, in May, will enhance the interfacewith ancillary systems, in particular allowingsettlement across central securities depositories(CSDs). The second release, in November,will incorporate various other enhancementsrequested by users.2.2 TARGET2-SECURITIESThe European securities settlement marketis still highly fragmented, although somepositive developments in the form of increasedconsolidation and cooperation have beenobserved. The existence of a large number ofsettlement systems, among other things, meansthat settlement costs are much higher for EUcross-border transactions than they are fordomestic transactions or for transactions in theUnited States. At the same time, demand foran integrated European securities settlementinfrastructure is increasing.T2S was proposed by the Eurosystem in 2006as a solution to the existing fragmentationof the settlement infrastructure. It will be amulti-currency settlement platform, owned andoperated by the Eurosystem, which will enableEuropean CSDs to settle securities transactionsin central bank money. The participatingCSDs will maintain legal relations withtheir customers and will continue to performcustody and notary functions. T2S will providea single technical platform where all EUsecurities can be exchanged for euro and otherparticipating currencies through standardisedprocesses and means of communication.Furthermore, T2S will significantly reduceparticipants’ liquidity needs and financialrisk exposure by providing facilities such asauto-collateralisation (i.e. automated generationof an intraday credit in central bank moneyagainst collateral when the buyer has insufficientfunds to settle securities transactions),continuous optimisation, recycling mechanismsand a night-time settlement window. Moreover,being able to settle all EU securities transactionsin central bank money on one single platformwill eliminate the financial risk exposurethat participants may currently encounter in4 Throughout 2008 the non-euro area countries connected toTARGET were Denmark, Estonia, Latvia, Lithuania and Poland.114 ECBAnnual Report2008

cross-CSD settlement. T2S will thus increasethe efficiency of collateral management, enableusers to optimise their financing across all EUassets and contribute to the stability of thefinancial system.In December 2007 the T2S Advisory Group 5completed the first draft version of the T2S userrequirements, which describe the features thatCSDs and financial market participants requirefrom T2S. The ECB coordinated the process andtook a major role in the drafting. On18 December 2007 the Eurosystem publishedthese draft user requirements, together with themethodology for an economic impact analysis,for public consultation.The Advisory Group finalised the userrequirements on the basis of the commentsreceived in the public consultation. On23 May 2008 the Governing Council invitedall European CSDs to join the T2S initiative,providing them with detailed information aboutthe work undertaken thus far.All euro area CSDs expressed their willingness,subject to certain conditions, to use the T2Splatform once it starts operations. In addition,the Danish CSD and Danmarks Nationalbankindicated that they wanted to use T2S for thesettlement of securities transactions denominatedin both Danish krone and euro. In addition, theCSDs of Sweden, Switzerland and the UnitedKingdom indicated their intention to participatefor euro settlement. In view of this widespreadsupport from European CSDs, the GoverningCouncil on 17 July 2008 officially launched theT2S project, with the T2S platform expected tobe in place by 2013 at the latest. The GoverningCouncil also approved the final version of theuser requirements and assigned the technicaldevelopment and operation of T2S to theDeutsche Bundesbank, the Banco de España,the Banque de France and the Banca d’Italia.As foreseen in the governance framework forthe specification phase, a new Advisory Groupwas subsequently established, consisting ofan equal number of central bank, CSD anduser representatives. It met for the first time inOctober 2008, when it created six sub-groupsto organise the T2S workstreams. Two of thesesub-groups focus on harmonisation efforts,one on “process efficiency” and another on“corporate actions”. Coordination with existingharmonisation initiatives, in particular thework undertaken by the European Commission(e.g. within the Clearing and SettlementAdvisory Monitoring Expert Group II and theLegal Certainty Group) is also ensured.Furthermore, in 2008 a change managementprocess for the T2S user requirements wasestablished, and the process of defining the T2Sgeneral functional specifications on the basis ofthe user requirements began. The ECB providedadvice to the non-euro area central banks to helpthem to decide, together with local CSDs andmarket participants, whether or not to includetheir currencies in T2S. By the end of 2008the Lithuanian CSD and Lietuvos bankas hadconfirmed that they intended to settle securitiestransactions in litas as well as euro via T2S.Furthermore, the CSDs of Bulgaria, Estoniaand Romania indicated that they intended to useT2S for the settlement of their euro transactions.The legal and contractual arrangements betweenthe participating CSDs and the Eurosystem arebeing prepared.2.3 SETTLEMENT PROCEDURES FOR COLLATERALEligible assets may be used to collateralise alltypes of Eurosystem credit operation, not onlyat the domestic level but also across nationalborders. Since the introduction of the euro,the use of cross-border collateral has growncontinuously. In December 2008 the amount ofcross-border collateral held by the Eurosystemincreased to €861 billion, from €683 billion inthe same month of the previous year. Overall,at the end of 2008 cross-border collateralrepresented 45.0% of the total collateralprovided to the Eurosystem.5 The T2S Advisory Group is composed of NCB and CSDrepresentatives as well as market participants.ECBAnnual Report2008115

Two main channels are available for thecross-border mobilisation of collateral. Theseare the correspondent central banking model(CCBM) provided by the Eurosystem andeligible links between euro area securitiessettlement systems (SSSs).EUROSYSTEM COLLATERAL MANAGEMENTSERVICESThe CCBM has remained the main channelfor transferring cross-border collateral inEurosystem monetary policy and intraday creditoperations. It accounted for 36.7% of the totalcollateral provided to the Eurosystem in 2008.Assets held in custody through the CCBMincreased from €558 billion at the end of 2007to €713 billion at the end of 2008.The CCBM framework has been revised inorder to allow for the integration of new euroarea countries. In this connection, the CCBMAgreement with Národná banka Slovenska wassigned in the context of Slovakia joining theeuro area.Despite its success and considerable contributionto the process of financial integration, theCCBM arrangement has some drawbacks,mainly linked to the fact that it was designed asan interim solution that relies on the principleof minimum harmonisation. These drawbacks,in combination with the growing importanceof cross-border collateral, led to the GoverningCouncil’s decision of 8 March 2007 to reviewthe existing Eurosystem collateral managementhandling procedures and to create a newsingle-platform collateral management systemfor the Eurosystem, called Collateral CentralBank Management, or CCBM2. Marketparticipants were involved by means of publicconsultations and ad hoc meetings in thedefinition of the principles and user requirementsfor CCBM2.Given the positive feedback on the Eurosysteminitiative, the Governing Council decided on17 July 2008 to launch the CCBM2 project.The development and operation of CCBM2, onbehalf of the Eurosystem, was assigned to theNationale Bank van België/Banque Nationalede Belgique and De Nederlandsche Bank, witha view to implementing the system before or, atthe latest, at the same time as T2S.The objective of CCBM2 is to consolidate theEurosystem’s internal systems for collateralmanagement, thereby rendering them moreefficient. In particular, it aims, where possible,to address the drawbacks of the current set-up byoptimising the cost of mobilising collateral andby enhancing liquidity management. The scope ofCCBM2 goes beyond that of the current CCBM,as it will provide for a single set of procedureswith a harmonised level of service for thedelivery and acceptance of all eligible collateral(securities and non-marketable assets) used onboth a domestic and a cross-border basis.The participation of the euro area NCBs inCCBM2 will be voluntary, and a modularapproach will be adopted. CCBM2 will consistof several modules, only one of which – themessage router – will be compulsory for theNCBs participating in CCBM2. Through thismandatory module, standardised interactionbetween the Eurosystem and counterpartieswill be ensured. The other modules, whichdeal with the actual handling of marketable andnon-marketable assets, will remain optional. Thismodular approach gives NCBs the flexibility tochoose the CCBM2 modules that suit their ownneeds and those of their market. CCBM2 willbe able to adjust to changes in the Eurosystem’scollateral and operational framework, as wellas to adapt to market developments in a smoothand timely manner.In the current project phase, detailed specificationsfor users are being developed by the Eurosystemon the basis of the approved user requirements 6 .The Eurosystem will maintain an open dialoguewith market participants throughout thesubsequent phases of the CCBM2 project.See 6 http://www.ecb.europa.eu/press/pr/date/2008/html/pr080717_1.en.html116 ECBAnnual Report2008

ELIGIBLE LINKS BETWEEN NATIONAL SECURITIESSETTLEMENT SYSTEMSNational SSSs can be linked by means ofcontractual and operational arrangements toallow the cross-border transfer of eligiblesecurities between systems. Once eligiblesecurities have been transferred via such linksto another SSS, they can be used through localprocedures in the same way as any domesticcollateral. 60 direct and 6 relayed links arecurrently available to counterparties, but onlya limited number of them are actively used.Furthermore, these links only cover part of theeuro area. Links become eligible for Eurosystemcredit operations if they fulfil the Eurosystem’suser standards (see Section 4 of Chapter 4).The amount of collateral held through linksincreased from €125 billion in December 2007to €148 billion in December 2008, butaccounted for only 8.3% of the total collateral(both cross-border and domestic) held by theEurosystem in 2008, compared with 8.9%in 2007.ECBAnnual Report2008117

3 BANKNOTES AND COINS3.1 THE CIRCULATION OF BANKNOTES ANDCOINS AND THE HANDLING OF CURRENCYDEMAND FOR EURO BANKNOTES AND COINSAt the end of 2008 the number of euro banknotesin circulation stood at 13.1 billion, with a valueof €762.8 billion. This represented an increaseof 8.3% in terms of volume and 12.7% in termsof value compared with the levels at the end of2007 (12.1 billion banknotes with a value of€676.6 billion).Following the intensification of the financialmarket turmoil, a strong increase in the numberof euro banknotes in circulation was recordedin the first half of October 2008, equivalent to avalue of €35 to €40 billion.In the last quarter of 2008 demand wasparticularly high for the denominations €100 and€500 and was to a large extent driven by demandfrom outside the euro area. As a result, by theend of the year the average value of a banknotein circulation had increased to €58.15 (comparedwith €55.85 at the end of the previous year).Statistics indicate that net shipments of eurobanknotes by euro area credit institutions todestinations outside the euro area reached atotal value of around €96 billion by the endof December 2008, which represents a shareof 13% of the total value of euro banknotes incirculation. These shipments were due to anincrease in demand from foreign residents.Given that there are additional reasons for eurobanknotes to travel beyond the euro area (suchas tourism or guest worker remittances), it isestimated that, in value terms, close to 20% ofthe euro banknotes in circulation are held bynon-euro area residents.Charts 46 and 47 illustrate the steady increasein the total number and value of euro banknotesin circulation, together with the annual growthrates.Looking at the breakdown of the denominations,the €500 banknote, which is to a large extentused for hoarding, showed the strongest growthin circulation, rising by 17.1% at the end of 2008compared with one year earlier. It was followedby the €100, €50 and €200 banknotes, whichrose by 14.2%, 10.6% and 9.3% respectively.The number of the lower denominations incirculation rose at rates of between around 3%and 6% (see Chart 48).Chart 46 Number of euro banknotes incirculation between 2002 and 2008Chart 47 Value of euro banknotes incirculation between 2002 and 2008annual growth rate (percentages; right-hand scale)total number (billions; left-hand scale)annual growth rate (percentages; right-hand scale)total value (EUR billions; left-hand scale)14258006013121120157006005040109105500400308760-5300200201052002 2003 2004 2005 2006 2007 2008-101002002 2003 2004 2005 2006 2007 20080Source: ECB.Source: ECB.118 ECBAnnual Report2008

Chart 48 Number of euro banknotes in circulation between 2002 and 2008(millions)EUR 500EUR 200EUR 100EUR 50EUR 20EUR 10EUR 51,4001,4005,0005,0001,2001,0008001,2001,0008004,0003,0004,0003,0006004002006004002002,0001,0002,0001,00002002 2003 2004 2005 2006 2007 2008002002 2003 2004 2005 2006 2007 20080Source: ECB.In 2008 the total number of euro coins incirculation (i.e. net circulation excluding stocksheld by the NCBs) grew by 7.9% to 82.3 billion,while their value rose by 5.7% to €20.4 billion.The 1 and 2 cent coins accounted for most ofthis increase. The share of the low-value coins,the 1, 2 and 5 cent coins, in the total number ofcoins in circulation remained stable at 59%.BANKNOTE HANDLING BY THE EUROSYSTEMIn 2008 the euro area NCBs issued 34.1 billionbanknotes, while 33.2 billion banknotes werereturned to them. The return frequency 7 ofbanknotes in circulation remained almostunchanged at 2.79, meaning that, on average,a banknote was checked for authenticity andcirculation fitness by the fully automatedbanknote processing machines of the euro areaNCBs around once every four months.Since 2004 the Eurosystem has conductedannual surveys with the aim of monitoring thecondition of euro banknotes in circulation atthe euro area level. In 2008 a trend towards animprovement in the condition of the banknotesin circulation was observed. The condition ofthe banknotes also became more homogeneouswithin the euro area, reflecting the Eurosystem’scoordinated sorting/issuing policies. The NCBsidentified some 5.6 billion banknotes as unfit forcirculation and replaced them accordingly. Theunfit rate, 8 at around 17.0%, remained close tothe rate recorded in the previous year.3.2 BANKNOTE COUNTERFEITING ANDCOUNTERFEIT DETERRENCECOUNTERFEIT EURO BANKNOTESThe total number of counterfeit euro banknotesreceived by National Analysis Centres 9 in 2008was around 666,000 10 , which represented anincrease from the relatively stable levelsobserved in previous years. However, thenumber of genuine banknotes in circulation alsoincreased significantly in 2008. Compared withthe number of genuine euro banknotes incirculation, which reached 13.1 billion by theend of 2008, the quantity of counterfeits is verysmall indeed. Therefore, the probability ofrandomly receiving a counterfeit banknote fromcirculation remains very low. Chart 49 showsthe trend in counterfeits removed fromcirculation, with figures taken at half-yearly7 Defined as the total number of banknotes returned to NCBs ina given period divided by the average number of banknotes incirculation during that period.8 Defined as the number of banknotes identified as unfit in a givenperiod divided by the total number of banknotes sorted duringthat period.9 Centres established in each EU Member State for the initialanalysis of counterfeit euro banknotes at the national level.10 This figure is subject to a very slight correction on account oflate reports, particularly from outside the EU.ECBAnnual Report2008119

Chart 49 Number of counterfeit eurobanknotes recovered from circulationbetween 2002 and 2008(thousands)4003503002502001501005002002 2003 2004 2005 2006 2007 2008400350300250200150100500Chart 50 Distribution of euro banknotecounterfeits by denomination in 2008€5035%€10020%€2005%€5000%€51%€101%Source: ECB.€2038%Source: ECB.Note: The figures have been rounded to the nearest percentagepoint.intervals since the euro banknotes werelaunched. In 2008 the €20 and €50 banknoteswere the counterfeiters’ biggest targets, betweenthem accounting for about three-quarters of thenumber of counterfeits. Chart 50 gives a detailedbreakdown of the distribution of counterfeits interms of volume.The public can remain confident in the securityof the euro: it has proven to be a well-protectedcurrency, in terms of both the sophisticationof its security features and the effectivenessof European and national law enforcementauthorities. However, this confidence shouldnever give rise to complacency, and the ECB’sadvice to the public remains to be alert tothe possibility of fraud and to remember the“feel-look-tilt” test. 11 The Eurosystem continuesto invest considerable effort in ensuring thatboth the public and professional cash handlersare well-informed with regard to the recognitionof counterfeit banknotes.COUNTERFEIT DETERRENCEThe Eurosystem continued in 2008 to workclosely with Europol and the EuropeanCommission (in particular the European Anti-Fraud Office, OLAF) in the fight againstcounterfeiting of the euro. The Eurosystem isactive, both in the EU and beyond, in trainingprofessional cash handlers in the recognitionand handling of counterfeit banknotes.The Eurosystem participates actively in thework of the Central Bank Counterfeit DeterrenceGroup (CBCDG) (a working group of 31 centralbanks and note-printing authorities cooperatingunder the auspices of the G10). The groupsponsors research into techniques designed toprevent the illicit reproduction of banknotes.The ECB hosts the International CounterfeitDeterrence Centre (ICDC), which acts as thetechnical centre for all CBCDG members. Itsmain role is to provide technical support and tooperate a centralised communication systemserving all parties involved in the field ofcounterfeit deterrence systems. The ICDC alsomaintains a public website 12 which providesinformation and guidance concerning thereproduction of banknote images as well as linksto country-specific websites.11 For details, see http://www.ecb.europa.eu/euro/banknotes/security/html/index.en.html12 For details, see http://www.rulesforuse.org120 ECBAnnual Report2008

3.3 BANKNOTE PRODUCTION AND ISSUANCEPRODUCTION ARRANGEMENTSA total of 6.4 billion euro banknotes wereproduced in 2008, compared with 6.3 billion in2007.The allocation of euro banknote productioncontinued to be based on the decentralisedproduction scenario with pooling, adopted in2002. Under this arrangement, each euro areaNCB is responsible for the procurement ofan allocated share of the total requirement forcertain denominations. Table 12 summarises the2008 production allocation.THE EXTENDED CUSTODIAL INVENTORY PILOTPROGRAMMEIn 2008 the Extended Custodial Inventory(ECI) pilot programme for euro banknotes inAsia, which had been established in 2007, wassuccessfully operated by two large commercialbanks active in the wholesale market forbanknotes. An ECI is a cash depot maintainedby a commercial bank that holds currency on acustodial basis. ECIs facilitate the internationaldistribution of euro banknotes and providestatistical data on euro banknote circulationoutside the euro area, as well as information oncounterfeits found in their region. In view of thesuccess of the pilot programme, the GoverningCouncil decided in March 2008 to launch a threeyearECI programme based on the experiencewith the pilot. Following a negotiated tenderTable 12 Allocation of euro banknoteproduction in 2008DenominationNumber (millionsof banknotes)NCB commissioningproduction€5 1,370.0 DE, ES, FR, PT€10 2,130.0 DE, GR, FR, AT€20 1,755.0 ES, FR, IE, IT, LU,NL, SI, FI€50 1,060.0 BE, DE, ES, IT, NL€100 130.0 IT€200 - -€500 - -Total 6,445.0Source: ECB.procedure, three wholesale banknote banksapplied for the three-year ECI programme. Onestarted operations in Hong Kong and another inSingapore in February 2009, and it is foreseenthat the third will start ECI operations in HongKong in mid-2009. These are the main logisticalhubs for trading euro banknotes in the EastAsian region, which has the highest turnover ofeuro banknotes outside Europe. The DeutscheBundesbank is the logistical and administrativecounterpart for the ECI banks. Before the end ofthe three-year term, the Eurosystem will assesswhether and where the ECI programme shouldbe continued.ROADMAP FOR GREATER CONVERGENCE OF NCBCASH SERVICESFollowing the Governing Council’s adoptionin 2007 of a roadmap which aimed to achieve,in the medium term, greater convergence of thecash services offered by euro area NCBs, theEurosystem continued its work in this area in2008. Greater convergence is important becauseit will allow stakeholders – in particular thosewith significant cross-border cash activities – tofully reap the benefits of the single currency,and will ensure fair competitive treatment. Inview of the different national economic andgeographical environments, the Eurosystemdoes not envisage a “one-size-fits-all” cashsupply system. The process of convergencewill require some flexibility regarding customerrequirements, the cash infrastructure andtransitional periods for implementation.The Eurosystem has also been working on anumber of further steps, including an electronicdata exchange with credit institutions for cashlodgements and withdrawals and banknotepackaging standards for the free-of-charge NCBcash services. Consultations with stakeholdershave been conducted at both the national andthe European level, in particular with regardto the issue of common banknote packaging,in view of the possible operational and costimplications.Technological developments with regard tobanknote processing machines now allowECBAnnual Report2008121

anknotes to be read and processed irrespectiveof the way in which they are fed into the machine.In time NCBs will introduce these improvementsfree of charge, as foreseen in the roadmap.THE SECOND SERIES OF EURO BANKNOTESIn 2005 the ECB started work on thedevelopment of a new series of euro banknotes.The functional and technical requirementswere established and the security features tobe included in the new series of banknoteswere developed. In 2008 work focused on thefurther development of the design and securityfeatures of the banknotes and the integrationof the security features into the design. Thedevelopment of the origination materials, themaster materials used for banknote production,also started in 2008.The design of the second series of euro banknoteswill be based on the “ages and styles of Europe”theme and will include the most important designelements from the first series of banknotes. Asthe design and development of the originationmaterials is an iterative process, this workwill continue in 2009. All major stakeholdersinvolved in the cash cycle are being consultedand kept informed of the progress made duringthe development process. The new series willbe launched over a period of several years, withthe first denomination expected to be issued in afew years’ time. The exact launch date will bedetermined at a later stage. The ECB will informthe public well in advance about the modalitiesof the introduction of the new banknotes. TheNCBs will redeem euro banknotes from the firstseries for an unlimited period of time.122 ECBAnnual Report2008

4 STATISTICSThe ECB, assisted by the NCBs, develops,collects, compiles and disseminates a wide rangeof statistics which support the monetary policyof the euro area and various tasks of the ESCB.They are also used increasingly by the financialmarkets, the media and the general public.The regular provision of euro area statisticsin 2008 proceeded in a smooth and timelymanner. A major achievement was the adoptionby the Governing Council of an improvedlegal framework that will significantly enricheuro area monetary and financial statistics, inparticular through the increased availabilityof data on loan sales and loan securitisations.Another key development was the adoptionof the medium-term work programme for theECB’s statistical function, which will guidethe production of ESCB statistics for the period2009-12. Finally, the ECB, in close collaborationwith the NCBs, continued to contribute to thefurther harmonisation of statistical concepts inEurope and to the review of global and Europeanstatistical standards.4.1 NEW OR ENHANCED EURO AREA STATISTICSThe legal framework for the collection ofmonetary and financial statistics was enhancedwith a new ECB Regulation concerningstatistics on the assets and liabilities of financialvehicle corporations engaged in securitisationtransactions 13 . In addition, the ECB’s legalacts on the collection of statistics from MFIswere amended to address new requirements(owing to financial innovation, for example) forbalance sheet statistics 14 , statistics on interestrates on deposits and loans vis-à-vis householdsand non-financial corporations 15 and statisticson securitisations 16 . These regulations alsoaddress additional statistical requirements thathave resulted from the financial turmoil, inparticular with regard to the measurement ofsynthetic securitisation as a means of creditrisk transfer. The reporting of these additionalstatistics is scheduled to begin in mid-2010(in order to provide NCBs and reporting agentswith the necessary time to implement the newreporting schemes), with the exception of MFIsecuritisation and financial vehicle corporationstatistics, for which data will be reportedfrom December 2009. The development ofthese regulations involved a comprehensiveassessment of the merits of the new statisticsand their estimated costs, for both reportingagents and NCBs, in order to ensure that thehighest-priority user requirements can be met ata reasonable cost.The Governing Council also adopted a recastGuideline on monetary, financial institution andmarket statistics, which consolidates previousamendments and now includes further provisionsfor these statistics. Further refinements to theECB’s legal framework comprised amendmentsto the ECB Guidelines on the statistical reportingrequirements in the field of government financestatistics (abolishing the remaining derogations)and of quarterly financial accounts (to improvethe efficiency of the data flows).With regard to statistics on the assets andliabilities of investment funds, the NCBs beganproviding the ECB with new harmonised data asof February 2009, using December 2008 as thereference period. 17Since June 2008 further statistics on thecirculation of euro banknotes and coins havebeen released in the statistics section of theECB’s website (for example, monthly dataon outstanding amounts and flows of eurobanknotes and coins in circulation and data onthe number and value of banknotes checked for13 A preliminary list of financial vehicle corporations had alreadybeen compiled, which made it possible to start work oncross-checking with other datasets and making a limitedpreliminary analysis of the recent developments in this field.14 Regulation ECB/2008/32 of 19 December 2008 concerningthe balance sheet of the monetary financial institutions sector(recast).15 A regulation amending Regulation ECB/2001/18 concerningstatistics on interest rates applied by monetary financialinstitutions to deposits and loans vis-à-vis households and nonfinancialcorporations will soon be published.16 Regulation ECB/2008/30 of 19 December 2008 concerningstatistics on the assets and liabilities of financial vehiclecorporations engaged in securitisation transactions.17 As set out in Regulation ECB/2007/8 concerning statistics onthe assets and liabilities of investment funds (other than moneymarket funds).ECBAnnual Report2008123

authenticity and fitness). Enhanced harmonisedcompetitiveness indicators for the euro areacountries based on consumer price indices, GDPdeflators and unit labour costs are now alsopublished regularly within the Eurosystem jointdissemination framework. Their purpose is toprovide comparable measures of price and costcompetitiveness developments in the euro areacountries that are also consistent with changesin the real effective exchange rates of the euro.The ECB continued to improve its Short-Term European Paper (STEP) statistics. Theseshow primary market volumes and yields forshort-term debt securities that have been issuedin the context of programmes which havereceived the STEP label (see also Section 3of Chapter 4). Detailed flow and stock data,including the outstanding amounts of theindividual STEP programmes, are expected tobe published in the first half of 2009.New MFI balance sheet statistics to underpinthe monetary analysis have also been released.For instance, following the improvements inthe availability of financial accounts data, theECB has started publishing sectoral statisticson holdings of M3 instruments by non-financialcorporations, households (including non-profitinstitutions serving households), other financialintermediaries (including investment funds), andinsurance corporations and pension funds. Timeseries are also available from the first quarterof 1999.In September 2008 the Governing Councilapproved the conduct of a Eurosystem survey oneuro area household finance and consumption.This project aims to fill a significant gap in theavailability of data on the financial situationof segments of the household sector, therebysupplementing the macroeconomic statistics (forinstance by providing information on the assetsand liabilities of households throughout the euroarea). A survey on access to finance by small andmedium-sized enterprises is also in preparation.It is planned that this survey will be undertakenin cooperation with the European Commission.The ESCB also continued its work on enhancingthe Centralised Securities Database (CSDB).The CSDB contains benchmark information onindividual securities that are relevant for ESCBstatistical purposes and plays a pivotal role inthe move towards security-by-security reporting.Systems which collect data on an item-by-itembasis have the potential to significantly alleviatethe reporting burden for respondents whileimproving the quality and flexibility of euro areastatistics. The database is already used by severalNCBs to compile national financial statistics, andfurther developments are under way.4.2 OTHER STATISTICAL DEVELOPMENTSThe two framework regulations on the collection,compilation and dissemination of statistics inEurope, issued by the European StatisticalSystem (the ESS, a partnership between Eurostatand the national statistical institutes) and by theESCB respectively, are being updated. Closecooperation between the ESCB and the ESS hasresulted in various mirroring provisions in thetwo draft legal acts, in particular concerning theexchange of confidential statistical informationbetween the ESCB and the ESS. The ECBissued a recommendation for a Councilregulation amending Regulation (EC)No 2533/98 on the collection of statisticalinformation by the ECB in September 2008. 18Since 2007 the ECB and Eurostat haveregularly published quarterly, integrated,non-financial and financial euro area sectoraccounts. In 2008 work began on enhancingthe timeliness, completeness and consistency ofthis comprehensive macroeconomic accountingframework.The dissemination of statistics was improvedthrough the publication of additional tableson euro area statistics and all correspondingnational data on the websites of both theECB and the NCBs. The extensions covered:i) lists of MFIs, ii) MFI interest rate statistics,18 http://www.ecb.europa.eu/ecb/legal/pdf/c_25120081003en00010005.pdf124 ECBAnnual Report2008

iii) payments statistics and iv) detailed dataon the HICP and GDP. The ECB’s StatisticalData Warehouse (SDW) is an increasinglypopular tool for accessing euro area statisticson the internet. In 2008 more financial marketstatistics were incorporated into the SDWand the number of SDW users doubled toaround 40,000 per month. The launch of a newinteractive visualisation tool for monitoringinflation on the ECB’s website is also part ofa better communication strategy with regardto euro area statistics. Finally, a wider rangeof statistics and indicators was presented invarious regular ECB publications, such asthe “Euro money market survey”, the reportentitled “Financial integration in Europe” andthe Financial Stability Review.Several documents published in 2008 served toraise awareness about ECB and ESCB statistics,their governance and their quality. The ECBStatistical Quality Framework and qualityassurance procedures, 19 the updated publication“ECB statistics – an overview” 20 and thepublication of the proceedings of the fourthECB conference on statistics 21 are examples ofthe ECB’s transparency in this field.The ECB continued to cooperate closely withEurostat and other international organisations(for example, in the preparation of the joint2008 “Status report on information requirementsin EMU” and in the revision of Eurostat’s“ESA95 manual on government deficit anddebt”) and played an important role in theupdate of global statistical standards (with thework on the System of National Accounts 93,the IMF’s Balance of Payments Manual and theOECD Benchmark Definition of Foreign DirectInvestment). The ECB supports Eurostat in therevision of the ESA 95. The ESA 95 guides aseries of policy decisions at the European level.The ECB also supports and implements globaltechnical standards for data exchange. Togetherwith the NCBs, the IMF and the BIS, it alsodeveloped a handbook on securities statistics.Finally, the ECB released an update of its“Government finance statistics guide”. 22Statistics for the euro area were adapted toaccount for the entry of Cyprus and Malta on1 January 2008. No problems were encounteredthanks to the long-term preparation undertakenby these countries, even before they joined theEU, in close cooperation with the ECB andother Member States. In addition, as in previousyears, statistics played an important role inmonitoring the convergence of EU MemberStates that do not yet belong to the euro area.The ECB, together with the central banks ofthese Member States, also assisted Eurostatwith the provision of long-term interest rateand exchange rate statistics, and collected andcompiled additional statistics supplementingthe four primary convergence indicators in theECB’s 2008 Convergence Report (see Section 1of Chapter 3).4.3 THE MEDIUM-TERM WORK PROGRAMME FORTHE ECB’S STATISTICAL FUNCTION (2009-12)The medium-term work programme for theECB’s statistical function (2009-12) waspublished on the ECB’s website in July 2008. 23It is the result of a detailed analysis and aims tofurther increase the efficiency and effectivenessof the collection and compilation of euro areastatistics, with a view to using the resultingefficiency gains to close some remaining gaps.Improvements are expected to be made in theform of, among other things: i) more detailedsecurities holdings statistics, ii) better data oncredit derivatives, iii) the compilation of timelyquarterly statistics on insurance corporationsand pension funds and iv) the enhanced re-useof available micro-data for statistical purposes.The latter include data derived from corporatefinancial statements held in national centralbalance sheet offices and information available19 http://www.ecb.europa.eu/stats/html/sqf.en.html20 http://www.ecb.europa.eu/pub/pdf/other/ecbstatisticsanoverview2008en.pdf21 http://www.ecb.europa.eu/pub/pdf/other/strategicvisionstatistics2008en.pdf22 http://www.ecb.europa.eu/pub/pdf/other/governmentfinancestatisticsguide200812en.pdf23 http://www.ecb.europa.eu/stats/html/workprogramme.en.htmlECBAnnual Report2008125

from central credit registers. Furthermore, workis being undertaken, together with the Committeeof European Banking Supervisors, to achieve,where possible, some reconciliation betweensupervisory and statistical requirements forcredit institutions. The ESCB also continues toassess the statistical needs resulting from thefinancial turmoil. This strategy for the mediumterm will require intensified cooperation amongall involved parties, i.e. the statistics departmentsof the NCBs and the ECB, as well as externalpartners such as statistical institutes, supervisorsand representatives of the financial industry.126 ECBAnnual Report2008

5 ECONOMIC RESEARCHThe main functions of research at the ECB, aswell as in the Eurosystem as a whole, are: toprovide research results that are relevant for theformulation of policy advice on monetary policyand other Eurosystem tasks, and to design andimplement the respective models and analyticaltools; to maintain and use econometric modelsfor economic forecasts and the comparisonof the effects of alternative policies; and tocommunicate with the academic community,for example through the publication of researchresults in peer-reviewed scientific journals andthe organisation of research conferences.5.1 RESEARCH PRIORITIES AND ACHIEVEMENTSEconomic research at the ECB is performed in adecentralised way: all business areas can conductresearch projects according to their needs andexpertise. The Directorate General Research, aswell as producing high-quality research itself,plays a central role in coordinating research. TheDirectorate chairs the Research CoordinationCommittee, which aligns research activities atthe ECB with the requirements of the institution.The Committee sets broad priority areas foreach year.The following fields were identified as the mainresearch priorities for 2008: forecasting andmodel development; improving the monetaryanalysis; understanding the transmissionmechanism of monetary policy; financialstability; the efficiency of the European financialsystem; and international and fiscal issues.In the area of forecasting and modeldevelopment, a number of existing projectswere continued in 2008 and some new oneswere launched. The New Area-Wide Model(NAWM) was introduced into the projectionexercises and was used both in the constructionof the central projections and for scenarioanalysis. The Christiano-Motto-Rostagno modelwas further developed and was used in a numberof policy exercises focusing on the behaviourof financial markets. Both are examples of thedynamic stochastic general equilibrium (DSGE)models that are becoming increasingly commonin policy work at central banks. Other DSGEmodels were developed in house to tacklespecific policy issues. Work initiated in 2006-07on short-term forecasting tools was brought tofruition in 2008, with the introduction of thesetools into the regular economic assessment andpolicy preparation work. Research work onexisting and new forecasting tools will continuein 2009.A new method for the construction ofprojection ranges was introduced in the courseof 2008 and used in the ECB/Eurosystemstaff macroeconomic projections published inSeptember and December. Forecast uncertaintywill be a topic of interest also in 2009.Research on monetary analysis concentrated onthe development and use of quantitative methodsfor monetary analysis, with an emphasis onproviding high-quality analytical tools for thepreparation of policy decisions. Work focusedon developing money-based indicator modelsfor inflation and on analysing money demand,as well as on designing monetary scenariosfrom a structural perspective. In this context,the Christiano-Motto-Rostagno model was usedextensively. Particular attention was paid to theuse of different structural models and other toolsas cross-checking devices.With regard to the monetary policy transmissionmechanism, the Wage Dynamics Network(WDN), which consists of ESCB researchers,presented the results of its work at a conferencein June 2008. The WDN investigates the featuresand sources of wage dynamics in the euro areaand their relationship with prices, at both theaggregate and the micro level. One importantachievement of the network in 2008 was asurvey it conducted, covering 17 countries, onwages, labour costs and price-setting behaviourat the firm level.The euro area-wide household finance andconsumption survey (see Section 4 of thischapter), prepared by a Eurosystem network,will cover micro-level information on a wideECBAnnual Report2008127

ange of household decisions related to theholding of real and financial assets, the takingof debt, risk attitudes, employment, income,pensions, intergenerational transfers, gifts,consumption and savings. Data collectionis expected to start in early 2009 in a numberof euro area countries. It is expected thatanonymised euro area micro-data on householdfinance and consumption will also be madeavailable to the research community in thefuture. Related research on household financeand consumption was presented at a conferenceorganised by the Center for Financial Studiesand the ECB in September 2008. Other topicsanalysed within this area of research were centralbank communication policies, the monitoring offinancial markets, housing markets, the role ofbanks and credit in the monetary transmissionmechanism, and heterogeneity in the euro areafrom various perspectives.Financial stability issues and their impact onmonetary policy were also explored, particularlyin the context of work carried out for the ECB’sFinancial Stability Review. The financial systemwas analysed along two dimensions: its degreeof integration and the evolution of capitalmarkets. The interaction of credit and marketrisks was also covered.Regarding research on payment and settlementsystems, the ECB joined forces with severalinterested central bankers (from the Bank ofEngland, the Reserve Bank of Australia, theFederal Reserve Bank of New York, the FederalReserve Bank of Chicago, the Bank of Canadaand De Nederlandsche Bank) and academics toestablish an informal Payment EconomicsNetwork. This network promotes awareness ofthe research undertaken on payment andsecurities settlement systems and reinforces thelink between research and practice in this field.The network’s website 24 provides links toworking papers, relevant policy documents,details on upcoming and past conferences, andinformation on research projects in this area.Under the research priority related tointernational issues, the main areas of interestwere global imbalances, on which a highlevelseminar was organised in 2008, and theinternational role of the euro. With regard tothe latter, work focused on the relationshipbetween currency invoicing and exchange ratepass-through. The results of this work will beintegrated into the report entitled “Review of theinternational role of the euro”. In the context ofthis research priority, an international extensionof the NAWM was developed.5.2 RESEARCH DISSEMINATION: PUBLICATIONSAND CONFERENCESAs in previous years, ECB staff research waspublished in the ECB’s Working Paper Seriesand Occasional Paper Series. 141 WorkingPapers and 22 Occasional Papers were publishedin 2008. A total of 116 Working Papers werewritten or co-written by ECB staff, many withEurosystem economists, while the remainderwere written by external visitors attendingconferences and workshops, working in thecontext of research networks or following aprolonged stay at the ECB for the completionof a research project. As is now the establishednorm, most of the papers are eventually expectedto be published in leading, peer-reviewedacademic journals. In 2008 ECB staff publishedmore than 30 articles in academic journals.The Research Bulletin is a regular ECBpublication which is used to disseminate researchwork of general interest to a wide audience. In2008 it focused on the credit market turmoil, thefeatures of the euro area business cycle, housingwealth and consumption, and regional inflationdynamics.The ECB organised or co-organised around 15conferences or workshops on research topics.Co-organised conferences involved the Centrefor Economic Policy Research (CEPR) andother central banks, both from the Eurosystemand from outside the Eurosystem. Furthermore,a large number of workshops and seminars24 http://www.paymenteconomics.org128 ECBAnnual Report2008

were organised to disseminate research withinthe ECB. As in previous years, most of theconferences and workshops were related tospecific research priority areas; the programmesfor these events and the papers presented areavailable on the ECB’s website.The conferences and workshops covered awide range of subjects. Financial topics werethe focus of seven of them: two tackled theimpact of the financial turmoil, one of themco-sponsored by the Federal Reserve Bankof Chicago, and another dealt with financialintegration. The remainder addressed differentaspects of the workings of the money and retailtransfer markets. The fifth conference of theInternational Research Forum on MonetaryPolicy (co-sponsored with the Federal ReserveBoard, Georgetown University and theUniversity of Frankfurt) in June 2008 analysedmonetary policy topics. Other conferencesexamined data issues (co-sponsored with theCEPR through the Euro Area Business CycleNetwork), labour markets and the first ten yearsof the euro.An additional mechanism for the disseminationof research was the organisation of seminarseries, of which two were of particularrelevance: the Joint Lunchtime Seminars,co-organised with the Deutsche Bundesbankand the Center for Financial Studies, and theInvited Speaker Seminars. The two seriescomprise weekly seminars at which externalresearchers are invited to present their recentwork at the ECB. The ECB also organisesresearch seminars outside the scope of thesetwo series on a more ad hoc basis.ECBAnnual Report2008129

6 OTHER TASKS AND ACTIVITIES6.1 COMPLIANCE WITH THE PROHIBITION OFMONETARY FINANCING AND PRIVILEGEDACCESSPursuant to Article 237(d) of the Treaty, theECB is entrusted with the task of monitoring thecompliance of the 27 EU NCBs and the ECBwith the prohibitions implied by Articles 101and 102 of the Treaty and Council Regulations(EC) Nos 3603/93 and 3604/93. Article 101prohibits the ECB and the NCBs from providingoverdraft facilities or any other type of creditfacility to governments and Communityinstitutions or bodies, as well as from purchasingdebt instruments directly from them. Article 102prohibits any measure, not based on prudentialconsiderations, which establishes privilegedaccess by governments and Communityinstitutions or bodies to financial institutions.In parallel with the Governing Council, theEuropean Commission monitors Member States’compliance with the above provisions.The ECB also monitors the EU central banks’secondary market purchases of debt instrumentsissued by the domestic public sector, the publicsector of other Member States and Communityinstitutions and bodies. According to the recitalsof Council Regulation (EC) No 3603/93, theacquisition of public sector debt instrumentsin the secondary market must not be used tocircumvent the objective of Article 101 of theTreaty. Such purchases should not becomea form of indirect monetary financing of thepublic sector.The monitoring exercise conducted for 2008,based on information provided by the 27 NCBsof the ESCB and the ECB, confirms that, withone exception, the provisions of Articles 101and 102 of the Treaty and the related CouncilRegulations were in general respected duringthe period under review.De Nederlandsche Bank reported an interdayoverdraft facility, leading to a situation ofnon-compliance limited to one day as regardsthe Treaty’s monetary financing prohibition,which was immediately corrected.6.2 ADVISORY FUNCTIONSArticle 105(4) of the Treaty requires that theECB be consulted on any proposed Communityor national legislation falling within its fields ofcompetence. 25 The obligation to consult theECB is not prejudiced in a scenario where adraft legislative provision is to be adopted undera fast-track procedure. In addition, the adoptionof legislative provisions within a very shortperiod of time following a consultation requestshould be permitted only in exceptional cases,such as the current period of market turmoil. AllECB opinions are published on the ECB’swebsite.The ECB adopted 92 opinions in 2008: 11were in response to consultations by theEU institutions and 81 were in response toconsultations by national authorities. Thiscompares with 43 consultations in 2007. A listof the opinions adopted in 2008 and early 2009is annexed to this Annual Report.The following ECB opinions issued at the requestof the EU Council are particularly noteworthy.The ECB issued an opinion 26 on a proposal toamend the Settlement Finality Directive 27 andthe Financial Collateral Directive 28 . The changesconcern the protection under the SettlementFinality Directive of night-time settlement andinterconnected systems owing to the expectedincrease in system interoperation resulting fromthe Markets in Financial Instruments Directiveand the European Code of Conduct for Clearingand Settlement. Among the categories offinancial collateral that may be provided under25 The United Kingdom is exempt from the consultation obligation,pursuant to the Protocol on certain provisions relating to theUnited Kingdom of Great Britain and Northern Ireland, annexedto the Treaty, OJ C 191, 29.7.1992, p. 87.26 CON/2008/37.27 Directive 98/26/EC of the European Parliament and of theCouncil of 19 May 1998 on settlement finality in payment andsecurities settlement systems, OJ L 166, 11.6.1998, p. 45.28 Directive 2002/47/EC of the European Parliament and of theCouncil of 6 June 2002 on financial collateral arrangements,OJ L 168, 27.6.2002, p. 43.130 ECBAnnual Report2008

the Financial Collateral Directive, the proposalalso includes credit claims eligible for thecollateralisation of central bank credit operationsin order to facilitate their use throughout the EU.In its opinion, the ECB welcomed the proposaland suggested in particular that the definitionof “system” should be extended i) to expresslyinclude systems established by an ECB legalact and ii) to allow the ECB to designate suchECB systems itself. The ECB also proposedthat credit claims be included in the scope ofthe Financial Collateral Directive accordingto a single general definition that is not linkedto central bank eligibility, and recommendedharmonising some elements of the conflict oflaw rules on credit claims in the EU.The ECB was also consulted on a proposal fora directive amending the Capital RequirementsDirective 29 with respect to banks affiliated tocentral institutions and certain own funds items.The ECB issued an opinion 30 on a proposalfor a directive amending the E-moneyDirective 31 which aims to open up the marketfor the issuance of electronic money, throughelectronic money institutions (ELMIs). TheECB supported the review but expressed seriousconcerns about changing the nature of ELMIs to“financial institutions”, as defined in the recastDirective 2006/48/EC, 32 since this would havefar-reaching consequences for the conduct ofmonetary policy. The proposed directive alsocauses concern from a supervisory perspective,as it lightens the supervisory regime of ELMIswhile simultaneously broadening the scope ofthe activities ELMIs may undertake.With regard to the Lamfalussy framework, 33 aspart of the process of clarifying and expandingthe scope of the tasks of the Level 3 Committees(the Committee of European BankingSupervisors (CEBS), the Committee of EuropeanInsurance and Occupational PensionsSupervisors (CEIOPS) and the Committee ofEuropean Securities Regulators (CESR)), theECB was consulted on a draft Commissiondecision establishing CEBS, replacingCommission Decision 2004/10 34 . The ECBopinion 35 welcomed the proposed amendmentsand emphasised that its specific comments werewithout prejudice to possible future contributionsto the broader debate, for instance in relation tothe high-level group chaired by Jacques deLarosière. The ECB suggested a fewamendments to the draft decision, in particularregarding the involvement of the ECB and theBanking Supervision Committee in certainCEBS tasks. The ECB recommended ensuringconsistency between the provisions of the draftdecision and those of the CEBS charter regardingvoting procedures and suggested that theCommission take into account these comments,wherever applicable, for the draft decisions onthe other two Level 3 Committees, on which theECB is not being consulted.The ECB also issued an opinion 36 on a proposalfor a regulation on cross-border paymentsreplacing Regulation (EC) No 2560/2001 37 .While welcoming the inclusion of crossborderdirect debits in the proposed regulation,the ECB warned that balance of payments(b.o.p.) reporting issues would require carefulconsideration. In this context, it is essential thatthe user needs for euro area and national b.o.p.statistics be met and that the timely emergenceof SEPA be safeguarded. The development ofSEPA implies that b.o.p. reporting systems basedmainly on payments data cannot be maintained,as these are for payments in euro within the29 The Capital Requirements Directive consists of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006relating to the taking up and pursuit of the business of creditinstitutions (recast), OJ L 177, 30.6.2006, p. 1 and Directive2006/49/EC of the European Parliament and of the Council of14 June 2006 on the capital adequacy of investment firms andcredit institutions (recast), OJ L 177, 30.6.2006, p. 201.30 CON/2008/84.31 Directive 2000/46/EC of the European Parliament and of theCouncil of 18 September 2000 on the taking up, pursuit ofand prudential supervision of the business of electronic moneyinstitutions, OJ L 275, 27.10.2000, p. 39.32 See Articles 4(1) and (5) of Directive 2006/48/EC, as cited infootnote 30.33 For more details, see Section 2 of Chapter 4.34 Commission Decision 2004/10 of 5 November 2003 establishingthe European Banking Committee, OJ L 3, 7.1.2004, p. 36.35 CON/2008/63.36 CON/2009/1.37 Regulation (EC) No 2560/2001 of the European Parliament andof the Council of 19 December 2001 on cross-border paymentsin euro, OJ L 344, 28.12.2001, p. 13.ECBAnnual Report2008131

EU. The reform of such systems may implyreduced reporting obligations for banks but alsoan increased reporting burden for non-banks,which should be kept to a minimum. It shouldalso be ensured that b.o.p. statistics continue tobe compiled with the high reliability, frequencyand timeliness required for the ECB’s conductof monetary policy.The ECB issued an opinion 38 on amendmentsto the Deposit-Guarantee Schemes Directive 39aimed at improving depositor confidence byincreasing the minimum coverage amount ofdeposit-guarantee schemes and reducing themaximum delays in payouts of guaranteeddeposits. The ECB supported these aims, whilestressing that the credibility of deposit-guaranteeschemes should be preserved by establishingefficient operational processes for verifyingclaims and paying depositors, ensuring thatsufficient funding is available, and enhancingdepositors’ awareness of the terms and conditionsof deposit protection. Any arrangements mustrespect the monetary financing prohibition ofArticle 101 of the Treaty. 40 The ECB expects tocontribute to further work in this field in 2009.The ECB continued to be consulted by nationalauthorities on issues pertaining to the NCBs, inparticular on amendments to the statutes of theBelgian, Bulgarian, Czech, German, Estonian,Spanish, Luxembourg, Hungarian, Romanianand Swedish NCBs. 41 With regard to a proposedamendment to the Law of the DeutscheBundesbank, the ECB noted that a MemberState may not impair an NCB’s ability toemploy and retain the qualified staff necessaryfor the NCB to perform independently the tasksconferred on it by the Treaty and the Statute ofthe ESCB, and that an NCB may not be put in aposition where the government may influenceits policy on staff matters. 42 The ECB indicatedthat it would welcome a revision of theproposed amendments, extending the powersof the Executive Board of the DeutscheBundesbank to adopt staff regulations. Inconnection with the proposed amendments tothe Statute of Banca Naţională a României, theECB was of the opinion that they wouldconsiderably limit central bank independence,in particular owing to the requirement forparliamentary approval of Banca Naţională aRomâniei’s annual report and the possibility ofcentral bank staff being held personally liablefor losses. 43 In its opinion on the financialindependence of Sveriges Riksbank in thecontext of capital structure and profitdistribution, the ECB emphasised that Swedenwas obliged to have brought into force thenecessary adaptations to comply with therelevant provisions of the Treaty and theStatute of the ESCB concerning central bankindependence by the time of the establishmentof the ESCB on 1 June 1998. 44 Moreover, theECB underlined that any legislative reformshould aim to gradually achieve consistencywith Eurosystem standards. In addition, theECB submitted an own-initiative opinion onthe reform of the Greek social security system,since the ECB considered that the proposedprovisions could affect the status of the Bankof Greece as an independent authority. 45 TheBank of Greece’s pension fund was integratedinto a state-run pension fund and the Bank wasrequired to contribute an amount of €23 millionannually for a period of 15 years. The relevantprovisions of the law would have warrantedconsideration with regard to the possibleimplications for central bank independence,including financial independence, and theprohibition of monetary financing.The ECB was consulted twice by Luxembourgon a draft law improving the legislativeframework for Luxembourg as a financial centreand amending the Law on monetary status and38 CON/2008/70.39 Directive 94/19/EC of the European Parliament and of theCouncil of 30 May 1994 on deposit-guarantee schemes,OJ L 135, 31.5.1994, p. 5.40 Interpreted in line with Council Regulation (EC) No 3603/93 of13 December 1993 specifying definitions for the application ofthe prohibitions referred to in Articles 104 and 104b(1) of theTreaty, OJ L 332, 31.12.1993, p. 1.41 CON/2008/33, CON/2008/73, CON/2008/2, CON/2008/21,CON/2008/9, CON/2008/14, CON/2008/82, CON/2008/17,CON/2008/83, CON/2008/31, CON/2008/4 and CON/2008/34.42 CON/2008/9.43 CON/2008/31.44 CON/2008/34.45 CON/2008/13.132 ECBAnnual Report2008

on the Banque centrale du Luxembourg. 46 Theopinions welcomed the strengthening of theBanque centrale du Luxembourg’s financialstability role and the establishment of a legalbasis for the possible extension of emergencyliquidity assistance by the Bank.In the area of payment and settlement systems,the ECB was consulted by Poland on a draftlaw amending the Law on trading in financialinstruments and other legislation. 47 In line withearlier opinions, the ECB recommended expressprovisions concerning the NCB’s competence inthe field of oversight of payment and settlementsystems.With regard to financial supervision, Finlandconsulted the ECB on a draft legislativeproposal on the integration of financial andinsurance supervision. 48 The ECB supported astrengthening of the supervisory structure, butemphasised the need for safeguards forbudgetary arrangements, the reimbursementmechanism, and auditing and reporting. In linewith previous opinions, the ECB stated thatcooperation and information-sharing betweensupervisory authorities and central banks wasessential for the conduct of macro-prudentialmonitoring and the oversight of paymentsystems. In the area of financial stability, theECB was consulted by Poland on a draft lawamending the Law on the Bank GuaranteeFund. 49 The ECB restated the criteria allowingthe NCBs to extend credit to national depositprotection schemes and emphasised theimportance of the effective coordination ofsuch schemes.In the context of the global financial crisis,the ECB issued a large number of opinions 50on national rescue measures concerning stateguarantees, the recapitalisation of distressedbanks, the purchase of banks’ assets and depositguaranteeschemes. In this connection, the ECBemphasised the importance of a coordinatedapproach in compliance with the concertedaction plan adopted on 12 October 2008 by theeuro area Heads of State or Government andwith Community law (in particular with regardto state aid provisions), and stressed that thestate’s role as shareholder should be limitedin time. 51With regard to the introduction of the euro inSlovakia, the ECB was consulted by Slovakiaon draft national legislation on the dual displayof prices and rounding rules. 52 The ECBrecalled the importance of the principles of priceneutrality and continuity of legal instrumentsand recommended adopting an approach thatwas consistent with comparable cases related tomethodologies and practices of rounding.As of 2008, information regarding clear andimportant cases of non-compliance with theobligation to consult the ECB on draft nationaland Community legislation is also included inthe Annual Report. In addition to the reformof the Greek social security system, on whichthe ECB issued an own-initiative opinion asdescribed above, there were six such casesof non-consultation of the ECB on proposednational legislation in 2008.In two cases, the Bulgarian and Cypriotauthorities failed to consult the ECB on legalprovisions providing grounds for dismissal ofthe central bank governor in addition to thoseof the Statute of the ESCB. The BulgarianLaw on prevention and disclosure of conflictsof interests of 16 October 2008 provides thatnon-compliance with its provisions and theexistence of a conflict of interests are groundsfor dismissal of public officials, includingthe Governor, the Deputy Governors and themembers of the Governing Council of Българсканародна банка (Bulgarian National Bank). The46 CON/2008/17 and CON/2008/42.47 CON/2008/20.48 CON/2008/16.49 CON/2008/32.50 CON/2008/44, CON/2008/46, CON/2008/48, CON/2008/50,CON/2008/51, CON/2008/52, CON/2008/54, CON/2008/55,CON/2008/56, CON/2008/57, CON/2008/58, CON/2008/59,CON/2008/60, CON/2008/61, CON/2008/62, CON/2008/65,CON/2008/66, CON/2008/67, CON/2008/68, CON/2008/69,CON/2008/74, CON/2008/75, CON/2008/76, CON/2008/79,CON/2008/80, CON/2008/81, CON/2008/88, CON/2008/89 andCON/2008/92.51 For more details, see Chapter 5.52 CON/2008/23, CON/2008/25 and CON/2008/27.ECBAnnual Report2008133

Cypriot Law imposes restrictions with respectto certain economic activities and benefits,non-compliance with which provides a groundfor dismissal of the Governor of the CentralBank of Cyprus. Had the ECB been consulted, itwould have made significant critical commentsas to the compliance of these provisions withArticle 14.2 of the Statute of the ESCB.The ECB was not consulted by the Frenchauthorities on two amendments to the draftlaw on the modernisation of the economywhich further simplified the statute of theBanque de France by, inter alia, abolishing themonetary committee of its General Council andtransferring to the Governor responsibility fortransposing ECB guidelines. Although the ECBwould not have objected to these institutionalchanges, it should have been consulted since theprovisions relate to the Banque de France.The Dutch authorities failed to consult theECB on the Law amending the law on financialsupervision. The Law states that in exceptionalcircumstances, De Nederlandsche Bankand the Autoriteit Financiële Markten mayadopt temporary rules to foster the stabilityof the financial sector. In a letter to the DutchMinister of Finance, the ECB noted that thedraft legislation related to an NCB and rulesapplicable to financial institutions that materiallyinfluence the stability of financial institutionsand markets, and that the ECB should thereforehave been consulted.The ECB was not consulted by the Portugueseauthorities on three legal acts adopted in thecontext of the financial turmoil. One assigned tothe Banco de Portugal tasks such as assessingcredit institutions’ requests for an increase ofown funds and overseeing compliance withrecapitalisation plans. The other two legal actsprovided for the Portuguese state to stand asguarantor to the financing of credit institutionsregistered in Portugal, with the Banco dePortugal being one of the authorities responsiblefor reviewing financing requests and monitoringthe enforcement of such state guarantees.Since the adopted legislation relates to an NCBand lays down rules applicable to financialinstitutions that materially influence the stabilityof financial institutions and markets, the ECBshould have been consulted.The ECB was not consulted by the Romanianauthorities on draft legislative provisionstransposing Directive 2006/43/EC on statutoryaudits of annual accounts and consolidatedaccounts into Romanian law. Although thisconcerned the transposition of an EC Directive,the ECB should have been consulted sincethe provisions concerned Banca Naţională aRomâniei.6.3 ADMINISTRATION OF THE BORROWING ANDLENDING OPERATIONS OF THE EUROPEANCOMMUNITYIn accordance with Article 123(2) of the Treatyand Article 9 of Council Regulation (EC) No332/2002 of 18 February 2002, the ECB continuesto have responsibility for the administration ofthe borrowing and lending operations of theEuropean Community under the medium-termfinancial assistance mechanism. In 2008 theECB received a principal sum from creditorsvis-à-vis the Community and paid the loanamount to the borrower country (Hungary). Thetotal amount of outstanding Community lendingoperations with Hungary as at 31 December2008 was €2 billion (by comparison, there wereno outstanding balances at the end of 2007).6.4 EUROSYSTEM RESERVE MANAGEMENTSERVICESIn 2008 a comprehensive set of servicescontinued to be offered under the frameworkestablished in 2005 for the management ofEurosystem customers’ euro-denominatedreserve assets. The complete set of services –which is available to central banks, monetaryauthorities and government agencies locatedoutside the euro area, as well as to internationalorganisations – is offered under harmonisedterms and conditions in line with general market134 ECBAnnual Report2008

standards by individual Eurosystem central banks(the Eurosystem service providers). The ECBperforms an overall coordination role, ensuringthe smooth functioning of the framework. Thenumber of customers maintaining a businessrelationship with the Eurosystem remainedstable over 2008. With respect to the servicesthemselves, there was a sizeable increase incustomers’ total cash balances and securitiesholdings, particularly in the second part of theyear. Following a customer satisfaction surveycarried out in 2007, which confirmed customers’overall satisfaction, the Eurosystem commencedwork in 2008 to further enhance the range ofservices available under the framework and thequality of service offered.ECBAnnual Report2008135

Cashiers being trained at Suomen Pankki – Finlands Bank in Helsinki in September 2001

CHAPTER 3ENTRY OF SLOVAKIAINTO THE EURO AREA

1 ECONOMIC AND MONETARY DEVELOPMENTSIN SLOVAKIAOn 8 July 2008 the ECOFIN Council adopteda decision allowing Slovakia to join the euroarea as from 1 January 2009, increasing thenumber of euro area countries from 15 to16. The Council’s decision was based on theconvergence reports prepared by the ECB andthe European Commission in May 2008, andfollowed discussions by the EU Council in thecomposition of the Heads of State or Government,an opinion of the European Parliament and aproposal from the European Commission. Onthe same day, the ECOFIN Council adopted aregulation irrevocably fixing the conversion ratebetween the Slovak koruna and the euro at SKK30.1260, the ERM II central rate at the time of thedecision. On the day that the conversion rate wasset, the Slovak koruna was trading close to thatrate. During the Slovak koruna’s participation inERM II, from 28 November 2005, its central paritywas revalued twice against the euro, by 8.5% inMarch 2007 and by 17.6472% in May 2008.Slovakia’s economy has grown at very robustrates in recent years, following a period ofsluggish economic growth below 2% in thelate 1990s. The improvement in the growthperformance over the past ten years has beensupported by deep structural reforms and theensuing significant inflow of foreign capital.Real GDP growth peaked above 10% in 2007,followed by a more moderate rate of 6.4%in 2008 (see Table 13). Slovakia’s economicperformance over the past few years has beenclosely related to significant improvementsin its production capacity, in particular in theindustrial sector. The majority of new plants,which are concentrated in the car and electronicindustries, are export-oriented. Looking at theexternal environment, Slovakia has recordedsignificant deficits in its combined current andcapital account for most of the past decade.These deficits, however, have to a large extentbeen financed by inflows of foreign directinvestment, with debt-creating flows playingonly a secondary role. In the first half of thedecade, large investment projects initially causedsome deterioration in the current and capitalaccount balances, reflecting in particular importsof new technologies. This effect was, however,temporary, as significant improvements in theexport capacity of industry contributed to areduction of these deficits. The average currentand capital account deficit has stood at 5.5% ofGDP over the past five years.The inflation performance of the Slovakeconomy over the past decade has been relativelyvolatile. Changes in administered prices andindirect taxes contributed significantly to thisvolatility. Following a period of high inflation,annual HICP inflation decreased graduallyfrom 2004, reaching a trough of 1.9% in 2007,notwithstanding a temporary increase in 2006.This decline followed the adoption of aninflation-targeting framework by Národnábanka Slovenska. The moderation in inflationwas supported by the gradual appreciation of theSlovak koruna against the euro. Subsequently,Slovak HICP inflation increased again, peakingin September 2008 at 4.5%, reflecting to asignificant extent developments in global energyand food prices. Against the background of thesignificant easing of global commodity prices,inflation rates started to moderate again in thelast few months of 2008 and in early 2009. For2008 as a whole, HICP inflation stood at 3.9%.Notwithstanding significant improvements, thelabour market continues to be characterisedby considerable structural rigidities. At thebeginning of this decade, the situation in thelabour market did not improve in spite ofrelatively robust economic growth. This changedin 2004, when substantial tax, social benefitand labour market reforms were implemented,which, together with the ensuing sizeable inflowof foreign capital, contributed to robust jobcreation. The unemployment rate also declinedbecause of the outward migration of workersfollowing Slovakia’s accession to the EU inMay 2004. Despite these improvements, theunemployment rate has remained close to 10%,reflecting the existing rigidities in the labourmarket. These rigidities contribute, in particular,to the high rate of long-term unemployment, anunfavourable skill mix among the unemployedand substantial disparities between regionallabour markets.138 ECBAnnual Report2008

Table 13 Main economic indicators for Slovakia(annual percentage changes, unless otherwise indicated)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Real GDP growth 0.0 1.4 3.4 4.8 4.7 5.2 6.5 8.5 10.4 6.4Contribution to real GDP growth(in percentage points)Domestic demand excluding stocks -6.7 -0.6 7.5 4.0 1.1 3.3 8.7 7.6 6.0 5.8Net exports 6.9 0.3 -5.0 0.4 5.7 -0.8 -2.2 2.2 4.6 0.0HICP inflation 1) 10.5 12.3 7.2 3.5 8.4 7.5 2.8 4.3 1.9 3.9Compensation per employee 6.9 13.3 5.8 8.7 8.2 8.4 9.7 7.7 8.8 9.0Nominal unit labour costs(whole economy) 4.1 9.6 2.9 3.9 4.4 2.9 4.3 1.5 0.6 5.2Import deflator (goods and services) 0.3 14.1 6.0 1.0 1.9 2.1 1.7 3.6 1.6 3.0Current and capital account balance(% of GDP) .. .. -1.8 -5.3 -4.1 -5.7 -6.7 -6.3 -4.2 -4.8Total employment -2.5 -2.0 0.6 0.1 1.1 -0.2 1.4 2.3 2.1 2.8Unemployment rate(% of labour force) 16.4 18.8 19.3 18.7 17.6 18.2 16.3 13.4 11.1 9.6General government surplus (+)/deficit (-) -7.4 -12.3 -6.5 -8.2 -2.7 -2.3 -2.8 -3.5 -1.9 -2.3General government gross debt 47.8 50.3 48.9 43.4 42.4 41.4 34.2 30.4 29.4 28.8Three-month interest rate(% per annum) 1) 15.7 8.6 7.8 7.8 6.2 4.7 2.9 4.3 4.3 4.2Long-term ten-year government bond yield(% per annum) 1) .. .. 8.0 6.9 5.0 5.0 3.5 4.4 4.5 4.7Exchange rate against the euro 1), 2) 44.1 42.6 43.3 42.7 41.5 40.0 38.6 37.2 33.8 31.3Sources: ECB and Eurostat.1) Average of period values.2) Slovak koruna per euro.Fiscal policy has become more supportive of theachievement of price stability over recent yearsin Slovakia. Starting from very high levels, thegeneral government deficit-to-GDP ratio fellfrom 12.3% of GDP in 2000 to 2.3% of GDP in2008. The excessive deficit procedure that hadbeen initiated upon Slovakia’s entry into the EUin 2004 was abrogated in June 2008. The generalgovernment debt-to-GDP ratio has also declinedin recent years, falling from 50.3% of GDP in2000 to 28.8% of GDP in 2008. However, fiscaldeficits in Slovakia are high considering thevery strong economic growth recorded in recentyears. Looking ahead, Slovakia must ensure thatits budget deficit is kept below 3% of GDP ina sustainable manner by implementing credibleand sustainable consolidation measures, whichwould also allow the country to reach itsmedium-term budgetary objective.Monetary policy played an important role instabilising the Slovak economy. In autumn 1998the exchange rate regime of the Slovak korunawas set to managed floating with the euro asthe reference currency from January 1999, andNárodná banka Slovenska adopted an implicitinflation-targeting monetary policy strategy. On1 January 2005 the monetary policy strategyof Národná banka Slovenska was modified tobecome an “inflation-targeting regime underthe conditions of ERM II”. The Slovak korunaentered ERM II on 28 November 2005 and itscentral rate against the euro was initially set atSKK 38.4550. The standard fluctuation bandof ±15% was applied. Reflecting improvingmacroeconomic fundamentals, the Slovakkoruna appreciated significantly and its centralparity was revalued twice against the euroduring its participation in ERM II.In the context of the inflation-targetingframework in effect between 2005 and 2008, themonetary policy of Národná banka Slovenskawas geared towards maintaining price stability.As a consequence, the mounting inflationarypressures that started to emerge towards theend of 2005 initiated a period of monetarytightening. Národná banka Slovenska increasedECBAnnual Report2008139

its policy rate in several steps by a total of175 basis points, so that it stood at 4.75% inSeptember 2006. The subsequent stabilisationof inflation and the strong commitment of thenewly elected government to the original euroadoption timetable helped to overcome thisbrief episode of economic instability. Moreover,renewed confidence in the euro adoption plansand solid macroeconomic developmentsprovided support for the exchange rate of theSlovak koruna, which started to appreciategradually against the euro. In 2007 Národnábanka Slovenska started to ease its monetarypolicy stance, reducing its policy rate in twosteps by a total of 50 basis points to 4.25%. Inthe light of the expected euro adoption, Národnábanka Slovenska followed the ECB’s interestrate decisions from October 2008, reducing itsrepo rate in three steps by a total of 175 basispoints to 2.5%. Money market interest rates inSlovakia moved broadly in line with the centralbank’s policy rate. Owing to excess liquidity inthe Slovak banking sector, money market rateswere below those in the euro area in the lastfew months of 2008. Long-term governmentbond yields have declined over recent years,reflecting strong market confidence in economicdevelopments in Slovakia.Now that it has adopted the euro, Slovakia canno longer benefit from its currency appreciatingagainst the euro, which helped to containinflation in the past. Following the adoption ofthe euro, the authorities should pursue ambitiouseconomic policies on all fronts. Priority must begiven to the achievement of further sustainableeconomic convergence. The preservation ofa low-inflation environment is crucial in thatrespect. In particular, the rigorous and credibleimplementation of fiscal policy in line withthe Stability and Growth Pact commitmentsis essential to contain inflationary pressuresin the economy. Despite the recent economicslowdown, the authorities should continue toavoid excessive fiscal deficits and proceed withfiscal consolidation so as to reach their mediumtermbudgetary objective as soon as possible.Further efforts should be made in Slovakiato underpin external competitiveness andstrengthen economic resilience. The functioningof Slovakia’s labour market must be furtherimproved and efforts need to be made to tacklethe high level of structural unemployment.There is also a need to improve the businessenvironment in order to enhance productivitygrowth and preserve the country’s attractivenessfor foreign capital.Box 11STATISTICAL IMPLICATIONS OF THE ENLARGEMENT OF THE EURO AREA TO INCLUDE SLOVAKIASlovakia’s entry into the euro area on 1 January 2009 is the fourth occasion on which statisticalseries for the euro area have had to be amended to include additional member countries. Thepreparation of statistics for the enlarged euro area has been coordinated, where necessary, withthe European Commission.The entry of Slovakia into the euro area means that Slovak residents have become residentsof the euro area. This affects statistics for which euro area aggregates are not a simple sumof national data, such as monetary, balance of payments and international investment positionstatistics, as well as financial accounts, because transactions between residents of Slovakia andother euro area residents must now be consolidated.140 ECBAnnual Report2008

As of January 2009 Slovakia is thus obliged to meet all the statistical requirements of the ECB,i.e. to provide fully harmonised and comparable national data. 1 Since the preparatory workfor new statistics requires a long lead time, Národná banka Slovenska and the ECB started thestatistical preparations well before Slovakia joined the EU. After becoming a member of theESCB, Národná banka Slovenska intensified its preparations to fulfil the requirements of theECB in the field of monetary, banking, balance of payments, government finance, financialaccounts and other financial statistics. In addition, it had to carry out the necessary preparationsfor the integration of Slovak credit institutions into the ECB’s minimum reserve system and tofulfil the relevant statistical requirements.For the data reporters and NCBs of the other euro area countries, the enlargement of the euroarea means that since January 2009 they have had to report transactions (or flows) and positionswith residents of Slovakia as part of the euro area data, rather than as transactions and positionswith non-euro area residents.In addition, Slovakia and the other euro area countries all had to provide backdata with sufficientgeographical and sector detail, dating back as far as 2004, the year Slovakia joined the EU.Regarding the publication of euro area statistics, the ECB has granted users online access to twosets of time series, one containing data for the current euro area (i.e. including Slovakia) as farback as available, and one linking the various compositions of the euro area, starting with the11 countries in 1999.1 The statistical requirements of the ECB are summarised in the document “ECB statistics: an overview”, April 2008.ECBAnnual Report2008141

2 LEGAL ASPECTS OF THE INTEGRATIONOF NÁRODNÁ BANKA SLOVENSKA INTOTHE EUROSYSTEMPursuant to Article 122(2) of the Treaty, theECB reviewed the statute of Národná bankaSlovenska and other relevant Slovak legislationfor compliance with Article 109 of the Treaty.The ECB made a favourable assessment of thecompatibility of Slovak legislation with theTreaty and with the Statute of the ESCB, asstated in its Convergence Report published inMay 2008.The ECB and Národná banka Slovenska putin place a number of legal instruments with aview to ensuring the integration of Národnábanka Slovenska into the Eurosystem on1 January 2009. The Eurosystem’s legalframework was adapted as a consequence ofthe decision taken by the ECOFIN Councilon 8 July 2008 to abrogate the derogation ofSlovakia 1 . The introduction of the euro inSlovakia and the integration of the central bankinto the Eurosystem also required changes tosome Slovak legal instruments.As regards legal preparations for the integrationof Národná banka Slovenska into theEurosystem, the ECB adopted the necessarylegal instruments to provide for the paying-upof the remaining capital and the transfer offoreign reserves to the ECB. 7 The ECB alsoreviewed its legal framework and introduced,where necessary, amendments resulting fromNárodná banka Slovenska’s membership of theEurosystem. This included a review of Slovaklegislation implementing the Eurosystem’s legalframework for monetary policy and TARGET2,which enabled Slovak counterparties toparticipate in the Eurosystem’s open marketoperations from 2 January 2009. The ECB alsoadopted a decision on transitional provisions forthe application of minimum reserves by theECB following the introduction of the euro inSlovakia. 8 Finally, the ERM II agreement 9 wasterminated for Národná banka Slovenska.By the end of 2007 Národná banka Slovenska’sstatute had been brought into line withrecommendations in the ECB’s 2004 and 2006Convergence Reports. Slovakia consulted theECB on the draft amendments to the statute ofNárodná banka Slovenska on 20 July 2007 andthe ECB adopted an opinion proposing certainchanges, which were reflected in the finalversion of the statute. 2The ECOFIN Council’s decision of 8 July 2008entailed amendments to Council Regulation(EC) No 974/98 to enable the introductionof the euro in Slovakia 3 , and the adoptionof Council Regulation (EC) No 694/2008 4amending Regulation (EC) No 2866/98, whichdetermined the irrevocably fixed exchange rateof the euro vis-à-vis the Slovak koruna. TheCouncil consulted the ECB on its proposalsfor both these regulations, on which the ECBadopted an opinion 5 . The ECB was alsoconsulted on national legislation governingthe euro changeover, payment and settlementsystems, rounding rules and currency circulationin Slovakia. 6123456789Council Decision 2008/608/EC of 8 July 2008 in accordancewith Article 122(2) of the Treaty on the adoption by Slovakiaof the single currency on 1 January 2009, OJ L 195, 24.7.2008,p. 24.CON/2007/43.Council Regulation (EC) No 693/2008 of 8 July 2008 amendingRegulation (EC) No 974/98 as regards the introduction of theeuro in Slovakia, OJ L 195, 24.7.2008, p. 1.Council Regulation (EC) No 694/2008 of 8 July 2008 amendingRegulation (EC) No 2866/98 as regards the conversion rate tothe euro for Slovakia, OJ L 195, 24.7.2008, p. 3.CON/2008/28.CON/2008/18, CON/2008/23, CON/2008/25, CON/2008/27,CON/2008/40 and CON/2008/86.Decision ECB/2008/33 of 31 December 2008 on the paying-upof capital, transfer of foreign reserve assets and contributionsby Národná banka Slovenska to the European Central Bank’sreserves and provisions, OJ L 21, 24.1.2009, p. 83.Decision ECB/2008/14 of 28 October 2008 on transitionalprovisions for the application of minimum reserves by the ECBfollowing the introduction of the euro in Slovakia, OJ L 319,29.11.2008, p. 73.Agreement of 8 December 2008 between the ECB and thenational central banks of the Member States outside the euro areaamending the Agreement of 16 March 2006 between the ECBand the national central banks of the Member States outside theeuro area laying down the operating procedures for an exchangerate mechanism in stage three of economic and monetary union,OJ C 16, 22.1.2009, p. 10.142 ECBAnnual Report2008

3 OPERATIONAL ASPECTS OF THE INTEGRATIONOF NÁRODNÁ BANKA SLOVENSKA INTOTHE EUROSYSTEMFollowing the ECOFIN Council’s decisionof 8 July 2008 on the adoption of the euro bySlovakia on 1 January 2009, the ECB conductedtechnical preparations with a view to fullyintegrating Národná banka Slovenska into theEurosystem. In line with the provisions of theTreaty, Národná banka Slovenska joined theEurosystem with exactly the same rights andobligations as the NCBs of the EU MemberStates that had already adopted the euro.The technical preparations for the integration ofNárodná banka Slovenska into the Eurosystemcovered a wide range of areas, notably financialreporting and accounting, monetary policyoperations, foreign reserve management andforeign exchange operations, payment systems,statistics and banknote production. In the fieldof operations, preparations involved extensivetesting of the instruments, procedures andtechnical systems for the implementationof monetary policy and foreign exchangeoperations.3.1 MONETARY POLICY OPERATIONSFollowing the adoption of the euro by Slovakiaon 1 January 2009, 26 Slovak credit institutions,a list of which is published on the ECB’swebsite, became subject to the Eurosystem’sreserve requirements as from that date. Theentry of Slovakia into the euro area changedthe liquidity conditions in the Eurosystem onlyslightly. The aggregate reserve requirements ofeuro area credit institutions increased by lessthan 0.5% (€740 million). Net autonomousliquidity factors in Slovakia for the period from1 to 20 January 2009 were liquidity-providing,reducing the liquidity needs of the entire euroarea banking sector by €7.21 billion on average.This liquidity-providing effect occurred despitethe fact that the liquidity-absorbing monetarypolicy operations launched by Národná bankaSlovenska before entering the euro area, whichmatured between 6 and 13 January 2009,were also treated as autonomous factors, aswere debt certificates issued by the centralbank which matured on 20 January. Takingall of these factors into account, the entry ofSlovakia into the euro area reduced the totalliquidity needs of the euro area banking sectorby €11 billion, roughly equal to 1% of aggregateliquidity needs.Given the liquidity surplus, counterpartiesfrom Slovakia submitted bids for relativelysmall amounts in the open market operationsconducted at the beginning of 2009: €1 millionin the main refinancing operation which settledon 14 January, and €15 million in both the threemonthand the six-month longer-term refinancingoperations which settled on 8 January.On entering the euro area, Národná bankaSlovenska also adopted the collateral frameworkof the Eurosystem and reported €17.6 billionin assets located in Slovakia which wereeligible for Eurosystem credit operations as of1 January 2009.3.2 CONTRIBUTION TO THE ECB’S CAPITAL,RESERVES AND FOREIGN RESERVE ASSETSUpon joining the ESCB on 1 May 2004,Národná banka Slovenska paid up 7% of itsshare of the subscribed capital of the ECB asa contribution to the ECB’s operational costs.In accordance with Article 49.1 of the Statuteof the ESCB and the legal acts adopted by theGoverning Council on 31 December 2008,Národná banka Slovenska paid up the remainingpart of its subscription on 1 January 2009. Itstotal subscribed share amounts to €39.9 million,equivalent to 0.6934% of the ECB’s subscribedcapital of €5.761 billion as at 1 January 2009.At the beginning of 2009, in accordance withArticles 30 and 49.1 of the Statute of theESCB, Národná banka Slovenska, on the basisof its share of the ECB’s subscribed capital,transferred to the ECB foreign reserve assetsequivalent to a total of €443.1 million (85% ofwhich was in US dollar-denominated assetsand 15% in gold). Národná banka Slovenskahas opted to conduct the operational activitiesrelated to the management of its share of theECBAnnual Report2008143

ECB’s US dollar reserve assets on an individualbasis via a separate US dollar-denominatedreserve management portfolio. As a result ofthe transfer of foreign reserve assets to theECB, Národná banka Slovenska was creditedwith a euro-denominated claim on the ECB inaccordance with Article 30.3 of the Statute ofthe ESCB.144 ECBAnnual Report2008

4 THE CASH CHANGEOVER IN SLOVAKIATHE LOGISTICS OF THE CASH CHANGEOVEROn 1 January 2009 Slovakia adopted the euroas its currency. After a dual circulation periodof two weeks, the euro had fully replaced theSlovak koruna.To ensure the smooth introduction of the eurobanknotes and coins, all relevant market players,in particular the banking sector, were involvedin the changeover preparations. The nationalchangeover plan provided all businesses andthe general public with a timetable, well before€-Day. Building on the experience gained withthe cash changeovers in Slovenia in 2007 andin Malta and Cyprus in 2008, the GoverningCouncil adopted a new ECB Guideline on certainpreparations for the euro cash changeover andon frontloading and sub-frontloading of eurobanknotes and coins outside the euro area. 10The Guideline provides, for example, for thepossibility of euro cash to be pre-distributedto micro-enterprises in accordance with verysimple procedures in addition to the normalprocedure applied in the previous changeovers.Each NCB joining the Eurosystem may decidewhether or not to make use of the provisionscontained in the Guideline.Following the ECOFIN Council’s decisionof 8 July 2008 on the adoption of the euro inSlovakia on 1 January 2009, Národná bankaSlovenska became eligible to borrow banknotesfrom the Eurosystem in preparation for the cashchangeover and for the banknote requirementsin 2009. For geographical and logistical reasons,the required 196.2 million banknotes, with a facevalue of €8.3 billion, were delivered on behalfof the Eurosystem by the OesterreichischeNationalbank.The initial supply of 499 million euro coins, witha face value of €165.22 million, was minted bythe Slovak Mint in Kremnica.The frontloading of euro coins and banknotes tofinancial institutions started in September andOctober 2008 respectively. Sub-frontloading tobusinesses began in November 2008. Národnábanka Slovenska, banks and post offices alsomade available coin starter kits (each containingcoins with a face value of €16.60) to the generalpublic as of 1 December 2008. These made exactpayments in retail transactions possible, thusreducing the amount of small change requiredimmediately after the changeover date.The frontloading and sub-frontloading operationsallowed the delivery of the euro banknotesand coins to be spread over a longer period oftime, thus avoiding supply bottlenecks. Thefrontloaded amounts were largely used for thetimely adaptation of automated teller machines(ATMs) to the euro. Virtually all ATMsdispensed euro banknotes as of 1 January 2009.In connection with the introduction of the euroin Slovakia, euro area NCBs exchanged Slovakkoruna banknotes against euro at par value fromthe first working day of 2009 until28 February 2009 as a free-of-charge service. 11The amount exchanged was limited to €1,000for any given party and transaction on any oneday. Národná banka Slovenska will continue toredeem Slovak koruna banknotes for anunlimited period of time and coins until the endof 2013.THE INFORMATION CAMPAIGN ON THEINTRODUCTION OF THE EUROThe ECB worked closely with Národnábanka Slovenska to prepare a comprehensiveinformation campaign in preparation forthe introduction of the euro in Slovakia on1 January 2009.The logo “€ Our money”, which was based onthe logo used successfully by the Eurosystemsince the euro information campaign in 2002,10 Guideline ECB/2008/4 amending Guideline ECB/2006/9on certain preparations for the euro cash changeover and onfrontloading and sub-frontloading of euro banknotes and coinsoutside the euro area.11 Article 52 of the Statute of the ESCB requires that the GoverningCouncil of the ECB take the necessary measures to ensure thatbanknotes denominated in currencies with irrevocably fixedexchange rates to the euro are exchanged by the euro area NCBsat par value. Against this background, the Governing Counciladopted a guideline on the exchange of such banknotes on24 July 2006.ECBAnnual Report2008145

was employed by Národná banka Slovenskain its communication activities relating to theintroduction of the euro in Slovakia.The euro information campaign organised bythe ECB and Národná banka Slovenska aimed tofamiliarise cash handlers and the general publicwith the visual appearance and security featuresof the euro banknotes and coins, as well as withthe cash changeover arrangements.publications, which they were able to adapt anduse in their own communication activities.Following contact with associations for theblind, the ECB developed a “talking card” forthe visually impaired, in which an embeddedMP3 file played a recording containing basicinformation about the euro banknotes and coins.The combination of communication toolsused in the campaign took into account theexperience gained in past changeovers andcomprised 17 different publications, includingtraining materials for professional cashhandlers. Národná banka Slovenska distributedover 7 million copies of the various publications(including a public information leaflet, euroconversion cards and other publications infour language versions) in the course of thefourth quarter of 2008. In December 2008 eachSlovak household received a copy of the publicinformation leaflet and two euro conversioncards. The euro conversion cards showeddifferent images depending on the angle atwhich they were viewed. On the front, a seriesof 28 prices were shown both in euro and inSlovak koruna, while the reverse displayed themain security features of the €20 banknote.Several press and public relations events wereheld, including an ECB media seminar on4 September 2008, an exhibition on the eurobanknotes and coins, which was launchedon 21 September 2008 at Národná bankaSlovenska, a euro conference in Bratislava on22 September 2008 and state celebrations on8 January 2009.The ECB co-financed the largest banner everproduced in Slovakia, which was displayedon the facade of Národná banka Slovenska’sbuilding in Bratislava, while smaller copiesof the banner appeared on the buildings of allthe central bank’s branches throughout thecountry. Over 100 partners, mainly banks andpublic authorities, were given access to thehigh-quality print files of the relevant ECB146 ECBAnnual Report2008

Willem F. Duisenberg accepting the Charlemagne Prize on behalf of the euro in Aachen on 9 May 2002

CHAPTER 4FINANCIAL STABILITYAND INTEGRATION

1 FINANCIAL STABILITYThe Eurosystem contributes to the smoothconduct of policies pursued by the competentnational authorities relating to the prudentialsupervision of credit institutions and the stabilityof the financial system. It also offers advice tothese authorities and the European Commissionon the scope and implementation of Communitylegislation in these fields.1.1 FINANCIAL STABILITY MONITORINGThe ECB, in collaboration with the ESCB’sBanking Supervision Committee (BSC), aims tosafeguard the stability of the financial system. 1Key activities are monitoring risks to financialstability and assessing the financial system’sshock-absorbing capacity. The principal focus ison banks, as they are still the primaryintermediaries of funds. At the same time, theincreasing importance of financial markets andother financial institutions and their linkageswith banks means that vulnerabilities in thesecomponents of the financial system are alsomonitored by the ESCB.CYCLICAL DEVELOPMENTSIn 2008 the stresses on the euro area financialsystem, which had been sparked in 2007 bylosses incurred by financial institutions aroundthe world on securities backed by US subprimemortgages, intensified further. As theyear progressed, euro area banks experiencedfurther asset valuation write-downs, higherloan impairments and credit costs, as wellas large falls in trading revenues. The maindevelopments and the lessons that may belearned from this episode are treated elsewherein this report (see Section 2 of Chapter 1), aswell as in a number of other ECB publications,notably the Financial Stability Review.As uncertainty grew about the global economicoutlook, with the balance of risks increasinglyskewed to the downside, risk aversion amongfinancial market participants rose, with mostfinancial asset prices falling as a result. Creditmarket liquidity and funding conditionsdeteriorated markedly during the course of theyear and securitisation markets became moreor less inactive. Persistent liquidity stresseseventually gave way to deeper concerns aboutthe creditworthiness and sufficiency of capitalbuffers. In this environment, investors andcreditors began to lose confidence in the abilityof some financial companies to meet theirobligations. This left many key financial firmsfacing mounting challenges in accessing shorttermfunding and capital markets. Some of theworld’s largest financial institutions sufferedboth rating downgrades and sharp drops in theirshare prices. This development ultimately forcedseveral euro area and international financialinstitutions to consolidate or to seek additionalsupport from shareholders or the government.However, for a number of international financialinstitutions, bankruptcy could not be avoided.Euro area banks initially faced the financialturmoil with their solvency positions generallywell above regulatory minimum requirementsfollowing several years of strong profitabilityperformances. Although some large euro areabanks were badly affected by valuation writedownson structured credit securities and relatedmarket stresses, which had persisted for morethan a year, they seemed to be broadly resilientto adverse disturbances until the situationdeteriorated considerably in September 2008.Euro area banks’ return on equity generallyfell during the first half of 2008, burdened bymark-to-market losses. In addition, impairmentcharges on loans and securities rose significantlywhile fee and commission income as well astrading revenues fell, given the challengingconditions in capital markets. Despite the fall inprofitability, regulatory capital ratios increasedduring the first half of 2008. This improvement1 Since the end of 2004 the ECB has published its FinancialStability Review, a semi-annual report on the stability of theeuro area financial system. In 2008 it also published the seventhedition of its report on “EU banking structures”, as well as adhoc reports on “Commercial property markets”, “The incentivestructure of the ‘originate and distribute’ model”, “Coveredbonds in the EU financial system” and “EU banks’ liquiditystress testing and contingency funding plans”. These publicationspresent the main findings of the monitoring by the BSC of thestructure and stability of the banking sector, and are available onthe ECB’s website.150 ECBAnnual Report2008

eflected discretionary deleveraging of riskweightedassets by individual banks, awidespread raising of capital despite challengingbusiness conditions and, to some degree, theimpact of both the implementation of theBasel II Framework and prudential filters.The prospects for profitability to return to preturmoillevels do not look very promising in theshort term. Significant further declines in thevalues of other structured finance products –including US consumer asset-backed securitiesand euro area residential mortgage-backedsecurities – cannot be ruled out. Lower growthrates for loans to households and firms, a virtualstandstill in securitisation activities, and reducedincome from fees and commissions as well astrading are likely to pose challenges to the financialperformance of banks in 2009. In response, bankshave tightened their lending standards and cutcosts. Against this background, significant policyactions were taken by the Eurosystem and byeuro area governments to bolster market liquidity,confidence and capital buffers.The financial performance of large euro areainsurers deteriorated in the first half of 2008,with most insurers witnessing reductions inpremiums compared with the same periodof 2007. A significant reason for this was afall in demand for life insurance productsfollowing the equity and credit market turmoil.The financial market turbulence and knockoneffects for the real economy will continueto pose further challenges for many insurancefirms. In addition, insurers which offer bankingservices or are part of a financial conglomeratecontinue to be affected by the challenges facingthe banking sector.Global hedge fund returns were strongly negativeacross almost all investment strategies by theend of September 2008. Volatile asset pricereversals, forced deleveraging and margin calls,sudden bans on short sales by public authoritiesand investor redemptions contributed to thisweak performance. While the hedge fund sectoris known to have deleveraged considerably sincethe start of the market turmoil, thereby reducingits vulnerability to further margin calls orunexpected cuts in bank credit lines, hedge funds’vulnerability to the risk of investor redemptionsappears to have grown during 2008 as investorredemptions tend to be sensitive to hedge funds’performance. Looking ahead, if hedge fundsincreasingly fail to retain their investors, thepossibility of further sizeable asset sales by thesector may represent a non-negligible threat tothe stability of the financial markets.STRUCTURAL DEVELOPMENTSThe major structural trends in the EU bankingsystem are in line with those observed inprevious years. 2 Consolidation continued, despiteshowing signs of a moderate slowdown. Trendsvaried across the 15 older EU Member States,while the number of credit institutions in thecountries that have joined the EU since 2004remained broadly unchanged, with Cyprus beinga notable exception owing to the ongoingconsolidation in the cooperative banking sector.Altogether, the number of credit institutions inthe EU declined by 166 in 2007 (from 8,514 to8,348), while the corresponding figure in theprevious year was 175.At the same time, the EU banking landscapecontinued to be dominated by domestic creditinstitutions (which had a 71.3% market share),with the remainder equally divided betweenbranches and subsidiaries of foreign institutions.It should be highlighted, however, that there aresignificant differences among countries, withthe newer Member States characterised by theprominence of foreign entities, especially thosewith a parent company in one of the older EUcountries. It is noteworthy that, in contrast to thesituation in 2006, branches of foreign institutionsin the EU showed an increase in terms of marketshare of total assets. This was particularly true inthe countries that have joined the EU since 2004,where the market share of foreign branchesincreased by approximately 1 percentage point,while that of foreign subsidiaries saw a declineof approximately 4 percentage points.2 The data in this section are taken from the ECB’s report entitled“EU banking structures”, which only contains data up to 2007.ECBAnnual Report2008151

With regard to merger and acquisition (M&A)activity, the total number of transactionsdeclined in 2007. However, a significantincrease was recorded in the number ofacquisitions by EU credit institutions of bankslocated in countries outside the EU, which haveexceeded the figures for domestic deals over thepast three years. The value of M&As has beengrowing since 2003, with 2007 being the secondconsecutive year in which the total value ofM&A transactions exceeded the peak recordedin 2000. Concentration increased, reflecting, onthe one hand, continuing market consolidationand, on the other hand, the dynamic growth ofcertain banking groups, partly as a result of theirM&A activity. It should be noted that smallercountries tend to have more concentratedbanking sectors, with the notable exceptions ofAustria and Luxembourg, the former having astrong savings and cooperative banking sector,and the latter hosting a large number of foreigncredit institutions.Finally, banking intermediation was strengthened,as evidenced by the fact that the total assets ofcredit institutions grew at a higher rate thanGDP. However, the growth of total assets(10.7%) in 2007 at the EU level decelerated incomparison with previous years (2005: 13.7%;2006: 11.9%). 3 It should be noted that thisaggregate figure conceals strong fluctuations: thenewer Member States experienced above averagegrowth of nearly 25% in nominal terms, whilethe United Kingdom, whose financial sectoraccounts for approximately a quarter of the EUbanking sector’s assets, reported only a 2.3%increase in total assets. With the structuralchanges in the financial system and the declinein investment funds and hedge funds, corecommercial banks will become more central tocredit intermediation.1.2 FINANCIAL STABILITY ARRANGEMENTSInitiatives were launched both internationallyand in the EU to address the weaknesses of theoverall financial stability framework revealedby the financial turmoil.In April 2008 the Financial Stability Forum(FSF) proposed recommendations to enhancemarket and institutional resilience. In thiscontext, authorities are expected to clarifyand strengthen national and cross-borderarrangements for dealing with weak banks,as well as to review and, where necessary,strengthen deposit insurance arrangements.In terms of bank resolution arrangements andcross-border crisis management, the BaselCommittee on Banking Supervision (BCBS)carried out a review of national practices.Meanwhile, the FSF is developing a setof high-level principles for financial crisismanagement.In May 2008 the ECOFIN Council updatedthe EU roadmap on strengthening financialstability arrangements adopted in October2007. In accordance with this roadmap, theMemorandum of Understanding (MoU) oncross-border financial stability among EUsupervisory authorities, finance ministriesand central banks entered into force on1 June 2008. 4 The BSC – through a dedicatedtask force – has been assisting the relevantauthorities in the implementation of thisMoU, focusing on implementing the commonanalytical framework for assessing the systemicimplications of a financial crisis. In addition, theBSC has reviewed the key crisis managementfunctions currently in place in the MemberStates, providing input on initiatives to reviewthe tools at the authorities’ disposal.In October 2008 EU Member States took anumber of initiatives to ensure that the designof national stabilisation measures to resolvethe financial turmoil does not lead to negative3 It should be noted that this analysis is based on stockon-balance-sheet data. The analysis of trends with regard tototal assets would be improved by the availability of flow dataon securitised assets (both publicly and privately placed). Thelack of data on securitised assets has less of an impact on theanalysis for the countries that have joined the EU since 2004,where asset securitisation is not so developed. In addition, fornon-euro area countries, figures are not exchange rate-adjusted,so developments could be partially influenced by changes in theexchange rate between local currencies and the euro.4 http://www.ecb.europa.eu/pub/pdf/other/mou-financialstability2008en.pdf152 ECBAnnual Report2008

spillover effects and that a level playing-field ismaintained across countries.First, the ECOFIN Council decided on 7 Octoberto increase the EU minimum protection forindividual deposits to €50,000 for at least oneyear. As a result, the Commission adopted aproposal for the amendment of the Directive ondeposit guarantee schemes on 15 October 2008.The Directive, with the amendments approvedby the European Parliament and the EU Council,is expected to be published in the OfficialJournal around March 2009. In particular, theDirective will increase the level of mandatoryprotection for individual deposits to €50,000 byJune 2009 and further to €100,000 by end-2010unless the Commission reports that this wouldbe inappropriate.Second, a set of “EU common principles”were defined, which were complemented bymore precise guidelines agreed at the summitof euro area countries in Paris on 12 Octoberand subsequently endorsed by all 27 MemberStates at the European Council meeting of15-16 October. They determined, among otherthings, the common features for MemberStates’ interventions, including the guaranteesapplied to the funding and recapitalisation ofbanks.In the case of measures aimed at supporting“liquidity-constrained solvent banks”, it was agreedthat government guarantees could be provided fornew medium-term (up to five years) bank seniordebt issuance. The criteria for determining whichfinancial institutions are eligible to take part in theguarantee scheme must be non-discriminatory andinclude subsidiaries of foreign institutions withsubstantial operations in an EU Member State.The scheme should also be limited in amountand expire on 31 December 2009. Importantly,the Paris declaration states that governmentsmust “work in cooperation with the EuropeanCentral Bank so as to ensure consistency withthe management of liquidity by the Eurosystemand compatibility with the operational frameworkof the Eurosystem”.With regard to recapitalisation measures,Member States decided to make core capitalavailable to relevant financial institutions,for instance by acquiring preferred shares.Although governments committed themselves toproviding the appropriate amount of capital whenneeded, they will generally favour the raising ofprivate capital.The European Council at its meeting of15-16 October underlined the importanceof cooperation mechanisms and announcedthe establishment of a “financial crisis cell”.This cell, in which the President of the ECBparticipates, aims to improve crisis managementamong EU Member States through measuresincluding informal warnings, informationexchange and an evaluation mechanism. TheEuropean Council also stressed the importanceof regular meetings of national supervisors.Finally, the ECOFIN Council, at its meetingon 2 December 2008, specifically emphasisedthe need to establish, without delay, nationalschemes to support the banking sector in respectof guarantees and, in particular, recapitalisationplans. The European Commission was requestedto work closely with the ECB on these issues.With the aim of enhancing the stability of thefinancial system and maintaining a level playingfield,the Eurosystem issued recommendationson government guarantees for bank debt and onthe pricing of bank recapitalisations. InDecember 2008 the European Commissionadopted a communication on the recapitalisationof financial institutions, which also reflected theECB’s recommendations on this matter. 5In February 2009 the ECOFIN Council agreedthat, in order to safeguard banking sectorstability, measures to deal with impaired assetscould in specific cases complement governmentguarantees for bank debt and recapitalisations.These measures should remain consistent5 The communication was published in January 2009 (OJ C 10,15.1.2009, pp. 2-10).ECBAnnual Report2008153

with the principles set out in October 2008,in particular with regard to: i) safeguardingfinancial stability and restoring the provision ofcredit and lending to the economy; ii) ensuring alevel playing-field within the Single Market; andiii) containing the impact on public finances. TheCommission, in cooperation with the ECB, hasprovided elements of guidance in this respect atthe EU level.154 ECBAnnual Report2008

2 FINANCIAL REGULATION AND SUPERVISION2.1 GENERAL ISSUESFollowing the conclusion of the review of theLamfalussy framework 6 for financial regulationand supervision, conducted by the EuropeanCommission with contributions from theEurosystem, the emphasis in 2008 was on theimplementation of the recommendations adoptedby the ECOFIN Council in December 2007.First, the Level 3 Committees 7 amended theirrespective charters to introduce the possibilityof applying qualified majority voting. Althoughthe committees’ decisions are not legally bindingfor their members, those who do not complyshould at least explain their decisions publicly.Second, the Level 3 Committees enhanced theiraccountability by starting to transmit their yearlywork programmes to the European Commission,the EU Council and the European Parliament toallow them to express their views on the keypriorities and give policy advice on supervisoryconvergence and cooperation.Third, the Member States were invited tointroduce a European dimension into themandates of their national supervisors. The ECBparticipated in the discussions in the variousEuropean committees on how to implementthe ECOFIN Council’s recommendations.On 14 May 2008 the ECOFIN Council askedthe Commission to revise the Decisionsestablishing the Level 3 Committees toinclude specific tasks to foster supervisoryconvergence and cooperation. The Eurosystemon 7 November 2008 adopted an opinion onthe revision of the Decision establishing theCommittee of European Banking Supervisors(CEBS). Among other things, the ECBcommented on the appropriate division oflabour between CEBS and the BSC with regardto the risk assessment of the EU banking sector.While the BSC, in line with its mandate, focuseson identifying the main prudential risks for thefinancial system and the banking sector, CEBSconcentrates on the proactive identification ofspecific risks, supervisory concerns and possiblepolicy actions.In addition to strengthening the Lamfalussyframework, authorities have launched a numberof concrete initiatives at both the internationaland the European level to address systemicconcerns and identify the possible long-termeffects of policy proposals related to the revisionof the current regulatory and supervisoryframework. At the international level, the FSFundertook work to analyse the challenges thatsupervisors and regulators face with regard tothe potential pro-cyclical effects of the capitaladequacy regime, loan loss provisioningpractices, compensation arrangements andthe valuation methods applied by financialinstitutions.At the EU level, the President of the EuropeanCommission established in October 2008 anindependent High-Level Group on EU financialsupervision that made recommendations inFebruary 2009 on strengthening Europeansupervisory arrangements covering all financialsectors. 8 The informal ECOFIN Council meetingon 12-13 September set up a working group,in which the ECB was represented, with amandate to assess the range of policy responsesthat could help to reduce the cyclical swingsinherent in the activities of the financial system.In addition, the ECB was asked to produce aregular report on the potential pro-cyclicalityof capital requirements under the CapitalRequirements Directive. To this end, the ECBworks closely with the BSC and CEBS, and apreliminary report, which is based on qualitativeinformation from competent authorities pendingthe availability of supervisory data series, wasproduced at the end of 2008.6 The Lamfalussy approach is a four-level process for approvingsecurities, banking and insurance legislation. For more details,see the report entitled “Final report of the Committee ofWise Men on the regulation of European securities markets”,15 February 2001, which is available on the EuropeanCommission’s website. See also the ECB’s Annual Report 2003,p. 111.7 Level 3 of the Lamfalussy framework focuses on strengtheningsupervisory convergence and cooperation. Three committeescarry out this work: the Committee of European BankingSupervisors (CEBS), the Committee of European SecuritiesRegulators (CESR) and the Committee of European Insuranceand Occupational Pensions Supervisors (CEIOPS).8 http://ec.europa.eu/commission_barroso/president/pdf/statement_20090225_en.pdfECBAnnual Report2008155

2.2 BANKINGCAPITAL REQUIREMENTS DIRECTIVEThe Capital Requirements Directive (CRD) aimsto safeguard the financial soundness of banks andinvestment firms by closely aligning regulatorycapital requirements with the underlying risksthat these institutions face. In October 2008 theEuropean Commission adopted a proposal toamend certain provisions of the CRD, to take intoaccount, among other things, the lessons learnedfrom the financial crisis. With regard to thelarge exposures regime, banks’ exposures to anysingle party will be restricted, resulting also inlimitations in the interbank market. Furthermore,clear EU-wide criteria will be introduced forassessing the eligibility of hybrid capital, withthe aim of improving the quality of banks’ ownfunds. In the area of risk management, revisionsapply to liquidity risk management and thetreatment of securitised products. With regardto the former, a number of provisions havebeen introduced, in line with the ongoing workof the BCBS and CEBS. With regard to thelatter, provisions aim to improve transparency,strengthen the risk management processesof originators and investors alike, and betteralign incentives along the securitisation chain.Finally, the Commission’s proposal foreseesthe establishment of “colleges of supervisors”for all cross-border banks and a clarification ofthe role of competent authorities with the aimof strengthening the supervision of cross-borderbanking groups. The ECB was consulted on thedraft proposal of the Commission. In providingits input, the ECB benefited from work carriedout by the BSC in the context of two reports itpublished in the fourth quarter of 2008.In November the BSC published a report on EUbanks’ liquidity stress-testing and contingencyfunding plans. The report contains a detaileddescription of liquidity stress-testing techniquesand liquidity contingency funding plans, whichare highly diverse across EU banks. It alsoanalyses the adequacy of liquidity stress-testingtechniques and liquidity contingency fundingplans with regard to the absorption of liquidityshocks, in particular during the market turmoil,reaching the conclusion that there is room forimprovement in both areas.In December the BSC produced a report on the“originate and distribute model”, examining thedevelopment of the model both during the timeof its growth in popularity and in the contextof the turmoil in the financial markets. Thereport presents the incentive structure and thevarious conflicts of interest between the actorsin the model. It proposes a number of marketsolutions and policy measures that could playan important role in reducing the effects of theconflicts of interest.ACCOUNTINGThe financial market turmoil has confirmedthe importance of accounting standards froma financial stability perspective. In particular,issues related to the enhanced disclosure ofexposure to structured products, the treatmentof off-balance-sheet vehicles and fair-valueaccounting when markets become inactiveor illiquid have been identified by both theECOFIN Council’s roadmap and the FSF asareas requiring attention.In response to a request by the FSF, theInternational Accounting Standards Board(IASB) set up an Expert Advisory Panel, inwhich the ECB participates, which issuedguidance on the application of fair-valueaccounting when markets became inactive at theend of October 2008.Another issue relates to the importance ofensuring a level playing-field globally withregard to accounting standards, in particularon both sides of the Atlantic. In this context,the IASB adopted decisions aimed at reachingconsistency between the International FinancialReporting Standards (IFRS) and the USGenerally Accepted Accounting Principles (US-GAAP) on the reclassification of items acrossaccounts. In addition, the IASB set up a High-Level Advisory Group to help to ensure thatreporting issues arising from the global economiccrisis are considered in an internationallycoordinated manner. Furthermore, the European156 ECBAnnual Report2008

Commission identified key areas of divergencebetween the IFRS and US-GAAP and urgedthe accounting standard-setters to address theseas a matter of priority. Following the positiveopinions of the ECOFIN Council, the EuropeanParliament and the European SecuritiesCommittee, the European Commission decidedon 12 December 2008 that the generallyaccepted accounting principles of the UnitedStates, Japan, China, Canada, South Korea andIndia would be considered equivalent to theIFRS as of January 2009. The Commission alsoannounced that it would keep the situation underreview and would report on its findings by 2011at the latest for the last four countries. The ECBis closely monitoring these developments.2.3 SECURITIESSince the outbreak of the financial marketturmoil, credit rating agencies have been widelycriticised for their initial ratings of structuredfinance securities, owing to the perception thattheir ratings did not fully reflect the risksinherent in those securities. The FSF report onenhancing market and institutional resilience of7 April 2008 9 highlighted some weaknesses inrating models and methodologies and made anumber of recommendations for furthermeasures to enhance the quality of the ratingprocess. In order to address such issues, on31 July 2008 the European Commissionpublished for consultation a draft regulation oncredit rating agencies. This draft regulationaddresses the conditions for the authorisation,operation and supervision of credit ratingagencies and aims to ensure that such agenciesmeet high standards of independence, integrityand quality in the performance of their tasks.The Eurosystem responded to the publicconsultation on 25 September 2008, 10 broadlywelcoming the draft proposal. It emphasisedthat an EU regulation on credit rating agenciesshould aim to increase the level of transparencyrelated to the issuance of ratings and the ongoingsurveillance of those ratings, ensure that theregulatory framework does not interfere withthe content of ratings, and safeguard the integrityand independence of agencies by dealing withconflicts of interest. The Eurosystem suggestedan EU regulatory and supervisory structureaccording to which credit rating agencies wouldstill be formally authorised and supervised bythe national supervisors, but this authorisationand supervision would follow a joint assessmentprocess and be accompanied by a jointsupervisory process. CESR could play a role inthe coordination of the competent nationalauthorities as regards both the authorisation andthe implementation of enforcement action.Finally, the Eurosystem stressed that anycoordination arrangements for the regulationand supervision of credit rating agencies shouldallow for an appropriate level of involvementby the Eurosystem, given that it has alreadyestablished a Eurosystem credit assessmentframework which monitors the performanceand activities of agencies in the context of theimplementation of monetary policy operations.Following a public consultation, the Commissionpublished a proposal for a regulation on creditrating agencies in November 2008.9 http://www.fsforum.org/publications/r_0804.pdf10 http://www.ecb.europa.eu/pub/pdf/other/regulationcreditratingagencies2008en.pdfECBAnnual Report2008157

3 FINANCIAL INTEGRATIONThe Eurosystem has a keen interest in financialintegration in Europe, as a well-integratedfinancial system enhances the smooth andeffective transmission of monetary policyimpulses in the euro area and has implicationsfor the Eurosystem’s task of safeguardingfinancial stability. Financial integration alsosupports the smooth functioning of paymentand securities settlement systems. Furthermore,financial integration, a priority objective of theEU, can help to promote the development of thefinancial system, thereby raising the potentialfor economic growth.The Eurosystem distinguishes between fourtypes of activity through which it contributesto enhancing European financial integration:i) raising awareness of and monitoring financialintegration, ii) acting as a catalyst for privatesector activities by facilitating collectiveaction, iii) giving advice on the legislative andregulatory framework for the financial systemand direct rule-making, and iv) providingcentral banking services that also foster financialintegration. The ECB continued its activities inall four areas throughout 2008.RAISING AWARENESS OF AND MONITORINGFINANCIAL INTEGRATIONIn April 2008 the ECB published its secondannual report on “Financial integration inEurope”. 11 The main purpose of this report isto contribute to the advancement of Europeanfinancial integration and to raise publicawareness of the Eurosystem’s role in supportingthe financial integration process. The reportfirst sets out the ECB’s assessment of the stateof financial integration in the euro area, basedon a set of quantitative indicators that are alsopublished semi-annually on the ECB’s website.In 2008 the range of indicators was extended tocover the European market infrastructure. Thereport also contains in-depth analyses of selectedissues, chosen on the basis of their importanceto the EU’s financial integration agenda andtheir relevance to the ECB’s tasks. These specialanalyses covered four topics in 2008: conceptsand measures of financial development, theShort-Term European Paper (STEP) initiative,the integration and development of mortgagemarkets in Europe, and the integration of largevaluepayment and securities transactions.Finally, the report provides an overview of theEurosystem’s contribution over the past calendaryear towards achieving more integrated anddeveloped financial markets in Europe.Given that financial integration is expected tohave implications for the development of thefinancial system and for economic growth, theECB’s work on financial integration is closelylinked to its wider analysis of factors supportingthe functioning of financial systems. Work inthis area continued in 2008, 12 with the aim ofsetting out a conceptual framework formonitoring and assessing potential frictions inthe financial systems on a regular basis.In 2008 the ECB also continued its involvementin the Research Network on Capital Marketsand Financial Integration in Europe, run incooperation with the Center for FinancialStudies at the University of Frankfurt am Main.The network continued its series of conferenceswith academics, market participants andpolicy-makers, with the active participationof NCBs. The network completed its secondphase in 2008, culminating in its secondsymposium on “Capital markets and financialintegration in Europe” held in Frankfurt on13-14 February. The third phase startedwith the network’s 11th conference, hostedby Česká národní banka in Prague on20-21 October 2008, which focused on “Themarket for retail financial services: development,integration, and economic effects”. As inprevious years, in 2008 the ECB awarded five“Lamfalussy Fellowships” to young researchersin the context of the network. The network’scurrent priorities are: i) financial systems as riskmanagers, risk distributors and risk creators,ii) the integration and development of retailfinancial services and the promotion of11 http://www.ecb.europa.eu/pub/pdf/other/financialintegrationineurope200804en.pdf12 For more details, see the section entitled “Financial development:concepts and measures” in Chapter 2 of “Financial integration inEurope”, April 2008.158 ECBAnnual Report2008

innovative firms, and iii) financial modernisationand governance and the integration of theEuropean financial system into global capitalmarkets.ACTING AS A CATALYST FOR PRIVATE SECTORACTIVITIESProgress in European financial integrationdepends to a large extent on private sectorinitiatives aiming to make use of the existingopportunities for cross-border business. Publicauthorities support such private efforts.In 2008 the Eurosystem continued to stronglysupport the Single Euro Payments Area (SEPA)initiative, which allows individuals, corporationsand public administrations to make cashlesspayments in euro throughout the euro area andthe other SEPA countries from a single accountanywhere in SEPA, using a single set of paymentinstruments, as easily, efficiently and safelyas they can make them today at the nationallevel. SEPA is a move towards an integratedpayments market in Europe which will bringsubstantial economic benefits to society. SEPAis the logical consequence of the introduction ofthe euro in, currently, 16 countries in Europe.The successful launch of the SEPA credittransfer in January 2008 marked the initiative’sfirst major milestone. Since then, the firstbenefits of SEPA have materialised for banksand, more importantly, have started to reach theend-users of payment services. The Eurosystemhas invited the operators of infrastructures toassess their SEPA compliance on a regular basis.Most automated clearing houses which processcredit transfers in euro are now compliantwith the credit transfer scheme, and several ofthem have made the step from offering purelydomestic operations towards providing serviceson a pan-European basis. However, as set out inthe sixth progress report on SEPA issued by theEurosystem in November 2008, the migrationprocess is still too slow and measures should betaken to accelerate it.The SEPA framework for card payments wasalso put in place in January 2008, but more effortis still needed in this field. The SEPA frameworkfor cards should bring about greater choice andefficiency through the gradual elimination oflegal, technical and scheme-imposed obstacles,as well as through increased competition inthe fields of issuing, acquiring, acceptance andprocessing. The migration to chip cards witha personal identification number (PIN), animportant SEPA building block, advanced wellin 2008. Several card schemes adapted their rulesto the SEPA requirements. However, doubtsremain about whether all card schemes haveeffectively separated their processing activitiesfrom their scheme management functions. TheEurosystem expects at least one additionalEuropean card scheme to emerge in the comingyears which meets its requirements and those ofcardholders, banks, merchants and competitionauthorities. The Eurosystem has been discussingthis topic with major European banks and otherstakeholders since April 2008, and has observedincreasing support. Several market initiativesare under way to create such a European cardscheme, which the Eurosystem considers to bea clear sign that the market recognises the needfor a scheme of this nature.Preparations continued to be made for thelaunch of the SEPA direct debit scheme on1 November 2009, resulting in the adoptionof two rulebooks on the core and businessto-businessservices. However, uncertaintiesstill surround the launch of the scheme, andthese must be resolved urgently, in particularthose related to the application of a multilateralinterchange fee. To support the timely launch ofthe scheme, in September 2008 the ECB, in closeconsultation with the European Commission,suggested an interim arrangement wherebyexisting multilateral interchange fees would beapplied to SEPA direct debits. During a transitionperiod, which would only last a few years, bankswould have to change their business models andinform their customers in an adequate manner.The Eurosystem continued its efforts to ensurethe timely launch of these new payment servicesat the European level. In this context, the sixthprogress report on SEPA suggests priorities andencourages further work on the project.ECBAnnual Report2008159

The market for short-term paper in Europeis of a largely domestic nature. The STEPinitiative, pursued by market participantsunder the auspices of the European BankingFederation and ACI – The Financial MarketsAssociation, and steered by the STEP MarketCommittee, has addressed this gap in financialintegration through the development of a coreset of commonly agreed market standardsand practices, with which market participantscomply on a voluntary basis.The Eurosystem has supported the STEPinitiative since its inception in 2001by facilitating interaction among marketparticipants, contributing to the developmentof the STEP Market Convention and raisingpublic awareness regarding the initiative.Following the successful launch of the STEPmarket in June 2006, the Eurosystem hascontinued to contribute to the initiative in twoways. First, the ECB provides statistics on theSTEP market. Second, the Eurosystem assiststhe STEP Secretariat in the labelling of STEPpaper. This second measure is a temporaryarrangement which will expire in June 2010.The STEP Market Committee has launcheda review of the STEP Market Convention,with the aim of making its applicationeasier for a larger number of markets from atechnical point of view, while maintaining oreven enhancing the standards of the MarketConvention. The ECB welcomes such areview. First, as markets evolve, the MarketConvention must be adjusted accordingly.Second, it is a good opportunity to take stockof the processes and procedures applied sincethe start of the STEP market in June 2006 andto make any necessary improvements to theMarket Convention.The ECB produces daily statistics on yieldson new issues of euro-denominated STEPsecurities, as well as monthly volumes of STEPdebt securities. Despite the distressed marketconditions, the total outstanding amount ofSTEP debt securities increased by 24% (year onyear) in the fourth quarter of 2008.ADVICE ON THE LEGISLATIVE AND REGULATORYFRAMEWORK FOR THE FINANCIAL SYSTEM ANDDIRECT RULE-MAKINGThe Eurosystem regularly contributes to thedevelopment of the EU legislative and regulatoryframework by providing advice on the mainpolicy initiatives under way.Activity with regard to financial supervision inthe EU focused in 2008 on the follow-up of thereview of the Lamfalussy framework, to whichthe Eurosystem contributed (see Section 2of this chapter). Furthermore, as part of itsadvisory role in accordance with Article 105(4)of the Treaty, the ECB regularly provides adviceon the legislative proposals of the EuropeanCommission (see also Section 2).The ECB provided advisory input on issuesrelated to the integration of securitiessettlement systems and of payment systems.In particular, the ECB was closely involvedin the work relating to the “Code of Conductfor Clearing and Settlement”. The code aimsto foster competition on the basis of pricetransparency, access and interoperability, andservice unbundling and accounting separation.Given that the code is a self-regulatory tool, astrict monitoring mechanism has been set up toensure that all the measures are implementedproperly and on time. The mechanism relieson external auditors and an ad hoc MonitoringGroup composed of the European Commission,CESR and the ECB. The Monitoring Group metfour times in the course of 2008. The ECB andthe European Central Securities DepositoriesAssociation conducted an analysis on pricetransparency and provided suggestions on howto improve price comparability.As the code of conduct ultimately aims toestablish freedom of choice, it needs to becomplemented by the full removal of the“Giovannini barriers” to efficient clearing andsettlement (named after the group that identifiedthem in 2001), which result from differences intechnical standards and business practices, legaluncertainty, and differences in tax procedures.The ECB continued to participate in the Clearing160 ECBAnnual Report2008

and Settlement Advisory Monitoring ExpertGroup (CESAME) which addresses the removalof the first set of barriers. The ECB also continuedto take part in the Legal Certainty Group, whichin August 2008 presented 15 recommendationson the removal of legal barriers related topost-trading.Since harmonisation of the European legalframework forms the basis for SEPA, theEurosystem has taken an active interest inCommunity legislation in this area. ThePayment Services Directive 13 was formallyadopted in November 2007. According to theEuropean Commission, the Member States arewell on track with their work on transposing theDirective into national law before the deadlineof 1 November 2009. The ECB participates inthe Commission’s transposition working group.The review of Regulation (EC) No 2560/2001on cross-border payments in euro 14 also hasmajor consequences for SEPA and especially forSEPA direct debits. It is widely recognised thatthis Regulation was the trigger for the bankingindustry’s decision to start developing SEPAin 2002. The Commission’s proposal 15 aims atadapting the Regulation to the current paymentslandscape, for example by extending it to directdebit transactions. This will mean that the pricesfor cross-border SEPA direct debit transactionscannot be higher than those for correspondingnational direct debit transactions. The ECB hasbeen involved in the Commission’s work on thedraft regulation and has published an opinion inthis context. 16The ECB has also been involved in theCommission’s preparations for a review of theE-Money Directive, which establishes the legalframework for e-money institutions’ activities. 17The Commission states that the provision anduse of e-money is not growing as expected andtherefore suggests amending the Directive.From the ECB’s point of view, the review iswelcome; however, some parts of theCommission’s proposal cause concern,particularly with regard to the prudentialframework and institutional status of e-moneyinstitutions. 18PROVIDING CENTRAL BANKING SERVICES WHICHFOSTER FINANCIAL INTEGRATIONTARGET2, the second generation of theEurosystem’s large-value payment system,successfully went live on 19 November 2007,and fully replaced the first-generation TARGETsystem on 19 May 2008. The new system isdesigned to give euro money and financialmarkets an effective and secure executionmechanism for the real-time settlementin central bank money of euro payments.TARGET2 represents a decisive contributionby the Eurosystem to European financialintegration. It is the first market infrastructure tobe completely integrated and harmonised at theEuropean level, and has remedied the previousfragmentation in the management of centralbank liquidity and the execution of large-valuepayments. The new system’s features haveboth enabled and driven organisational changesamong credit institutions that operate in severalEuropean countries, by allowing these entitiesto rationalise their back office functions and toconsolidate their management of euro liquidity(see Section 2.1 of Chapter 2).Furthermore, the Eurosystem and marketparticipants have continued their work onthe TARGET2-Securities (T2S) project. T2Swill be a multi-currency platform used byEuropean central securities depositories for thesettlement of securities transactions in centralbank money. The Governing Council decidedon 17 July 2008 to build T2S and to assign itsdevelopment and operation to the DeutscheBundesbank, the Banco de España, the Banque13 Directive 2007/64/EC of the European Parliament and of theCouncil of 13 November 2007 on payment services in the internalmarket amending Directives 97/7/EC, 2002/65/EC, 2005/60/ECand 2006/48/EC and repealing Directive 97/5/EC.14 Regulation (EC) No 2560/2001 of the European Parliament andof the Council of 19 December 2001 on cross-border paymentsin euro.15 See http://ec.europa.eu/internal_market/payments/crossborder/index_en.htm16 Opinion on a new regulation on cross-border payments in theCommunity (CON/2009/1).17 See http://ec.europa.eu/internal_market/payments/emoney/index_en.htm18 Opinion on a directive on the taking up, pursuit andprudential supervision of the business of electronic moneyinstitutions (CON/2008/84).ECBAnnual Report2008161

de France and the Banca d’Italia. By offeringharmonised, borderless and neutral settlementservices in euro and other currencies, T2S willbe a major step forward in the delivery of anintegrated securities market and an importantcontribution to financial integration in Europe(see Section 2.2 of Chapter 2).Finally, in the area of collateral management,the Governing Council decided in July 2008 toestablish a single shareable platform (CCBM2)for euro area NCBs with a view to consolidatingand increasing the efficiency of the Eurosystem’sinternal systems and enhancing counterparties’liquidity and collateral management. TheGoverning Council assigned the Nationale Bankvan België/Banque Nationale de Belgique andDe Nederlandsche Bank to develop and operatethe platform on behalf of the Eurosystem.It is being developed in close cooperationwith market participants (see Section 2.3 ofChapter 2).162 ECBAnnual Report2008

4 PAYMENT SYSTEMS AND MARKETINFRASTRUCTURE OVERSIGHTPayment and securities clearing and settlementsystems are basic infrastructures which arenecessary for the proper functioning of marketeconomies. They are indispensable for theefficient flow of payments for goods, servicesand financial assets, and their smooth functioningis crucial for the implementation of the centralbank’s monetary policy and for maintaining thestability of and confidence in the currency, thefinancial system and the economy in general.Through its oversight function, the Eurosystemaims to ensure the safety and efficiency ofpayment and securities settlement systems andof central counterparties operating in euro,by applying, among other things, minimumstandards and requirements. In particular, theoversight function aims to maintain systemicstability in the payment system by containingthe exposure to systemic risk. In this context,overseers are generally concerned with bothindividual payment and securities settlementsystems and – given the interdependenciesbetween these systems – the marketinfrastructure as a whole. Payment instrumentsalso fall within the scope of the Eurosystem’soversight, which focuses in particular on theirsafety and efficiency.The Treaty assigns oversight responsibilities tothe Eurosystem. For the purpose of effective andefficient oversight, the ECB and the NCBs ofthe Eurosystem carry out these responsibilitiesin a way that allows the Eurosystem to benefitfrom its decentralised structure, while ensuringcoordination of its oversight activities and equalapplication of its policies. The Eurosystem’soversight policies and requirements reflectinternationally recognised standards, the detailsof which are adjusted to the specific conditionsand needs of the Eurosystem.4.1 LARGE-VALUE PAYMENT SYSTEMS ANDINFRASTRUCTURE SERVICE PROVIDERSThe Eurosystem oversees all large-valuepayment systems which settle euro transactions,including those managed by the Eurosystemitself. The Eurosystem applies the sameoversight standards to both its own systems andthose that are privately operated. These standardsare the Core Principles for SystemicallyImportant Payment Systems, defined by theG10 Committee on Payment and SettlementSystems (CPSS) and adopted by the GoverningCouncil in 2001. They are complemented by theEurosystem’s business continuity oversightexpectations for systemically important paymentsystems which were adopted by the GoverningCouncil in 2006 and are to be implemented byall systemically important payment systems inthe euro area by June 2009.Key payment infrastructures settling eurodenominatedtransactions (TARGET2, EURO1and CLS), infrastructure service providers (suchas SWIFT) and euro securities clearing andsettlement infrastructures coped successfullywith the challenges arising from the marketturmoil that continued in 2008. From anoversight perspective, a number of lessons couldbe learned from these events, not least withregard to the importance of adequate capacitymanagement by system operators and wellestablishedframeworks for crisis communicationbetween overseers, other relevant authoritiesand market infrastructure providers.TARGET2The gradual transition from TARGET toTARGET2, which started in November 2007,was completed smoothly and on schedulewhen the third and last group of nationalbanking communities successfully connectedto TARGET2 on 19 May 2008. All TARGET2oversight activities are led and coordinated bythe ECB, which acts in close cooperation withthe participating NCBs. The latter conduct theoversight of the local features of TARGET2 andcontribute to the oversight of the central featuresof TARGET2 on a voluntary basis.In early 2007, when TARGET2 was still underdevelopment, the TARGET2 overseers startedto conduct a comprehensive assessment of theTARGET2 design against the Core Principlesfor Systemically Important Payment SystemsECBAnnual Report2008163

and the Eurosystem’s business continuityoversight expectations for systemicallyimportant payment systems. The first resultsof the assessment were encouraging and, atthe end of 2007, the TARGET2 overseersconcluded that TARGET2 was likely to fullycomply with all relevant Core Principles,provided that a number of oversight findingswere addressed by the system operator in thecourse of 2008 on the basis of an agreed actionplan. In November 2008 the system operatorprovided a report to the overseers, detailinghow the points included in the action planhad been addressed. The TARGET2 overseersreviewed the report and the actions taken by theTARGET2 operator and provided a final reporton the oversight assessment of the TARGET2design to the decision-making bodies of theECB in March 2009. A public version of theassessment report will be made available.The TARGET2 overseers consider that theoperation of the system has been in line withexpectations. Only one major incident, whichoccurred on 30 June 2008, required specialattention and action on the part of the TARGET2overseers. Some oversight recommendationsrelated to this incident have been discussed withthe system operator and mitigation measureshave been implemented.EURO1EURO1 is a large-value payment system forcross-border and domestic transactions ineuro between banks operating in the EU. It isoperated by the clearing company of the EuroBanking Association, EBA CLEARING.EURO1 works on a multilateral net basis. Theend-of-day positions of EURO1 participantsare ultimately settled in central bank money viathe TARGET2 system, with the ECB acting assettlement agent. Oversight activities in 2008focused on, among other things, the migration ofthe settlement of EURO1 end-of-day positionsto TARGET2 in May 2008, when the previousTARGET system ceased to exist. The migrationof settlement to TARGET2 was completedwithout any problems.On 7 July 2008 EBA CLEARING implementedtwo additional liquidity distribution windowsin EURO1 under the Flexible SettlementCapability (also referred to as the liquiditybridge), one at 1 p.m. and the other at 3.30 p.m.The liquidity bridge arrangement facilitates theprocessing of payments that would otherwisebe placed on hold as a result of banks havingreached their debit or credit caps in EURO1.The two additional liquidity distributionwindows aim to reduce the balance kept on theEURO1 pre-settlement account in TARGET2and to maximise the recycling of pre-fundedliquidity. Their implementation received apositive assessment from the overseers fromboth a EURO1 and a TARGET2 perspective.CONTINUOUS LINKED SETTLEMENT SYSTEMThe Continuous Linked Settlement (CLS)system provides a multi-currency service forthe simultaneous, i.e. payment-versus-payment(PvP), settlement with finality of paymentinstructions relating to foreign exchangetransactions. Through its PvP mechanism, CLSvirtually eliminates foreign exchange settlementrisk, i.e. the risk that one party to a foreignexchange transaction will pay the currency it hassold, but not receive the currency it has bought.CLS was launched in 2002 and initially settledforeign exchange transactions in seven majorcurrencies, including the euro. Following theapproval by CLS overseers of the Mexican pesoand the Israeli shekel for settlement by CLS in2008, CLS now settles in 17 currencies. Inaddition, CLS settles single-currency paymenttransactions that are linked to a limited set offinancial instruments, i.e. over-the-counter(OTC) transactions in credit derivatives andnon-deliverable forward 19 transactions.CLS is managed by CLS Bank International(CLS Bank), New York. CLS Bank is ownedby private sector banks and other financial19 Defined as “net cash settled” forward foreign exchange transactions,whereby two parties agree to enter into two notional foreignexchange transactions and settle the difference between the twonotional transactions in cash in an agreed currency. The currenciesspecified in the two notional foreign exchange transactions are notphysically exchanged by the parties to the non-deliverable forward.164 ECBAnnual Report2008

institutions. The Federal Reserve Systemaccepts primary oversight responsibility forCLS under a cooperative oversight arrangementinvolving the G10 central banks and the centralbanks of CLS-settled currencies. Within thiscooperative oversight arrangement, the ECB(in close cooperation with the euro area NCBs)has primary oversight responsibility for thesettlement of the euro by CLS.In terms of value, CLS is the largest paymentsystem settling euro transactions outside the euroarea. Accordingly, the safety and efficiency ofCLS and its compliance with the Eurosystempolicy principles 20 is of primary importance tothe Eurosystem. In December 2008 CLS settledan average of 473,000 foreign exchangetransactions per day with an average dailysettlement value equivalent to €3.3 trillion. 21 Thisis a substantial increase in terms of volumecompared with December 2007, when CLSsettled an average daily volume of 381,436transactions with an average daily settlementvalue equivalent to €2.9 trillion. With a share ofaround 21% of all transactions settled in CLS, theeuro has continued to be the second mostimportant currency for settlement, after the USdollar (around 44%). In 2008 the average dailyvalue of CLS transactions settled in euro was€560 billion.In 2008 the BIS published a report entitled“Progress in reducing foreign exchangesettlement risk”. 22 The report, which includescontributions from the Eurosystem, indicatesthat the comprehensive long-term strategyendorsed by the G10 central banks in 1996has significantly reduced the systemic riskarising from the way in which foreign exchangetransactions are settled. However, it alsopoints out that more can and should be doneby individual institutions, industry groups andcentral banks to tackle remaining exposureand to guard against the risk of reversing theprogress that has already been made.SWIFTThe ECB participates with the other G10 centralbanks in the cooperative oversight of SWIFT,with the Nationale Bank van België/BanqueNationale de Belgique being the overseer withprimary responsibility. The G10 cooperativeoversight of SWIFT concentrates on theobjectives of security, operational reliability,business continuity and resilience of the SWIFTinfrastructure. During 2008 the oversightgroup reviewed whether SWIFT was pursuingthese objectives by ensuring the existence ofgovernance arrangements, structures, processes,risk management procedures and controls thatenable it to effectively manage the potentialrisks to the proper functioning of marketinfrastructures using SWIFT and to financialstability in general.In 2008 the SWIFT overseers paid particularattention to SWIFT’s project to move to amulti-zone messaging architecture. SWIFT’sprocessing will be divided into two zones,namely the transatlantic and the Europeanzone, with the aim of increasing the processingcapacity of its infrastructure, enhancing itsresilience and meeting European data protectionrequirements. As part of the project, whichwill be implemented in two phases by 2010and 2013 respectively, a new global operatingcentre will be established in Europe to serveboth the transatlantic and European zones.European-based customers of SWIFT will beautomatically assigned to the European zone,with all their intra-European traffic beingprocessed and stored in Europe. The overseersare reviewing SWIFT’s processes for the designand roll-out of this architecture, while at the sametime monitoring whether due attention is beingpaid to the continued resilience and availabilityof the SWIFT services which are crucial formaintaining global financial stability.20 “The Eurosystem policy principles on the location andoperation of infrastructures settling euro-denominated paymenttransactions”, ECB, July 2007.21 The cash settlement of each foreign exchange trade consists oftwo payment transactions, one in each currency involved. Thus,in December 2008 CLS settled 236,396 trades with an averagedaily value equivalent to around €1.65 trillion.22 http://www.bis.org/publ/cpss83.htmECBAnnual Report2008165

4.2 RETAIL PAYMENT SYSTEMS ANDINSTRUMENTSThe Eurosystem’s oversight also covers retailpayment systems and payment instruments. In2008 the ECB continued to monitor the smoothfunctioning of STEP2, which is a paymentsystem for cross-border, and increasingly alsofor domestic, retail payments in euro, operatedby EBA CLEARING. In 2008 a number ofchanges in the system had to be assessed againstthe applicable oversight standards.On 28 January 2008 EBA CLEARING launcheda SEPA credit transfer service in STEP2 for theprocessing of credit transfers in compliancewith the SEPA credit transfer scheme rulebookof the European Payments Council (EPC).In May 2008 an additional intraday cyclewas introduced for the SEPA credit transferservice to cater for the demands arising fromthe migration of euro area countries’ domestictraffic to this new service. A major change inthe system occurred on 8 December 2008,when the settlement of the SEPA credit transferservice was moved to TARGET2. Prior tothat date, the credit transfer service settled inEURO1, as the other STEP2 services continueto do. These changes did not alter the levelof compliance of STEP2 with the applicableoversight standards.In January 2008 the Governing Councilapproved the oversight framework for cardpayment schemes operating in the euro area,taking into account the comments receivedin the public consultation held in 2007. InMay 2008 the Eurosystem started its oversightassessment of card payment schemes operatingin the euro area against the newly establishedoversight standards. The assessment includes26 schemes, four of which are international.International card schemes are being assessedby cooperative assessment groups consistingof a lead overseeing central bank and othervolunteering central banks. 23 The assessmentsof all individual national and international cardschemes will be subject to peer reviews in orderto ensure equal application of the oversightstandards. It is envisaged that an overallassessment report describing the main results atthe aggregate level will be published.In 2008 the Eurosystem started to developoversight frameworks for the new SEPApayment instruments developed by the EPC,namely the credit transfer scheme that wasput in place as from 28 January 2008 and thedirect debit scheme planned for 2009. Once theoversight frameworks have been set out, it isenvisaged that they will be published for publicconsultation.4.3 SECURITIES AND DERIVATIVES CLEARINGAND SETTLEMENTThe Eurosystem has a strong interest in thesmooth functioning of securities clearing andsettlement systems because failures in theclearing, settlement and custody of collateralcould jeopardise the implementation ofmonetary policy, the smooth functioning ofpayment systems and the maintenance offinancial stability.In its capacity as a user of securities settlementsystems (SSSs), the Eurosystem assesses thecompliance of SSSs in the euro area, as well aslinks between those SSSs, against theEurosystem user standards. 24 SSSs and links areeligible for Eurosystem credit operations if theyfulfil these user standards, which also providethe basis against which the Eurosystem assessesany new SSSs and links or significant updates ofthose systems already eligible.In 2008 a new system (VP Lux) and one newrelayed link were assessed and found to becompliant with the Eurosystem user standards.The Governing Council also assessed theSlovakian SSS in preparation for the entry of23 The ECB is the Eurosystem’s lead overseer for VISA, AmericanExpress and Diners/Discover. It participates as an assessmentgroup member in the cooperative oversight of MasterCard, whilethe Nationale Bank van België/Banque Nationale de Belgiqueacts as lead overseeing central bank.24 “Standards for the use of EU securities settlement systems inESCB credit operations”, January 1998.166 ECBAnnual Report2008

Slovakia into the euro area on 1 January 2009.It found the SSS to be compliant with the userstandards and thus eligible for use in Eurosystemmonetary policy and intraday credit operations.In addition, the Eurosystem also undertook itsfirst comprehensive assessment of all SSSs,links and relayed links already in use, the resultsof which are expected to become available inspring 2009.In 2008 the Eurosystem assessed a new holdingarrangement for international debt securitiesin global registered form issued jointly by thetwo international central securities depositories(ICSDs), Euroclear Bank (Belgium) andClearstream Banking Luxembourg. This newarrangement – to be introduced by mid-2010 –will replicate the main principles of the NewGlobal Note arrangement introduced in 2006for international debt securities in global bearerform. In view of the decreasing issuance ofinternational debt securities in individual noteform, a revision of their holding structure was notjustified. It was therefore decided to withdrawthese securities from the list of eligible assetsfor Eurosystem credit operations. A transitionalperiod ending on 30 September 2010 has beendefined, in which securities of this type issuedbefore or on that date will continue to be eligiblefor use as collateral until their maturity.ESCB-CESR RECOMMENDATIONS FOR SECURITIESCLEARING AND SETTLEMENT IN THE EUROPEANUNIONIn 2001 the Governing Council approved aframework for cooperation between the ESCBand CESR on issues related to securitiesclearing and settlement systems. A jointworking group was created in the same year toadapt the recommendations for SSSs drawn upby the CPSS and the International Organizationof Securities Commissions (the CPSS-IOSCOrecommendations) to the EU landscape, andfrom 2004 also the recommendations for centralcounterparties. The work was frozen in 2005owing to three open issues regarding the scope,content and legal basis of the ESCB-CESRrecommendations.On 3 June 2008 the ECOFIN Council formallyinvited the ESCB and CESR to adapt and finalisetheir draft “Standards for securities clearingand settlement in the EU” by autumn 2008,respecting a number of principles, namelythat: i) the adopted text should take the form ofnon-binding recommendations addressed solelyto public authorities and not to market participants,ii) its scope should include ICSDs and excludecustodian banks, and iii) on credit and liquidityrisk controls, the benchmark accepted by theG10 – namely CPSS-IOSCO Recommendation 9for SSSs – should be adopted.In accordance with the ECOFIN Council’srequest, the ESCB-CESR working groupresumed its work and prepared a set of draftrecommendations which were subject to apublic consultation from 23 October 2008until 23 January 2009. During the consultationperiod, a public hearing for interested partieswas held.The European Parliament, the EuropeanCommission, CEBS, market participants andassociations were closely involved in thiswork at various stages. The final approval ofthe revised recommendations by CESR, theGoverning Council and the non-euro area NCBsis expected to take place at the end of the firstquarter of 2009. In parallel, CEBS is carryingout an analysis to identify areas where furthermeasures may be needed to bridge the gapbetween the ESCB-CESR recommendationsand the banking regulation applicable to bankswhich have internalised clearing and settlementactivities.The recommendations, once finalised, will be usedby central bank overseers and securities regulatorswith a view to safeguarding both the soundnessand efficiency of securities clearing and settlementin the EU as well as ensuring a level playing-fieldfor the various infrastructures. The ESCB-CESRrecommendations complement the work of otherEU fora and are regarded as one of the pillars ofthe EU policy on the post-trading sector, togetherwith TARGET2-Securities, the Code of ConductECBAnnual Report2008167

for Clearing and Settlement, and the dismantlingof the Giovannini barriers.REDUCING COUNTERPARTY RISK IN CREDITDEFAULT SWAPSAccording to BIS figures, the outstandingnotional amount of credit default swaps stoodat USD 57 trillion in June 2008, accounting foraround 8% of all OTC derivatives. The needfor a more resilient operational frameworkto support the orderly processing of OTCderivatives trades, which had been identifiedin the CPSS’s March 2007 report entitled“New developments in clearing and settlementarrangements for OTC derivatives”, becamemore urgent as a result of the financial marketturmoil in 2008. The ECB hosted a meeting on3 November 2008 with European stakeholdersconcerning the establishment of centralcounterparties (CCPs) for credit default swaps.Participants included the potential providersof such CCPs, dealers, users and regulators.The meeting complemented initiatives by theFederal Reserve Bank of New York and theEuropean Commission in this field. The ECBalso participated in a working group set up bythe European Commission addressing bothshort-term and long-term supervisory, regulatoryand competition issues in the derivatives marketwith the aim of promoting financial stability.Stakeholders have underlined the merits ofhaving multiple solutions, and at least oneEuropean solution. On 18 December 2008 theGoverning Council recalled the importanceof strengthening the infrastructure for OTCderivatives, and the need for at least oneEuropean CCP for credit derivatives. Given itspotentially systemic importance, this EuropeanCCP should be located within the euro area.The Eurosystem shares the views of the FinancialStability Forum and the European Commissionon the importance of reducing counterpartyrisk and of enhancing transparency in OTCderivatives markets, in particular in areas ofsystemic importance (e.g. credit derivatives).The introduction of CCPs for OTC derivativesis considered an appropriate solution becauseCCPs, by virtue of concentrating outstandingpositions in one place, i) reduce the counterpartyrisk to which market participants are exposedand render risk management more efficient,ii) increase market integrity, transparency andthe availability of information, iii) standardisethe criteria for evaluating exposure, andiv) free up collateral. The Eurosystem announcedits intention to cooperate with other authoritiesto facilitate effective collective action by theprivate sector in this regard. In December 2008the ECOFIN Council invited the ESCB andCESR to adapt their draft recommendationson CCPs to explicitly address the risk ofOTC derivatives.4.4 OTHER ACTIVITIESIn order to inform public authorities, marketinfrastructure providers and their participants, aswell as the general public‚ about developmentsrelated to its oversight framework, and about itsoversight activities related to specific paymentsystems, the ECB published its “Paymentsystems and market infrastructure oversightreport 2007” on 11 July 2008. This report wasthe first publication dedicated to the ECB’soversight activities. The scope of the report willbe widened, with subsequent issues taking theform of a Eurosystem oversight report.Given that payment and securities infrastructuresare crucial for the proper functioning of marketeconomies, it is important that theseinfrastructures, including their participants andthird-party service providers, implementeffective and efficient risk management andbusiness continuity procedures and are compliantwith the relevant national and internationalstandards. In view of the many interdependenciesbetween the various market infrastructures andthe need to ensure a high level of informationexchange and mutual understanding, the ECBand the EU NCBs have agreed to promoteinformation-sharing on international andnational standards relevant to operationalresilience, and in particular those relevant tobusiness continuity. In February 2008 the ECBestablished on its website a dedicated webpage168 ECBAnnual Report2008

on market infrastructure business continuity. 25The webpage provides interested parties withinformation on the latest business continuitystandards applicable to infrastructures operatingin Europe, a glossary of terms related to businesscontinuity and up-to-date information on thelatest European developments in this field. Thewebpage also provides links to central banksand other regulators that have issued relevantstandards and market practices applicable intheir countries (including non-Europeancountries such as the United States, Hong Kongand Japan).To ensure the consistent use of terms in all ofthe ESCB’s publications that relate to payments,clearing and settlement, on 30 September 2008the ECB published for public consultationa glossary of terms relating to the technicalaspects of payment, clearing and settlementsystems in the EU. The terms included in theglossary have been defined in a user-friendlyand non-legalistic style in order to promote theiracceptance. The final version of the glossarywill be published on the ECB’s website.Finally, the ECB publishes statistical dataon payments and securities trading, clearingand settlement on an annual basis. Data arebroken down by country and, as of 2007, aremade available solely in electronic form viathe Statistical Data Warehouse on the ECB’swebsite. The data for 2007 were published on26 November 2008.The webpage can be found under25 http://www.ecb.europa.eu/paym/pol/bc/html/index.en.htmlECBAnnual Report2008169

Willem F. Duisenberg at his farewell event on 22 October 2003 handing over the bell used at the Governing Council meetings toJean-Claude Trichet

CHAPTER 5EUROPEAN ANDINTERNATIONALRELATIONS

1 EUROPEAN ISSUESIn 2008 the ECB continued to have regularcontacts with European institutions and fora,particularly with the European Parliament(see Chapter 6), the ECOFIN Council, theEurogroup and the European Commission. ThePresident of the ECB participated in meetingsof the ECOFIN Council when matters relatingto the objectives and tasks of the ESCB werediscussed, as well as in the meetings of theEurogroup. The President of the Eurogroup andthe Commissioner for Economic and MonetaryAffairs attended meetings of the GoverningCouncil when they deemed it appropriate.1.1 POLICY ISSUESTHE STABILITY AND GROWTH PACTIn 2008 the initially favourable macroeconomicenvironment supported the improvement ofbudget balances in most countries and hencethe abrogation of excessive deficit proceduresfor five out of the six Member States with anexcessive deficit at the end of 2007. In June2008 the ECOFIN Council brought to an endthe excessive deficit procedures for the CzechRepublic, Italy, Portugal and Slovakia, andtook the same step for Poland in July 2008. ForSlovakia, this removed a major obstacle to itsadoption of the euro in 2009. The revision ofthe Greek deficit for 2007 from 2.8% to 3.5% ofGDP did not lead to procedural steps under theexcessive deficit procedure.However, the deterioration of the macroeconomicenvironment in the course of the year and theimpact of the financial crisis on tax revenuesput pressure on public finances and led to there-emergence of high deficits, especially incountries which were vulnerable owing toinsufficient consolidation in good times. InJuly 2008 the ECOFIN Council launched anexcessive deficit procedure against the UnitedKingdom, recommending under Article 104(7)of the Treaty that the United Kingdom shouldbring the deficit below 3% of GDP by thefinancial year 2009/10. Hungary remainedsubject to an ongoing excessive deficit procedureduring 2008, with a deadline to correct thedeficit by 2009 at the latest. In addition, inMay 2008 the Commission issued “economicand budgetary policy advice” to France,inviting the country to carry out the necessaryconsolidation of public finances and to pursuestructural reforms. Reflecting on the need for abinding medium-term fiscal framework and therisk of the deficit exceeding 3% of GDP, theCommission also gave advice to Romania inJune 2008.In May the Eurogroup endorsed the policyframework set by the Stability and Growth Pact.Ministers noted that in several countries moreambitious policies would be needed to complywith the provisions of the preventive arm of thePact and achieve the budgetary objectives of the2007 Berlin agreement, namely that MemberStates would achieve their medium-termobjectives in 2008 or 2009 and that all of themshould aim for 2010 at the latest.As the financial turbulence increased overthe year, leading to diminishing confidencein the financial sector, the ECOFIN Councilcalled in October for fiscal prudence to supportconfidence. Ministers reiterated that the Pactremained the adequate framework and should befully applied. In particular, automatic stabilisersshould help to cushion the expected slowdown.With regard to the long-term sustainability ofpublic finances, the Council discussed proposalson how to include the ageing-induced fiscalburden in the definition of the medium-termobjectives.THE LISBON STRATEGYThe Lisbon strategy – the EU’s widerangingprogramme of economic, social andenvironmental reform – entered a new threeyearpolicy cycle in 2008, the second cycle sincethe review of the strategy in 2005.In spring 2008 the European Council confirmedthe Integrated Guidelines adopted for the2005-08 cycle and stressed that the focusduring the present cycle should be on theimplementation of agreed objectives. Italso complemented these guidelines with172 ECBAnnual Report2008

country-specific recommendations for eachMember State and a horizontal guidelineaddressed to the euro area countries. TheEuropean Commission was invited to continueworking with Member States on a clear andtransparent methodology for the monitoringand evaluation of Lisbon reforms. Furthermore,to ensure continued commitment to structuralreforms, the European Council invited theCommission, the EU Council and the nationalLisbon coordinators to start reflecting on thefuture of the Lisbon strategy after 2010.In the autumn of 2008 Member States submittedtheir national reform programmes. Theseprogrammes set out the progress Member Stateshave made so far in implementing their structuralreform strategies. These strategies aim to ensurethe sustainability and quality of public finances,improve the regulatory environment ofbusinesses, increase investment in research anddevelopment as well as innovation, andintroduce measures to boost labour participationand enhance labour market flexibility. At theend of 2008 the European Commission publishedits first assessment of the implementation of the2008-10 Community Lisbon Programme, whichwas adopted at the end of 2007 and complementsthe national reform programmes by detailingactions to be taken at the EU level. TheCommission also suggested additional measuresto reinforce the Lisbon strategy as part of theEuropean Economic Recovery Plan. 1The ECB has repeatedly stressed the importanceof implementing structural reforms aimedat enhancing growth and employment. Euroarea countries in particular should implementcomprehensive reform measures to foster thesmooth functioning of EMU.FINANCIAL MARKET DEVELOPMENTS ANDFINANCIAL INTEGRATIONThe policies pursued by the EU during 2008 inthe financial market area were to a large extentdriven by the financial crisis. In the secondhalf of 2007 the EU Council had adopted threeroadmaps in response to the financial marketturbulence which emerged in August of thatyear. These three roadmaps specified themeasures to be taken regarding i) the responseto the financial turbulence, ii) the strengtheningof EU arrangements for financial stability andiii) the review of the Lamfalussy process onfinancial regulation and supervision.In the course of 2008 substantial progress wasmade on all three roadmaps. Regarding theresponse to the financial turbulence, the EuropeanCommission in July published its suggestionsconcerning the conditions for the authorisation,operation and supervision of credit ratingagencies. In October it presented a proposalfor an amendment of the Capital RequirementsDirective (for more details, see Section 2 ofChapter 4). To strengthen the EU arrangementsfor financial stability, the supervisory authorities,central banks and finance ministries of the EUadopted a Memorandum of Understanding oncooperation on cross-border financial stability,which entered into force in June. Substantialprogress was also made on the review of theLamfalussy process, leading to the agreementthat the mandates of national supervisors shouldinclude an EU dimension by mid-2009 and that“colleges of supervisors” should be establishedfor the largest cross-border financial groups.When the financial crisis intensified in autumn2008, EU institutions and Member Statesstepped up their coordination of measures toaddress the renewed challenges. On 12 Octoberthe euro area Heads of State or Governmentadopted a concerted action plan. On 15 Octoberthe European Council endorsed the principlesagreed by the euro area countries and calledon EU countries to adopt national measures inconformity with the action plan. The Presidentof the ECB participated in both meetings.The main objectives of the concerted action planwere to ensure appropriate liquidity conditions1 These measures include: i) speeding up the implementation ofmeasures to enhance the business environment, ii) improvingthe functioning of labour markets, iii) reducing skills shortagesand iv) bringing forward public infrastructure investments. TheEuropean Economic Recovery Plan also stresses the importanceof improving international market access and intensifyinginternational regulatory cooperation.ECBAnnual Report2008173

for financial institutions, to facilitate the fundingof banks, to provide financial institutionswith additional capital resources, to allowfor the efficient recapitalisation of distressedbanks and to ensure sufficient flexibility in theimplementation of accounting rules. In addition,a financial crisis cell was established to facilitaterapid and effective action in a crisis situation.This cell brings together representatives of thecountry holding the EU presidency, the Presidentof the European Commission, the President ofthe ECB (in conjunction with other EU centralbanks), the President of the Eurogroup and thegovernments of the Member States.OTHER EU POLICIESThe ECB monitored developments in the fieldof EU climate change and energy policies, inview of their potential impact on macroeconomicdevelopments, price stability and fiscal positions.As regards energy policies, improving thefunctioning of the EU’s internal market forenergy can be expected to have a positive impacton energy price developments and to enhancethe predictability of energy supply. In bothpolicy fields, the focus during 2008 was onturning the EU’s ambitious commitments intolegislation. 2 The ECB also monitoreddevelopments in the Common AgriculturalPolicy (CAP), in particular as regards theirimpact on food prices. In response to the surgein food prices, the EU Council agreed on severalmeasures to improve food supply, such as thesale of public stocks, the suspension of theobligation for farmers to leave some of theirarable land uncultivated, an increase in milkquotas and the suspension of import duties forcereals. Following the launch of the “CAPHealth Check” by the Commission, the EUCouncil reached an agreement in November2008 to modernise and streamline the CAP andto remove remaining restrictions on farmers inresponse to the growing demand for food.2 According to the climate and energy legislative package, theEU should, by 2020, reduce greenhouse gas emissions by 20%compared with 1990 and increase the use of renewable energysources to 20% of overall EU energy consumption. Moreover, itshould increase energy efficiency by 20%.Box 12TEN YEARS OF EMU2008 marked the tenth anniversary of the ECB and of the Eurosystem and the ESCB. Thisanniversary provided an opportunity to review the first decade of EMU and to draw lessons fromthe experience gained during this period.In May 2008 the ECB published a special edition of the Monthly Bulletin, which gave anaccount of the Eurosystem’s work and achievements and looked at the challenges that theEurosystem and the euro area face as they enter their second decade. The first ten years of EMUhave demonstrated the ECB’s ability to fully live up to its Treaty mandate. In spite of a difficultexternal environment, characterised by a significant increase in commodity prices, price stabilityhas been broadly achieved. In the euro area, consumer prices rose, on average, at an annual rate of2.1% between 1999 and 2007, well below average annual consumer price inflation in the periodfrom 1990 to 1998, which amounted to 3%. Moreover, the ECB has succeeded in anchoringlonger-term inflation expectations at levels consistent with price stability. EMU has also fosteredemployment creation. Employment in the euro area rose by around 16 million persons between1999 and 2007, as compared with around 6 million persons in the period 1990-98.The European Commission published a communication in May, together with a report entitled“EMU@10: successes and challenges after 10 years of Economic and Monetary Union”, in174 ECBAnnual Report2008

which it emphasised that ten years after the introduction of the euro, the currency is a success.The Commission also put forward several proposals to improve coordination and surveillancewithin EMU, to enhance the euro area’s international role and to promote effective governanceof EMU.The ECOFIN Council discussed the first ten years of EMU at its meeting of 7 October 2008.Ministers concluded that EMU had contributed to macroeconomic stability over the past ten yearsand that, following the reform processes within EMU, the EU was now better equipped to copewith economic shocks. In order to reap further benefits from EMU and to improve the economicperformance of Member States, the ECOFIN Council agreed on several proposals, includingi) better monitoring of competitiveness developments (particularly in countries participating inthe euro area and ERM II), ii) a prioritisation of structural reform recommendations in orderto take account of the economic situation and iii) measures to better account for the effects ofeconomic cycles, and related cycles in asset prices, on tax revenues.The European Parliament also adopted a resolution on the first ten years of EMU(see Chapter 6).The general conclusion emerging from the reflections on the first ten years of EMU was thatEMU’s institutional set-up works well. However, to make EMU a continued success, policymakersneed to be firmly committed to the objectives agreed at the European level and vigorouslyimplement the necessary policies.1.2 INSTITUTIONAL ISSUESTHE TREATY OF LISBONFollowing the signing of the Treaty of Lisbonby the Heads of State or Government on13 December 2007, Member States started theratification procedure in accordance with theirrespective constitutional requirements. So far,23 Member States have ratified the LisbonTreaty. Germany and Poland are very close toformal completion of the ratification procedure.In the Czech Republic, parliamentary ratificationis still pending.In Ireland, the Lisbon Treaty was submittedto a binding referendum and failed to achievemajority support. Against this background, theEuropean Council at its meeting on 19-20 June2008 reiterated that the Lisbon Treaty, withits aim “to help an enlarged Union act moreeffectively and more democratically”, shouldstill be pursued. At the European Councilmeeting on 11-12 December 2008, the Headsof State or Government agreed to give “legalguarantees” to Ireland following the rejection ofthe Lisbon Treaty. The Irish government madea commitment to seek ratification of the LisbonTreaty by the end of the term of the currentEuropean Commission.CONVERGENCE REPORTSIn line with Article 122 of the Treaty, theECB and the European Commission preparedconvergence reports on the progress madeby Bulgaria, the Czech Republic, Estonia,Latvia, Lithuania, Hungary, Poland, Romania,Slovakia and Sweden in meeting the conditionsto join the euro area. In these reports, whichwere published on 7 May 2008, Slovakia wasassessed in somewhat more depth than theother countries because the Slovak authoritieshad submitted a request for an examinationin view of Slovakia’s intention to adopt theeuro as of 1 January 2009. On the basis of aproposal from the Commission, the ECOFINCouncil decided on 8 July 2008 that Slovakiafulfilled the conditions to join the euro area on1 January 2009 (see Chapter 3).ECBAnnual Report2008175

1.3 DEVELOPMENTS IN AND RELATIONS WITH EUCANDIDATE COUNTRIESThe ECB continued its policy dialogue withthe central banks of the EU candidate countriesthrough bilateral meetings and within the overallinstitutional framework for the enlargementprocess set up by the EU.Accession negotiations with Croatia began inOctober 2005. Negotiations on the individualchapters of the acquis communautaire wereopened in June 2006 and advanced significantlyin the course of 2008. By the end of the year,negotiations had been opened on 21 chapters andprovisionally closed on 4. The ECB continuedits fruitful bilateral relations with the CroatianNational Bank, for example in the context ofthe high-level policy dialogue.After opening accession negotiations withTurkey in October 2005, the EuropeanCommission started negotiations on theindividual chapters of the acquis communautairein June 2006. In December 2006 the EuropeanCouncil decided to suspend talks for 8 out ofthe 35 chapters in the EU accession process,owing to the lack of progress in the extensionof the customs union to the EU Member States.The EU institutions are continuing to evaluatethe compatibility of Turkish legislation with theacquis communautaire and are making progresswith the opening of the other chapters. The ECBcontinued its long-standing high-level policydialogue with the Central Bank of the Republicof Turkey.Although the former Yugoslav Republic ofMacedonia was granted candidate status in 2005,it still needs to fulfil a number of institutionalcriteria before EU membership negotiations canstart, including some related to crucial areas ofpolitical reform. Staff level contacts betweenthe ECB and the National Bank of the Republicof Macedonia remained strong.176 ECBAnnual Report2008

2 INTERNATIONAL ISSUES2.1 KEY DEVELOPMENTS IN THE INTERNATIONALMONETARY AND FINANCIAL SYSTEMSURVEILLANCE OF MACROECONOMIC POLICIES INTHE GLOBAL ECONOMYGiven the high level of economic and financialintegration, the global economic environmentis extremely relevant for the conduct ofeconomic policy in the euro area. As a result,the Eurosystem closely monitors and analysesmacroeconomic policies and underlyingdevelopments in countries outside the euro area.The ECB also plays an important role in theprocess of international multilateral surveillanceof macroeconomic policies, which takesplace mainly at the meetings of internationalorganisations such as the BIS, the IMF and theOECD, as well as in fora such as the G7 andG20 groups of finance ministers and centralbank governors. The assessment of internationaldevelopments with a view to contributing to astable macroeconomic environment and soundmacroeconomic and financial policies wasespecially important in 2008.The international economic environment in 2008was largely dominated by the global financialturmoil, reflecting the disorderly unwinding ofdomestic and external imbalances that had builtup in preceding years and the materialisation ofsurrounding risks.The problems resulting from the realisation ofthese risks were rapidly transmitted around theworld, given the global nature of regulatory,accounting and business models whichcontributed to practices that subsequentlyproved to be opaque and unsustainable, as wellas the strength of cross-border financial andtrade linkages. The original shock, which hadstarted in the US sub-prime housing market, wasconsiderably amplified by, among other things,financial institutions’ high debt leverage and theunderpricing of risks at the global level. Whileepisodes of market turbulence between August2007 and September 2008 were comparativelyshort-lived and limited to a relatively smallnumber of financial institutions, the occurrenceof difficulties in a number of very large andglobally active institutions caused majorshockwaves from September 2008 onwards.These triggered high tensions in the interbankmarkets and in other key financing markets,severe episodes of stress in the banking sectorsof several countries, significant changes in globalexchange rates and oil prices, a pronouncedfall in asset prices worldwide, and a markedslowdown in real activity (see also Chapter 1).Although this financial crisis originated in theUnited States, an increasing number of countrieshave been affected, including both advancedand, more recently, emerging market economies.Several countries requested assistance from theIMF (see the section below on the internationalfinancial architecture). Liquidity assistanceto central banks of other countries was alsoprovided by the major central banks, includingthe ECB and the Federal Reserve System. Forexample, the latter set up liquidity swap facilitieswith the central banks of four large systemicallyimportant economies (Brazil, Mexico,South Korea and Singapore) at the end ofOctober 2008, in an effort to unfreeze moneymarkets among emerging nations. 3Largely as a result of these developments,current account balances changed markedly in2008. First, the US current account deficit fellby 0.7 percentage point, to 4.6% of GDP, mostlyas a result of lower domestic demand. 4 Second,some countries registering current accountsurpluses saw these surpluses declinesignificantly: China recorded a decline of1.9 percentage points of GDP and Japan a fall of0.8 percentage point. Meanwhile, oil-exportingcountries as a whole recorded a rise in theircurrent account surpluses in 2008; although oilprices declined strongly towards the end of theyear, they remained above their 2007 level formost of the year. The euro area’s current accountposition moved from a surplus in 2007 to adeficit of 0.5% of GDP in 2008.3 For information on swap lines provided by the ECB, see Section1 of Chapter 2.4 The figures in this paragraph are taken from the IMF’s “WorldEconomic Outlook”, October 2008.ECBAnnual Report2008177

On a number of occasions in 2008, theEurosystem stressed the risks and distortionsrelated to the persistence of global imbalances. Italso confirmed its full support for a cooperativeapproach to ensure an orderly adjustment ofglobal imbalances. In particular, the Eurosystemrepeatedly called for policies aimed at increasingprivate and public savings in countries withcurrent account deficits, the implementation offurther structural reforms in mature economieswith relatively low potential growth, measuresto increase domestic demand in emergingmarket economies with large current accountsurpluses, improved capital allocation in thesecountries, and a better appreciation of risksmore generally. In the context of the ongoingreflections on how to improve the internationalfinancial architecture (see below), in which theECB and other Eurosystem central banks areparticipating, the Eurosystem has underscoredthe importance of ensuring that such animprovement also enhances macroeconomicpolicy discipline, in addition to fosteringfinancial market discipline. A strengthenedmultilateral economic surveillance frameworkshould help to ensure that economic policies,especially in systemically important countries,are stability-oriented and sustainable.Finally, the euro area itself is subject tointernational policy surveillance exercises. In2008 both the IMF and the OECD conductedregular reviews of the monetary, financial andeconomic policies of the euro area, as acomplement to their reviews of the individualeuro area countries. The Article IV consultationsof the IMF and the review by the OECD’sEconomic and Development Review Committeeprovided an opportunity for useful discussionsbetween these international organisations andthe ECB, the Eurogroup presidency and theEuropean Commission. Following thesediscussions, both the IMF and the OECDproduced individual reports assessing the euroarea policies. 5INTERNATIONAL FINANCIAL ARCHITECTUREThe financial turmoil led to a wide-rangingdebate on the set-up and functioning of theinternational monetary and financial system.The EU Heads of State or Government agreedat their informal meeting in Brussels on7 November 2008 to coordinate their responsesto the financial crisis and to implement commonprinciples upon which to build a new internationalfinancial system. On 15 November the leadersof the G20 countries convened in Washington,D.C. for their first ever summit on financialmarkets and the world economy. They calledfor action in the areas of financial regulation andmacroeconomic policies and underlined theircommitment to free trade. The follow-up workto this summit has been organised through fourworking groups reporting to the G20 finance andcentral bank deputies, who prepared the meetingof the G20 finance ministers and central bankgovernors in spring 2009.In response to calls from the IMF’s members,concrete changes were made to the Fund’sfacilities for financial support. In October anew financing instrument was created, theshort-term liquidity facility. The purpose ofthis instrument is to provide quick-disbursingfinancing for countries with strong policies anda good track record that are facing temporaryliquidity problems arising from developments inexternal capital markets. As well as establishingthis new instrument, the Fund embarked on areview of the various aspects of its lending role.Furthermore, it provided financing to some of itsmember countries, including Belarus, Hungary,Iceland, Latvia, Pakistan and Ukraine, throughits regular standby arrangements.Various efforts to reform the IMF continuedin 2008. Key areas for reform which werediscussed included IMF surveillance, theFund’s lending role, the governance of the Fund(including quotas and voice), and its income andexpenditure framework. Agreement on theseissues has been pursued through discussionsboth inside the IMF and in other fora, suchas the G7 and G20, with the ESCB and theEurosystem playing their part by monitoring and5 “Euro area policies: 2008 Article IV consultation – staff report”,IMF, August 2008 and “Economic survey of the euro area”,OECD, January 2009.178 ECBAnnual Report2008

contributing to the discussions on these issuesas appropriate.Following the introduction of a new decisionon bilateral surveillance over members’policies in mid-2007, the Fund focused onits implementation in the regular Article IVconsultations with its member countries. Thisnew decision aims to ensure that greater attentionis paid to cross-country spillovers by employingthe concept of external stability as the organisingprinciple for surveillance. External stabilityis defined with reference to the exchange rate,the analysis of which consequently becomes akey component of the surveillance process. InOctober the Fund adopted its first “Statement ofsurveillance priorities”, which is to guide IMFsurveillance until 2011. This statement identifiesfour key priorities for Fund surveillance: toresolve financial market stress, to strengthenthe global financial system, to adjust to sharpchanges in commodity prices and to promotethe orderly reduction of global imbalances. Insupport of these priorities, the Fund intendsto improve its early warnings of risks andvulnerabilities, among other things through theanalysis of macro-financial linkages, and toextend its vulnerability exercise to advancedeconomies. The Fund also continued to focuson financial sector issues and related policylessons and to improve its collaboration with theFinancial Stability Forum.In addition, the Board of Governors of the IMFagreed on a comprehensive quota and voicereform package, which mainly provides for anew quota formula; a second round of ad hocquota increases based on the new formula; atripling of basic votes to increase the voiceof low-income countries; and an additionalAlternate Executive Director for the two Africanchairs on the Executive Board. The two keyobjectives of the reform were to realign quotashares with members’ relative weight and rolein the global economy and to enhance the voiceand participation of low-income countries inthe IMF. Work on the Fund’s governance willcontinue on the basis of, among other things, the2008 report of the IMF’s Independent EvaluationOffice and the report of the committee ofeminent persons on IMF governance reform, tobe released by spring 2009.The Board of Governors of the IMF also agreedon measures to put the institution on a sounderfinancial footing. On the income side, the Fundwill rely in the future on broader and moresustainable income sources. This includes abroadening of the Fund’s investment authorityand the establishment of an endowmentfunded by the profits from a strictly limitedsale of gold consistent with the Central BankGold Agreement. On the expenditure side,consideration of the Fund’s core mandate andcareful priority-setting guide a new expenditureframework, entailing substantial budgetreductions. Moreover, in the context of thefinancial turmoil, discussions are ongoing withregard to the adequacy of IMF resources.An important contribution to strengtheningthe resilience of the global financial systemwas made by the Financial Stability Forum,which facilitated the coordination of variousnational and international initiatives andoversaw their timely implementation. It alsoissued, and reviewed the implementation of,recommendations in five key areas, namelyprudential oversight, transparency and valuation,credit ratings, the authorities’ responsiveness torisks and arrangements for dealing with stress inthe financial system.The agenda of the international financialcommunity also continued to feature thepromotion of mechanisms for crisis preventionand orderly crisis resolution. In this context,further progress was made in the implementationof the principles for stable capital flows andfair debt restructuring in emerging markets,which were endorsed by G20 finance ministersand central bank governors in 2004. The aimof these principles, which are market-basedand voluntary, is to provide guidelines forthe behaviour of sovereign issuers and theirprivate creditors regarding information-sharing,dialogue and close cooperation. An increasingnumber of financial institutions and issuingECBAnnual Report2008179

countries have voiced support for the principlesand expressed particular interest in advancingtheir implementation. At its last meeting inWashington, D.C. in October 2008, the Groupof Trustees, a body comprising senior leadersin global finance established to guide theimplementation of the principles, reviewed theprogress being made within the framework ofthe international financial architecture and gaveguidance for future work.Another financial market initiative taken in 2008was the development of the Santiago Principlesby the International Working Group of SovereignWealth Funds. Jointly agreed by sovereignwealth funds from advanced, emerging anddeveloping economies, the principles representa collaborative effort to set out a comprehensiveframework to improve the understanding of theoperations of sovereign wealth funds. The aim ofthese principles, which are voluntary in nature,is to enhance the stabilising role played bysovereign wealth funds in financial markets andto help to maintain the free flow of cross-borderinvestment. The OECD is providing guidance onthe policies of recipient countries with regard toinvestments by sovereign wealth funds.2.2 COOPERATION WITH COUNTRIES OUTSIDETHE EUThe Eurosystem continued to foster itsinternational activities with the central bankingcommunity outside the EU through theorganisation of seminars and workshops. Inaddition, the technical assistance provided bythe Eurosystem remained an important tool forstrengthening the administrative capacity ofcentral banks, especially in the EU’s neighbouringregions, and enhancing compliance withEuropean and international standards. The ECBalso actively participated alongside the EuropeanCommission in the EU’s macroeconomicdialogue with China, India and Russia.began a nine-month programme of technicalassistance with the National Bank of Serbia. Theprogramme, funded by the European Agency forReconstruction, will provide the National Bank ofSerbia with a needs analysis report on progress tobe made in selected central banking areas inpreparation for EU accession. The areas to becovered are the supervision of banks; theharmonisation of legislation in line with the acquiscommunautaire under the competence of theNational Bank of Serbia; the liberalisation ofcapital movements; the conduct of monetarypolicy and the foreign exchange rate regime;monetary, financial and balance of paymentsstatistics; and financial services consumerprotection.Technical cooperation with the Bank of Russiaintensified with the start on 1 April 2008 ofa new central bank cooperation programme,funded by the European Commission. Thisprogramme involves the ECB in partnershipwith the Deutsche Bundesbank, the Bank ofGreece, the Banco de España, the Banque deFrance, the Banca d’Italia, De NederlandscheBank, the Oesterreichische Nationalbank, andSuomen Pankki – Finlands Bank in cooperationwith Rahoitustarkastus (the financial supervisionauthority of Finland). It will end in December2010. The aim of the programme is to share EUknowledge and experience with the Bank ofRussia in the area of internal audit and to supportit in the gradual implementation of the Basel IIprinciples in the banking supervisory framework.The fifth high-level Eurosystem seminarwith governors of central banks of the EU’ssouthern and eastern Mediterranean partners –co-organised by the ECB and the Central Bank ofEgypt – took place on 26 and 27 November 2008in Alexandria. Governors reviewed recenteconomic and financial developments in theregion and discussed monetary policy strategiesand exchange rate regimes as well as bankingsector issues in Mediterranean countries. ECBThe ECB continued to deepen its relations withcountries in the western Balkans. On1 September 2008 the ECB and 17 EU NCBs 6180 ECBAnnual Report20086The NCBs of Belgium, Bulgaria, the Czech Republic, Denmark,Germany, Estonia, Greece, France, Italy, Cyprus, Latvia,Hungary, the Netherlands, Austria, Poland, Romania and theUnited Kingdom.

epresentatives also participated in a number ofmeetings that focused on economic and financialissues within the framework of the BarcelonaProcess: Union for the Mediterranean.Continued cooperation with the Central Bankof Egypt led to the launch of a new three-yearprogramme on 1 January 2009, funded by theEuropean Commission. The programme willinvolve experts from Българска народна банка(Bulgarian National Bank), Česká národníbanka, the Deutsche Bundesbank, the Bankof Greece, the Banque de France, the Bancad’Italia and Banca Naţională a României. Theprogramme has three main objectives: to prepareguidelines that help the Central Bank of Egypt toestablish new regulations in line with the basicBasel II regime, to finalise the regulations andthe organisation of their implementation, andto design a new scheme for data reporting frombanks to the Central Bank of Egypt in order thatthe new regulations can be implemented.Cooperation has greatly intensified over the pastfew years, comprising both high-level meetingsand enhanced cooperation at the staff level.The President of the ECB and the Governor ofthe People’s Bank of China met at the ECB on5 September for policy discussions.For the first time, a high-level Eurosystemseminar, co-organised by the ECB and theDeutsche Bundesbank, was held with governorsof central banks and monetary agencies of themember states of the Gulf Cooperation Council(GCC) 7 . It was held in Mainz on 11 and12 March 2008. Discussions focused on economicdevelopments and structures in GCC countriesand the GCC’s role in the global economy, inparticular as regards money and finance as wellas energy and trade.The ECB, the People’s Bank of China andthe Banca d’Italia jointly organised the fourthhigh-level seminar of central banks in the EastAsia-Pacific region and the euro area at theBanca d’Italia in Rome on 26 and 27 June. Thepurpose of the seminar was to exchange viewson issues confronting policy-makers in bothregions, such as the financial turmoil, globalimbalances and the growth outlook.During 2008 the ECB further strengthened itsrelations with the People’s Bank of China. AMemorandum of Understanding signed by thetwo institutions in 2002 was renewed in 2008.7Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UnitedArab Emirates.ECBAnnual Report2008181

Former Italian President Carlo Azeglio Ciampi (right) and Jean-Claude Trichet on their way to the ceremony to mark the tenthanniversary of the ECB at the Alte Oper Frankfurt on 2 June 2008

CHAPTER 6ACCOUNTABILITY

1 ACCOUNTABILITY VIS-À-VIS THE GENERALPUBLIC AND THE EUROPEAN PARLIAMENTCentral bank independence has established itselfover the past decades as an indispensable elementof the monetary policy regimes of mature andemerging economies. The decision to grantcentral banks independence is firmly groundedin economic theory and empirical evidence, bothof which show that such a set-up is conducive tomaintaining price stability. At the same time, itis a founding principle of democratic societiesthat any independent institution bestowed with apublic function should be accountable to citizensand their elected representatives. In the case ofan independent central bank, accountabilitycan thus be understood as the obligation toexplain and justify its decisions to citizens andtheir political representatives. Accountabilityis therefore an important counterpart to centralbank independence.Since its establishment, the ECB has alwaysrecognised the fundamental importance of beingaccountable for its policy decisions. As requiredby the Treaty, it has maintained a regular dialoguewith EU citizens and the European Parliament.The ECB’s commitment in this respect is alsoillustrated by the many publications it releasedin 2008 and the numerous speeches delivered bythe members of the Governing Council duringthe year.The Treaty lays down precise reportingrequirements for the ECB, which include thepublication of a quarterly report, a weeklyfinancial statement and an annual report. TheECB in fact exceeds these statutory obligations,for instance by publishing a Monthly Bulletin(rather than the required quarterly report) andby holding monthly press conferences followingthe first Governing Council meeting of eachmonth.regularly on the ECB’s monetary policy andits other tasks during his quarterly hearingsbefore the European Parliament’s Committeeon Economic and Monetary Affairs. ThePresident also appeared before a joint meetingof the European Parliament and the nationalparliaments to discuss the EU’s framework forsafeguarding financial stability.Other members of the Executive Board alsoappeared before the European Parliament ona number of occasions. The Vice-Presidentpresented the ECB’s Annual Report 2007 tothe Committee on Economic and MonetaryAffairs. Gertrude Tumpel-Gugerell appearedtwice before the Committee to inform itsmembers about recent developments in the fieldof securities clearing and settlement and theEurosystem’s TARGET2-Securities project.Jürgen Stark presented the ECB’s ConvergenceReport 2008 to the Committee and participatedin a discussion on the entry of Slovakia into theeuro area. Lorenzo Bini Smaghi participated ina panel discussion organised by the Committeeon the first ten years of EMU and the futurechallenges.In addition, discussions took place between ECBstaff and members of the European Parliament onmatters in which the ECB has specific expertise(e.g. euro counterfeiting, capital requirementsand statistics). In line with established practice,a delegation of the Committee on Economic andMonetary Affairs visited the ECB to exchangeviews with the members of the Executive Boardon a variety of issues. The ECB also continuedits voluntary practice of replying to writtenquestions from members of the EuropeanParliament on issues related to the ECB’s fieldsof competence.The European Parliament – as the body whichderives its legitimacy directly from the citizensof the EU – has continued to play a key role inholding the ECB to account. In accordance withthe Treaty, the President of the ECB presentedthe ECB’s Annual Report 2007 to the plenarysession of the European Parliament in 2008.In addition, the President continued to report184 ECBAnnual Report2008

2 SELECTED TOPICS RAISED AT MEETINGS WITHTHE EUROPEAN PARLIAMENTDuring the various exchanges of views betweenthe European Parliament and the ECB, a widerange of issues were addressed. The key issuesraised during these discussions are outlinedbelow.EUROPEAN PARLIAMENT RESOLUTION ON THEECB’S ANNUAL REPORT 2007In line with established practice, the EuropeanParliament adopted on 9 July 2008 an owninitiativeresolution on the ECB’s Annual Report2007. In its resolution, the European Parliamentacknowledged the full independence of theECB and recognised that publishing the minutesof Governing Council meetings could leadto political pressure on Governing Councilmembers. The resolution also recognised theexcellent work of the ECB in managing thefinancial turmoil and highlighted the fact thatthe major central banks – including the ECB –had warned against underestimating risks priorto the onset of the financial crisis. In addition,the resolution underscored the benefits of theEurosystem’s two-pillar monetary strategy.FINANCIAL REGULATIONThe European Parliament and the ECBcontinued their close dialogue on mattersconcerning financial regulation. In its resolutionson this issue, the European Parliament called forappropriate counter-cyclical capital requirementsfor all entities operating in financial markets.The European Parliament also saw a need forappropriate disclosure and accounting treatmentof off-balance-sheet items, and called for moreand better information on complex productsand the securitisation process. As regardsrating agencies, the Parliament advocated theestablishment of an EU review mechanism,and pressed for measures to improve boththe transparency of rating methodologies andquality assurance systems.During his appearance before the joint meetingof the European Parliament and the nationalparliaments on 23 January 2008, the Presidentwarned that the growing complexity of financialinstruments and the lack of clarity regardingthe exposure of financial institutions could giverise to increased uncertainty about the degree ofrisk involved and the ultimate bearer of theserisks, which could prompt a more generalisedcontagion. The President emphasised the needto increase transparency and to render theregulatory framework more counter-cyclical.He also called upon financial institutions toimprove their risk management practices. Onseveral occasions, the President underlined theneed for a swift implementation of the strategicroadmap of the ECOFIN Council setting outthe necessary policy responses to the financialturmoil.THE EU FRAMEWORK FOR FINANCIALSUPERVISION AND STABILITYThe EU framework for financial supervisionand stability also featured prominently duringthe discussions between the ECB and theEuropean Parliament. In its various resolutionson this topic, the European Parliament noted thatfinancial supervision in Europe had not kept pacewith the integration of EU financial markets.Accordingly, the European Parliament saw aneed for the creation of “colleges of supervisors”for the largest cross-border financial groups, andfor the strengthening and clarification of thestatus and accountability of the three Level 3Committees of the Lamfalussy framework (seeSection 2 of Chapter 4 for further informationon the Lamfalussy framework). The EuropeanParliament also urged the ECB and the ESCBto play an active role in the elaboration andimplementation of EU policies on macroprudentialsupervision and financial stability,and called upon supervisors and central banks toprovide the ECB – via the Banking SupervisionCommittee – with relevant micro-prudentialinformation. Finally, the Parliament advocatedlegislative action with a view to enhancing crisisprevention and management arrangements.During his appearances before the Parliament,the President emphasised that the potential ofthe Lamfalussy framework should be furtherexploited and that the decisions foreseen inthe roadmap on the review of the Lamfalussyframework should be implemented swiftly.The President also called for the rapidECBAnnual Report2008185

implementation of the steps foreseen in theroadmap for strengthening EU arrangements forfinancial stability. In particular, he stressed theneed for smooth interplay and an appropriateexchange of information between supervisorsand central banks.TEN YEARS OF EMUThe European Parliament also contributed tothe discussion on the first ten years of EMU(see Box 12). On 18 November 2008 it adopteda resolution setting out its views that the firstten years of EMU had been a success, with thesingle currency enhancing economic stabilityand integration in the euro area countries. Atthe same time, the Parliament considered thatmore needed to be done to reap the full benefitsof EMU, in particular as regards the pursuit ofstructural reforms and sound fiscal policies.The President of the ECB concurred thatstructural reforms and prudent fiscal policieswere crucial to ensure the smooth functioning ofEMU. He also expressed his concerns about theslowdown in the implementation of structuralreforms and fiscal consolidation efforts.186 ECBAnnual Report2008

Jean-Claude Trichet cutting the birthday cake at the ceremony to mark the tenth anniversary of the ECB at the Alte Oper Frankfurton 2 June 2008. Left to right: José Manuel Barroso, Jean-Claude Juncker, Jean-Claude Trichet, Aline Trichet, Hans-Gert Pöttering,Gretta Duisenberg, Janez Janša

CHAPTER 7EXTERNALCOMMUNICATION

1 COMMUNICATION POLICYExternal communication at the ECB aims toenhance the public’s understanding of theECB’s policies and decisions. It is an integralpart of the ECB’s monetary policy and of itsother tasks. Two key elements – openness andtransparency – guide the ECB’s communicationactivities. Both contribute to the effectiveness,efficiency and credibility of the ECB’s monetarypolicy. They also support the ECB’s efforts togive full account of its actions, as explained inmore detail in Chapter 6.the ECB’s key publications are undertaken inclose collaboration with the NCBs.The concept of real-time, regular andcomprehensive explanations of the monetarypolicy assessment and decisions, which wasintroduced in 1999, represents a uniquelyopen and transparent approach to central bankcommunication. Monetary policy decisions areexplained at a press conference immediatelyafter the Governing Council has taken them.The President delivers a detailed introductorystatement at the press conference, explaining theGoverning Council’s decisions. The Presidentand the Vice-President are then at the media’sdisposal to answer questions. Since December2004 decisions taken by the Governing Councilother than those setting interest rates have alsobeen published every month on the websites ofthe Eurosystem central banks.The ECB’s legal acts are made available in allthe official languages of the EU, as are theconsolidated financial statements of theEurosystem. 1 The ECB’s Annual Report and thequarterly issues of its Monthly Bulletin are alsomade available in full in the official EUlanguages. 2 The Convergence Report is madeavailable either in full or in summary form in allofficial EU languages. 3 For the purposes ofpublic accountability and transparency, the ECBpublishes other documentation in addition to thestatutory publications in some or all officiallanguages, in particular press releasesannouncing monetary policy decisions, staffmacroeconomic projections, 4 policy positionsand information material of relevance to thegeneral public. The preparation, publication anddistribution of the national language versions of1234With the exception of Irish, for which a derogation at the EUlevel is in effect.With the exception of Irish (by EU derogation) and Maltese (byagreement with the Central Bank of Malta, following the liftingof the temporary EU derogation in May 2007).See footnote 2.ECB staff projections since September 2004 and Eurosystemstaff projections since December 2000.190 ECBAnnual Report2008

2 COMMUNICATION ACTIVITIESThe ECB addresses a variety of audiences, suchas financial experts, the media, governments,parliaments and the general public, with varyinglevels of knowledge of finance and economics.Its mandate and decisions are therefore explainedthrough a range of communication tools andactivities which are constantly being refinedin order to make them as effective as possible,taking into account the different audiences andthe communication environment and needs.The ECB publishes a number of studies andreports, such as the Annual Report, whichpresents a review of the ECB’s activities in theprevious year and thus contributes to the ECB’saccountability. The Monthly Bulletin providesregular updates of the ECB’s assessment ofeconomic and monetary developments and thedetailed information underlying its decisions,while the Financial Stability Review assesses thestability of the euro area financial system withregard to its ability to absorb adverse shocks.All members of the Governing Council directlycontribute to enhancing public knowledgeand understanding of the Eurosystem’s tasksand policies by giving testimonies before theEuropean Parliament and national parliaments,delivering public speeches and grantinginterviews to the media. In 2008 the Presidentof the ECB appeared five times before theEuropean Parliament. The members of theExecutive Board of the ECB delivered around300 speeches to a variety of audiences in thecourse of 2008 and granted some 200 interviewsto the media, as well as having articles publishedin journals, magazines and newspapers.The euro area NCBs play an important rolein ensuring the dissemination at the nationallevel of Eurosystem information and messagesto the general public and interested parties.They address a variety of national andregional audiences in their own languages andenvironments.In 2008 the ECB organised 12 seminars aimed atenhancing the knowledge and understanding ofinternational and national media representatives,either on its own or in cooperation with the EUNCBs and the European Journalism Centre. Forthe first time, one of these seminars was organisedon the occasion of an external Governing Councilmeeting, on 4 December in Brussels.The ECB welcomed approximately 14,000visitors to its premises in Frankfurt in 2008.The visitors received first-hand informationin the form of presentations given by ECBexperts and managers. Secondary school anduniversity students, together with professionalsfrom the financial sector, made up the majorityof visitors.All documents published by the ECB and itsvarious activities are presented on the ECB’swebsite. In 2008 the website received 18 millionvisits (20% more than in the previous year),with 126 million pages viewed and 25 milliondocuments downloaded. In 2008 the ECBreplied to around 60,000 enquiries from thepublic requesting information on a number ofissues related to the ECB’s activities, policiesand decisions.The ECB’s communication activities in 2008focused in particular on explaining the eventsand consequences of the global financialturmoil and the measures adopted by theECB and the Eurosystem. A quarter of allpublic speeches delivered by the members ofthe Executive Board and a third of the ECB’spress releases were related to this issue andwere concentrated in the second half of 2008.An increase was witnessed in the numberof opinions issued by the ECB on fiscal andregulatory measures taken by individual EUMember States. There was also a significantrise in the number of requests received fromthe press, the public and visitors to the ECBfor information on the financial turmoil and themeasures taken by the Eurosystem. The openmarket operations section of the ECB’s websitewas enhanced to meet the increased demandfor information: a news feed with informationon monetary policy tender operations wasintroduced, and data on all market operationssince 1999 were published.ECBAnnual Report2008191

On the occasion of its tenth anniversary, theECB opened its doors to the general publicon 1 June 2008. Guided tours of the building,workshops, exhibitions and games wereorganised for 1,400 registered visitors.The Cultural Days of the ECB, organised in2008 in cooperation with all central banks of theESCB, were dedicated to the EU and featuredartistic contributions from all 27 EU MemberStates. The Cultural Days programme wastimed to coincide with the ECB’s anniversarycelebrations, which were attended by EU Headsof State and Government and a number offigures who had made a major contribution to therealisation of EMU. An anniversary edition ofthe Monthly Bulletin was published, providingan overview of the first ten years of EMU andexamining the challenges ahead. The Fifth ECBCentral Banking Conference held in Frankfurton 13 and 14 November 2008 on “The euro atten: lessons and challenges” brought togethercentral bankers, academics, market participantsand the media from all over the world.In 2008 the ECB, in conjunction with Národnábanka Slovenska, organised an informationcampaign in preparation for the introduction ofthe euro in Slovakia on 1 January 2009. The logo“€ Our money”, developed by the Eurosystem,was used in all communication activities relatedto the introduction of the euro in Slovakia. TheSlovakian campaign followed the pattern of thecommunication concept developed for Slovenia,Cyprus and Malta. It aimed to familiariseprofessional cash handlers and the general publicwith the visual appearance and security featuresof the euro banknotes and coins, as well as withthe cash changeover procedures (see Chapter 3).In preparation for the launch of the secondseries of euro banknotes in the coming years, acommunication concept is being developed bythe Eurosystem central banks.192 ECBAnnual Report2008

Panel at the Fifth ECB Central Banking Conference on 13 and 14 November 2008

CHAPTER 8INSTITUTIONALFRAMEWORK,ORGANISATION ANDANNUAL ACCOUNTS

1 DECISION-MAKING BODIES AND CORPORATEGOVERNANCE OF THE ECB1.1 THE EUROSYSTEM AND THE EUROPEAN SYSTEM OF CENTRAL BANKSEUROPEAN SYSTEM OF CENTRAL BANKS (ESCB)General CouncilGoverningCouncilNationale Bank van België/Banque Nationale de BelgiqueDeutsche BundesbankCentral Bank and FinancialServices Authority of IrelandBank of GreeceBanco de EspañaBanque de FranceBanca d’ItaliaČeská národní bankaDanmarks NationalbankEesti PankEuropean Central Bank (ECB)Бълrapcκa нapoднa бaнкa(Bulgarian National Bank)ExecutiveBoardCentral Bank of CyprusBanque centrale du LuxembourgCentral Bank of MaltaDe Nederlandsche BankOesterreichische NationalbankBanco de PortugalBanka SlovenijeNárodná banka SlovenskaSuomen Pankki – Finlands BankLatvijas BankaLietuvos bankasMagyar Nemzeti BankNarodowy Bank PolskiEUROSYSTEMBanca Naţională a RomânieiSveriges RiksbankBank of EnglandThe Eurosystem is the central banking systemof the euro area. It comprises the ECB and theNCBs of the EU Member States whose currencyis the euro (16 since 1 January 2009). TheGoverning Council adopted the term“Eurosystem” in order to facilitate understandingof the structure of central banking in the euroarea. The term underlines the shared identity,teamwork and cooperation of all of its members.The Treaty of Lisbon incorporates the term“Eurosystem”. 1The ESCB is composed of the ECB and theNCBs of all EU Member States (27 since1 January 2007), i.e. it includes the NCBs of theMember States which have not yet adopted theeuro.The ECB is the core of the Eurosystem and theESCB and ensures that their respective tasksare carried out either through its own activitiesor via the NCBs. It has legal personality underpublic international law.Each NCB has legal personality accordingto the law of its respective country. The euroarea NCBs, which form an integral part of theEurosystem, carry out the tasks conferred uponthe Eurosystem in accordance with the rulesestablished by the ECB’s decision-makingbodies. The NCBs also contribute to the workof the Eurosystem and the ESCB through1For more information on the Treaty of Lisbon, see Section 1.2of Chapter 5.196 ECBAnnual Report2008

their participation in the Eurosystem/ESCBcommittees (see Section 1.5 of this chapter).They may perform non-Eurosystem functions ontheir own responsibility, unless the GoverningCouncil finds that such functions interfere withthe objectives and tasks of the Eurosystem.The Eurosystem and the ESCB are governedby the decision-making bodies of the ECB: theGoverning Council and the Executive Board.The General Council is constituted as a thirddecision-making body of the ECB, for as longas there are EU Member States which havenot yet adopted the euro. The functioning ofthe decision-making bodies is governed bythe Treaty, the Statute of the ESCB and therelevant Rules of Procedure. 2 Decision-makingwithin the Eurosystem and the ESCB iscentralised. However, the ECB and the euroarea NCBs jointly contribute, strategically andoperationally, to attaining the common goalsof the Eurosystem, with due respect to theprinciple of decentralisation in accordance withthe Statute of the ESCB.1.2 THE GOVERNING COUNCILThe Governing Council comprises themembers of the Executive Board of the ECBand the governors of the NCBs of the MemberStates which have adopted the euro. Its mainresponsibilities, as laid down in the Treaty, are:––to adopt the guidelines and take the decisionsnecessary to ensure the performance of thetasks entrusted to the Eurosystem;to formulate the monetary policy of theeuro area, including, as appropriate,decisions relating 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, twicea month at the ECB’s premises in Frankfurtam Main, Germany. It conducts, inter alia, anin-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 and responsibilitiesof the ECB and the Eurosystem. In 2008 twomeetings were held outside Frankfurt: one washosted by the Bank of Greece in Athens and theother by the Nationale Bank van België/BanqueNationale 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 is reflectedby the principle of “one member, one vote”applied within the Governing Council. On18 December 2008 the Governing Councildecided to continue its current voting regime 3and to introduce the rotation system only whenthe number of governors of the euro area NCBsexceeds 18. 4 This decision was triggered by theincrease in the number of governors in theGoverning Council to 16 as a result of theadoption of the euro by Slovakia on1 January 2009. At the same time, the Governing2 For the ECB’s Rules of Procedure, see Decision ECB/2004/2of 19 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 concerningthe Rules of Procedure of the Executive Board of the ECB,OJ L 314, 8.12.1999, p. 34. These rules are also available on theECB’s website.3 As provided for by Article 10.2 of the Statute of the ESCB,which limits the number of governors with a voting right to15 but also foresees the possibility for the Governing Councilto postpone the implementation of the rotation system until thenumber of governors exceeds 18.4 See the press release of 18 December 2008 and DecisionECB/2008/29 to postpone the start of the rotation system in theGoverning Council of the European Central Bank.ECBAnnual Report2008197

Council decided on the main aspects of theimplementation of the rotation system 5 once thenumber of governors exceeds 18. Havinganalysed a number of models, the GoverningCouncil opted for the following rotation model:governors will rotate in and out of the votingright after one month. The number of governorsrotating at any one time will be determined bythe difference between the number of governorsand the number of votes allocated to each groupminus two, taking the absolute value in the eventof a negative number. This rotation modelachieves short periods without vote forindividual governors and ensures the relativestability of the composition of the votingcollege. 656On 19 December 2002 the Governing Council decided on arotation system according to which the NCB governors willexercise a voting right with different frequencies dependingon an indicator of the relative size of the economies of theircountries within the euro area. Based on this indicator, NCBgovernors will be allocated to different groups. This allocationdetermines how often the governors can exercise a voting right.Initially, there will be two groups and, once there are 22 euroarea countries, there will be three groups. For a description ofthe rotation system, see also the press release of 20 December2002 at http://www.ecb.europa.eu/press/pr/date/2002/html/index.en.htmlThe rotation model will be formally implemented via an ECBDecision amending Decision ECB/2004/2 of 19 February 2004adopting the Rules of Procedure of the European Central Bank;further details can be found in a forthcoming ECB MonthlyBulletin article.198 ECBAnnual Report2008

THE GOVERNING COUNCILFront row (left to right):John Hurley,Michael C. Bonello,Gertrude Tumpel-Gugerell,Jean-Claude Trichet,Lucas D. Papademos,Miguel Fernández Ordóñez,Yves MerschJean-Claude TrichetPresident of the ECBLucas D. PapademosVice-President of the ECBLorenzo Bini SmaghiMember of the Executive Board of the ECBMichael C. BonelloGovernor of the Central Bank of MaltaVítor ConstâncioGovernor of the Banco de PortugalMario DraghiGovernor of the Banca d’ItaliaMiguel Fernández OrdóñezGovernor of the Banco de EspañaNicholas C. GarganasGovernor of the Bank of Greece (until 13 June 2008)José Manuel González-PáramoMember of the Executive Board of the ECBTony GrimesActing Governor of the Central Bank andFinancial Services Authority of Ireland(from 19 July until 19 September 2008)John HurleyGovernor of the Central Bank and FinancialServices Authority of Ireland(from 1 January until 18 July 2008 and from20 September 2008)Marko KranjecGovernor of Banka SlovenijeKlaus LiebscherGovernor of the Oesterreichische Nationalbank(until 31 August 2008)Erkki LiikanenGovernor of Suomen Pankki – Finlands BankYves MerschGovernor of the Banque centrale du LuxembourgEwald NowotnyGovernor of the Oesterreichische Nationalbank(from 1 September 2008)Christian NoyerGovernor of the Banque de FranceAthanasios OrphanidesGovernor of the Central Bank of CyprusGeorge A. ProvopoulosGovernor of the Bank of Greece(from 20 June 2008)Guy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueIvan Šramko 7Governor of Národná banka Slovenska(from 1 January 2009)Jürgen StarkMember of the Executive Board of the ECBGertrude Tumpel-GugerellMember of the Executive Board of the ECBPanayotis-Aristidis ThomopoulosActing Governor of the Bank of Greece(from 14 June until 19 June 2008)Axel A. WeberPresident of the Deutsche BundesbankNout WellinkPresident of De Nederlandsche Bank7 The Governor of Národná banka Slovenska attended the meetingsof the Governing Council in 2008 as a “special invitee” followingthe decision taken by the ECOFIN Council on 8 July 2008 toabrogate Slovakia’s derogation with effect from 1 January 2009.Middle row (left to right):Christian Noyer,Marko Kranjec,Vítor Manuel Ribeiro Constâncio,George A. Provopoulos,Erkki Liikanen, Ewald NowotnyBack row (left to right):Ivan Šramko,José Manuel González-Páramo,Axel A. Weber, Nout Wellink,Guy Quaden, Lorenzo Bini Smaghi,Jürgen StarkNote: Mario Draghi and AthanasiosOrphanides were not available when thephotograph was taken.ECBAnnual Report2008199

1.3 THE EXECUTIVE BOARDThe Executive Board comprises the Presidentand the 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 theeuro area in accordance with the guidelinesand decisions laid down by the Governing––Council 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 bythe Governing Council, including some of aregulatory nature.The Executive Board is assisted by aManagement Committee in matters relatingto the ECB’s management, business planningand annual budget process. The ManagementCommittee is composed of one Executive Boardmember, who acts as Chairman, and a numberof senior managers.Back row (left to right):Jürgen Stark,José Manuel González-Páramo,Lorenzo Bini SmaghiFront row (left to right):Gertrude Tumpel-Gugerell,Jean-Claude Trichet,Lucas D. PapademosJean-Claude TrichetPresident of the ECBLucas D. PapademosVice-President of the ECBLorenzo Bini SmaghiMember of the Executive Board of the ECBJosé Manuel González-PáramoMember of the Executive Board of the ECBJürgen StarkMember of the Executive Board of the ECBGertrude Tumpel-GugerellMember of the Executive Board of the ECB200 ECBAnnual Report2008

Divisions:Archives, Library and RecordsLanguage ServicesSecretariatDivisions:Euro Area Accountsand Economic DataExternal StatisticsMonetary and Financial StatisticsStatistical Information ServicesStatistics Development/CoordinationDivisions: Administrative ServicesPremisesSecurityDirectorate Internal Finance: Ian IngramDivisions: Accounting and ProcurementFinancial Reporting and PolicyDivisions:Currency ManagementCurrency DevelopmentDivisions:Divisions:Market IntegrationOversightTARGET and CollateralTARGET2-SecuritiesEconometric ModellingFinancial ResearchMonetary Policy ResearchDirectorate GeneralResearchFrank SmetsDeputy: Huw PillDirectorate General Paymentsand Market InfrastructureJean-Michel GodeffroyDeputy: Daniela RussoDirectorate General Secretariatand Language ServicesPierre van der Haegen 3Deputy: Klaus RiemkeDirectorate GeneralStatisticsSteven KeuningDeputy: Werner BierExecutive BoardDirectorate GeneralAdministrationGerald GrisseDirectorateBanknotesTon RoosDirectorateCommunicationsElisabeth Ardaillon-PoirierDivisions:Counselto the Executive BoardChristian ThimannECB Representationin Washington, D.C.Georges PineauPress and InformationPublishing, Events and ProtocolDivisions:Back OfficeFront OfficeInvestmentMarket Operations AnalysisMarket Operations SystemsDivisions:Lawyer-LinguistsLegal Advice ¹Directorate GeneralMarket OperationsFrancesco PapadiaDeputies: Paul Mercier,Werner StudenerDirectorate GeneralLegal ServicesAntonio Sáinz de VicuñaDirectorate GeneralInternational andEuropean RelationsFrank MossDeputy: Gilles NobletDirectorateInternal AuditKlaus GressenbauerDirectorate GeneralInformation SystemsHans-Gert PenzelDeputy: François LaurentDirectorate GeneralEconomicsWolfgang SchillDeputies: Hans-Joachim Klöckers,Philippe MoutotDirectorate Financial Stabilityand SupervisionMauro GrandeDirectorate GeneralHR, Budget andOrganisationKoenraad De GeestDeputy: Berend van BaakDivisions:Divisions: Fiscal PoliciesDirectorate Economic DevelopmentsHans-Joachim KlöckersDivisions: Euro Area MacroeconomicDevelopmentsEU CountriesExternal DevelopmentsDirectorate Monetary PolicyPhilippe MoutotDivisions: Capital Markets/Financial StructureMonetary Policy StanceMonetary Policy StrategyFinancial StabilityFinancial SupervisionDivisions:EU Institutions and ForaEU Neighbouring RegionsInternational Policy AnalysisDivisions:Audit MissionsAudit ServicesDivisions: IT Management FunctionsIT Operations and SupportDirectorate IT Projects: Magi ClavéDivisions:Budget and ProjectsHR Policies and Staff RelationsOrganisational PlanningRecruitment and CompensationRisk Management ²1 Includes the data protection function.2 Reports directly to the Executive Board.3 Secretary to the Executive Board,the Governing Counciland the General Council.Back row (left to right):Front row (left to right):Executive BoardJürgen Stark, José Manuel González-Páramo, Lorenzo Bini SmaghiGertrude Tumpel-Gugerell, Jean-Claude Trichet (President), Lucas D. Papademos (Vice-President)

1.4 THE GENERAL COUNCILThe General Council is composed of thePresident and the Vice-President of the ECBand the governors of the NCBs of all 27 EUMember States. It mainly carries out those taskstaken over from the EMI which still have to beperformed by the ECB on account of the fact thatnot all the Member States have adopted the euro.In 2008 the General Council met five times.Front row (left to right):Marko Kranjec,John Hurley,Michael C. Bonello,Jean-Claude Trichet,Lucas D. Papademos,Miguel Fernández Ordóñez,Yves Mersch, Christian NoyerMiddle row (left to right):Ivan Šramko,George A. Provopoulos,Vítor Manuel Ribeiro Constâncio,Erkki Liikanen, Ewald Nowotny,Reinoldijus Šarkinas, Stefan IngvesBack row (left to right):Axel A. Weber, Zdeněk Tůma,Ilmãrs Rimšēvičs, Nout Wellink,Guy Quaden, Ivan Iskrov,Nils Bernstein, Andres Lipstok,Sławomir Skrzypek, András SimorNote: Mario Draghi, Mervyn King,Athanasios Orphanides and MugurConstantin Isărescu were not availablewhen the photograph was taken.Jean-Claude TrichetPresident of the ECBLucas D. PapademosVice-President of the ECBNils BernsteinGovernor of Danmarks NationalbankMichael C. BonelloGovernor of the Central Bank of MaltaVítor ConstâncioGovernor of the Banco de PortugalMario DraghiGovernor of the Banca d’ItaliaMiguel Fernández OrdóñezGovernor of the Banco de EspañaNicholas C. GarganasGovernor of the Bank of Greece(until 13 June 2008)Tony GrimesActing Governor of the Central Bank andFinancial Services Authority of Ireland(from 19 July until 19 September 2008)John HurleyGovernor of the Central Bank and FinancialServices Authority of Ireland(from 1 January until 18 July 2008 and from20 September 2008)Stefan IngvesGovernor of Sveriges RiksbankMugur Constantin IsărescuGovernor of Banca Naţională a RomânieiIvan IskrovGovernor of Българска народна банка(Bulgarian National Bank)Mervyn KingGovernor of the Bank of EnglandMarko KranjecGovernor of Banka SlovenijeKlaus LiebscherGovernor of the Oesterreichische Nationalbank(until 31 August 2008)Erkki LiikanenGovernor of Suomen Pankki – Finlands BankAndres LipstokGovernor of Eesti PankYves MerschGovernor of the Banque centrale du LuxembourgEwald NowotnyGovernor of the Oesterreichische Nationalbank(from 1 September 2008)Christian NoyerGovernor of the Banque de France202 ECBAnnual Report2008

Athanasios OrphanidesGovernor of the Central Bank of CyprusGeorge A. ProvopoulosGovernor of the Bank of Greece(from 20 June 2008)Guy QuadenGovernor of the Nationale Bank van België/Banque Nationale de BelgiqueIlmārs RimšēvičsGovernor of Latvijas BankaReinoldijus ŠarkinasChairman of the Board of Lietuvos bankasAndrás SimorGovernor of the Magyar Nemzeti BankSławomir SkrzypekPresident of Narodowy Bank PolskiIvan ŠramkoGovernor of Národná banka SlovenskaPanayotis-Aristidis ThomopoulosActing Governor of the Bank of Greece(from 14 June until 19 June 2008)Zdeněk TůmaGovernor of Česká národní bankaAxel A. WeberPresident of the Deutsche BundesbankNout WellinkPresident of De Nederlandsche Bank1.5 EUROSYSTEM/ESCB COMMITTEES, THE BUDGET COMMITTEE, THE HUMAN RESOURCES CONFERENCEAND THE EUROSYSTEM IT STEERING COMMITTEEEUROSYSTEM/ESCB COMMITTEES, B UDG ET COMMITTEE, HUMAN R ESOUR CESCONFER ENCE AND THEIR CHAIR PER SONSAccounting and Monetary Income Committee (AMICO)Ian IngramInternational Relations Committee (IRC)José ViñalsBanking Supervision Committee (BSC)Peter PraetLegal Committee (LEGCO)Antonio Sáinz de VicuñaBanknote Committee (BANCO)Ton RoosMarket Operations Committee (MOC)Francesco PapadiaCommittee on Cost Methodology (COMCO)Wolfgang DuchatczekMonetary Policy Committee (MPC)Wolfgang SchillEurosystem/ESCB Communications Committee (ECCO)Elisabeth Ardaillon-PoirierPayment and Settlement Systems Committee (PSSC)Jean-Michel GodeffroyInformation Technology Committee (ITC)Hans-Gert PenzelStatistics Committee (STC)Steven KeuningInternal Auditors Committee (IAC)Klaus GressenbauerBudget Committee (BUCOM)José de MatosHuman Resources Conference (HRC)Koenraad De GeestECBAnnual Report2008203

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 providedexpertise in their fields of competence andhave facilitated 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 eurotake part in the meetings of a committeewhenever it deals with matters that fall withinthe field of competence of the General Council.Where appropriate, other competent bodies,such as national supervisory authorities in thecase of the Banking Supervision Committee,may also be invited. As at 31 December 2008,13 Eurosystem/ESCB committees had beenestablished under Article 9.1 of the Rules ofProcedure of the ECB.The Budget Committee, which was establishedunder Article 15 of the Rules of Procedure,assists the Governing Council in matters relatedto the ECB’s budget.The Human Resources Conference wasestablished in 2005 under Article 9a of theRules of Procedure as a forum for the exchangeof experience, expertise and information amongEurosystem/ESCB central banks in the field ofhuman resources management.In line with the Eurosystem mission statementand the organisational principles, which statethe aim of exploiting synergies within theEurosystem and achieving cost-efficiency gainsthrough economies of scale, the GoverningCouncil established the Eurosystem IT SteeringCommittee (EISC) in August 2007, with amandate to steer continuous improvement in theuse of IT within the Eurosystem. The EISC’sresponsibilities relate in particular to EurosystemIT governance, and it aims to increase theefficiency and effectiveness of the GoverningCouncil’s decision-making on Eurosystem/ESCBIT projects and operations. The EISC, composedof one member per Eurosystem central bank,reports to the Governing Council via theExecutive Board.1.6 CORPORATE GOVERNANCEIn addition to the decision-making bodies, thecorporate governance of the ECB encompassesa number of external and internal controllayers, three codes of conduct as well as rulesconcerning public access to ECB documents.EXTERNAL CONTROL LAYERSThe Statute of the ESCB provides for two layers,namely the external auditor, which is appointedto audit the annual accounts of the ECB(Article 27.1 of the Statute of the ESCB), and theEuropean Court of Auditors, which examines theoperational efficiency of the management of theECB (Article 27.2). The annual report of theEuropean Court of Auditors, together with theECB’s reply, is published on the ECB’s websiteand in the Official Journal of the European Union.In order to reinforce public assurance as to theindependence of the ECB’s external auditor,the principle of audit firm rotationis applied. 8 In 2008, in the context of theGoverning Council’s statutory task of makingrecommendations to the EU Council on theappointment of external auditors for the centralbanks of the ESCB, as provided for underArticle 27.1 of the Statute of the ESCB, theGoverning Council approved “Good practices forthe selection and mandate of External Auditors”,which were published on the ECB’s website.These good practices, which provide high-levelguidance for each Eurosystem central bank whenselecting external auditors and determining theirmandate thereafter, enable the Governing Councilto formulate its recommendations to the EUCouncil on the basis of harmonised, consistentand transparent selection criteria.8 KPMG Deutsche Treuhand-Gesellschaft AG Wirtschaftsprüfungsgesellschaftwas the ECB’s external auditor for thefinancial years 2003-07. Following the conclusion of a tenderprocedure and in line with the agreed practice of rotatingaudit firms, PricewaterhouseCoopers AktiengesellschaftWirtschaftsprüfungsgesellschaft was appointed as the ECB’sexternal auditor for the financial years 2008-12.204 ECBAnnual Report2008

INTERNAL CONTROL LAYERSThe internal control structure of the ECB is basedon an approach in which each organisationalunit (section, division, directorate or directorategeneral) is responsible for managing its own risksand controls, as well as the effectiveness andefficiency of its operations. Each organisationalunit implements operational control procedureswithin its area of responsibility in accordancewith the risk tolerance set ex ante by theExecutive Board. For example, a set of rulesand procedures – known as a Chinese wall – isin place to prevent inside information originatingin the areas responsible for monetary policyfrom reaching the areas responsible for themanagement of the ECB’s foreign reserves andown funds portfolio. In 2008 the ECB continuedto make progress in its approach to operationalrisk management. First, a central unit in theDirectorate General Human Resources, Budgetand Organisation coordinated a comprehensivetop-down exercise in which business areasidentified operational risks which, if they wereto materialise, could have significant negativebusiness, reputational or financial consequencesfor the ECB. On the basis of this exercise, actionplans were established for the treatment of suchrisks. Second, the ECB and the euro area NCBsdeveloped a framework for operational riskmanagement for Eurosystem tasks and processes,which will be implemented as of 2009.Independently from the internal control structureand risk monitoring of the ECB, audit missionsare performed by the Directorate Internal Auditunder the direct responsibility of the ExecutiveBoard. In accordance with the mandate definedin the ECB Audit Charter, 9 the ECB’s internalauditors provide independent and objectiveassurance and consulting services, bringing asystematic approach to evaluating and improvingthe effectiveness of risk management, control andgovernance processes. The Directorate InternalAudit abides by the International Standards forthe Professional Practice of Internal Auditing ofthe Institute of Internal Auditors.A Eurosystem/ESCB committee, the InternalAuditors Committee, which is composed ofthe heads of internal audit at the ECB and theNCBs, is responsible for coordinating theauditing of Eurosystem/ESCB joint projects andoperational systems.In order to enhance corporate governance,the Governing Council created an ECB AuditCommittee in April 2007, composed of three ofits members, with John Hurley (Governor of theCentral Bank and Financial Services Authorityof Ireland) as Chairman.CODES OF CONDUCTThere are three codes of conduct in place at theECB. The first is for the members of the GoverningCouncil and reflects their responsibility tosafeguard the integrity and reputation of theEurosystem and to maintain the effectiveness ofits operations. 10 It gives guidance to, and setsethical standards for, the members of theGoverning Council and their alternates whenexercising their functions as members of theGoverning Council. An adviser has also beenappointed by the Governing Council to provideguidance to its members on some aspects ofprofessional conduct. The second code is the Codeof Conduct of the ECB, which gives guidance to,and sets benchmarks for, the staff of the ECB andthe members of the Executive Board, all of whomare expected to maintain high standards ofprofessional ethics in the performance of theirduties. 11 In accordance with the Code of Conduct’srules against insider trading, the ECB’s staff andthe members of the Executive Board are prohibitedfrom taking advantage of inside information whenconducting private financial activities at their ownrisk and for their own account, or at the risk andfor the account of a third party. 12 The third code isa Supplementary Code of Ethical Criteria for the9 This charter is published on the ECB’s website to foster thetransparency of audit arrangements in place at the ECB.10 See the Code of Conduct for the members of the GoverningCouncil, OJ C 123, 24.5.2002, p. 9, its amendment, OJ C 10,16.1.2007, p. 6 and the ECB’s website.11 See the Code of Conduct of the European Central Bank in accordancewith Article 11.3 of the Rules of Procedure of the European CentralBank, OJ C 76, 8.3.2001, p. 12 and the ECB’s website.12 See Part 1.2 of the ECB Staff Rules containing the ruleson professional conduct and professional secrecy, OJ C 92,16.4.2004, p. 31 and the ECB’s website.ECBAnnual Report2008205

members of the Executive Board. 13 It complementsthe other two codes by further detailing the ethicalregime applicable to members of the ExecutiveBoard. An Ethics Adviser appointed by theExecutive Board ensures a consistent interpretationof these rules.ANTI-FRAUD MEASURESIn 1999 the European Parliament and the EUCouncil adopted a regulation 14 to step up thefight against fraud, corruption and any otherillegal activity detrimental to the Communities’financial interests. The regulation provides interalia for the internal investigation of suspectedfraud by the European Anti-Fraud Office(OLAF) within the Community institutions,bodies, offices and agencies.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 decision 15 concerning the terms andconditions for investigations by OLAF of theECB, which entered into force on 1 July 2004.PUBLIC ACCESS TO ECB DOCUMENTSThe ECB’s Decision on public access to ECBdocuments 16 adopted in March 2004 is in linewith the objectives and standards applied byother Community institutions and bodies withregard to public access to their documents. Itenhances transparency, while at the same timetaking into account the independence of theECB and of the NCBs and ensuring theconfidentiality of certain matters specific to theperformance of the ECB’s tasks. 17In 2008 the number of public access requestsremained limited.13 See the Supplementary Code of Ethical Criteria for the membersof the Executive Board, OJ C 230, 23.9.2006, p. 46 and theECB’s website.14 Regulation (EC) No 1073/1999 of the European Parliamentand of the Council of 25 May 1999 concerning investigationsconducted by the European Anti-Fraud Office (OLAF), OJ L 136,31.5.1999, p. 1.15 Decision ECB/2004/11 concerning the terms and conditionsfor European Anti-Fraud Office investigations of the EuropeanCentral Bank, in relation to the prevention of fraud, corruptionand any other illegal activities detrimental to the EuropeanCommunities’ financial interests and amending the Conditions ofEmployment for Staff of the European Central Bank, OJ L 230,30.6.2004, p. 56. This Decision was adopted in response to thejudgement of the European Court of Justice on 10 July 2003 inCase-11/00 Commission v European Central Bank, ECR I-7147.16 Decision ECB/2004/3 on public access to European CentralBank documents, OJ L 80, 18.3.2004, p. 42.17 In line with the ECB’s commitment to openness and transparency,an “Archives” section of the ECB’s website provides access tohistorical documentation.206 ECBAnnual Report2008

2 ORGANISATIONAL DEVELOPMENTS2.1 HUMAN RESOURCESIn 2008 the ECB continued to implement itshuman resources (HR) policy framework, whichincorporates the ECB’s values and the basic HRprinciples. 18 The HR policy framework explainswhy specific HR policies have been chosen andhow they relate to one another. Under theframework, policies relating to HR managementfall into four main areas:CORPORATE CULTUREWith staff from the 27 EU Member States, theECB has integrated diversity management intoits HR practices to ensure that the individualcompetencies of staff are recognised and fullyutilised for the purpose of achieving the ECB’sobjectives. The management of diversity at theECB is based on the diversity strategy launchedin 2006. It seeks to ensure that all membersof staff are treated with respect and that theirperformance is assessed on the basis of merit.In 2008 the ECB organised its first diversityforum for managers with the aim of increasingawareness of diversity issues and sharing viewsand experiences on various topics linked togender, nationality and age.The six ECB common values (competence,effectiveness and efficiency, integrity, teamspirit, transparency and accountability, andworking for Europe) were further embedded inthe HR policies with a view to shaping day-todaybehaviour and improving performance.STAFF DEVELOPMENTThe general principles for internal mobility atthe ECB, which encourage members of staffto change positions after five years of service,continued to receive considerable support.Mobility is seen as an opportunity for staffto widen their expertise and develop theirskills and as a means for the ECB to broadenawareness among its staff and increase synergiesacross business areas. The internal recruitmentpolicy, which places emphasis on broadcompetencies, thus aims to further facilitateinternal staff mobility. In 2008 165 membersof staff, including 17 managers and advisers,moved internally to other positions, either on atemporary or on a long-term basis.The ECB’s external work experience schemefacilitates the secondment of staff to the 27NCBs in the EU or to relevant internationalorganisations (e.g. the IMF and the BIS) forperiods of two to twelve months. 23 membersof staff were seconded under this scheme in2008. In addition, the ECB granted unpaidleave, for up to three years, to 30 members ofstaff. Many of them (19) took up employmentat NCBs, international organisations or privatecompanies. Others used these periods of unpaidleave for study purposes. The total number ofstaff members on unpaid leave at the end ofDecember 2008 was 54 (compared with 56 in2007), while the number of staff on parentalleave was 26 (compared with 23 in 2007).In addition to promoting mobility, includingmanagerial rotation, the HR strategy continuedto focus on the development of ECB staff and,in particular, on strengthening managerialskills through training and individual coaching.Training for managers concentrated on theenhancement of team performance, leadershipand recruitment skills, and various aspects ofperformance management.Managers also participated in the multi-sourcefeedback exercise in which directly reportingstaff, peers and external contacts identify areasfor managers’ personal development. Basedon the results of the multi-source feedback,individual coaching was provided.The continuous acquisition and development ofskills and competencies by all members of staffremains a cornerstone of the ECB’s HR strategy.As a basic principle, learning and developmentare a shared responsibility between staff andinstitution. On the one hand, the ECB providesthe budgetary means and training frameworkand managers define the training needs of staff18 The basic HR principles are: organisational need, decentralisedstaff management, merit, diversity, attractive employmentconditions and reciprocal commitment.ECBAnnual Report2008207

for their current position. On the other hand,staff have to take the necessary steps for learningand development and ensure that their expertiseis maintained at the highest level. In additionto numerous in-house training opportunities,staff continued to take up external trainingopportunities to address individual trainingneeds of a more “technical” nature. They alsobenefited from training opportunities organisedas part of ESCB programmes or offered bythe NCBs.In the context of its secondary training policy,the ECB provided 12 members of staff withsupport to acquire a qualification that wouldincrease their professional competence beyondthe requirements of their current position.RECRUITMENTAt the end of 2008 the actual full-time equivalentnumber of staff holding contracts with the ECBwas 1,536 19 (compared with 1,478 at the endof 2007).External recruitment to fill permanent positionswas carried out on the basis of fixed-termcontracts of five years for managerial positionsand three years for other positions, whichmay be converted into unlimited contracts,subject to organisational considerations andindividual performance. Fixed-term contractsmay also be issued to replace permanent staffwho are temporarily absent for periods ofmore than 12 months, for instance in cases ofparental or unpaid leave. In 2008 the ECBoffered a total of 108 fixed-term contracts. Bycontrast, 45 members of staff with fixed-termor permanent contracts left the ECB in 2008.Furthermore, 113 short-term contracts wereissued during 2008 (in addition to some contractextensions from 2007) to cover for absences ofless than one year, while 83 short-term contractsexpired in the course of the year.The ECB also offers short-term contractsto staff from NCBs and internationalorganisations, thus allowing the ECB andthese organisations to gain from each other’sexperience. Employing NCB staff on ashort-term basis also helps to foster anESCB-wide team spirit. On 31 December 2008122 employees from NCBs and internationalorganisations were working at the ECB onvarious assignments (compared with 91 on31 December 2007).In September 2008 the third intake ofparticipants in the ECB’s Graduate Programme,which is aimed at recent graduates with a broadeducational background, joined the Bank onthe basis of two-year non-convertible contracts.The first generation of participants completedthe Graduate Programme in 2008, and a largenumber of them successfully applied forconvertible fixed-term positions at the ECB.The internship opportunities offered by theECB focused on students and graduates withbackgrounds in economics, statistics, businessadministration, law and translation. On31 December 2008 84 interns were being hostedby the ECB.The ECB also offered two fellowships as partof the Wim Duisenberg Research FellowshipProgramme, which is open to leadingeconomists, and five fellowships to youngresearchers in the context of its LamfalussyFellowship Programme.EMPLOYMENT CONDITIONSTaking into account the most recentdevelopments regarding life expectancyand long-term financing, the ECB has beenconducting a review of the retirement plan itoffers to its staff. The results of this review areexpected to be implemented in early 2009.In 2008 the ECB also started a review of itsdisciplinary and appeals procedures. Thechanges introduced were aimed at increasing theeffectiveness and efficiency of both procedureswhile preserving the rights granted to membersof staff.19 Staff on unpaid leave of absence are excluded. This numberincludes staff with permanent, fixed or short-term contracts andthe participants in the ECB’s Graduate Programme. Staff onmaternity or long-term sick leave are also included.208 ECBAnnual Report2008

In order to improve the balance betweenprofessional and private life, and to furtherdevelop the resilience of the ECB, the ExecutiveBoard decided in 2008 to launch a pilot projectwith a view to progressively introducingteleworking. After completion of the projectin 2009, the benefits and drawbacks will becarefully assessed before a decision is taken onwhether to extend the scheme.2.2 THE HUMAN RESOURCES CONFERENCEThe activities of the Human ResourcesConference (HRC) and its substructurescovered multiple aspects of staff trainingand development in 2008. Based on a needsanalysis, new ESCB training activities havebeen developed and will be introduced in2009. The HRC also took measures to increaseintra-ESCB mobility with a view to extendingopportunities for staff from Eurosystem/ESCBcentral banks to learn from one another andpromoting cooperation and team spirit.Furthermore, with the aim of exchangingexperiences and moving towards theestablishment of best practices, the HRC and theEurosystem/ESCB Communications Committeeorganised a conference on communicationin HR, at which all ESCB central banks wererepresented. At its meetings, the HRC coveredother topics, such as demographics, assessmentcentres, and the future of HR in Europe and thekey challenges up until 2015.2.3 NEW ECB PREMISESFurther progress was made in 2008 with regardto the ECB’s new premises in the Ostend part ofFrankfurt.In April 2008 preparatory works commenced onthe new site in advance of the building works.The two four-storey annex buildings at theend of the Grossmarkthalle were demolishedmanually, with most of the clinker bricks beingreserved for the renovation of the facade of theGrossmarkthalle in order to retain the colouringand texture of the original bricks. In late springinitial excavation works began for the twobasement floors of the office towers and theunderground staff car park in the southern part ofthe site. The foundation piles were subsequentlyinserted into the ground. These preliminaryworks were completed by September 2008, onschedule and within budget.On 6 May 2008 the Lord Mayor of theCity of Frankfurt, Petra Roth, presented thebuilding permit for the ECB’s new premisesto the President of the ECB. The buildingpermit constitutes formal legal approval forthe new premises on the site of the formerGrossmarkthalle.On 25 June 2008 the ECB decided to formallyclose the international public tender procedurefor a general contractor to construct the newECB premises, since it had not produced asatisfactory economic result, with the receivedbid considerably exceeding the ECB’s estimatedbudget. During the summer and autumn of2008, the architects and planners conducted anin-depth analysis of the situation in theconstruction market. On the basis of thisanalysis, the Governing Council decided inNovember 2008 to change the tender strategy,dividing up the construction works into separatetrades and lots, and to re-launch the tenderprocess for the construction works accordingly.In the course of 2009 around 15 distinctinvitations to tender will be issued for thestructural works, the facade and other parts ofthe building. The aim of this tender strategy isto attract more competitive bids, including frommedium-sized companies, and to find specialisedcompanies for each trade. The tender strategywill be based on balanced contractual termswhich are frequently used in the constructionmarket.The ECB remains fully committed to adheringto the estimated building costs of around€500 million (at 2005 constant prices). Thesecosts are revaluated in line with the relevantofficial price indices compiled by the GermanECBAnnual Report2008209

statistical office (Statistisches Bundesamt).The construction of new premises designed tomeet the ECB’s specific needs is considered torepresent the best option in terms of value formoney.At the end of 2009, following the evaluation ofthe tenders, the Governing Council will take thenecessary follow-up decisions.2.4 THE EUROSYSTEM PROCUREMENTCOORDINATION OFFICEIn July 2007 the Governing Council decidedto establish the Eurosystem ProcurementCoordination Office (EPCO) in order toenhance cooperation within the Eurosystem inthe field of procurement. A total of 20 centralbanks from the ESCB participate on a voluntarybasis. In December 2007 the Banque centrale duLuxembourg was designated to host EPCO from1 January 2008 to 31 December 2012. In 2008all four EPCO staff members were recruitedand seven meetings of procurement expertsfrom the participating central banks were held.Work focused on establishing best practices.In November 2008 the Governing Counciladopted a decision laying down the frameworkfor joint Eurosystem procurement. Based onthis decision, which aims to ensure a levelplaying-field for central banks participating injoint procurements, the Governing Council alsoapproved a procurement plan for 2009. EPCOis guided by the EPCO Steering Committee,which reports to the Governing Council via theExecutive Board.210 ECBAnnual Report2008

3 ESCB SOCIAL DIALOGUEThe ESCB Social Dialogue is a consultativeforum involving the ECB and employeerepresentatives from the central banks of theESCB and from European trade unionfederations 20 . Its purpose is to provideinformation and foster exchanges of views onissues that may have a major impact onemployment conditions at the central banks ofthe ESCB.This information is provided in a biannualnewsletter and at meetings held in April andOctober. The meetings held in 2008 focusedon the issues of cooperation and specialisationin the Eurosystem, the Treaty of Lisbon andits impact on the ESCB, and the role of marketoperations and financial supervision in timesof turbulence. Issues relating to banknoteproduction and circulation, as well as paymentsystems (TARGET2, TARGET2-Securities andCCBM2), were also discussed. The employeerepresentatives were also informed of the workbeing carried out by the HRC.An ad hoc working group on banknoteproduction and circulation was set up. Itinvolved a very limited number of participantsand aimed to address technical questions relatingto banknotes prior to the plenary meeting of theESCB Social Dialogue.20 The Standing Committee of European Central Bank Unions(SCECBU), Union Network International – Europa (UNI-EuropaFinance) and the European Federation of Public Service Unions(EPSU).ECBAnnual Report2008211

4 ANNUAL ACCOUNTS OF THE ECB212 ECBAnnual Report2008

MANAGEMENT REPORT FOR THE YEARENDING 31 DECEMBER 20081 NATURE OF THE BUSINESSThe ECB’s activities in 2008 are described indetail in the relevant chapters of the AnnualReport.2 OBJECTIVES AND TASKSThe ECB’s objectives and tasks are describedin the Statute of the ESCB (Articles 2 and 3).An overview of performance against theseobjectives is included in the President’sforeword to the Annual Report.3 KEY RESOURCES, RISKS AND PROCESSESGOVERNANCE OF THE ECBInformation relating to the governance of theECB is given in Chapter 8.MEMBERS OF THE EXECUTIVE BOARDThe members of the Executive Board are appointedfrom among persons of recognised standing andprofessional experience in monetary or bankingmatters by common accord of the governmentsof the Member States at the level of the Headsof State or Government, upon a recommendationfrom the EU Council after it has consulted theEuropean Parliament and the Governing Council.The terms and conditions of members’employment are determined by the GoverningCouncil, based on a proposal from a Committeecomprising three members appointed bythe Governing Council and three membersappointed by the EU Council.The emoluments of the members of theExecutive Board are set out in note 29 “Staffcosts” of the Annual Accounts.in 2007 to 1,499 in 2008. At the end of that year1,536 staff were employed. For further details,see note 29 “Staff costs” of the Annual Accountsand Chapter 8, Section 2, which also describesthe ECB’s human resources strategy.INVESTMENT ACTIVITIES AND RISK MANAGEMENTThe ECB’s foreign reserves portfolio consists offoreign reserve assets transferred to it by the euroarea NCBs in accordance with the provisionsof Article 30 of the Statute of the ESCB, andthe income thereon. It serves to fund the ECB’soperations in the foreign exchange market forthe purposes set out in the Treaty.The ECB’s own funds portfolio reflects theinvestment of its paid-up capital, the counterpartof the provision against foreign exchange,interest rate and gold price risks, the generalreserve fund and income accumulated on theportfolio in the past. Its purpose is to provide theECB with income to contribute to the coverageof its operating expenses.The ECB’s investment activities and itsmanagement of the associated risks are describedin greater detail in Chapter 2.THE BUDGET PROCESSThe Budget Committee (BUCOM), composedof ECB and euro area NCB experts, is a keycontributor to the ECB’s financial governanceprocess. In accordance with Article 15 of theRules of Procedure, BUCOM supports theGoverning Council by providing a detailedevaluation of annual ECB budget proposals andrequests for supplementary budget funding bythe Executive Board, prior to their submission tothe Governing Council for approval. Spendingagainst agreed budgets is monitored regularlyby the Executive Board, taking into accountthe advice of the ECB’s internal controllingEMPLOYEESThe average number of staff (full-time equivalent)holding contracts with the ECB 1 rose from 1,4481Staff on unpaid leave of absence are excluded. This numberincludes staff with permanent, fixed or short-term contracts andthe participants in the ECB’s Graduate Programme. Staff onmaternity or long-term sick leave are also included.ECBAnnual Report2008213

function, and by the Governing Council with theassistance of BUCOM.4 FINANCIAL RESULTFINANCIAL ACCOUNTSUnder Article 26.2 of the Statute of the ESCB,the Annual Accounts of the ECB are drawn upby the Executive Board, in accordance withthe principles established by the GoverningCouncil. The accounts are then approved by theGoverning Council and subsequently published.PROVISION FOR FOREIGN EXCHANGE RATE,INTEREST RATE AND GOLD PRICE RISKSSince most of the ECB’s assets and liabilities areperiodically revalued at current market exchangerates and security prices, the ECB’s profitabilityis strongly affected by exchange rate exposuresand, to a lesser extent, interest rate exposures.These exposures stem mainly from its holdingsof foreign reserve assets held in US dollars,Japanese yen and gold, which are predominantlyinvested in interest-bearing instruments.In 2005, taking into account the ECB’s largeexposure to these risks and the size of itsrevaluation accounts, the Governing Councildecided to establish a provision against foreignexchange rate, interest rate and gold pricerisks. As at 31 December 2007, this provisionamounted to €2,668,758,313. In accordancewith Article 49.2 of the Statute of the ESCB,the Central Bank of Cyprus and the CentralBank of Malta also contributed the amountsof €4,795,450 and €2,388,127 respectivelyto the provision with effect from 1 January2008. Taking the results of its assessment intoaccount, the Governing Council decided totransfer as at 31 December 2008 an additionalamount of €1,339,019,690 to the provision.This transfer increased the size of the provisionto its permitted maximum of €4,014,961,580.The Governing Council has decided that theprovision, together with any amounts held in theECB’s general reserve fund, may not exceed thevalue of the capital shares paid up by the euroarea NCBs.This provision will be used to cover realisedand unrealised losses, in particular valuationlosses not covered by the revaluation accounts.Its size and continuing requirement is reviewedannually, taking a range of factors into account,including in particular the level of holdings ofrisk-bearing assets, the extent of materialisedrisk exposures in the current financial year,projected results for the coming year, and a riskassessment involving calculations of Valuesat Risk (VaR) on risk-bearing assets, which isapplied consistently over time.FINANCIAL RESULT FOR 2008The net income of the ECB prior to the transferto the provision against risks was €2,661 million,compared with €286 million in 2007. The netprofit of €1,322 million after the transfer wasmade was distributed to the NCBs.In 2007, the appreciation of the euro vis-à-visthe US dollar and, to a lesser extent, the Japaneseyen resulted in write-downs in the euro valueof the ECB’s holdings of assets denominated inthese currencies. These write-downs amounted tosome €2.5 billion and were expensed in the Profitand Loss Account. In 2008, the depreciationof the euro vis-à-vis the Japanese yen and theUS dollar resulted in unrealised gains of some€3.6 billion. These gains were recorded inrevaluation accounts, in line with the commonaccounting policies that have been establishedby the Governing Council for the Eurosystem.In 2008, net interest income decreased to€2,381 million from €2,421 million in 2007,owing mainly to (a) lower net interest incomedenominated in US dollars, and (b) higherremuneration of NCBs’ claims in respect offoreign reserves transferred. The resultingdecrease in net interest income was only partiallyoffset by the increase in interest income arisingfrom the allocation of euro banknotes withinthe Eurosystem, mainly reflecting the generalincrease in euro banknotes in circulation.214 ECBAnnual Report2008

Net realised gains arising from financialoperations decreased from €779 million in 2007to €662 million in 2008, due mainly to the lowervolume of gold sold in accordance with theCentral Bank Gold Agreement, which came intoeffect on 27 September 2004 and of which theECB is a signatory. The resulting lower realisedgains from these operations were only partiallyoffset by higher net realised gains from securitysales in 2008, following the drop in US interestrates in that year.Total administrative expenses of the ECB,including depreciation, increased from€385 million in 2007 to €388 million in 2008.INFORMATION TECHNOLOGY SERVICEMANAGEMENTIn 2008, the ECB was the first central bankto receive certification of compliance withinternational standard ISO/IEC 20000 forexcellence in IT service management (ITSM).ISO/IEC 20000 describes an integrated set ofmanagement processes for the effective deliveryof IT services to the business and its customers.Its application was a major contribution to thedelivery of IT services at the ECB and it hasalready resulted in measurable benefits andhigher end-user satisfaction.CHANGE TO THE CAPITAL OF THE ECBPursuant to Council Decisions 2007/503/ECand 2007/504/EC of 10 July 2007, Cyprusand Malta adopted the single currency on1 January 2008. Consequently, in accordancewith Article 49.1 of the Statute of the ESCB,the Central Bank of Cyprus and the CentralBank of Malta paid up the remainder of theircapital subscription to the ECB as of thatdate. As a result of these payments, the ECB’spaid-up capital increased from €4,127 millionon 31 December 2007 to €4,137 million on1 January 2008.5 OTHER ISSUESENVIRONMENTAL ISSUESOn the basis of the ECB’s “EnvironmentalPolicy Framework”, adopted at the end of2007, an inventory of environmental aspects ofthe ECB’s administration and a first estimateof its ecological impact were prepared in2008. The ECB has also decided to establishan environmental management system that iscompliant with the internationally recognisedstandards ISO 14001 and EMAS. A projecthas been launched to obtain certification of thebank’s environmental management system in2010, and some measures were successfullyimplemented in 2008.ECBAnnual Report2008215

BALANCE SHEET AS AT 31 DECEMBER 2008ASSETSNOTENUMBER2008€2007€Gold and gold receivables 1 10,663,514,154 10,280,374,109Claims on non-euro area residentsdenominated in foreign currency 2Receivables from the IMF 346,651,334 449,565,998Balances with banks and securityinvestments, external loans and otherexternal assets 41,264,100,632 28,721,418,91241,610,751,966 29,170,984,910Claims on euro area residentsdenominated in foreign currency 2 22,225,882,711 3,868,163,459Claims on non-euro area residentsdenominated in euro 3Balances with banks, securityinvestments and loans 629,326,381 0Other claims on euro area creditinstitutions denominated in euro 4 25,006 13,774Intra-Eurosystem claims 5Claims related to the allocation of eurobanknotes within the Eurosystem 61,021,794,350 54,130,517,580Other claims within the Eurosystem (net) 234,095,515,333 17,241,183,222295,117,309,683 71,371,700,802Other assets 6Tangible fixed assets 202,690,344 188,209,963Other financial assets 10,351,859,696 9,678,817,294Off-balance-sheet instruments revaluationdifferences 23,493,348 34,986,651Accruals and prepaid expenses 1,806,184,794 1,365,938,582Sundry 1,272,185,672 69,064,93413,656,413,854 11,337,017,424Total assets 383,903,223,755 126,028,254,478216 ECBAnnual Report2008

LIABILITIESNOTENUMBER2008€2007€Banknotes in circulation 7 61,021,794,350 54,130,517,580Liabilities to other euro area residentsdenominated in euro 8 1,020,000,000 1,050,000,000Liabilities to non-euro area residentsdenominated in euro 9 253,930,530,070 14,571,253,753Liabilities to euro area residentsdenominated in foreign currency 10 272,822,807 0Liabilities to non-euro area residentsdenominated in foreign currency 10Deposits, balances and other liabilities 1,444,797,283 667,076,397Intra-Eurosystem liabilities 11Liabilities equivalent to the transfer offoreign reserves 40,149,615,805 40,041,833,998Other liabilities 12Off-balance-sheet instruments revaluationdifferences 1,130,580,103 69,589,536Accruals and income collected in advance 2,284,795,433 1,848,257,491Sundry 1,797,414,878 659,763,9205,212,790,414 2,577,610,947Provisions 13 4,038,858,227 2,693,816,002Revaluation accounts 14 11,352,601,325 6,169,009,571Capital and reserves 15Capital 4,137,159,938 4,127,136,230Profit for the year 1,322,253,536 0Total liabilities 383,903,223,755 126,028,254,478ECBAnnual Report2008217

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING31 DECEMBER 2008NOTENUMBER2008€2007€Interest income on foreign reserve assets 997,075,442 1,354,887,368Interest income arising from the allocationof euro banknotes within the Eurosystem 2,230,477,327 2,004,355,782Other interest income 8,430,894,437 4,380,066,479Interest income 11,658,447,206 7,739,309,629Remuneration of NCBs’ claims in respectof foreign reserves transferred (1,400,368,012) (1,356,536,045)Other interest expense (7,876,884,520) (3,962,006,944)Interest expense (9,277,252,532) (5,318,542,989)Net interest income 23 2,381,194,674 2,420,766,640Realised gains/losses arising fromfinancial operations 24 662,342,084 778,547,213Write-downs on financial assets andpositions 25 (2,662,102) (2,534,252,814)Transfer to/from provisions for foreignexchange rate and price risks (1,339,019,690) (286,416,109)Net result of financial operations,write-downs and risk provisions (679,339,708) (2,042,121,710)Net expense from fees and commissions 26 (149,007) (621,691)Income from equity shares andparticipating interests 27 882,152 920,730Other income 28 7,245,593 6,345,668Total net income 1,709,833,704 385,289,637Staff costs 29 (174,200,469) (168,870,244)Administrative expenses 30 (183,224,063) (184,589,229)Depreciation of tangible fixed assets (23,284,586) (26,478,405)Banknote production services 31 (6,871,050) (5,351,759)Profit for the year 1,322,253,536 0Frankfurt am Main, 24 February 2009EUROPEAN CENTRAL BANKJean-Claude TrichetPresident218 ECBAnnual Report2008

ACCOUNTING POLICIES 1FORM AND PRESENTATION OF THE FINANCIALSTATEMENTSThe financial statements of the ECB have beendesigned to present fairly the financial positionof the ECB and the results of its operations.They have been drawn up in accordance withthe following accounting policies, 2 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, goingconcern, consistency and comparability.RECOGNITION OF ASSETS AND LIABILITIESAn asset or liability is only recognised inthe Balance Sheet when it is probable thatany associated future economic benefit willflow to or from the ECB, substantially all ofthe associated risks and rewards have beentransferred to the ECB, and the cost or value ofthe asset or the amount of the obligation can bemeasured reliably.BASIS OF ACCOUNTINGThe accounts have been prepared on a historicalcost basis, modified to include market valuationof marketable securities, gold and all other onbalance-sheetand off-balance-sheet assets andliabilities denominated in foreign currency.Transactions in financial assets and liabilitiesare reflected in the accounts on the basis of thedate on which they were settled.With the exception of securities, transactionsin financial instruments denominated in foreigncurrency are recorded in off-balance-sheetaccounts on the trade date. At the settlementdate the off-balance-sheet entries are reversedand transactions are booked on-balance-sheet.Purchases and sales of foreign currency affectthe net foreign currency position on the trade dateand realised results arising from sales are alsocalculated on that date. Accrued interest, premiumsand discounts related to financial instrumentsdenominated in foreign currency are calculatedand recorded daily, and the foreign currencyposition is also affected daily by these accruals.GOLD AND FOREIGN CURRENCY ASSETS ANDLIABILITIESAssets and liabilities denominated in foreigncurrency are converted into euro at theexchange rate prevailing on the Balance Sheetdate. Income and expenses are converted at theexchange rate prevailing on the recording date.The revaluation of foreign exchange assets andliabilities, including on-balance-sheet and offbalance-sheetinstruments, is performed on acurrency-by-currency basis.Revaluation to the market price for assets andliabilities denominated in foreign currencyis treated separately from the exchange raterevaluation.Gold is valued at the market price prevailing atthe year-end. No distinction is made betweenthe 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, for the yearending 31 December 2008, was derived fromthe exchange rate of the euro against the USdollar on 31 December 2008.SECURITIESAll marketable securities and similar assets arevalued either at the mid-market prices or on thebasis of the relevant yield curve prevailing at theBalance Sheet date, on a security-by-securitybasis. For the year ending 31 December 2008,1 The detailed accounting policies of the ECB are laid down inDecision ECB/2006/17, OJ L 348, 11.12.2006, p. 38, as amended.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.ECBAnnual Report2008219

mid-market prices on 30 December 2008 wereused. Non-marketable securities are valued atcost, while illiquid equity shares are valued atcost subject to impairment.INCOME RECOGNITIONIncome and expenses are recognised in theperiod in which they are earned or incurred.Realised gains and losses arising from the sale offoreign exchange, gold and securities are takento the Profit and Loss Account. Such realisedgains and losses are calculated by reference tothe average cost of the respective asset.Unrealised gains are not recognised as incomebut are transferred directly to a revaluationaccount.Unrealised losses are taken to the Profit and LossAccount if they exceed previous revaluationgains registered in the corresponding revaluationaccount. Unrealised losses in any one securityor currency or in gold are not netted againstunrealised gains in other securities or currenciesor gold. In the event of an unrealised loss on anyitem at the year-end, the average cost of thatitem is reduced to the year-end exchange rate ormarket price.Premiums or discounts arising on purchasedsecurities are calculated and presented as partof interest income and are amortised over theremaining life of the assets.REVERSE TRANSACTIONSReverse transactions are operations wherebythe ECB buys or sells assets under a repurchaseagreement or conducts credit operations againstcollateral.Under a repurchase agreement, securities aresold for cash with a simultaneous agreementto repurchase them from the counterparty at anagreed price on a set future date. Repurchaseagreements are recorded as collateralised inwarddeposits 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.Reverse repurchase agreements are recordedas collateralised loans on the asset side of theBalance Sheet but are not included in the ECB’ssecurity holdings. They give rise to interestincome in the Profit and Loss Account.Reverse transactions (including security lendingtransactions) conducted under an automatedsecurity lending programme are recorded on theBalance Sheet only where collateral is providedin the form of cash placed on an account ofthe ECB. In 2008 the ECB did not receive anycollateral in the form of cash in connection withsuch transactions.OFF-BALANCE-SHEET INSTRUMENTSCurrency instruments, namely foreign exchangeforward transactions, forward legs of foreignexchange swaps and other currency instrumentsinvolving an exchange of one currency foranother at a future date, are included in the netforeign currency position for the purpose ofcalculating foreign exchange gains and losses.Interest rate instruments are revalued on an itemby-itembasis. Daily changes in the variationmargin of open interest rate futures contractsare recorded in the Profit and Loss Account. Thevaluation of forward transactions in securitiesand of interest rate swaps is based on generallyaccepted valuation methods using observablemarket prices and rates and the discount factorsfrom the settlement dates to the valuation date.POST-BALANCE-SHEET EVENTSAssets and liabilities are adjusted for events thatoccur between the annual Balance Sheet dateand the date on which the Governing Councilapproves the financial statements, if such events220 ECBAnnual Report2008

materially affect the condition of assets andliabilities at the Balance Sheet date.Important post-balance-sheet events that do notaffect the condition of assets and liabilities at theBalance Sheet date are disclosed in the notes.INTRA-ESCB BALANCES/INTRA-EUROSYSTEMBALANCESIntra-ESCB transactions are cross-bordertransactions that occur between two EUcentral banks. These transactions are processedprimarily via TARGET2 3 – the Trans-EuropeanAutomated Real-time Gross settlement ExpressTransfer system (see Chapter 2) – and giverise to bilateral balances in accounts heldbetween those EU central banks connected toTARGET2. 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.Euro-denominated intra-ESCB balances ofthe euro area NCBs with the ECB (except forthe capital of the ECB and positions resultingfrom the transfer of foreign reserve assets tothe ECB) are described as intra-Eurosystemclaims or liabilities and are presented in theBalance Sheet of the ECB as a single net assetor liability position.Intra-Eurosystem balances arising fromthe allocation of euro banknotes within theEurosystem are included as a single netasset under “Claims related to the allocationof euro banknotes within the Eurosystem”(see “Banknotes in circulation” in the notes onaccounting policies).Intra-ESCB balances of non-euro area NCBswith the ECB, arising from their participation inTARGET2, 4 are disclosed under “Liabilities tonon-euro area residents denominated in euro”.TREATMENT OF FIXED ASSETSFixed assets, with the exception of land,are valued at cost less depreciation. Land isvalued at cost. Depreciation is calculated on astraight-line basis, beginning in the quarter afteracquisition and continuing over the period forwhich the asset is expected to be available foruse, as follows:Computers, related hardware andsoftware, and motor vehiclesEquipment, furniture and plant inbuildingFixed assets costing less than €10,000The depreciation period for capitalised buildingand refurbishment expenditure relating to theECB’s existing premises has been reduced inorder to ensure that these assets are completelywritten off before the ECB moves to its newpremises.THE ECB’S RETIREMENT PLAN AND OTHERPOST-EMPLOYMENT BENEFITSThe ECB operates a defined benefit schemefor its staff. This is funded by assets held in along-term employee-benefit fund.BALANCE SHEET4 years10 yearsWritten off in theyear of acquisitionThe liability recognised in the Balance Sheet inrespect of the defined benefit plans is the presentvalue of the defined benefit obligation at theBalance Sheet date, less the fair value of planassets used to fund the obligation, adjusted forunrecognised actuarial gains or losses.3 The technically decentralised first-generation system wasprogressively replaced by a second-generation system(TARGET2) system, which is based on a single technicalinfrastructure, the Single Shared Platform (SSP). The migrationto TARGET2 started in November 2007 and was completed inMay 2008.4 As at 31 December 2008, the non-euro area NCBs participatingin TARGET2 were: Danmarks Nationalbank, Latvijas Banka,Lietuvos bankas, Narodowy Bank Polski and Eesti Pank.ECBAnnual Report2008221

The defined benefit obligation is calculatedannually by independent actuaries using theprojected unit credit method. The present valueof the defined benefit obligation is determinedby discounting the estimated future cash flows,using interest rates of high quality corporatebonds that are denominated in euro and havesimilar terms of maturity to the term of therelated pension liability.Actuarial gains and losses can arise fromexperience adjustments (where actual outcomesare different from the actuarial assumptionspreviously made) and changes in actuarialassumptions.PROFIT AND LOSS ACCOUNTThe net amount charged to the Profit and LossAccount comprises:(a) the current service cost of the benefitsaccruing for the year;(b) interest at the discount rate on the definedbenefit obligation;(c) the expected return on the plan assets; and(d) any actuarial gains and losses recognised inthe Profit and Loss Account, using a “10%corridor” approach.“10% CORRIDOR” APPROACHNet cumulative unrecognised actuarial gains andlosses which exceed the greater of (a) 10% of thepresent value of the defined benefit obligationand (b) 10% of the fair value of plan assets,are to be amortised over the expected averageremaining working lives of the participatingemployees.PENSIONS OF EXECUTIVE BOARD MEMBERS ANDOTHER POST-RETIREMENT OBLIGATIONSUnfunded arrangements are in place for thepensions of members of the Executive Boardof the ECB and disability benefit provisions forthe staff. The expected costs of these benefitsare accrued over the Executive Board/staffmembers’ terms of office/employment using anaccounting approach similar to that of definedbenefit pension plans. Actuarial gains andlosses are recognised in the same manner asoutlined above.These obligations are valued annually byindependent actuaries to establish the appropriateliability in the financial statements.BANKNOTES IN CIRCULATIONThe ECB and the euro area NCBs, whichtogether comprise the Eurosystem, issue eurobanknotes. 5 The total value of euro banknotes incirculation is allocated to the Eurosystem centralbanks on the last working day of each month inaccordance with the banknote allocation key. 6The ECB has been allocated a share of 8% ofthe total value of euro banknotes in circulation,which is disclosed under the Balance Sheetliability item “Banknotes in circulation”. TheECB’s share of the total euro banknote issue isbacked by claims on the NCBs. These claims,which bear interest, 7 are disclosed under thesub-item “Intra-Eurosystem claims: claimsrelated to the allocation of euro banknotes withinthe Eurosystem” (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies). Interest income on theseclaims is included within the item “Net interestincome”. This income is due to the NCBs in thefinancial year in which it accrues, but isdistributed on the second working day of thefollowing year. 8 It is distributed in full unless5 Decision ECB/2001/15 of 6 December 2001 on the issue of eurobanknotes, OJ L 337, 20.12.2001, p. 52, as amended.6 “Banknote allocation key” means the percentages that result fromtaking into account the ECB’s share in the total euro banknoteissue and applying the subscribed capital key to the NCBs’ sharein that total.7 Decision ECB/2001/16 of 6 December 2001 on the allocation ofmonetary income of the national central banks of participatingMember States from the financial year 2002, OJ L 337,20.12.2001, p. 55, as amended.8 Decision ECB/2005/11 of 17 November 2005 on the distributionof the income of the European Central Bank on euro banknotesin circulation to the national central banks of the participatingMember States, OJ L 311, 26.11.2005, p. 41.222 ECBAnnual Report2008

the ECB’s net profit for the year is less than itsincome earned on euro banknotes in circulation,and subject to any decisions by the GoverningCouncil to make transfers to a provision forforeign exchange rate, interest rate and goldprice risks and/or to charge costs incurred by theECB in connection with the issue and handlingof euro banknotes against this income.RECLASSIFICATIONSA number of items were reclassified in 2008 forpresentational reasons and the comparablebalances as at 31 December 2007 have beenadjusted accordingly. These reclassifications aredescribed in the Notes on the Balance Sheet. 9OTHER ISSUESTaking account of the ECB’s role as a centralbank, the Executive Board considers that thepublication of a cash flow statement would notprovide the readers of the financial statementswith any additional relevant information.In accordance with Article 27 of theStatute of the ESCB, and on the basis of arecommendation of the Governing Council,the EU Council has approved the appointmentof PricewaterhouseCoopers AktiengesellschaftWirtschaftsprüfungsgesellschaft as the externalauditors of the ECB for a five-year period up tothe end of the financial year 2012.9The reclassifications comply with the accounting policies of theECB laid down in Decision ECB/2006/17, OJ L 348, 11.12.2006,p. 38, as amended.ECBAnnual Report2008223

NOTES ON THE BALANCE SHEET1 GOLD AND GOLD RECEIVABLESAs at 31 December 2008 the ECB held17,156,546 ounces of fine gold (2007:18,091,733 ounces). The reduction was due to(a) sales of 963,987 ounces of fine gold inaccordance with the Central Bank GoldAgreement, which came into effect on27 September 2004 and of which the ECB is asignatory, and (b) the transfer by the CentralBank of Cyprus and the Central Bank of Maltato the ECB of 19,151 and 9,649 ounces of finegold 10 respectively upon the adoption of thesingle currency by Cyprus and Malta, inaccordance with Article 30.1 of the Statute ofthe ESCB. The decrease in the euro equivalentvalue of this holding, resulting from thesetransactions, was more than offset by asignificant rise in the price of gold during 2008(see “Gold and foreign currency assets andliabilities” in the notes on accounting policies).2 CLAIMS ON NON-EURO AREA AND EUROAREA RESIDENTS DENOMINATED IN FOREIGNCURRENCYRECEIVABLES FROM THE IMFThis asset represents the ECB’s holdingsof special drawing rights (SDRs) as at31 December 2008. It arises as the result of atwo-way SDR buying and selling arrangementwith the International Monetary Fund (IMF),whereby the IMF is authorised to arrangesales or purchases of SDRs against euro,on behalf of the ECB, within minimum andmaximum holding levels. The SDR is definedin terms of a basket of currencies. Its valueis determined as the weighted sum of theexchange rates of four major currencies (euro,Japanese yen, pound sterling and US dollar).For accounting purposes, SDRs are treatedas a foreign currency (see “Gold and foreigncurrency assets and liabilities” in the notes onaccounting policies).BALANCES WITH BANKS AND SECURITYINVESTMENTS, EXTERNAL LOANS AND OTHEREXTERNAL ASSETS; AND CLAIMS ON EURO AREARESIDENTS DENOMINATED IN FOREIGN CURRENCYThese two items consist of balances with banksand loans denominated in foreign currency,and investments in securities denominated inUS dollars and Japanese yen. The amortisationof discounts and premiums on securitiesdenominated in foreign currency was previouslyincluded under the headings “Accruals andprepaid expenses” and “Accruals and incomecollected in advance” respectively. The ECB hasdecided, for presentational reasons, to reclassifythese items under the heading “Balances withbanks and security investments, external loansand other external assets”. The comparablebalances as at 31 December 2007 have beenadjusted accordingly.Claims onnon-euro arearesidents2008€2007€Change€Currentaccounts 5,808,582,148 761,073,851 5,047,508,297Money marketdeposits 573,557,686 688,783,688 (115,226,002)Reverserepurchaseagreements 379,961,453 543,247,188 (163,285,735)Securityinvestments 34,501,999,345 26,728,314,185 7,773,685,160Total 41,264,100,632 28,721,418,912 12,542,681,720Claims oneuro arearesidents2008€2007€Change€Currentaccounts 619,534 574,945 44,589Money marketdeposits 22,225,263,177 3,867,588,514 18,357,674,663Total 22,225,882,711 3,868,163,459 18,357,719,252The increase in current accounts held withnon-euro area residents is due mainly to(a) the settlement of the Danish krone leg of swaptransactions with Danmarks Nationalbank thatwere outstanding on 31 December 2008 amounting10The transfers, with an aggregate value equivalent to €16.5 million,were made with effect from 1 January 2008.224 ECBAnnual Report2008

to €3.9 billion (see note 20, “Foreign exchangeswap and forward transactions”), and (b) balancesin Swiss francs with a value of €1.2 billion whicharose in connection with the swap arrangementestablished with the Swiss National Bank 11(see note 9, “Liabilities to non-euro area residentsdenominated in euro”). The appreciation ofthe Japanese yen and the US dollar against theeuro, unrealised gains on securities (see note 14,“Revaluation accounts”), the investment of theproceeds of gold sales (see note 1, “Gold and goldreceivables”), and the income received primarilyon the US dollar portfolio have also contributed tothe increase in the total value of these items.Deposits related to operations conducted byEurosystem central banks in order to provide USdollar liquidity to credit institutions in the euroarea are included under the component moneymarket deposits with euro area residents.Additionally, upon the adoption of the singlecurrency by Cyprus and Malta with effect from1 January 2008, the Central Bank of Cyprusand the Central Bank of Malta transferred USdollars with an aggregate value of €93.5 millionto the ECB, in accordance with Article 30.1 ofthe Statute of the ESCB.The ECB’s net foreign currency holdings 12 ofUS dollars and Japanese yen, as at31 December 2008, were as follows:million currency unitsUS dollars 40,062Japanese yen 1,084,5483 CLAIMS ON NON-EURO AREA RESIDENTSDENOMINATED IN EUROIn 2007 money market deposits and currentaccounts held with non-euro area residents as adirect counterpart to the capital and reserves ofthe ECB were included under this heading. TheECB has decided to reclassify these holdingsas a dedicated portfolio, which is now includedunder the heading “Other financial assets”. Thecomparable balance as at 31 December 2007 hasbeen adjusted accordingly.As at 31 December 2008 this item consistedmainly of a claim of €460.0 million on theMagyar Nemzeti Bank in connection withan agreement established with the ECB onrepurchase transactions. This agreementprovides the Magyar Nemzeti Bank with afacility to borrow up to €5 billion in order tosupport its domestic operations for the provisionof euro liquidity.4 OTHER CLAIMS ON EURO AREA CREDITINSTITUTIONS DENOMINATED IN EUROIn 2007 money market deposits and currentaccounts held with euro area residents as adirect counterpart to the capital and reserves ofthe ECB were included under this heading. TheECB has decided to reclassify these holdingsas a dedicated portfolio, which is now includedunder the heading “Other financial assets”. Thecomparable balance as at 31 December 2007 hasbeen adjusted accordingly.As at 31 December 2008 this claim consisted ofa current account with a euro area resident.5 INTRA-EUROSYSTEM CLAIMSCLAIMS RELATED TO THE ALLOCATION OF EUROBANKNOTES WITHIN THE EUROSYSTEMThis item consists of the claims of the ECBvis-à-vis the euro area NCBs relating tothe allocation of euro banknotes within the11 The balances in Swiss francs reflect the risk control measuresapplied by the ECB in its EUR/CHF foreign exchange swaptender operations, which take the form of initial margins of 5%for one-week operations and 15% for 84-day operations.12 Assets minus liabilities denominated in the respective foreigncurrency that are subject to foreign currency revaluation. Theseare included under the headings “Claims on non-euro arearesidents denominated in foreign currency”, “Claims on euroarea residents denominated in foreign currency”, “Accruals andprepaid expenses”, “Liabilities to euro area residents denominatedin foreign currency”, “Liabilities to non-euro area residentsdenominated in foreign currency”, “Off-balance-sheet instrumentsrevaluation differences” (Liabilities side) and “Accruals andincome collected in advance”, also taking into account foreignexchange forward and swap transactions under off-balance-sheetitems. The effects of the price revaluation gains on financialinstruments denominated in foreign currency are not included.ECBAnnual Report2008225

Eurosystem (see “Banknotes in circulation” inthe notes on accounting policies).OTHER CLAIMS WITHIN THE EUROSYSTEM (NET)In 2008 this item consisted mainly of theTARGET2 balances of the euro area NCBsvis-à-vis the ECB (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies). The increase in thisposition was due mainly to back-to-backswap transactions conducted with NCBs inconnection with US dollar liquidity-providingoperations (see note 9, “Liabilities to non-euroarea residents denominated in euro”).This item also includes the amount due to euroarea NCBs in respect of the interim distributionof the ECB’s income derived from banknotes(see “Banknotes in circulation” in the notes onaccounting policies).2008 2007€ €Due from euro areaNCBs in respect ofTARGET2 420,833,781,929 145,320,642,526Due to euro areaNCBs in respect ofTARGET2 (185,532,591,178) (128,079,459,304)Due to euro areaNCBs in respectof the interimdistribution of theECB’s incomederived frombanknotes (1,205,675,418) 0Other claims withinthe Eurosystem (net) 234,095,515,333 17,241,183,2226 OTHER ASSETSTANGIBLE FIXED ASSETSThese assets comprised the following items on31 December 2008:2008€2007€Change€CostLand andbuildings 159,972,149 156,964,236 3,007,913Computerhardware andsoftware 174,191,055 168,730,634 5,460,4212008€The increase in the category “Assets underconstruction” is due mainly to initial worksrelated to the ECB’s new premises. Transfersfrom this category to the relevant fixed assetheadings will occur once the assets are in use.OTHER FINANCIAL ASSETS2007€Change€Equipment,furniture, plantin building andmotor vehicles 28,862,720 27,105,564 1,757,156Assets underconstruction 83,407,619 59,791,855 23,615,764Other fixed assets 3,577,485 1,195,290 2,382,195Total cost 450,011,028 413,787,579 36,223,449AccumulateddepreciationLand andbuildings (59,885,983) (49,672,589) (10,213,394)Computerhardware andsoftware (160,665,542) (150,195,777) (10,469,765)Equipment,furniture, plantin building andmotor vehicles (26,618,732) (25,562,068) (1,056,664)Other fixed assets (150,427) (147,182) (3,245)Totalaccumulateddepreciation (247,320,684) (225,577,616) (21,743,068)Net book value 202,690,344 188,209,963 14,480,381The amortisation of discounts and premiums onsecurities denominated in euro was previouslyincluded under the headings “Accruals andprepaid expenses” and “Accruals and incomecollected in advance”, respectively. The ECBhas decided, for presentational reasons, toreclassify these items under this heading. Inaddition, money market deposits and currentaccounts in euro held as a direct counterpartto the capital and reserves of the ECB are nowincluded under this heading (see note 3, “Claimson non-euro area residents denominated ineuro”, and note 4, “Other claims on euro areacredit institutions denominated in euro”). Thecomparable balances as at 31 December 2007have been adjusted accordingly.226 ECBAnnual Report2008

The main components of this item are asfollows:2008€(a) Current accounts, money market deposits,securities and reverse repurchase agreementsin euro constitute the investment of theECB’s own funds (see note 12, “Otherliabilities”). The net increase in the value ofthe ECB’s own fund assets was due mainlyto the investment in the own funds portfolioof the counterpart of the amount transferredto the ECB’s provision against foreignexchange rate, interest rate and gold pricerisks in 2007, unrealised gains on securities(see note 14, “Revaluation accounts”) andincome received on the own funds portfolio.(b) The ECB holds 3,211 shares in the Bankfor International Settlements (BIS), whichare included at the acquisition cost of€41.8 million.OFF-BALANCE-SHEET INSTRUMENTS REVALUATIONDIFFERENCESIn 2008 this item was composed mainly ofvaluation gains in outstanding interest rate swaptransactions (see note 19, “Interest rate swaps”).ACCRUALS AND PREPAID EXPENSES2007€Change€Currentaccounts ineuro 4,936,630 5,153,295 (216,665)Money marketdeposits ineuro 150,000,000 120,000,000 30,000,000Securitiesdenominatedin euro 9,675,505,128 8,843,080,586 832,424,542Reverserepurchaseagreements ineuro 479,293,075 668,392,837 (189,099,762)Other financialassets 42,124,863 42,190,576 (65,713)Total 10,351,859,696 9,678,817,294 673,042,402In 2008 this position included accrued interestreceivable on the ECB’s claims related tothe allocation of euro banknotes within theEurosystem for the final quarter (see “Banknotesin circulation” in the notes on accountingpolicies), amounting to €500.4 million, andaccrued interest receivable on the TARGET2balances due from euro area NCBs for the finalmonth of 2008, amounting to €648.9 million.Also included under this item is accrued intereston securities (see also note 2, “Claims onnon-euro area and euro area residentsdenominated in foreign currency”, and note 6,“Other assets”) and other financial assets.SUNDRYThis item consists mainly of the accrued interimdistribution of the ECB’s income derived frombanknotes (see “Banknotes in circulation” inthe notes on accounting policies and note 5,“Intra-Eurosystem claims”).This item also includes positive balancesrelated to swap and forward transactions inforeign currency that were outstanding on31 December 2008 (see note 20, “Foreignexchange swap and forward transactions”).These balances arise from the conversion ofsuch transactions into their euro equivalents atthe respective currency’s average cost on theBalance Sheet date, compared with the eurovalues at which the transactions were initiallyrecorded (see “Off-balance-sheet instruments”in the notes on accounting policies).A claim against the German Federal Ministry ofFinance in respect of recoverable value addedtax and other indirect taxes paid is also includedunder this heading. Such taxes are refundableunder the terms of Article 3 of the Protocol onthe privileges and immunities of the EuropeanCommunities, which applies to the ECB byvirtue of Article 40 of the Statute of the ESCB.7 BANKNOTES IN CIRCULATIONThis item consists of the ECB’s share (8%)of the total euro banknotes in circulationECBAnnual Report2008227

(see “Banknotes in circulation” in the notes onaccounting policies).8 LIABILITIES TO OTHER EURO AREARESIDENTS DENOMINATED IN EUROThis 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 settled throughthe TARGET2 system.9 LIABILITIES TO NON-EURO AREA RESIDENTSDENOMINATED IN EUROThis item consists mainly of a liability to theFederal Reserve amounting to €219.7 billionin connection with the US dollar Term AuctionFacility. Under this programme, US dollarswere provided by the Federal Reserve tothe ECB by means of a temporary reciprocalcurrency arrangement (swap line), with theaim of offering short-term US dollar fundingto Eurosystem counterparties. The ECBsimultaneously entered into back-to-backswap transactions with euro area NCBs, whichused the resulting funds to conduct US dollarliquidity-providing operations with Eurosystemcounterparties in the form of reverse andswap transactions. The back-to-back swaptransactions between the ECB and the NCBsresulted in intra-Eurosystem balances betweenthe ECB and the NCBs reported under “Otherclaims within the Eurosystem (net)”.A liability to the Swiss National Bankamounting to €18.4 billion is also includedunder this heading. Swiss francs were providedby the Swiss National Bank by means of aswap arrangement with the aim of offeringshort-term Swiss franc funding to Eurosystemcounterparties. The ECB simultaneouslyentered into swap transactions with euro areaNCBs, which used the resulting funds to conductSwiss franc liquidity-providing operations withEurosystem counterparties against euro cashin the form of swap transactions. The swaptransactions between the ECB and the NCBsresulted in intra-Eurosystem balances reportedunder “Other claims within the Eurosystem(net)”. In addition, this item includes a liabilityto the Swiss National Bank amounting to€15.4 billion. This liability arose from theplacement with the ECB of euro funds receivedby the Swiss National Bank from operationswith other counterparties.The remainder of this item reflects balancesheld with the ECB by non-euro area NCBsarising from transactions processed via theTARGET2 system (see “Intra-ESCB balances/intra-Eurosystem balances” in the notes onaccounting policies).10 LIABILITIES TO EURO AREA AND NON-EUROAREA RESIDENTS DENOMINATED IN FOREIGNCURRENCYThis position consists mainly of repurchaseagreements conducted with euro area andnon-euro area residents in connection with themanagement of the foreign currency reserves ofthe ECB.11 INTRA-EUROSYSTEM LIABILITIESThese represent the liabilities to the euro areaNCBs that arose from the transfer of foreignreserve assets to the ECB when they joined theEurosystem. They are remunerated at the latestavailable marginal rate for the Eurosystem’smain refinancing operations, adjusted to reflect azero return on the gold component (see note 23,“Net interest income”).The transfer of foreign reserve assets by theCentral Bank of Cyprus and the Central Bank ofMalta upon the adoption of the single currencyby Cyprus and Malta led to an increase in theseliabilities of €107,781,807.228 ECBAnnual Report2008

To31 December 2007From1 January 2008 1€ €Nationale Bankvan België/BanqueNationale de Belgique 1,423,341,996 1,423,341,996Deutsche Bundesbank 11,821,492,402 11,821,492,402Central Bank andFinancial ServicesAuthority of Ireland 511,833,966 511,833,966Bank of Greece 1,046,595,329 1,046,595,329Banco de España 4,349,177,351 4,349,177,351Banque de France 8,288,138,644 8,288,138,644Banca d’Italia 7,217,924,641 7,217,924,641Central Bank of Cyprus - 71,950,549Banque centrale duLuxembourg 90,730,275 90,730,275Central Bank of Malta - 35,831,258De Nederlandsche Bank 2,243,025,226 2,243,025,226OesterreichischeNationalbank 1,161,289,918 1,161,289,918Banco de Portugal 987,203,002 987,203,002Banka Slovenije 183,995,238 183,995,238Suomen Pankki –Finlands Bank 717,086,011 717,086,011Total 40,041,833,998 40,149,615,8051) Individual amounts are shown rounded to the nearest euro. Thecomponents may not add up to the total due to rounding.The claims of the Central Bank of Cyprusand the Central Bank of Malta were set at€71,950,549 and €35,831,258 respectively inorder to ensure that the ratio between theseclaims and the aggregate claim credited to theother NCBs that have adopted the euro willbe equal to the ratio between the weightingsof the Central Bank of Cyprus and the CentralBank of Malta in the ECB’s capital key andthe other participating NCBs’ aggregateweighting in this key. The difference betweenthe claim and the value of the assets transferred(see note 1, “Gold and gold receivables”, andnote 2, “Claims on non-euro area and euro arearesidents denominated in foreign currency”)was treated as part of the contributions of theCentral Bank of Cyprus and the Central Bankof Malta, due under Article 49.2 of the Statuteof the ESCB, to the reserves and provisionsequivalent to reserves of the ECB existing as at31 December 2007 (see note 13, “Provisions”,and note 14, “Revaluation accounts”).12 OTHER LIABILITIESOFF-BALANCE-SHEET INSTRUMENTS REVALUATIONDIFFERENCESThis item is composed mainly of valuationchanges in swap and forward transactions inforeign currency that were outstanding on31 December 2008 (see note 20, “Foreignexchange swap and forward transactions”).These valuation changes are the result of theconversion of such transactions into their euroequivalents at the exchange rates prevailingon the Balance Sheet date, compared with theeuro values resulting from the conversion of thetransactions at the average cost of the respectiveforeign currency (see “Gold and foreign currencyassets and liabilities” in the notes on accountingpolicies and also note 6, “Other assets”).Valuation losses on interest rate swaps are alsoincluded in this item.ACCRUALS AND INCOME COLLECTED IN ADVANCEThis item consists mainly of interest payableto the NCBs in respect of their claims relatingto the foreign reserves transferred (see note 11,“Intra-Eurosystem liabilities”), amounting to€1.4 billion. It also includes accruals onbalances due to NCBs in respect of TARGET2,accruals on financial instruments (see alsonote 2, “Claims on non-euro area and euro arearesidents denominated in foreign currency”, andnote 6, “Other assets”) and other accruals.SUNDRYThis item consists mainly of negative balancesrelated to swap and forward transactions inforeign currency that were outstanding on31 December 2008 (see note 20, “Foreignexchange swap and forward transactions”).These balances arise from the conversion ofsuch transactions into their euro equivalents atthe respective currency’s average cost on theBalance Sheet date, compared with the euroECBAnnual Report2008229

values at which the transactions were initiallyrecorded (see “Off-balance-sheet instruments”in the notes on accounting policies).This item also includes outstanding repurchasetransactions of €337.6 million conducted inconnection with the management of the ECB’sown funds (see note 6, “Other assets”) and thenet liability in respect of the ECB’s pensionobligations as described below.THE ECB’S RETIREMENT PLAN AND OTHERPOST-EMPLOYMENT BENEFITSThe amounts recognised in the Balance Sheetin respect of the ECB’s pension obligations(see “The ECB’s retirement plan and otherpost-employment benefits” in the notes onaccounting policies) are as follows:2008 2007€ millions € millionsPresent value of obligations 317.0 285.8Fair value of plan assets (226.7) (229.8)Unrecognised actuarialgains/(losses) 7.6 35.4Liability recognised in theBalance Sheet 97.9 91.4The present value of the obligations includesunfunded obligations of €42.3 million (2007:€36.8 million) relating to the pensions ofExecutive Board members and to staff disabilityprovisions.The amounts recognised in the Profit andLoss Account in 2008 and 2007 in respect of“Current service cost”, “Interest on obligation”,“Expected return on plan assets” and “Netactuarial (gains)/losses recognised in the year”are as follows:2008€ millions2007€ millionsCurrent service cost 24.7 26.5Interest on obligation 10.7 8.6Expected return on plan assets (10.0) (7.9)Net actuarial (gains)/lossesrecognised in the year (1.1) 0Under the “10% corridor” approach (see “TheECB’s retirement plan and other postemploymentbenefits” in the notes on accountingpolicies), net cumulative unrecognised actuarialgains exceeding the greater of (a) 10% of thepresent value of the defined benefit obligationand (b) 10% of the fair value of plan assets, areamortised over the expected average remainingworking lives of the participating employees.Changes in the present value of the definedbenefit obligation are as follows:2008€ millions2007€ millionsOpening defined benefitobligation 285.8 258.5Service cost 24.7 26.5Interest cost 10.7 8.6Contributions paid by planparticipants 17.9 14.2Other net changes in liabilitiesrepresenting plan participants’contributions (12.3) 2.5Benefits paid (3.8) (2.5)Actuarial (gains)/losses (6.0) (22.0)Closing defined benefitobligation 317.0 285.8Changes in the fair value of plan assets are asfollows:2008€ millions2007€ millionsOpening fair value of plan assets 229.8 195.3Expected return 10.0 7.9Actuarial gains/(losses) (32.7) (4.0)Contributions paid by employer 17.5 16.2Contributions paid by planparticipants 17.8 14.1Benefits paid (3.4) (2.2)Other net changes in assetsrepresenting plan participants’contributions (12.3) 2.5Closing fair value of plan assets 226.7 229.8In preparing the valuations referred to in thisnote, the actuaries have used assumptionswhich the Executive Board has accepted for thepurposes of accounting and disclosure.Total included in “Staff costs” 24.3 27.2230 ECBAnnual Report2008

The principal assumptions used for the purposesof calculating the staff scheme liability are asshown in the following table. The expected rateof return on plan assets is used by the actuariesfor the purpose of calculating the annual chargeto the Profit and Loss Account.2008%2007%Discount rate 5.75 5.30Expected return on plan assets 6.50 6.50Future salary increases 2.00 2.00Future pension increases 2.00 2.0013 PROVISIONSThis item consists of a provision against foreignexchange rate, interest rate and gold price risks andother miscellaneous provisions. The latter includean appropriate provision against the contractualobligation of the ECB to restore its currentpremises to their original condition when they arevacated and the ECB moves to its new site.The Governing Council, taking into account theECB’s large exposure to foreign exchange rate,interest rate and gold price risks, and the size ofits revaluation accounts, deemed it appropriateto establish a provision as at 31 December 2005against these risks. This provision will be usedto the extent deemed necessary by the GoverningCouncil to offset future realised and unrealisedlosses, in particular valuation losses not coveredby the revaluation accounts. The size andcontinuing requirement for this provision isreviewed annually, based on the ECB’sassessment of its exposure to the above risks.This assessment takes a range of factors intoaccount, including in particular the level ofholdings of risk-bearing assets, the extent ofmaterialised risk exposures in the currentfinancial year, projected results for the comingyear, and a risk assessment involvingcalculations of Values at Risk (VaR) on riskbearingassets, which is applied consistentlyover time. 13 The provision, together with anyamount held in the general reserve fund, maynot exceed the value of the ECB’s capital paidup by the euro area NCBs.As at 31 December 2007 the provision againstforeign exchange rate, interest rate and goldprice risks amounted to €2,668,758,313. Inaccordance with Article 49.2 of the Statute ofthe ESCB, the Central Bank of Cyprus and theCentral Bank of Malta contributed the amountsof €4,795,450 and €2,388,127 respectively tothe provision with effect from 1 January 2008.Taking the results of its assessment into account,the Governing Council decided to transfer, asat 31 December 2008, an additional amount of€1,339,019,690 14 to the provision. This increasedthe size of the provision to €4,014,961,580,which is the value of the ECB’s capital paid upby the euro area NCBs as at 31 December 2008,and reduced net profit to €1,322,253,536.14 REVALUATION ACCOUNTSThese accounts represent revaluation balancesarising from unrealised gains on assets andliabilities. In accordance with Article 49.2 of theStatute of the ESCB, the Central Bank of Cyprusand the Central Bank of Malta contributed theamounts of €11.1 million and €5.5 millionrespectively to these balances with effect from1 January 2008.2008€2007€Change€Gold 6,449,713,267 5,830,485,388 619,227,879Foreign currency 3,616,514,710 0 3,616,514,710Securities andother instruments 1,286,373,348 338,524,183 947,849,165Total 11,352,601,325 6,169,009,571 5,183,591,754The foreign exchange rates used for the yearendrevaluation were as follows:Exchange rates 2008 2007US dollars per euro 1.3917 1.4721Japanese yen per euro 126.14 164.93Euro per SDR 1.1048 1.0740Swiss francs per euro 1.4850 Not applicableDanish kroner per euro 7.4506 Not applicableEuro per fine ounce of gold 621.542 568.23613 See also Chapter 2 of the ECB’s Annual Report.14 This transfer was funded from realised gains on gold salesof €0.3 billion and the ECB’s income on euro banknotes incirculation amounting to €1.0 billion.ECBAnnual Report2008231

15 CAPITAL AND RESERVESCAPITALPursuant to Council Decisions 2007/503/ECand 2007/504/EC of 10 July 2007, taken inaccordance with Article 122(2) of the Treaty,Cyprus and Malta adopted the single currency on1 January 2008. In accordance with Article 49.1of the Statute of the ESCB and the legal actsadopted by the Governing Council on31 December 2007, 15 the Central Bank of Cyprusand the Central Bank of Malta paid up amountsof €6,691,401 and €3,332,307 respectively as at1 January 2008, representing the remainder oftheir capital subscriptions to the ECB. As aconsequence, the ECB’s paid-up capital increasedfrom €4,127,136,230 on 31 December 2007 to€4,137,159,938 on 1 January 2008, as shown inthe table below: 1615 Decision ECB/2007/22 of 31 December 2007 on the paying-upof capital, transfer of foreign reserve assets and contributions bythe Central Bank of Cyprus and the Central Bank of Malta to theEuropean Central Bank’s reserves and provisions, OJ L 28, 1.2.2008,p. 36; Agreement of 31 December 2007 between the EuropeanCentral Bank and the Central Bank of Cyprus regarding the claimcredited to the Central Bank of Cyprus by the European Central Bankunder Article 30.3 of the Statute of the European System of CentralBanks and of the European Central Bank, OJ C 29, 1.2.2008, p. 4;Agreement of 31 December 2007 between the European CentralBank and the Central Bank of Malta regarding the claim creditedto the Central Bank of Malta by the European Central Bank underArticle 30.3 of the Statute of the European System of Central Banksand of the European Central Bank, OJ C 29, 1.2.2008, p. 6.16 Individual amounts are shown rounded to the nearest euro.Subtotals in the tables of this section may not add up to the totaldue to rounding.Capital key until31 December 2007%Paid-up capital until31 December 2007€Capital key from1 January 2008%Paid-up capital from1 January 2008€Nationale Bank van België/Banque Nationale deBelgique 2.4708 142,334,200 2.4708 142,334,200Deutsche Bundesbank 20.5211 1,182,149,240 20.5211 1,182,149,240Central Bank and Financial Services Authority ofIreland 0.8885 51,183,397 0.8885 51,183,397Bank of Greece 1.8168 104,659,533 1.8168 104,659,533Banco de España 7.5498 434,917,735 7.5498 434,917,735Banque de France 14.3875 828,813,864 14.3875 828,813,864Banca d’Italia 12.5297 721,792,464 12.5297 721,792,464Central Bank of Cyprus - - 0.1249 7,195,055Banque centrale du Luxembourg 0.1575 9,073,028 0.1575 9,073,028Central Bank of Malta - - 0.0622 3,583,126De Nederlandsche Bank 3.8937 224,302,523 3.8937 224,302,523Oesterreichische Nationalbank 2.0159 116,128,992 2.0159 116,128,992Banco de Portugal 1.7137 98,720,300 1.7137 98,720,300Banka Slovenije 0.3194 18,399,524 0.3194 18,399,524Suomen Pankki – Finlands Bank 1.2448 71,708,601 1.2448 71,708,601Subtotal for euro area NCBs 69.5092 4,004,183,400 69.6963 4,014,961,580Българска народна банка (Bulgarian National Bank) 0.8833 3,561,869 0.8833 3,561,869Česká národní banka 1.3880 5,597,050 1.3880 5,597,050Danmarks Nationalbank 1.5138 6,104,333 1.5138 6,104,333Eesti Pank 0.1703 686,727 0.1703 686,727Central Bank of Cyprus 0.1249 503,654 - -Latvijas Banka 0.2813 1,134,330 0.2813 1,134,330Lietuvos bankas 0.4178 1,684,760 0.4178 1,684,760Magyar Nemzeti Bank 1.3141 5,299,051 1.3141 5,299,051Central Bank of Malta 0.0622 250,819 - -Narodowy Bank Polski 4.8748 19,657,420 4.8748 19,657,420Banca Naţională a României 2.5188 10,156,952 2.5188 10,156,952Národná banka Slovenska 0.6765 2,727,957 0.6765 2,727,957Sveriges Riksbank 2.3313 9,400,866 2.3313 9,400,866Bank of England 13.9337 56,187,042 13.9337 56,187,042Subtotal for non-euro area NCBs 30.4908 122,952,830 30.3037 122,198,358Total 100.0000 4,127,136,230 100.0000 4,137,159,938232 ECBAnnual Report2008

The non-euro area NCBs are required to pay up7% of their subscribed capital as a contributionto the operational costs of the ECB. Thiscontribution amounted to a total of €122,198,358at end-2008. The non-euro area NCBs are notentitled to receive any share of the distributableprofits of the ECB, including income arisingfrom the allocation of euro banknotes within theEurosystem, nor are they liable to fund any lossof the ECB.16 POST-BALANCE-SHEET EVENTSCHANGES TO THE ECB’S CAPITAL KEYPursuant to Article 29 of the Statute of theESCB, the shares of the NCBs in the ECB’scapital key are weighted according to theshares of the respective Member States inthe EU’s total population and GDP in equalmeasure, as notified to the ECB by the EuropeanCommission. These weights are adjustedevery five years. 17 The second such adjustmentfollowing the establishment of the ECB wasmade on 1 January 2009. Based on CouncilDecision 2003/517/EC of 15 July 2003 on thestatistical data to be used for the adjustmentof the key for subscription to the capital of theEuropean Central Bank, 18 the NCBs’ capitalkey shares were adjusted on 1 January 2009 asfollows:Capital key from1 January 2008to 31 December2008%Capital key from1 January 2009Nationale Bank van België/Banque Nationale deBelgique 2.4708 2.4256Deutsche Bundesbank 20.5211 18.9373Central Bank and FinancialServices Authority ofIreland 0.8885 1.1107Bank of Greece 1.8168 1.9649Banco de España 7.5498 8.3040Banque de France 14.3875 14.2212Banca d’Italia 12.5297 12.4966Central Bank of Cyprus 0.1249 0.1369Banque centrale duLuxembourg 0.1575 0.1747Central Bank of Malta 0.0622 0.0632%Capital key from1 January 2008to 31 December2008%ENTRY OF SLOVAKIA INTO THE EURO AREACapital key from1 January 2009%De Nederlandsche Bank 3.8937 3.9882OesterreichischeNationalbank 2.0159 1.9417Banco de Portugal 1.7137 1.7504Banka Slovenije 0.3194 0.3288Národná banka Slovenska - 0.6934Suomen Pankki – FinlandsBank 1.2448 1.2539Subtotal for euro areaNCBs 69.6963 69.7915Българска народна банка(Bulgarian National Bank) 0.8833 0.8686Česká národní banka 1.3880 1.4472Danmarks Nationalbank 1.5138 1.4835Eesti Pank 0.1703 0.1790Latvijas Banka 0.2813 0.2837Lietuvos bankas 0.4178 0.4256Magyar Nemzeti Bank 1.3141 1.3856Narodowy Bank Polski 4.8748 4.8954Banca Naţională aRomâniei 2.5188 2.4645Národná banka Slovenska 0.6765 -Sveriges Riksbank 2.3313 2.2582Bank of England 13.9337 14.5172Subtotal for non-euro areaNCBs 30.3037 30.2085Total 100.0000 100.0000Pursuant to Council Decision 2008/608/EC of8 July 2008, taken in accordance withArticle 122(2) of the Treaty, Slovakia adoptedthe single currency on 1 January 2009. Inaccordance with Article 49.1 of the Statute ofthe ESCB and the legal acts adopted by theGoverning Council on 31 December 2008, 19Národná banka Slovenska paid up an amountof €37,216,407 as at 1 January 2009,17 These weights are also adjusted whenever new Member Statesjoin the EU.18 OJ L 181, 19.7.2003, p. 43.19 Decision ECB/2008/33 of 31 December 2008 on the paying-upof capital, transfer of foreign reserve assets and contributionsby Národná banka Slovenska to the European Central Bank’sreserves and provisions, OJ L 21, 24.1.2009, p. 83; Agreementof 31 December 2008 between Národná banka Slovenska and theEuropean Central Bank regarding the claim credited to Národnábanka Slovenska by the European Central Bank under Article 30.3of the Statute of the European System of Central Banks and of theEuropean Central Bank, OJ C 18, 24.1.2009, p. 3.ECBAnnual Report2008233

epresenting the remainder of its capitalsubscription to the ECB. In accordance withArticle 30.1 of the Statute of the ESCB,Národná banka Slovenska transferred foreignreserve assets with a total value equivalent to€443,086,156 to the ECB with effect from1 January 2009. The total amount transferredwas determined by multiplying the euro value,at the exchange rates prevailing on31 December 2008, of the foreign reserveassets already transferred to the ECB by theratio between the number of shares subscribedby Národná banka Slovenska and the numberof shares already paid up by the other NCBswithout a derogation. These foreign reserveassets comprised amounts of US dollars in theform of securities and cash, and gold, inproportions of 85 to 15 respectively.Národná banka Slovenska was credited withclaims in respect of the paid-up capital andforeign reserve assets equivalent to the amountstransferred. The latter is to be treated in anidentical manner to the existing claims of theother participating NCBs (see note 11, “Intra-Eurosystem liabilities”).EFFECT ON THE ECB’S CAPITALThe adjustment of the NCBs’ capital key sharesin conjunction with Slovakia joining the euroarea resulted in an increase of €5,100,251 in theECB’s paid-up capital.EFFECT ON THE NCBS’ CLAIMS EQUIVALENT TOTHE FOREIGN RESERVE ASSETS TRANSFERRED TOTHE ECBThe net effect of the change in NCBs’weightings in the ECB’s capital key and of thetransfer by Národná banka Slovenska of foreignreserve assets on the NCBs’ claims equivalentto the foreign reserve assets transferred to theECB was an increase of €54,841,411.OFF-BALANCE-SHEET INSTRUMENTS17 AUTOMATIC SECURITY LENDING PROGRAMMEAs part of the management of the ECB’s ownfunds, the ECB has concluded an automaticsecurity lending programme agreement,whereby an appointed agent enters into securitylending transactions on behalf of the ECBwith a number of counterparties, designatedby the ECB as eligible counterparties. Underthis agreement, reverse transactions witha value of €1.2 billion (2007: €3.0 billion)were outstanding as at 31 December 2008(see “Reverse transactions” in the notes onaccounting policies).18 INTEREST RATE FUTURESIn 2008 interest rate futures were used as part ofthe management of the ECB’s foreign reservesand own funds. As at 31 December 2008 thefollowing transactions were outstanding:Foreign currency interestrate futuresContract value€Purchases 2,041,082,857Sales 1,209,470,518Contract valueEuro interest rate futures€Purchases 50,000,000Sales 33,000,00019 INTEREST RATE SWAPSInterest rate swap transactions with a contractvalue of €459.3 million were outstanding as at31 December 2008. These transactions wereconducted in the context of the management ofthe ECB’s foreign reserves.234 ECBAnnual Report2008

20 FOREIGN EXCHANGE SWAP AND FORWARDTRANSACTIONSMANAGEMENT OF THE FOREIGN RESERVESIn the context of the management of the ECB’sforeign reserves, foreign exchange swap andforward transaction claims of €358.1 millionand liabilities of €404.3 million remainedoutstanding as at 31 December 2008.LIQUIDITY-PROVIDING OPERATIONSForward liabilities to Danmarks Nationalbankamounting to €3.9 billion remained outstandingas at 31 December 2008. These liabilities arosein connection with the reciprocal currencyarrangement (swap line) established withthe ECB. Under this arrangement, the ECBprovides euro funds to Danmarks Nationalbankagainst Danish kroner for the duration of thetransactions. The resulting funds are used insupport of measures to improve liquidity in euroshort-term markets.In addition, forward claims on NCBs andliabilities to the Federal Reserve, whicharose in connection with the provision of USdollar liquidity to Eurosystem counterparties(see note 9, “Liabilities to non-euro area residentsdenominated in euro”), were outstanding on31 December 2008.Forward claims on NCBs and liabilities to theSwiss National Bank, which arose in connectionwith the provision of Swiss franc liquidityto Eurosystem counterparties (see note 9,“Liabilities to non-euro area residentsdenominated in euro”), were also outstandingon 31 December 2008.the borrowing and lending operations of theEuropean Community under the medium-termfinancial assistance mechanism. Under thisscheme, a loan from the European Communityto Hungary for an amount of €2.0 billion wasoutstanding as at 31 December 2008.22 PENDING LAWSUITSAn action for damages was brought against theECB before the Court of First Instance of theEuropean Communities (CFI) by DocumentSecurity Systems Inc. (DSSI), alleging that theECB had infringed a DSSI patent 20 in theproduction of euro banknotes. The CFIdismissed DSSI’s action for damages againstthe ECB. 21 The ECB is currently pursuingactions to revoke the patent in a number ofnational jurisdictions. Furthermore, the ECBfirmly maintains that it has in no way infringedthe patent, and will consequently also enter adefence against any infringement action thatmay be brought by DSSI before any competentnational court.As a result of the CFI’s dismissal of DSSI’saction for damages against the ECB, as well asthe ECB’s successful actions to date in certainnational jurisdictions to revoke national portionsof DSSI’s patent, the ECB remains confidentthat the possibility of payments to DSSI isremote. The ECB is actively monitoring alldevelopments in the continuing litigation.21 ADMINISTRATION OF BORROWING ANDLENDING OPERATIONSIn accordance with Article 123(2) of theTreaty and Article 9 of Council Regulation(EC) No 332/2002 of 18 February 2002, theECB is responsible for the administration of20 DSSI’s European Patent No 0455 750 B1.21 Order of the Court of First Instance of 5 September 2007, CaseT-295/05. Available at www.curia.eu.ECBAnnual Report2008235

NOTES ON THE PROFIT AND LOSS ACCOUNT23 NET INTEREST INCOMEINTEREST INCOME ON FOREIGN RESERVE ASSETSThis item includes interest income, net of interestexpense, in respect of assets and liabilitiesdenominated in foreign currency, as follows:2008 2007 Change€ € €Interest income oncurrent accounts 11,202,181 24,052,321 (12,850,140)Interest incomeon money marketdeposits 218,184,237 196,784,561 21,399,676Interest income onreverse repurchaseagreements 42,404,485 138,079,630 (95,675,145)Interest income onsecurities 885,725,044 1,036,836,752 (151,111,708)Net interestincome on interestrate swaps 2,299,631 0 2,299,631Net interestincome onforward and swaptransactions inforeign currencies 0 19,766,033 (19,766,033)Total interestincome on foreignreserve assets 1,159,815,578 1,415,519,297 (255,703,719)Interest expense oncurrent accounts (45,896) (154,041) 108,145Interest expenseon deposits taken (1,574,337) 0 (1,574,337)Net interestexpense onrepurchaseagreements (29,492,415) (60,476,997) 30,984,582Net interestexpense oninterest rate swaps 0 (891) 891Net interestexpense onforward and swaptransactions inforeign currencies (131,627,488) 0 (131,627,488)Interest incomeon foreign reserveassets (net) 997,075,442 1,354,887,368 (357,811,926)INTEREST INCOME ARISING FROM THEALLOCATION OF EURO BANKNOTES WITHIN THEEUROSYSTEMThis item consists of the interest income relatingto the ECB’s share of the total euro banknoteissue. Interest on the claims of the ECB in respectof its share of banknotes is earned at the latestavailable marginal rate for the Eurosystem’smain refinancing operations. The increase inincome in 2008 mainly reflected the generalincrease in euro banknotes in circulation.This income is distributed to the NCBs asdescribed in “Banknotes in circulation” in thenotes on accounting policies. Based on theECB’s estimated financial result for 2008, andthe decision to fund the transfer to the provisionagainst foreign exchange rate, interest rateand gold price risks out of the ECB’s incomeon euro banknotes in circulation (see note 13,“Provisions”), the Governing Council decidedto distribute the remaining €1.2 billionof this income to the euro area NCBs, inaccordance with their respective shares in theECB’s capital.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 30.1of the Statute of the ESCB is disclosed underthis item.OTHER INTEREST INCOME AND OTHER INTERESTEXPENSEThese items include interest income of€8.0 billion (2007: €3.9 billion) and expensesof €7.6 billion (2007: €3.8 billion) on balancesarising from TARGET2 (see “Intra-ESCBbalances/intra-Eurosystem balances” inthe notes on accounting policies). Interestincome and expenses in respect of other assetsand liabilities denominated in euro are alsoshown here.24 REALISED GAINS/(LOSSES) ARISING FROMFINANCIAL OPERATIONSNet realised gains/(losses) arising from financialoperations in 2008 were as follows:236 ECBAnnual Report2008

2008 2007 Change€ € €Net realised pricegains/(losses) onsecurities andinterest rate futures 349,179,481 69,252,941 279,926,540Net realisedexchange rate andgold price gains 313,162,603 709,294,272 (396,131,669)Realised gainsarising fromfinancial operations 662,342,084 778,547,213 (116,205,129)The overall reduction in net realised exchangerate and gold price gains in 2008 was duemainly to the lower volume of gold sold in thatyear (see note 1, “Gold and gold receivables”).25 WRITE-DOWNS ON FINANCIAL ASSETS ANDPOSITIONS2008€2007€Change€Unrealisedprice losses onsecurities (2,164,000) (15,864,181) 13,700,181Unrealised pricelosses on interestrate swaps (476,831) (18,899) (457,932)Unrealisedexchange ratelosses (21,271) (2,518,369,734) 2,518,348,463Total writedowns(2,662,102) (2,534,252,814) 2,531,590,712In 2008 this expense was due mainly to thewrite-down of the acquisition cost of individualsecurities shown on the Balance Sheet to theirmarket value as at 30 December 2008.26 NET EXPENSE FROM FEES AND COMMISSIONS2008€2007€Change€Income from fees andcommissions 588,052 263,440 324,612Expenses relating tofees and commissions (737,059) (885,131) 148,072Net expense from feesand commissions (149,007) (621,691) 472,684Income under this heading includespenalties imposed on credit institutions fornon-compliance with the minimum reserverequirements. Expenses relate to fees payableon current accounts and in connection withthe execution of foreign currency interest ratefutures (see note 18, “Interest rate futures”).27 INCOME FROM EQUITY SHARES ANDPARTICIPATING INTERESTSDividends received on shares in the BIS(see note 6, “Other assets”) are shown under thisheading.28 OTHER INCOMEOther miscellaneous income during the yeararose principally from the contributions of othercentral banks to the cost of a service contractheld centrally by the ECB with an externalprovider of an IT network, and the transfers ofunused administrative provisions to the Profitand Loss Account.29 STAFF COSTSSalaries, allowances, staff insurance and othermiscellaneous costs of €149.9 million (2007:€141.7 million) are included under this heading.Staff costs of €1.1 million (2007: €1.1 million)incurred in connection with the construction of thenew ECB premises have been capitalised and areexcluded from this item. 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.Members of the Executive Board receive a basicsalary and additional allowances for residenceand representation. In the case of the President,an official residence owned by the ECB isprovided in lieu of a residence allowance. Subjectto the Conditions of Employment for Staff ofthe European Central Bank, members of theExecutive Board are entitled to household, childand education allowances, depending on theirECBAnnual Report2008237

individual circumstances. Basic salaries aresubject to a tax for the benefit of the EuropeanCommunities as well as to deductions in respect ofcontributions to the pension, medical and accidentinsurance schemes. Allowances are non-taxableand non-pensionable.Basic salaries paid to members of the ExecutiveBoard in 2008 and 2007 were as follows:2008€2007€Jean-Claude Trichet (President) 351,816 345,252Lucas D. Papademos (Vice-President) 301,548 295,920Gertrude Tumpel-Gugerell(Board Member) 251,280 246,588José Manuel González-Páramo(Board Member) 251,280 246,588Lorenzo Bini Smaghi (Board Member) 251,280 246,588Jürgen Stark (Board Member) 251,280 246,588Total 1,658,484 1,627,524The total allowances paid to the members ofthe Executive Board and their benefits from theECB’s contributions to the medical and accidentinsurance schemes amounted to €600,523(2007: €579,842), resulting in total emolumentsof €2,259,007 (2007: €2,207,366).Transitional payments are made to formermembers of the Executive Board for a periodafter the end of their terms of office. In 2008these payments and the ECB’s contributions tothe medical and accident insurance schemes offormer members amounted to €30,748 (2007:€52,020). Pension payments, including relatedallowances, to former members of the ExecutiveBoard or their dependents and contributions tothe medical and accident insurance schemesamounted to €306,798 (2007: €249,902).Also included under this item is an amount of€24.3 million (2007: €27.2 million) recognisedin connection with the ECB’s retirement planand other post-employment benefits (see note 12,“Other liabilities”).At the end of 2008 the actual full-time equivalentnumber of staff holding contracts with the ECBwas 1,536, 22 including 144 with managerialpositions. The change in the number of staffduring 2008 was as follows: 232008 2007As at 1 January 1,478 1,416New staff 307 310Resignations/end of contract 238 235Net decrease due to changes inpart-time working patterns 11 13As at 31 December 1,536 1,478Average number of staff employed 1,499 1,44830 ADMINISTRATIVE EXPENSESThese 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 and supplies,together with staff-related expenses includingrecruitment, relocation, installation, training andresettlement expenses.31 BANKNOTE PRODUCTION SERVICESThis expense relates to costs arising from thecross-border transportation of euro banknotesbetween NCBs to meet unexpected fluctuationsin demand for banknotes. These costs are bornecentrally by the ECB.22 Staff on unpaid leave of absence are excluded. This numberincludes staff with permanent, fixed or short-term contracts andthe participants in the ECB’s Graduate Programme. Staff onmaternity or long-term sick leave are also included.23 In 2007, staff numbers in this table included staff on unpaid/parental leave, while staff with short-term contracts, as wellas staff from other central banks of the ESCB with temporaryassignments with the ECB and the participants in the ECB’sGraduate Programme, were excluded. The change in thepresentation of the figures for 2008 was considered to make themmore useful for the users of the financial statements. The 2007figures have been adjusted accordingly.238 ECBAnnual Report2008

NOTE ON PROFIT DISTRIBUTION/ALLOCATION OF LOSSESThis note is not part of the fi nancial statementsof the ECB for the year 2008.INCOME RELATED TO THE ECB’S SHARE OF TOTALBANKNOTES IN CIRCULATIONIn 2007, following a decision by the GoverningCouncil, the full income of €2,004 millionearned on the ECB’s share of total banknotes incirculation was retained to ensure that the ECB’stotal profit distribution for the year did not exceedits net profit for the year. In respect of 2008, anamount of €1,206 million, comprising part ofthe income earned on the ECB’s share of totaleuro banknotes in circulation, was distributed tothe NCBs on 5 January 2009, in proportion totheir paid-up shares in the subscribed capital ofthe ECB.€117 million to the euro area NCBs in proportionto their paid-up capital.Non-euro area NCBs are not entitled to receiveany share of the ECB’s profit.2008 2007€ €Profit for the year 1,322,253,536 0Income on the ECB’s banknoteissue distributed to NCBs (1,205,675,418) 0Profit for the year afterdistribution of income on theECB’s banknote issue 116,578,118 0Distribution of profit to NCBs (116,578,118) 0Total 0 0PROFIT DISTRIBUTION/COVERAGE OF LOSSESPursuant to Article 33 of the Statute of the ESCB,the net profit of the ECB shall be transferred inthe following order:(a) an amount to be determined by the GoverningCouncil, which may not exceed 20% of thenet profit, shall be transferred to the generalreserve fund subject to a limit equal to 100%of the capital; and(b) the remaining net profit shall be distributedto the shareholders of the ECB in proportionto their paid-up shares.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 NCBs in accordancewith Article 32.5 of the Statute of the ESCB. 1The Governing Council decided on 5 March2009 to make no transfer to the general reservefund and to distribute the remaining balance of1Under Article 32.5 of the Statute of the ESCB, the sum of theNCBs’ monetary income shall be allocated to the NCBs inproportion to their paid-up shares in the capital of the ECB.ECBAnnual Report2008241

5 CONSOLIDATED BALANCE SHEET OF THEEUROSYSTEM AS AT 31 DECEMBER 2008(EUR MILLIONS)ASSETS31 DECEMBER 31 DECEMBER2008 1 2007 21 Gold and gold receivables 217,722 201,5842 Claims on non-euro area residents denominatedin foreign currency 160,372 139,0302.1 Receivables from the IMF 13,192 9,0572.2 Balances with banks and security investments,external loans and other external assets 147,180 129,9733 Claims on euro area residents denominated inforeign currency 234,293 41,9754 Claims on non-euro area residents denominated in euro 18,651 18,8224.1 Balances with banks, security investments and loans 18,651 18,8224.2 Claims arising from the credit facility under ERM II 0 05 Lending to euro area credit institutions related tomonetary policy operations denominated in euro 860,312 637,1785.1 Main refinancing operations 239,527 368,6075.2 Longer-term refinancing operations 616,662 268,4775.3 Fine-tuning reverse operations 0 05.4 Structural reverse operations 0 05.5 Marginal lending facility 4,057 915.6 Credits related to margin calls 66 26 Other claims on euro area credit institutions denominatedin euro 56,988 23,7987 Securities of euro area residents denominated in euro 271,196 143,9838 General government debt denominated in euro 37,438 37,0629 Other assets 218,134 264,454Total assets 2,075,107 1,507,887Totals/subtotals may not add up due to rounding.1 Consolidated figures as at 31.12.2008 also include the Central Bank of Cyprus and the Central Bank of Malta which have beenmembers of the Eurosystem since 01.01.2008.2 Comparative data as at 31.12.2007 has been restated to include reclassifications which took place on 31.12.2008.242 ECBAnnual Report2008

LIABILITIES31 DECEMBER200831 DECEMBER20071 Banknotes in circulation 762,921 676,6782 Liabilities to euro area credit institutions related tomonetary policy operations denominated in euro 492,310 379,1832.1 Current accounts (covering the minimum reserve system) 291,710 267,3372.2 Deposit facility 200,487 8,8312.3 Fixed-term deposits 0 101,5802.4 Fine-tuning reverse operations 0 02.5 Deposits related to margin calls 113 1,4353 Other liabilities to euro area credit institutions denominatedin euro 328 1264 Debt certificates issued 0 05 Liabilities to other euro area residents denominated in euro 91,077 46,1835.1 General government 83,282 38,1155.2 Other liabilities 7,794 8,0696 Liabilities to non-euro area residents denominated in euro 293,592 45,0947 Liabilities to euro area residents denominated inforeign currency 5,723 2,4908 Liabilities to non-euro area residents denominated inforeign currency 10,258 15,5538.1 Deposits, balances and other liabilities 10,258 15,5538.2 Liabilities arising from the credit facility under ERM II 0 09 Counterpart of special drawing rights allocated by the IMF 5,465 5,27910 Other liabilities 166,500 123,07611 Revaluation accounts 175,735 147,12312 Capital and reserves 71,200 67,101Total liabilities 2,075,107 1,507,887ECBAnnual Report2008243

ANNEXES

LEGAL INSTRUMENTS ADOPTED BY THE ECBThe following table lists the legal instrumentsthat were adopted by the ECB in 2008 and early2009 and published in the Official Journal of theEuropean Union. Copies of the Official Journalcan be obtained from the Office for OfficialPublications of the European Communities. Fora list of all the legal instruments adopted by theECB since its establishment and published inthe Official Journal, see the “Legal framework”section of the ECB’s website.Number Title OJ referenceECB/2008/1 Recommendation of the European Central Bank of28 January 2008 to the Council of the European Union onthe external auditors of Suomen PankkiECB/2008/2 Recommendation of the European Central Bank of30 April 2008 to the Council of the European Union onthe external auditors of the European Central BankOJ C 29,1.2.2008, p. 1OJ C 114,9.5.2008, p. 1ECB/2008/3Decision of the European Central Bank of 15 May 2008 onsecurity accreditation procedures for manufacturers of eurosecure items for euro banknotesOJ L 140,30.5.2008, p. 26ECB/2008/4 Guideline of the European Central Bank of 19 June 2008amending Guideline ECB/2006/9 on certain preparations for theeuro cash changeover and on frontloading and sub-frontloading ofeuro banknotes and coins outside the euro areaOJ L 176,4.7.2008, p. 16ECB/2008/5Guideline of the European Central Bank of 20 June 2008 onthe management of the foreign reserve assets of the EuropeanCentral Bank by the national central banks and the legaldocumentation for operations involving such assets (recast)OJ L 192,19.7.2008, p. 63ECB/2008/6 Guideline of the European Central Bank of 26 August 2008amending Guideline ECB/2002/7 on the statistical reportingrequirements of the European Central Bank in the field ofquarterly financial accountsECB/2008/7 Guideline of the European Central Bank of 5 September 2008amending Guideline ECB/2005/5 of 17 February 2005 onthe statistical reporting requirements of the European CentralBank and the procedures for exchanging statistical informationwithin the European System of Central Banks in the field ofgovernment finance statisticsECB/2008/8 Guideline of the European Central Bank of 11 September 2008on data collection regarding the euro and the operation of theCurrency Information System 2ECB/2008/9 Recommendation for a Council Regulation amendingRegulation (EC) No 2533/98 concerning the collection ofstatistical information by the ECBOJ L 259,27.9.2008, p. 12OJ L 276,17.10.2008, p. 32OJ L 346,23.12.2008, p. 89OJ C 251,3.10.2008, p. 1246 ECBAnnual Report2008

Number Title OJ referenceECB/2008/10 Regulation of the European Central Bank of 22 October 2008amending Regulation ECB/2003/9 on the application ofminimum reservesECB/2008/11 Regulation of the European Central Bank of 23 October 2008on temporary changes to the rules relating to eligibility ofcollateralECB/2008/13 Guideline of the European Central Bank of 23 October 2008amending Guideline ECB/2000/7 on monetary policyinstruments and procedures of the EurosystemOJ L 282,25.10.2008, p. 14OJ L 282,25.10.2008, p. 17OJ L 36,5.2.2009, p. 31ECB/2008/14Decision of the European Central Bank of 28 October 2008 ontransitional provisions for the application of minimum reservesby the European Central Bank following the introduction ofthe euro in SlovakiaOJ L 319,29.11.2008, p. 73ECB/2008/15 Decision of the European Central Bank of 14 November 2008on the implementation of Regulation ECB/2008/11 of23 October 2008 on temporary changes to the rules relating toeligibility of collateralECB/2008/16 Recommendation of the European Central Bank of17 November 2008 to the Council of the European Union on theexternal auditors of the Banque centrale du LuxembourgECB/2008/17 Decision of the European Central Bank of 17 November 2008laying down the framework for joint Eurosystem procurementECB/2008/18 Guideline of the European Central Bank of 21 November 2008on temporary changes to the rules relating to eligibility ofcollateralECB/2008/19 Recommendation of the European Central Bank of5 December 2008 to the Council of the European Union on theexternal auditors of the Central Bank of MaltaECB/2008/20 Decision of the European Central Bank of 11 December 2008on the approval of the volume of coin issuance in 2009ECB/2008/21 Guideline of the European Central Bank of 11 December 2008amending Guideline ECB/2006/16 on the legal framework foraccounting and financial reporting in the European System ofCentral BanksECB/2008/22 Decision of the European Central Bank of 11 December 2008amending Decision ECB/2006/17 on the annual accounts ofthe European Central BankOJ L 309,20.11.2008, p. 8OJ C 299,22.11.2008, p. 5OJ L 319,29.11.2008, p. 76OJ L 314,25.11.2008, p. 14OJ C 322,17.12.2008, p. 1OJ L 352,31.12.2008, p. 58OJ L 36,5.2.2009, p. 46OJ L 36,5.2.2009, p. 22ECBAnnual Report2008247

Number Title OJ referenceECB/2008/23 Decision of the European Central Bank of 12 December 2008on the national central banks’ percentage shares in the key forsubscription to the European Central Bank’s capitalECB/2008/24 Decision of the European Central Bank of 12 December 2008laying down the measures necessary for the paying-up of theEuropean Central Bank’s capital by the participating nationalcentral banksECB/2008/25 Decision of the European Central Bank of 12 December 2008laying down the terms and conditions for transfers of theEuropean Central Bank’s capital shares between the nationalcentral banks and for the adjustment of the paid-up capitalECB/2008/26 Decision of the European Central Bank of 12 December 2008amending Decision ECB/2001/15 of 6 December 2001 on theissue of euro banknotesECB/2008/27 Decision of the European Central Bank of 12 December 2008laying down the measures necessary for the contribution to theEuropean Central Bank’s accumulated equity value and foradjusting the national central banks’ claims equivalent to thetransferred foreign reserve assetsECB/2008/28 Decision of the European Central Bank of 15 December 2008laying down the measures necessary for the paying-up of theEuropean Central Bank’s capital by the non-participatingnational central banksECB/2008/29 Decision of the European Central Bank of 18 December 2008to postpone the start of the rotation system in the GoverningCouncil of the European Central BankECB/2008/30 Regulation of the European Central Bank of 19 December 2008concerning statistics on the assets and liabilities of financialvehicle corporations engaged in securitisation transactionsECB/2008/31 Guideline of the European Central Bank of 19 December 2008amending Guideline ECB/2007/9 on monetary, financialinstitutions and markets statistics (recast)ECB/2008/32 Regulation of the European Central Bank of 19 December 2008concerning the balance sheet of the monetary financialinstitutions sector (recast)ECB/2008/33 Decision of the European Central Bank of 31 December 2008on the paying-up of capital, transfer of foreign reserve assetsand contributions by Národná banka Slovenska to the EuropeanCentral Bank’s reserves and provisionsOJ L 21,24.1.2009, p. 66OJ L 21,24.1.2009, p. 69OJ L 21,24.1.2009, p. 71OJ L 21,24.1.2009, p. 75OJ L 21,24.1.2009, p. 77OJ L 21,24.1.2009, p. 81OJ L 3,7.1.2009, p. 4OJ L 15,20.1.2009, p. 1OJ L 53,26.2.2009, p. 76OJ L 15,20.1.2009, p. 14OJ L 21,24.1.2009, p. 83248 ECBAnnual Report2008

Number Title OJ referenceECB/2009/1 Guideline of the European Central Bank of 20 January 2009amending Guideline ECB/2000/7 on monetary policy instrumentsand procedures of the EurosystemECB/2009/2 Decision of the European Central Bank of 27 January 2009amending Decision ECB/2007/5 laying down the Rules onProcurementOJ L 36,5.2.2009, p. 59OJ L 51,24.2.2009, p. 10ECB/2009/3Recommendation of the European Central Bank of 16 February2009 to the Council of the European Union on the externalauditors of the Deutsche BundesbankOJ C 43,21.2.2009, p. 1ECBAnnual Report2008249

OPINIONS ADOPTED BY THE ECBThe following table lists the opinions adoptedby the ECB in 2008 and early 2009 underArticle 105(4) of the Treaty and Article 4 of theStatute of the ESCB, Article 112(2)(b) of theTreaty and Article 11.2 of the Statute. For a listof all the opinions adopted by the ECB since itsestablishment, see the ECB’s website.(a) ECB opinions following a consultation by a Member State 1Number 2 Originator SubjectCON/2008/1 Cyprus Control of reproduction of euro banknotes and coins inCyprusCON/2008/2 Czech Republic Distribution of powers between Česká národní bankaand the Ministry of Finance to prepare and submitcertain draft laws to the GovernmentCON/2008/3 Germany German legislation on coinsCON/2008/4 Sweden Amendments to Sveriges Riksbank’s statutes regardingthe terms of office of members of its Executive BoardCON/2008/5 Poland Amendments relating to the governance, supervisionand mode of financing of the deposit protection scheme,in particular as regards the participation of NarodowyBank PolskiCON/2008/6 Portugal Principles, rules and structure of the National StatisticalSystem and the role of the Banco de PortugalCON/2008/7 Romania Amendments to the laws on cheques, bills of exchangeand promissory notesCON/2008/8 France Consequences for their monetary regime of the changeof status of Saint-Martin and Saint-Barthélemy underFrench lawCON/2008/9 Germany The Deutsche Bundesbank’s employment relationshipswith its staffCON/2008/10 Italy Remuneration at the Banca d’Italia and structural reformto the government account held with the Banca d’ItaliaCON/2008/11 Portugal Supervision of auditors and the role of the Banco dePortugal in this respectCON/2008/13 Greece Reform of the Greek social security system in relation tothe Bank of GreeceCON/2008/14 Estonia Administrative amendments to the Law on Eesti Pank1 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.250 ECBAnnual Report2008

Number 2 Originator SubjectCON/2008/16 Finland Integration of financial and insurance supervisionCON/2008/17 Luxembourg Powers of the Banque centrale du Luxembourg and itsagents’ pension schemeCON/2008/18 Slovakia Legislative regime regarding payment systems, itscompatibility with the Treaty, and the facilitation of asmooth migration of the domestic payment system toTARGET2CON/2008/20 Poland Narodowy Bank Polski’s role regarding securitiesclearing and settlement and the central securitiesdepository systemCON/2008/21 Czech Republic Draft law on Česká národní bankaCON/2008/23 Slovakia Draft legislative provisions on dual display in thebanking, capital market, insurance industry and pensionsaving sectors and on rounding rules for certain types ofsecurityCON/2008/24 Greece Derogation from the company law with regard to certaintransactions by credit institutionsCON/2008/25 Slovakia Dual display of amounts in the gambling sectorCON/2008/26 Poland Rules for replacing damaged banknotes and coinsCON/2008/27 Slovakia Dual display and rounding rules in the labour and socialsecurity sectorsCON/2008/29 Bulgaria Amendments to the law relating to statisticsCON/2008/30 Austria Introduction of investment-oriented life assurance andconduct of business rules for insurance companiesCON/2008/31 Romania Amendments to the Statute of Banca Naţională aRomânieiCON/2008/32 Poland Amendments relating to the governance, supervisionand mode of financing of the deposit protection scheme,in particular as regards the participation of NarodowyBank PolskiCON/2008/33 Belgium Establishment of the audit committee of the NationaleBank van België/Banque Nationale de BelgiqueCON/2008/34 Sweden Financial independence of Sveriges RiksbankCON/2008/35 Denmark Withdrawing the smallest denomination coin as legaltenderCON/2008/36 Latvia Legislation on banknotes and coinsECBAnnual Report2008251

Number 2 Originator SubjectCON/2008/38 Malta Legal framework for the recycling of euro banknotes bycredit institutions and other professional cash handlersCON/2008/39 Poland Financial stability committeeCON/2008/40 Slovakia Further detailed technical rules on the euro changeoverCON/2008/41 Austria Financing of an Austrian contribution to debt relief forLiberiaCON/2008/42 Luxembourg Amendments enabling the Banque centrale duLuxembourg to contribute more effectively tofinancial stability and clarifying the minimum reserverequirements regimeCON/2008/43 Slovenia Restrictions and prohibitions for public office holdersCON/2008/44 Ireland Financial support measures for credit institutionsCON/2008/46 Belgium State guarantee covering credit extended by the NationaleBank van België/Banque Nationale de Belgique in thecontext of its contribution to financial stabilityCON/2008/47 Sweden Exchange and withdrawal of banknotes and coinsCON/2008/48 Ireland Implementation of financial support measures for creditinstitutionsCON/2008/49 Germany Replacement of euro coins and German eurocommemorative coinsCON/2008/50 Belgium State guarantee covering liabilities of credit institutionsCON/2008/51 Greece Deposit guarantee and investor protection schemesCON/2008/52 Spain Creation of a financial asset acquisition fund and othergovernment measures contributing to financial stabilityCON/2008/53 Poland Extending the legal framework for Narodowy BankPolski’s collection of statistical informationCON/2008/54 Denmark Financial stability scheme guaranteeing full coverage ofclaims by depositors and ordinary creditorsCON/2008/55 Austria Legal measures to restore the stability of the financialmarketCON/2008/56 France Provision of state guarantees in order to contribute tofinancial stabilityCON/2008/57 Germany Establishment of a Financial Market Stabilisation Fundand other financial stability measuresCON/2008/58 Italy Measures to guarantee the stability of the banking system252 ECBAnnual Report2008

Number 2 Originator SubjectCON/2008/59 Sweden Stabilising measures for the financial systemCON/2008/60 Spain Operations of the fund for the acquisition of financial assetsCON/2008/61 Belgium Protection of deposits and certain life insurance productsCON/2008/62 Sweden Provision of state guarantees to banks and credit marketcompaniesCON/2008/64 Belgium Management of information about issuers in the contextof the dematerialisation of their securitiesCON/2008/65 Italy Implementation of the measures to guarantee the stabilityof the banking systemCON/2008/66 Lithuania Amendments to the minimum reserve requirementsCON/2008/67 Spain Requirements for granting state guaranteesCON/2008/68 Finland Financial stability measures related to the governmentguarantee fundCON/2008/69 Ireland Extension of the scope of the Deposit Guarantee SchemeCON/2008/71 Bulgaria Establishment of a register of financial institutions managedby Българска народна банка (Bulgarian National Bank)CON/2008/72 Romania Use of foreign reserves for tourismCON/2008/73 Bulgaria Amendments to the statutes of Българска народнабанка (Bulgarian National Bank) in preparation for theintroduction of the euroCON/2008/74 Belgium State guarantee aimed at avoiding liquidity outflowsCON/2008/75 Finland State capital investment in deposit banksCON/2008/76 Slovenia State guarantees and other measures to maintain thestability of the financial systemCON/2008/78 Bulgaria Role of Българска народна банка (Bulgarian NationalBank) relating to payment institutions and payment systemoperators, and oversight of payment and settlement systemsECBAnnual Report2008253

Number 2 Originator SubjectCON/2008/79 Greece Measures to enhance liquidity in the economyCON/2008/80 Poland Provision of state Treasury support to financialinstitutionsCON/2008/81 Hungary Measures to strengthen the financial intermediary systemin order to maintain financial stabilityCON/2008/82 Spain Payment of the Banco de España’s profits to the TreasuryCON/2008/83 Hungary Aligning the Magyar Nemzeti Bank’s statutes withCommunity lawCON/2008/85 France Modernisation of the legal framework for financialinstrumentsCON/2008/86 Slovakia Cash currency circulationCON/2008/87 Spain Amendments to the Law on payment and securitiessettlement systemsCON/2008/88 Slovenia Criteria and conditions for granting a state guaranteeCON/2008/89 Latvia Monetary policy instrumentsCON/2008/90 Hungary Processing and distribution of banknotes and coins andtechnical measures to prevent counterfeitingCON/2008/91 Belgium Application to the Nationale Bank van België/BanqueNationale de Belgique of the limitations related toseverance payments of executive directors of listedcompaniesCON/2008/92 Slovenia Criteria and conditions for granting state loansCON/2009/2 Latvia State guarantees for bank loansCON/2009/3 Slovenia Conditions for state capital investments and debt toequity swaps under the Law on public financeCON/2009/4 Belgium Amendments to the rules governing the distribution ofthe income of the Nationale Bank van België/BanqueNationale de Belgique and the allocation of its profits tothe Belgian state254 ECBAnnual Report2008

Number 2 Originator SubjectCON/2009/5 Austria Payment by the Oesterreichische Nationalbank of theproposed increase in Austria’s IMF quotaCON/2009/6 Denmark Extension of the financial stability scheme guaranteeingfull coverage of claims by depositors and ordinarycreditors and a scheme for provision of state capital tocredit institutionsCON/2009/7 Luxembourg The Banque centrale du Luxembourg’s role in thecompilation of certain statisticsCON/2009/8 Sweden The smallest denomination coin ceasing to be legal tenderand amendments to the rounding rulesCON/2009/9 Hungary Operating rules of the central securities depository, theclearing house and the central counterpartyCON/2009/10 Latvia Deposit-guarantee scheme and the supervisoryauthority’s role in insolvency proceedingsCON/2009/11 Latvia Compensation paid by the state in the context of banktakeoversCON/2009/12 Cyprus Terms and conditions for granting state loans andguarantees in emergency situationsCON/2009/13 Bulgaria Additional eligibility criteria for the Governing Councilmembers of Българска народна банка (BulgarianNational Bank) and further rules for submittinginformation in this respectCON/2009/15 Ireland Financial support measures related to the remunerationof public servantsCON/2009/16 Ireland Legislation to allow the Minister for Finance to directthe National Pensions Reserve Fund to invest in financialinstitutions as part of the recapitalisation of the banksECBAnnual Report2008255

(b) ECB opinions following a consultation by a European institution 3Number 4 Originator Subject OJ referenceCON/2008/12 EU Council Community statistics relating to externaltrade with non-member countriesCON/2008/15 EU Council Codification of the Council Regulationon the application of the Protocol on theexcessive deficit procedureCON/2008/19 EU Council Introduction of the regulatory procedurewith scrutiny regarding some statisticalinstrumentsOJ C 70,15.3.2008, p. 1OJ C 88,9.4.2008, p. 1OJ C 117,14.5.2008, p. 1CON/2008/22EuropeanCommissionImplementing the Regulation on statisticson Community job vacancies as regardsseasonal adjustment procedures, qualityreports, data collection, transmissionspecifications and feasibility studiesOJ C 134,31.5.2008, p. 10CON/2008/28 EU Council Introduction of the euro in Slovakia andthe conversion rate to the euro for theSlovak korunaCON/2008/37 EU Council Amendment to the Directive onsettlement finality in payment andsecurities settlement systems andthe Directive on financial collateralarrangements as regards linked systemsand credit claimsOJ C 180,17.7.2008, p. 1OJ C 216,23.8.2008, p. 1CON/2008/45 EU Council Medals and tokens similar to euro coins OJ C 283,7.11.2008, p. 1CON/2008/63EuropeanCommissionNew decision on the Committee ofEuropean Banking SupervisorsOJ C 45,24.2.2009, p. 1CON/2008/70 EU Council Amendments to the Directive on depositguaranteeschemes as regards thecoverage level and the payment delayOJ C 314,9.12.2008, p. 1CON/2008/77 EU Council Proposal for a Council Regulationestablishing a facility providing mediumtermfinancial assistance for MemberStates’ balances of paymentsOJ C 328,23.12.2008, p. 13 Also published on the ECB’s website.4 Consultations are numbered in the order in which the Governing Council adopted them.256 ECBAnnual Report2008

Number 4 Originator Subject OJ referenceCON/2008/84 EU Council Directive on the taking up, pursuit andprudential supervision of the business ofelectronic money institutionsCON/2009/1 EU Council New Regulation on cross-border paymentsin the CommunityOJ C 30,6.2.2009, p. 1OJ C 21,28.1.2009, p.1CON/2009/14EuropeanCommissionStandards for the treatment of seasonalproducts in the Harmonised Indices ofConsumer PricesNot yet publishedECBAnnual Report2008257

CHRONOLOGY OF MONETARY POLICYMEASURES OF THE EUROSYSTEM 111 JANUARY AND 8 FEBRUARY 2007The Governing Council of the ECB decidesthat the minimum bid rate on the mainrefinancing operations and the interest rates onthe marginal lending facility and the depositfacility will remain unchanged at 3.50%,4.50% and 2.50% respectively.8 MARCH 2007The Governing Council of the ECB decidesto increase the minimum bid rate on the mainrefinancing operations by 25 basis points to3.75%, starting from the operation to be settledon 14 March 2007. In addition, it decides toincrease the interest rates on both the marginallending facility and the deposit facility by25 basis points, to 4.75% and 2.75%, both witheffect from 14 March 2007.12 APRIL AND 10 MAY 2007The Governing Council of the ECB decidesthat the minimum bid rate on the mainrefinancing operations and the interest rates onthe marginal lending facility and the depositfacility will remain unchanged at 3.75%, 4.75%and 2.75% respectively.6 JUNE 2007The Governing Council of the ECB decidesto increase the minimum bid rate on the mainrefinancing operations by 25 basis points to4%, starting from the operation to be settled on13 June 2007. In addition, it decides to increaseby 25 basis points the interest rates on boththe marginal lending facility and the depositfacility, to 5% and 3% respectively, with effectfrom 13 June 2007.5 JULY, 2 AUGUST, 6 SEPTEMBER, 4 OCTOBER,8 NOVEMBER AND 6 DECEMBER 2007, AND10 JANUARY, 7 FEBRUARY, 6 MARCH, 10 APRIL,8 MAY AND 5 JUNE 2008The Governing Council of the ECB decides thatthe minimum bid rate on the main refinancingoperations and the interest rates on the marginallending facility and the deposit facility willremain unchanged at 4.00%, 5.00% and 3.00%respectively.3 JULY 2008The Governing Council of the ECB decidesto increase the minimum bid rate on the mainrefinancing operations by 25 basis pointsto 4.25%, starting from the operation to besettled on 9 July 2008. In addition, it decidesto increase by 25 basis points the interestrates on both the marginal lending facilityand the deposit facility, to 5.25% and 3.25%respectively, with effect from 9 July 2008.7 AUGUST, 4 SEPTEMBER AND2 OCTOBER 2008The Governing Council of the ECB decides thatthe minimum bid rate on the main refinancingoperations and the interest rates on the marginallending facility and the deposit facility willremain unchanged at 4.25%, 5.25% and 3.25%respectively.8 OCTOBER 2008The Governing Council of the ECB decidesto decrease the minimum bid rate on the mainrefinancing operations by 50 basis points to3.75%, starting from the operations to be settledon 15 October 2008. In addition, it decides todecrease by 50 basis points the interest rates on1The chronology of monetary policy measures taken by theEurosystem between 1999 and 2006 can be found in the ECB’sAnnual Report for the respective years.258 ECBAnnual Report2008

oth the marginal lending facility and the depositfacility, to 4.75% and 2.75% respectively, withimmediate effect. Moreover, the GoverningCouncil decides that, as from the operation settledon 15 October, the weekly main refinancingoperations will be carried out through a fixedratetender procedure with full allotment at theinterest rate on the main refinancing operation.Furthermore, as of 9 October, the ECB willreduce the corridor of standing facilities from200 basis points to 100 basis points around theinterest rate on the main refinancing operation.The two measures will remain in place for aslong as needed, and at least until the end of thefirst maintenance period of 2009, on 20 January.15 OCTOBER 2008The Governing Council of the ECB decides tofurther expand the collateral framework andenhance the provision of liquidity. To do so, theGoverning Council decides: (i) to expand thelist of assets eligible as collateral in Eurosystemcredit operations, with this expansion remainingin force until the end of 2009, (ii) to enhancethe provision of longer-term refinancing, witheffect from 30 October 2008 and until the end ofthe first quarter of 2009, and (iii) to provide USdollar liquidity through foreign exchange swaps.6 NOVEMBER 2008The Governing Council of the ECB decidesto decrease the interest rate on the mainrefinancing operations by 50 basis points to3.25%, starting from the operations to be settledon 12 November 2008. In addition, it decides todecrease by 50 basis points the interest rates onboth the marginal lending facility and the depositfacility, to 3.75% and 2.75% respectively, witheffect from 12 November 2008.4 DECEMBER 2008The Governing Council of the ECB decides todecrease the interest rate on the main refinancingoperations of the Eurosystem by 75 basis pointsto 2.50%, starting from the operations to besettled on 10 December 2008. In addition,it decides to decrease by 75 basis points theinterest rates on both the marginal lendingand the deposit facility to 3.00% and 2.00%respectively, with effect from 10 December2008.18 DECEMBER 2008The Governing Council of the ECB decidesthat the main refinancing operations willcontinue to be carried out through a fixed ratetender procedure with full allotment beyond themaintenance period ending on 20 January 2009.This measure will be in place for as long asneeded, and at least until the last allotment of thethird maintenance period in 2009 on 31 March.Moreover, as of 21 January 2009, the corridor ofstanding facility rates, which on 9 October 2008was reduced to 100 basis points around theprevailing interest rate of the main refinancingoperation, will be be re-widened symmetricallyto 200 basis points.15 JANUARY 2009The Governing Council of the ECB decides todecrease the fixed rate on the main refinancingoperations by 50 basis points to 2.00%,starting from the operations to be settled on21 January 2009. In addition, it decides thatthe interest rates on the marginal lending andthe deposit facility will be 3.00% and 1.00%respectively, with effect from 21 January 2009,in line with the decision of 18 December 2008.5 FEBRUARY 2009The Governing Council of the ECB decidedthat the interest rate on the main refinancingoperations and the interest rates on the marginallending facility and the deposit facility willremain unchanged at 2.00%, 3.00% and 1.00%respectively.ECBAnnual Report2008259

5 MARCH 2009The Governing Council of the ECB decides todecrease the fixed rate on the main refinancingoperations by 50 basis points to 1.50%,starting from the operations to be settled on11 March 2009. In addition, it decides thatthe interest rates on the marginal lending andthe deposit facility will be 2.50% and 0.50%respectively, with effect from 11 March 2009.Moreover, the Governing Council decidesto continue the fixed rate tender procedurewith full allotment for all main refinancingoperations, special-term refinancing operationsand supplementary and regular longer-termrefinancing operations for as long as needed,and in any case beyond the end of 2009. Inaddition, the Governing Council decidesto continue with the current frequency andmaturity profile of supplementary longertermrefinancing operations and special-termrefinancing operations for as long as needed,and in any case beyond the end of 2009.260 ECBAnnual Report2008

OVERVIEW OF THE ECB’S COMMUNICATIONRELATED TO THE PROVISION OF EURO LIQUIDITY 114 JANUARY 2008MAIN REFINANCING OPERATIONSThe ECB continues to closely monitor liquidityconditions and aims at keeping very short-termrates close to the minimum bid rate on the mainrefinancing operations. The ECB will, for aslong as needed, allocate more liquidity thanthe benchmark amount in main refinancingoperations to accommodate the demand ofcounterparties to fulfil reserve requirementsearly in the maintenance period. The ECB aimsat balanced liquidity conditions at the end of themaintenance period.7 FEBRUARY 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONSThe Governing Council today decided to renewthe two supplementary longer-term refinancingoperations (LTROs) that were allotted on23 November 2007 (€60 billion) and on12 December 2007 (€60 billion) and thatwill mature on 21 February 2008 and on13 March 2008 respectively. The renewal ofthese two supplementary LTROs is aimed atfurther consolidating the progress achieved so farin the normalisation of the euro money market.The renewal will be carried out as followsand will not affect the regular LTROs: Thetwo supplementary LTROs will be carried outthrough variable rate tenders, each with a presetamount of €60 billion. The first operation willbe settled on 21 February 2008 and will matureon 22 May 2008. The second operation will besettled on 13 March 2008 and will mature on12 June 2008. The two supplementary LTROswill be carried out through a standard tenderprocedure, with announcement and allotmenttaking place two days and one day respectivelybefore settlement.28 MARCH 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONSThe Governing Council decided at its meetingon 27 March 2008 to conduct supplementarylonger-term refinancing operations (LTROs)with a maturity of six months. In addition, theGoverning Council decided to conduct furthersupplementary LTROs with a three-monthmaturity. The regular monthly LTROs remainunaffected. These supplementary three-monthand six-month LTROs are aimed at supportingthe normalisation of the functioning of the euromoney market. The supplementary three-monthand six-month operations will be carried outas follows: They will all be carried out througha variable rate standard tender procedure withpreset amounts. As a rule, they will matureon the second Thursday of the given month.One supplementary six-month LTRO with apreset amount of €25 billion will be allottedon Wednesday, 2 April, settled on Thursday,3 April, and will mature on Thursday,9 October 2008. Another supplementary sixmonthLTRO, in the amount of €25 billion,will be allotted on Wednesday, 9 July, settledon Thursday, 10 July 2008, and will matureon Thursday, 8 January 2009. Two newsupplementary three-month LTROs, with presetamounts of €50 billion each, will replace thetwo currently outstanding supplementary threemonthLTROs of €60 billion each. The first willbe allotted on Wednesday, 21 May, settled onThursday, 22 May, and will mature on Thursday,14 August 2008. The second will be allottedon Wednesday, 11 June, settled on Thursday,12 June, and will mature on Thursday,11 September 2008.1 An overview of the communication related to the provision ofliquidity in currencies other than euro is available on the ECB’swebsite.ECBAnnual Report2008261

31 JULY 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONSThe Governing Council decided today to renewthe two outstanding three-month supplementarylonger-term refinancing operations (LTROs)that were allotted on 21 May 2008 (€50 billion)and on 11 June 2008 (€50 billion) and that willmature on 14 August 2008 and on 11 September2008 respectively. The renewal of these twosupplementary three-month LTROs is aimedat further consolidating the progress achievedso far in the normalisation of the euro moneymarket. The renewal will not affect the regularLTROs and will be carried out as follows: Thetwo supplementary LTROs will be carried outthrough variable rate tenders, each with a presetamount of €50 billion. The first operation willbe settled on 14 August 2008 and will mature on13 November 2008. The second operation willbe settled on 11 September 2008 and will matureon 11 December 2008. The two supplementaryLTROs will be carried out through a standardtender procedure, with their announcement andallotment taking place two days and one dayrespectively before settlement.4 SEPTEMBER 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONSThe Governing Council today decided to renewthe outstanding six-month supplementary longertermrefinancing operation (LTRO) of €25 billionthat was allotted on 2 April and that will matureon 9 October 2008. It also decided to renewthe two three-month supplementary LTROs(€50 billion) that will mature on 13 Novemberand 11 December 2008 respectively. The renewalof these supplementary LTROs is aimed atsupporting the further normalisation of the euromoney market. The renewal will not affect theregular LTROs. The supplementary LTROs willbe carried out as follows: The two supplementarythree-month LTROs will be carried out throughvariable rate tenders, each with a preset amountof €50 billion. The first operation will be settledon 13 November 2008 and will mature on12 February 2009. The second operation will besettled on 11 December 2008 and will mature on12 March 2009. The supplementary six-monthLTRO will be carried out through a variable ratetender, with a preset amount of €25 billion. Theoperation will be settled on 9 October 2008 andwill mature on 9 April 2009. As in previous cases,a maximum bid amount of €2.5 billion will beapplied in the six-month supplementary LTRO.The supplementary LTROs will be carried outthrough a standard tender procedure, with theirannouncement and allotment taking place twodays and one day respectively before settlement.29 SEPTEMBER 2008SPECIAL-TERM REFINANCING OPERATIONThe Governing Council of the ECB decided toconduct a special-term refinancing operation.The aim of this operation is to improve theoverall liquidity position of the euro areabanking system. The operation will be carriedout as follows: It will be conducted todaythrough a standard tender procedure, using avariable rate tender with no preset amount. Itwill be settled on Tuesday, 30 September 2008and will mature on Friday, 7 November 2008.The ECB will continue to steer liquidity towardsbalanced conditions in a way which is consistentwith the objective to keep very short-term ratesclose to the minimum bid rate. The special-termrefinancing operation will be renewed until atleast beyond the end of the year.3 OCTOBER 2008 2GENERAL ANNOUNCEMENT ON LIQUIDITY POLICYThe Governing Council of the ECB has decidedthat, from 6 October 2008 until further notice,all institutions that are eligible to participatein Eurosystem open market operations basedon standard tenders and that fulfil additionaloperational or other selection criteria specified2 General announcements on liquidity policy which were notdirectly related to the provision of liquidity are not included inthis list. They are available on the ECB’s website.262 ECBAnnual Report2008

y the respective NCBs will also be eligibleto participate in quick tenders, i.e. the tenderprocedure normally used for fine-tuningoperations. The NCBs may announce furtherdetails applicable for institutions established inthe respective Member States, where necessary.7 OCTOBER 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONToday the Governing Council of the ECBdecided to increase from €25 billion to€50 billion the allotment amount in the sixmonthsupplementary longer-term refinancingoperation that was pre-announced in the pressrelease of 4 September 2008 and will be allottedon 8 October 2008. Accordingly, a maximumbid amount of €5 billion will be applied inthis operation.8 OCTOBER 2008GENERAL ANNOUNCEMENT ON LIQUIDITY POLICYThe Governing Council of the ECB todaydecided, by means of a teleconference, onthe following two measures: As from theoperation settled on 15 October, the weeklymain refinancing operations will be carriedout through a fixed rate tender procedure withfull allotment at the interest rate on the mainrefinancing operation, i.e. currently 3.75%. Asof 9 October, the ECB will reduce the corridorof standing facility rates from 200 basis pointsto 100 basis points around the interest rate onthe main refinancing operation. Therefore, as of9 October, the rate of the marginal lendingfacility will be reduced from 100 to 50 basispoints above the interest rate on the mainrefinancing operation, i.e. currently to 4.25%,and the rate of the deposit facility will beincreased from 100 to 50 basis points below theinterest rate on the main refinancing operation,i.e. currently to 3.25%. The two measures willremain in place for as long as needed, and atleast until the end of the first maintenance periodof 2009, on 20 January. The ECB will continueto steer liquidity towards balanced conditions ina way which is consistent with the objective tokeep short-term rates close to the interest rate onthe main refinancing operation.9 OCTOBER 2008FINE-TUNING OPERATIONThe operation implements the decision ofyesterday (see press release of 8 October) tosatisfy all demand of counterparties, i.e. fullallotment, for refinancing at the main refinancingrate of 3.75% against eligible collateral, foras long as needed, and at least until the endof the first maintenance period of 2009, on20 January.15 OCTOBER 2008SUPPLEMENTARY LONGER-TERM REFINANCINGOPERATIONS/SPECIAL-TERM REFINANCINGOPERATION 3The Governing Council of the ECB todaydecided, by means of a teleconference, that asfrom the operation settling on 30 October 2008and until the end of the first quarter of 2009,the provision of longer-term refinancing bythe Eurosystem will be enhanced as follows,consistent with the temporary expansion of thecollateral pool:All longer-term refinancing operations will,until March 2009, be carried out through afixed rate tender procedure with full allotment.The two three-month supplementary longertermrefinancing operations (LTROs) maturingin February and in March 2009 will be rolledover and an additional three-month operationwill be conducted in January 2009. Theoutstanding six-month supplementary LTROmaturing in January 2009 will be rolled over,and four additional six-month supplementaryLTROs will be carried out in November 2008,3 Announcements on the fixed rate applied in the LTROs,supplementary LTROs and special-term refinancing operationsbetween 30 October and 31 December 2008 are not included inthis list. They are available on the ECB’s website.ECBAnnual Report2008263

December 2008, February 2009 and March2009 in parallel with the respective three-monthsupplementary LTROs. As a result, two threemonthLTROs/supplementary LTROs and onesix-month LTRO will be carried out each monthup to and including March 2009. Moreover, thespecial-term refinancing operation allotted on29 September 2008 will be rolled over whenit matures on 7 November 2008 and will havea maturity equal to the length of the reservemaintenance period.The ECB will continue to steer liquidity towardsbalanced conditions in a way which is consistentwith the objective to keep short-term rates closeto the interest rate on the main refinancingoperation. For that purpose it will also acceptfixed-term deposits with a one-week maturity.16 OCTOBER 2008OTHER EURO LIQUIDITY PROVISIONOn 10 October 2008 the Magyar NemzetiBank announced new open market operationsto support liquidity in the domestic foreignexchange swap market. Today, the MagyarNemzeti Bank and the ECB are jointlyannouncing an agreement to support the MagyarNemzeti Bank’s instruments of euro liquidityprovision. They have established an agreementon repurchase transactions, which will providethe Magyar Nemzeti Bank with a facility toborrow up to €5 billion in order to provideadditional support to its operations. Furtherinformation about the Magyar Nemzeti Bank’sforeign exchange swap tenders is providedon the Magyar Nemzeti Bank’s website:http://www.mnb.hu.27 OCTOBER 2008OTHER EURO LIQUIDITY PROVISIONDanmarks Nationalbank is today announcingmeasures to improve liquidity in euro shorttermmarkets. In support of these measures, theECB and Danmarks Nationalbank have todayestablished a reciprocal currency arrangement(swap line) amounting to €12 billion, which willremain in place as long as needed.21 NOVEMBER 2008OTHER EURO LIQUIDITY PROVISIONNarodowy Bank Polski and the ECB are jointlyannouncing an agreement to support NarodowyBank Polski’s instruments of euro liquidityprovision. The agreement, which was concludedon 6 November 2008, relates to repurchasetransactions and will provide NarodowyBank Polski with a facility to borrow up to€10 billion in order to provide additionalsupport to its operations. Further informationabout Narodowy Bank Polski’s operations isprovided on Narodowy Bank Polski’s website:http://www.nbp.pl.18 DECEMBER 2008GENERAL ANNOUNCEMENT ON LIQUIDITY POLICYFurther to the press release on changes intender procedures and in the standing facilitiescorridor of 8 October 2008, the GoverningCouncil of the ECB today decided thefollowing: The main refinancing operationswill continue to be carried out through a fixedrate tender procedure with full allotmentbeyond the maintenance period ending on20 January 2009. This measure will be in placefor as long as needed, and at least until thelast allotment of the third maintenance periodin 2009 on 31 March. As of 21 January 2009,the corridor of standing facility rates, which on9 October 2008 was reduced to 100 basispoints around the prevailing interest rate on themain refinancing operation, will be restored to200 basis points. Therefore, as of 21 January,the rate of the marginal lending facility willbe increased from 50 to 100 basis pointsabove the interest rate on the main refinancingoperation, and the rate of the deposit facilitywill be reduced from 50 to 100 basis pointsbelow the rate on the main refinancingoperation.264 ECBAnnual Report2008

OPEN MARKET OPERATIONS BY CURRENCYEUR operationsType of Durationoperation 1) (days)Date ofsettlementAllottedamount 2)(€ billions)Total bidamount 2)(€ billions)Marginalrate (%)Weightedaveragerate (%)Fixed rate(%)Number ofbiddersBid-coverratioFTO 1 2 Jan. 2008 -168.6 -168.6 - - 4.00 54 1.00FTO 1 3 Jan. 2008 -200.0 -212.6 - - 4.00 69 1.06MRO 5 4 Jan. 2008 128.5 275.3 4.18 4.21 - 269 2.14MRO 7 9 Jan. 2008 151.5 285.4 4.20 4.22 - 301 1.87FTO 1 15 Jan. 2008 -20.0 -45.7 - - 4.00 28 2.29MRO 7 16 Jan. 2008 190.5 242.1 4.16 4.21 - 281 1.27MRO 7 23 Jan. 2008 175.5 234.6 4.16 4.19 - 276 1.34MRO 7 30 Jan. 2008 167.5 253.3 4.18 4.20 - 264 1.51LTRO 92 31 Jan. 2008 50.0 98.2 4.21 4.33 - 151 1.96MRO 7 6 Feb. 2008 161.5 223.8 4.17 4.20 - 226 1.39FTO 1 12 Feb. 2008 -16.0 -29.2 - - 4.00 22 1.82MRO 7 13 Feb. 2008 187.5 223.7 4.10 4.18 - 229 1.19MRO 7 20 Feb. 2008 178.0 226.7 4.10 4.15 - 262 1.27SLTRO 91 21 Feb. 2008 60.0 110.5 4.15 4.26 - 105 1.84MRO 7 27 Feb. 2008 183.0 233.2 4.10 4.15 - 260 1.27LTRO 91 28 Feb. 2008 50.0 109.6 4.16 4.23 - 165 2.19MRO 7 5 Mar. 2008 176.5 240.5 4.11 4.14 - 264 1.36FTO 1 11 Mar. 2008 9.0 45.1 4.13 4.14 - 32 5.01MRO 7 12 Mar. 2008 209.5 260.4 4.12 4.16 - 298 1.24SLTRO 91 13 Mar. 2008 60.0 132.6 4.25 4.40 - 139 2.21MRO 7 19 Mar. 2008 202.0 295.7 4.16 4.20 - 336 1.46FTO 5 20 Mar. 2008 15.0 65.8 4.13 4.20 - 44 4.39MRO 7 26 Mar. 2008 216.0 302.5 4.23 4.28 - 301 1.40LTRO 91 27 Mar. 2008 50.0 131.3 4.44 4.53 - 190 2.63FTO 1 31 Mar. 2008 15.0 30.7 4.06 4.13 - 25 2.05MRO 7 2 Apr. 2008 150.0 283.7 4.21 4.25 - 306 1.89SLTRO 189 3 Apr. 2008 25.0 103.1 4.55 4.61 - 177 4.12MRO 7 9 Apr. 2008 130.0 247.6 4.23 4.24 - 295 1.90FTO 1 15 Apr. 2008 -14.9 -14.9 - - 4.00 7 0.71MRO 7 16 Apr. 2008 204.5 249.7 4.21 4.26 - 310 1.22MRO 7 23 Apr. 2008 173.0 218.4 4.21 4.25 - 302 1.26MRO 7 30 Apr. 2008 170.0 247.5 4.26 4.29 - 316 1.46LTRO 90 2 May 2008 50.0 101.2 4.67 4.75 - 177 2.02MRO 7 7 May 2008 150.0 229.3 4.26 4.29 - 304 1.53FTO 1 13 May 2008 -23.5 -32.5 - - 4.00 29 1.38MRO 7 14 May 2008 191.5 208.5 4.18 4.26 - 287 1.09MRO 7 21 May 2008 176.5 203.1 4.15 4.22 - 326 1.15SLTRO 84 22 May 2008 50.0 86.6 4.50 4.68 - 138 1.73MRO 7 28 May 2008 170.0 224.1 4.19 4.23 - 330 1.32LTRO 91 29 May 2008 50.0 97.7 4.51 4.62 - 171 1.95MRO 7 4 June 2008 153.0 210.1 4.17 4.22 - 336 1.37FTO 1 10 June 2008 -14.0 -18.5 - - 4.00 15 1.32MRO 7 11 June 2008 191.0 202.8 4.03 4.18 - 343 1.06SLTRO 91 12 June 2008 50.0 99.8 4.60 4.72 - 128 2.00MRO 7 18 June 2008 188.0 224.3 4.03 4.13 - 425 1.19MRO 7 25 June 2008 208.0 243.3 4.07 4.25 - 439 1.17LTRO 91 26 June 2008 50.0 89.8 4.50 4.67 - 174 1.80MRO 7 2 July 2008 154.5 254.7 4.10 4.15 - 433 1.65FTO 1 8 July 2008 -14.6 -14.6 - - 4.00 12 0.69MRO 7 9 July 2008 175.0 263.6 4.32 4.37 - 400 1.51SLTRO 182 10 July 2008 25.0 74.6 4.93 5.03 - 141 2.98MRO 7 16 July 2008 155.0 265.9 4.34 4.36 - 440 1.72MRO 7 23 July 2008 175.5 268.2 4.35 4.38 - 461 1.53MRO 7 30 July 2008 166.0 247.4 4.38 4.42 - 430 1.49LTRO 91 31 July 2008 50.0 107.7 4.70 4.76 - 189 2.15MRO 7 6 Aug. 2008 160.0 241.9 4.38 4.41 - 424 1.51FTO 1 12 Aug. 2008 -21.0 -22.6 - - 4.25 10 1.08MRO 7 13 Aug. 2008 176.0 233.4 4.37 4.40 - 430 1.331) MRO = main refinancing operation; LTRO = longer-term refinancing operation; SLTRO = supplementary longer-term refinancingoperation; STRO = special-term refinancing operation.2) Positive amounts in the case of liquidity-providing operations; negative amounts in the case of liquidity-absorbing operations.ECBAnnual Report2008265

EUR operationsType of Durationoperation 1) (days)Date ofsettlementAllottedamount 2)(€ billions)Total bidamount 2)(€ billions)Marginalrate (%)Weightedaveragerate (%)Fixed rate(%)Number ofbiddersBid-coverratioSLTRO 91 14 Aug. 2008 50.0 78.9 4.61 4.74 - 124 1.58MRO 7 20 Aug. 2008 151.0 228.7 4.38 4.40 - 454 1.51MRO 7 27 Aug. 2008 167.0 226.5 4.39 4.42 - 424 1.36LTRO 91 28 Aug. 2008 50.0 77.2 4.60 4.74 - 191 1.54MRO 7 3 Sep. 2008 160.0 226.3 4.39 4.41 - 411 1.41FTO 1 9 Sep. 2008 -20.1 -20.1 - - 4.25 17 0.63MRO 7 10 Sep. 2008 176.5 223.3 4.39 4.41 - 422 1.27SLTRO 91 11 Sep. 2008 50.0 69.5 4.45 4.66 - 114 1.39FTO 1 15 Sep. 2008 30.0 90.3 4.30 4.39 - 51 3.01FTO 1 16 Sep. 2008 70.0 102.5 4.32 4.40 - 56 1.46MRO 7 17 Sep. 2008 150.0 328.7 4.53 4.58 - 533 2.19FTO 1 18 Sep. 2008 25.0 49.3 4.30 4.39 - 43 1.97MRO 7 24 Sep. 2008 180.0 334.0 4.73 4.78 - 506 1.86FTO 1 24 Sep. 2008 40.0 50.3 4.25 4.35 - 36 1.26LTRO 84 25 Sep. 2008 50.0 154.6 4.98 5.11 - 246 3.09STRO 38 30 Sep. 2008 120.0 141.7 4.36 4.88 - 210 1.18MRO 7 1 Oct. 2008 190.0 228.0 4.65 4.96 - 419 1.20FTO 1 1 Oct. 2008 -173.0 -173.0 - - 4.25 52 1.00FTO 1 2 Oct. 2008 -200.0 -216.1 - - 4.25 65 1.08FTO 3 3 Oct. 2008 -193.8 -193.8 - - 4.25 54 1.00FTO 1 6 Oct. 2008 -171.9 -171.9 - - 4.25 111 1.00FTO 1 7 Oct. 2008 -147.5 -147.5 - - 4.25 97 1.00MRO 7 8 Oct. 2008 250.0 271.3 4.70 4.99 - 436 1.09SLTRO 182 9 Oct. 2008 50.0 113.8 5.36 5.57 - 181 2.28FTO 6 9 Oct. 2008 24.7 24.7 - - 3.75 99 1.00MRO 7 15 Oct. 2008 310.4 310.4 - - 3.75 604 1.00MRO 7 22 Oct. 2008 305.4 305.4 - - 3.75 703 1.00MRO 7 29 Oct. 2008 325.1 325.1 - - 3.75 736 1.00LTRO 91 30 Oct. 2008 103.1 103.1 - - 3.75 223 1.00MRO 7 5 Nov. 2008 312.0 312.0 - - 3.75 756 1.00STRO 33 7 Nov. 2008 20.4 20.4 - - 3.75 55 1.00FTO 1 11 Nov. 2008 -79.9 -149.7 3.60 3.51 - 117 1.87MRO 7 12 Nov. 2008 334.4 334.4 - - 3.25 848 1.00SLTRO 91 13 Nov. 2008 66.8 66.8 - - 3.25 139 1.00SLTRO 182 13 Nov. 2008 41.6 41.6 - - 3.25 127 1.00MRO 7 19 Nov. 2008 338.0 338.0 - - 3.25 851 1.00MRO 7 26 Nov. 2008 334.5 334.5 - - 3.25 836 1.00LTRO 91 27 Nov. 2008 42.2 42.2 - - 3.25 161 1.00MRO 7 3 Dec. 2008 339.5 339.5 - - 3.25 787 1.00FTO 1 9 Dec. 2008 -137.5 -152.7 3.05 2.94 - 95 1.11MRO 7 10 Dec. 2008 217.9 217.9 - - 2.50 783 1.00STRO 42 10 Dec. 2008 134.9 134.9 - - 2.50 139 1.00SLTRO 91 11 Dec. 2008 55.9 55.9 - - 2.50 105 1.00SLTRO 182 11 Dec. 2008 38.1 38.1 - - 2.50 96 1.00MRO 6 17 Dec. 2008 209.7 209.7 - - 2.50 792 1.00LTRO 98 18 Dec. 2008 50.8 50.8 - - 2.50 169 1.00MRO 7 23 Dec. 2008 223.7 223.7 - - 2.50 640 1.00MRO 7 30 Dec. 2008 238.9 238.9 - - 2.50 629 1.001) MRO = main refinancing operation; LTRO = longer-term refinancing operation; SLTRO = supplementary longer-term refinancingoperation; STRO = special-term refinancing operation.2) Positive amounts in the case of liquidity-providing operations; negative amounts in the case of liquidity-absorbing operations.266 ECBAnnual Report2008

USD operationsType oftransaction 1)Date ofsettlementDuration(days)Allottedamount($ billions)Marginalrate (%)Fixed rate(%) (RT) /Fixed swappoints (FX)Total bidamount($ billions)Number ofbiddersBid-coverratioRT 17 Jan. 2008 28 10.0 - 3.95 14.8 22 1.48RT 31 Jan. 2008 28 10.0 - 3.12 12.4 19 1.24RT 27 Mar. 2008 28 15.0 - 2.62 31.2 34 2.08RT 10 Apr. 2008 28 15.0 - 2.82 30.8 32 2.05RT 24 Apr. 2008 28 15.0 - 2.87 30.1 33 2.01RT 8 May 2008 28 25.0 - 2.22 39.5 31 1.58RT 22 May 2008 28 25.0 - 2.10 58.9 54 2.36RT 5 June 2008 28 25.0 - 2.26 64.9 50 2.59RT 19 June 2008 28 25.0 - 2.36 78.5 56 3.14RT 3 July 2008 28 25.0 - 2.34 84.8 57 3.39RT 17 July 2008 28 25.0 - 2.30 90.1 59 3.60RT 31 July 2008 28 25.0 - 2.35 101.7 63 4.07RT 14 Aug. 2008 28 20.0 - 2.45 91.1 66 4.55RT 14 Aug. 2008 84 10.0 - 2.75 38.5 57 3.85RT 28 Aug. 2008 28 20.0 - 2.38 89.2 69 4.46RT 11 Sep. 2008 28 10.0 - 2.53 43.3 53 4.33RT 11 Sep. 2008 84 10.0 - 2.67 31.7 40 3.17RT 18 Sep. 2008 1 40.0 4.00 - 101.7 61 2.54RT 19 Sep. 2008 3 40.0 3.50 - 96.7 64 2.42RT 22 Sep. 2008 1 40.0 3.25 - 82.1 48 2.05RT 23 Sep. 2008 1 40.0 3.30 - 77.6 48 1.94RT 24 Sep. 2008 1 40.0 2.50 - 61.7 40 1.54RT 25 Sep. 2008 1 40.0 2.55 - 72.7 43 1.82RT 25 Sep. 2008 28 25.0 - 3.75 110.1 71 4.40RT 26 Sep. 2008 3 30.0 2.25 - 41.4 33 1.38RT 26 Sep. 2008 7 35.0 4.50 - 82.5 52 2.36RT 29 Sep. 2008 1 30.0 3.00 - 57.4 42 1.91RT 30 Sep. 2008 1 30.7 0.50 - 30.7 32 1.00RT 30 Sep. 2008 1 30.0 11.00 - 77.3 57 2.58RT 1 Oct. 2008 1 50.0 3.25 - 70.9 61 1.42RT 2 Oct. 2008 1 50.0 2.75 - 67.2 55 1.34RT 3 Oct. 2008 3 50.0 2.51 - 82.9 59 1.66RT 6 Oct. 2008 1 50.0 4.00 - 90.9 59 1.82RT 7 Oct. 2008 1 50.0 6.75 - 109.2 67 2.18RT 8 Oct. 2008 1 70.0 9.50 - 122.0 69 1.74RT 9 Oct. 2008 1 100.0 5.00 - 116.2 66 1.16RT 9 Oct. 2008 85 20.0 - 1.39 88.7 70 4.43RT 10 Oct. 2008 4 93.9 0.50 - 93.9 62 1.00RT 14 Oct. 2008 1 98.4 0.20 - 98.4 67 1.00RT 15 Oct. 2008 1 100.0 0.50 - 120.2 70 1.20RT 16 Oct. 2008 7 170.9 - 2.28 170.9 86 1.00FX 23 Oct. 2008 7 3.9 - -2.45 3.9 11 1.00RT 23 Oct. 2008 7 68.0 - 2.03 68.0 61 1.00FX 23 Oct. 2008 28 22.6 - -8.60 22.6 16 1.00RT 23 Oct. 2008 28 101.9 - 2.11 101.9 91 1.00FX 30 Oct. 2008 7 14.5 - -3.03 14.5 16 1.00RT 30 Oct. 2008 7 92.1 - 1.91 92.1 70 1.00FX 6 Nov. 2008 7 1.0 - -3.61 1.0 5 1.00RT 6 Nov. 2008 7 58.6 - 1.53 58.6 47 1.00FX 6 Nov. 2008 84 0.7 - -26.55 0.7 3 1.00RT 6 Nov. 2008 84 70.8 - 1.60 70.8 67 1.00FX 13 Nov. 2008 7 1.0 - -3.22 1.0 7 1.00RT 13 Nov. 2008 7 60.6 - 1.43 60.6 42 1.00FX 20 Nov. 2008 8 0.9 - -3.29 0.9 6 1.00RT 20 Nov. 2008 8 72.5 - 1.48 72.5 52 1.00FX 20 Nov. 2008 28 4.8 - -9.64 4.8 4 1.00RT 20 Nov. 2008 28 52.3 - 1.51 52.3 54 1.00FX 28 Nov. 2008 6 0.8 - -2.53 0.8 6 1.00RT 28 Nov. 2008 6 84.6 - 1.42 84.6 60 1.001) RT = reverse transaction; FX = foreign exchange swap.ECBAnnual Report2008267

USD operationsType oftransaction 1)Date ofsettlementDuration(days)Allottedamount($ billions)Marginalrate (%)Fixed rate(%) (RT) /Fixed swappoints (FX)Total bidamount($ billions)Number ofbiddersBid-coverratioFX 4 Dec. 2008 7 0.8 - -2.28 0.8 6 1.00RT 4 Dec. 2008 7 75.1 - 1.47 75.1 50 1.00FX 4 Dec. 2008 84 1.5 - -13.03 1.5 3 1.00RT 4 Dec. 2008 84 67.5 - 1.42 67.5 53 1.00FX 11 Dec. 2008 7 0.8 - -1.75 0.8 6 1.00RT 11 Dec. 2008 7 57.4 - 1.24 57.4 39 1.00FX 18 Dec. 2008 5 5.1 - -1.30 5.1 7 1.00RT 18 Dec. 2008 5 41.6 - 1.18 41.6 36 1.00FX 18 Dec. 2008 28 0.1 - -6.00 0.1 1 1.00RT 18 Dec. 2008 28 47.6 - 1.28 47.6 47 1.00FX 23 Dec. 2008 16 5.4 - -4.07 5.4 7 1.00RT 23 Dec. 2008 16 52.3 - 1.16 52.3 46 1.00FX 30 Dec. 2008 83 0.1 - -8.30 0.1 2 1.00RT 30 Dec. 2008 83 10.8 - 1.20 10.8 30 1.001) RT = reverse transaction; FX = foreign exchange swap.CHF operationsType oftransaction 1)Date ofsettlementDuration(days)Allottedamount(€ billions)Marginalrate (%)FixedswappointsTotal bidamount(€ billions)Number ofbiddersBid-coverratioFX 22 Oct. 2008 7 15.3 - -6.36 15.3 50 1.00FX 29 Oct. 2008 7 13.6 - -6.04 13.6 33 1.00FX 5 Nov. 2008 7 15.0 - -6.84 15.0 36 1.00FX 7 Nov. 2008 84 0.9 - -60.22 0.9 6 1.00FX 12 Nov. 2008 7 10.6 - -6.97 10.6 35 1.00FX 19 Nov. 2008 7 12.5 - -6.95 12.5 38 1.00FX 21 Nov. 2008 84 0.5 - -65.17 0.5 7 1.00FX 26 Nov. 2008 7 13.7 - -8.23 13.7 37 1.00FX 3 Dec. 2008 7 13.9 - -8.23 13.9 36 1.00FX 5 Dec. 2008 84 0.5 - -84.15 0.5 6 1.00FX 10 Dec. 2008 7 12.8 - -6.19 12.8 29 1.00FX 17 Dec. 2008 6 9.7 - -5.49 9.7 28 1.00FX 19 Dec. 2008 84 0.7 - -70.63 0.7 6 1.00FX 23 Dec. 2008 7 11.6 - -6.25 11.6 29 1.00FX 30 Dec. 2008 8 15.8 - -6.97 15.8 36 1.001) FX = foreign exchange swap.268 ECBAnnual Report2008

DOCUMENTS PUBLISHED BY THEEUROPEAN CENTRAL BANK SINCE 2008This list is designed to inform readers about selected documents published by the European CentralBank since January 2008. For Working Papers, the list only refers to publications released betweenDecember 2008 and February 2009. Unless otherwise indicated, hard copies can be obtained orsubscribed to free of charge, stock permitting, by contacting info@ecb.europa.eu.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.europa.eu).ANNUAL REPORT“Annual Report 2007”, April 2008.CONVERGENCE REPORT“Convergence Report May 2008”.MONTHLY BULLETIN SPECIAL EDITION“10th anniversary of the ECB 1998-2008”, May 2008.MONTHLY BULLETIN ARTICLES“Productivity developments and monetary policy”, January 2008.“Globalisation, trade and the euro area macroeconomy”, January 2008.“The Eurosystem’s experience with forecasting autonomous factors and excess reserves”,January 2008.“The analysis of the euro money market from a monetary policy perspective”, February 2008.“Securitisation in the euro area”, February 2008.“The new euro area yield curves”, February 2008.“Business investment in the euro area and the role of firms’ financial positions”, April 2008.“Short-term forecasts of economic activity in the euro area”, April 2008.“Developments in the EU arrangements for financial stability”, April 2008.“Price stability and growth”, May 2008.“The Eurosystem’s open market operations during the recent period of financial market volatility”,May 2008.“One monetary policy and many fiscal policies: ensuring a smooth functioning of EMU”,July 2008.“Euro area trade in services: some key stylised facts”, July 2008.“The Eurosystem as a provider of technical assistance to EU neighbouring regions”, July 2008.“The external dimension of monetary analysis”, August 2008.“The role of banks in the monetary policy transmission mechanism”, August 2008.“Ten years of the Stability and Growth Pact”, October 2008.“Cross-border bank mergers & acquisitions and institutional investors”, October 2008.“Monitoring labour cost developments across euro area countries”, November 2008.“Valuing stock markets and the equity risk premium”, November 2008.“Ten years of TARGET and the launch of TARGET2”, November 2008.“Housing wealth and private consumption in the euro area”, January 2009.“Foreign asset accumulation by authorities in emerging markets”, January 2009.“New survey evidence on wage setting in Europe”, February 2009.“Assessing global trends in protectionism”, February 2009.ECBAnnual Report2008269

STATISTICS POCKET BOOKAvailable monthly since August 2003.LEGAL WORKING PAPER SERIES6 “The legal implications of the prudential supervisory assessment of bank mergers andacquisitions under EU law” by S. Kerjean, June 2008.7 “Electronic money institutions: current trends, regulatory issues and future prospects”by P. Athanassiou and N. Mas-Guix, July 2008.OCCASIONAL PAPER SERIES78 “A framework for assessing global imbalances” by T. Bracke, M. Bussière, M. Fidora andR. Straub, January 2008.79 “The workings of the Eurosystem: monetary policy preparations and decision-making –selected issues” by P. Moutot, A. Jung and F. P. Mongelli, January 2008.80 “China’s and India’s roles in global trade and finance: twin titans for the new millennium?”by M. Bussière and A. Mehl, January 2008.81 “Measuring financial integration in new EU Member States” by M. Baltzer, L. Cappiello,R. A. De Santis and S. Manganelli, March 2008.82 “The sustainability of China’s exchange rate policy and capital account liberalisation”by L. Cappiello and G. Ferrucci, March 2008.83 “The predictability of monetary policy” by T. Blattner, M. Catenaro, M. Ehrmann,R. Strauch and J. Turunen, March 2008.84 “Short-term forecasting of GDP using large monthly datasets: a pseudo real-time forecastevaluation exercise” by G. Rünstler, K. Barhoumi, R. Cristadoro, A. Den Reijer,A. Jakaitiene, P. Jelonek, A. Rua, K. Ruth, S. Benk and C. Van Nieuwenhuyze, May 2008.85 “Benchmarking the Lisbon strategy” by D. Ioannou, M. Ferdinandusse, M. Lo Ducaand W. Coussens, June 2008.86 “Real convergence and the determinants of growth in EU candidate and potential candidatecountries: a panel data approach” by M. M. Borys, É. K. Polgár and A. Zlate, June 2008.87 “Labour supply and employment in the euro area countries: developments and challenges”,by a Task Force of the Monetary Policy Committee of the European System of CentralBanks, June 2008.88 “Real convergence, financial markets, and the current account – emerging Europe versusemerging Asia” by S. Herrmann and A. Winkler, June 2008.89 “An analysis of youth unemployment in the euro area” by R. Gomez-Salvador andN. Leiner-Killinger, June 2008.90 “Wage growth dispersion across the euro area countries: some stylised facts”by M. Andersson, A. Gieseck, B. Pierluigi and N. Vidalis, July 2008.91 “The impact of sovereign wealth funds on global financial markets” by R. Beck andM. Fidora, July 2008.92 “The Gulf Cooperation Council countries: economic structures, recent developments androle in the global economy” by M. Sturm, J. Strasky, P. Adolf and D. Peschel, July 2008.93 “Russia, EU enlargement and the euro” by Z. Polański and A. Winkler, August 2008.94 “The changing role of the exchange rate in a globalised economy” by F. di Mauro, R. Rüfferand I. Bunda, September 2008.270 ECBAnnual Report2008

95 “Financial stability challenges in candidate countries managing the transition to deeper andmore market-oriented financial systems” by the International Relations Committee expertgroup on financial stability challenges in candidate countries, September 2008.96 “The monetary presentation of the euro area balance of payments” by L. Bê Duc,F. Mayerlen and P. Sola, September 2008.97 “Globalisation and the competitiveness of the euro area” by F. di Mauro and K. Forster,September 2008.98 “Will oil prices decline over the long run?” by R. Kaufmann, P. Karadeloglou andF. di Mauro, October 2008.99 “The ECB and IMF indicators for the macro-prudential analysis of the banking sector: acomparison of the two approaches” by A. M. Agresti, P. Baudino and P. Poloni, November2008.100 “Survey data on household finance and consumption: research summary and policy use” by theEurosystem Household Finance and Consumption Network, January 2009.RESEARCH BULLETIN“Research Bulletin”, No 7, June 2008.WORKING PAPER SERIES973 “Do China and oil exporters influence major currency configurations?” by M. Fratzscherand A. Mehl, December 2008.974 “Institutional features of wage bargaining in 23 European countries, the United Statesand Japan” by P. Du Caju, E. Gautier, D. Momferatou and M. Ward-Warmedinger,December 2008.975 “Early estimates of euro area real GDP growth: a bottom-up approach from the productionside” by E. Hahn and F. Skudelny, December 2008.976 “The term structure of interest rates across frequencies” by K. Assenmacher-Wescheand S. Gerlach, December 2008.977 “Predictions of short-term rates and the expectations hypothesis of the term structure ofinterest rates” by M. Guidolin and D. L. Thornton, December 2008.978 “Measuring monetary policy expectations from financial market instruments” by M. Joyce,J. Relleen and S. Sorensen, December 2008.979 “Futures contract rates as monetary policy forecasts” by G. Ferrero and A. Nobili,December 2008.980 “Extracting market expectations from yield curves augmented by money market interestrates: the case of Japan” by T. Nagano and N. Baba, December 2008.981 “Why the effective price for money exceeds the policy rate in the ECB tenders?”by T. Välimäki, December 2008.982 “Modelling short-term interest rate spreads in the euro money market” by N. Cassolaand C. Morana, December 2008.983 “What explains the spread between the euro overnight rate and the ECB’s policy rate?”by T. Linzert and S. Schmidt, December 2008.984 “The daily and policy-relevant liquidity effects” by D. L. Thornton, December 2008.985 “Portuguese banks in the euro area market for daily funds” by L. Farinha and V. Gaspar,December 2008.986 “The topology of the federal funds market” by M. L. Bech and E. Atalay, December 2008.ECBAnnual Report2008271

987 “Probability of informed trading on the euro overnight market rate: an update” by J. Idierand S. Nardelli, December 2008.988 “The interday and intraday patterns of the overnight market: evidence from an electronicplatform” by R. Beaupain and A. Durré, December 2008.989 “Modelling loans to non-financial corporations in the euro area” by C. Kok Sørensen,D. Marqués Ibáñez and C. Rossi, January 2009.990 “Fiscal policy, housing and stock prices” by A. Afonso and R. M. Sousa, January 2009.991 “The macroeconomic effects of fiscal policy” by A. Afonso and R. M. Sousa, January 2009.992 “FDI and productivity convergence in central and eastern Europe: an industry-levelinvestigation” by M. Bijsterbosch and M. Kolasa, January 2009.993 “Has emerging Asia decoupled? An analysis of production and trade linkages using theAsian international input-output table” by G. Pula and T. A. Peltonen, January 2009.994 “Fiscal sustainability and policy implications for the euro area” by F. Balassone, J. Cunha,G. Langenus, B. Manzke, J. Pavot, D. Prammer and P. Tommasino, January 2009.995 “Current account benchmarks for central and eastern Europe: a desperate search?”by M. Ca’ Zorzi, A. Chudik and A. Dieppe, January 2009.996 “What drives euro area break-even inflation rates?” by M. Ciccarelli and J. A. García,January 2009.997 “Financing obstacles and growth: an analysis for euro area non-financial corporations”by C. Coluzzi, A. Ferrando and C. Martinez-Carrascal, January 2009.998 “Infinite-dimensional VARs and factor models” by A. Chudik and M. H. Pesaran,January 2009.999 “Risk-adjusted forecasts of oil prices” by P. Pagano and M. Pisani, January 2009.1000 “Wealth effects in emerging market economies” by T. A. Peltonen, R. M. Sousaand I. S. Vansteenkiste, January 2009.1001 “Identifying the elasticity of substitution with biased technical change”by M. A. León-Ledesma, P. McAdam and A. Willman, January 2009.1002 “Assessing portfolio credit risk changes in a sample of EU large and complex bankinggroups in reaction to macroeconomic shocks” by O. Castrén, T. Fitzpatrick and M. Sydow,February 2009.1003 “Real wages over the business cycle: OECD evidence from the time and frequencydomains” by J. Messina, C. Strozzi and J. Turunen, February 2009.1004 “Characterising the inflation-targeting regime in South Korea” by M. Sánchez,February 2009.1005 “Labour market institutions and macroeconomic volatility in a panel of OECD countries”by F. Rumler and J. Scharler, February 2009.1006 “Understanding sectoral differences in downward real wage rigidity: workforcecomposition, institutions, technology and competition” by P. Du Caju, C. Fuss and L. Wintr,February 2009.1007 “Sequential bargaining in a new-Keynesian model with frictional unemployment andstaggered wage negotiation” by G. de Walque, O. Pierrard, H. Sneessens and R. Wouters,February 2009.1008 “Liquidity (risk) concepts: definitions and interactions” by K. Nikolaou, February 2009.1009 “Optimal sticky prices under rational inattention” by B. Maćkowiak and M. Wiederholt,February 2009.1010 “Business cycles in the euro area” by D. Giannone, M. Lenza and L. Reichlin,February 2009.1011 “The global dimension of inflation – evidence from factor-augmented Phillips curves”by S. Eickmeier and K. Moll, February 2009.272 ECBAnnual Report2008

1012 “Petrodollars and imports of oil-exporting countries” by R. Beck and A. Kamps,February 2009.1013 “Structural breaks, cointegration, and the Fisher effect” by A. Beyer, A. Haug andB. Dewald, February 2009.1014 “Asset prices and current account fluctuations in G7 economies” by M. Fratzscher andR. Straub, February 2009.1015 “Inflation forecasting in the new EU Member States” by O. Arratibel, C. Kamps andN. Leiner-Killinger, February 2009.OTHER PUBLICATIONS“Bond markets and long-term interest rates in non-euro area Member States of the EuropeanUnion”, January 2008 (online only).“Oversight framework for card payment schemes – standards”, January 2008 (online only).“The role of money – money and monetary policy in the twenty-first century – proceedings of theFourth ECB Central Banking Conference 2006”, February 2008.“Euro area balance of payments and international investment position statistics – Annual qualityreport”, March 2008 (online only).“ECB statistics quality framework (SQF)”, April 2008 (online only).“Quality assurance procedures within the ECB statistical function”, April 2008 (online only).“ECB statistics – an overview”, April 2008 (online only).“TARGET Annual Report 2007”, April 2008 (online only).“Financial integration in Europe”, April 2008.“Financial Stability Review”, June 2008.“Labour supply and employment in the euro area countries: developments and challenges”,June 2008.“The international role of the euro”, July 2008 (online only).“Payment systems and market infrastructure oversight report”, July 2008 (online only).“Letter from the ECB President to Mr Dimitrios Papadimoulis, Member of the EuropeanParliament”, July 2008 (online only).“Letter from the ECB President to Mr Ashley Mote, Member of the European Parliament”,July 2008 (online only).“Legal framework of the Eurosystem and the ESCB – ECB legal acts and instruments”, July 2008.“CCBM2 User Requirements 4.1”, July 2008 (online only).“Simulating financial instability – conference on stress testing and financial crisis simulationexercises, 12-13 July 2007”, September 2008.“New procedure for constructing ECB staff projection ranges”, September 2008 (online only).“Commission’s draft directive/regulation on credit rating agencies – Eurosystem contribution tothe public consultation”, September 2008 (online only).“Euro money market survey”, September 2008 (online only).“EU banking structures”, October 2008 (online only).“Letter from the ECB President to Mr Mario Borghezio, Member of the European Parliament”,October 2008 (online only).“Letter from the ECB President to Mr Ashley Mote, Member of the European Parliament”,October 2008 (online only).“A strategic vision for statistics: challenges for the next 10 years – Fourth ECB Conference onStatistics, 24 and 25 April 2008”, November 2008.“The implementation of monetary policy in the euro area: General documentation on Eurosystemmonetary policy instruments and procedures”, November 2008.ECBAnnual Report2008273

“The Eurosystem policy principles on the location and operation of infrastructures settlingeuro-denominated payment transactions: specification of ‘legally and operationally located in theeuro area’ ”, November 2008 (online only).“Single Euro Payments Area – sixth progress report”, November 2008 (online only).“EU banks’ liquidity stress-testing and contingency funding plans”, November 2008 (online only).“Government finance statistics guide”, December 2008 (online only).“Financial Stability Review”, December 2008.“Covered bonds in the EU financial system”, December 2008 (online only).“The incentive structure of the ‘originate and distribute’ model”, December 2008 (online only).“Recommendations of the Governing Council of the European Central Bank on the pricingof recapitalisations”, December 2008 (online only).“Recommendations of the Governing Council of the European Central Bank on governmentguarantees for bank debt”, December 2008 (online only).“Commercial property markets – financial stability risks, recent developments and EU banks’exposures”, December 2008 (online only).“Correspondent central banking model (CCBM) – procedures for Eurosystem counterparties”,December 2008 (online only).“Letter from the ECB President to Mr Robert Sturdy, Member of the European Parliament”,January 2009 (online only).“Euro money market study 2008”, February 2009 (online only).“Eurosystem oversight policy framework”, February 2009 (online only).“Harmonised oversight approach and oversight standards for payment instruments”, February 2009(online only).“European Commission’s consultation on hedge funds – Eurosystem contribution”, February 2009(online only).INFORMATION BROCHURES“The European Central Bank, the Eurosystem, the European System of Central Banks”,2nd edition, April 2008.“Price stability – why is it important for you?”, June 2008.“A single currency – an integrated market infrastructure”, September 2008.274 ECBAnnual Report2008

GLOSSARYThis glossary contains selected terms that are used in the Annual Report. A more comprehensiveand detailed glossary can be found on the ECB’s website.Balance of payments (b.o.p.): a statistical statement that summarises, for a specific period of time,the economic transactions of an economy with the rest of the world. The transactions considered arethose involving goods, services and income; those involving financial claims on, and liabilities to,the rest of the world; and those (such as debt forgiveness) that are classified as transfers.Benchmark portfolio: in relation to investments, a reference portfolio or index constructed on thebasis of the objectives for the liquidity and risk of, as well as the return on, the investments. Thebenchmark portfolio serves as a basis for comparison of the performance of the actual portfolio.Bond market: the market in which longer-term debt securities are issued and traded.Candidate countries: countries for which the EU has accepted an application for EU membership.Accession negotiations with Croatia and Turkey began on 3 October 2005, while those with theformer Yugoslav Republic of Macedonia have not yet started.Central counterparty: an entity that interposes itself between the counterparties to the contractstraded in one or more financial markets, becoming the buyer to every seller and the seller to everybuyer.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 i) enables securities transactions to be processedand settled by book entry, and ii) plays an active role in ensuring the integrity of securities issues.Securities can be held in physical (but immobilised) or dematerialised form (i.e. so that they existonly as electronic records).Collateral: assets pledged or otherwise transferred (e.g. by credit institutions to central banks) asa guarantee for the repayment of loans, as well as assets sold (e.g. by credit institutions to centralbanks) under repurchase 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. It providesstatistical information on the MFI sector’s assets and liabilities vis-à-vis residents of the euroarea not belonging to this sector (i.e. the general government and other euro area residents) andvis-à-vis non-euro area residents. It is the main statistical source for the calculation of monetaryaggregates, and it provides the basis for the regular analysis of the counterparts of M3.Corporate governance: rules, procedures and processes according to which an organisation isdirected and 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 for decision-making.Corporate profitability: a measure of the earnings performance of corporations, mainly inrelation to their sales, assets or equity. There are a number of different corporate profitabilityratios based on company financial statements, such as the ratio of operating income (sales minusECBAnnual Report2008275

operating expenses) to sales, the ratio of net income (operating and non-operating income, aftertax, depreciation and extraordinary items) to sales, the return on assets (relating net income to totalassets) and the return on equity (relating net income to shareholders’ funds). At the macroeconomiclevel, the gross operating surplus, based on national accounts, for instance in relation to GDP orvalue added, is often used as a measure of profitability.Correspondent central banking model (CCBM): a mechanism established by the Eurosystemwith the aim of enabling counterparties to use eligible assets on a cross-border basis. In theCCBM, NCBs act as custodians for one another. Each NCB has a securities account in its securitiesadministration for each of the other NCBs (and for the European Central Bank).Cost of the external financing of non-financial corporations (real): the cost incurred by nonfinancialcorporations when taking up new external funds. For euro area non-financial corporations,it is calculated as a weighted average of the cost of bank lending, the cost of debt securities and thecost of equity, based on the amounts outstanding (corrected for valuation effects) and deflated byinflation expectations.Counterparty: the opposite party in a financial transaction (e.g. any party transacting with a centralbank).Credit derivative: a financial instrument which separates the credit risk from an underlyingfinancial transaction, enabling the credit risk to be priced and transferred separately.Credit institution: i) an undertaking whose business is to receive deposits or other repayable fundsfrom the public and to grant credit for its own account; or ii) an undertaking or any other legalperson, other than those under i), which issues means of payment in the form of electronic money.Credit risk: the risk that a counterparty will not settle an obligation for full value, either whendue or at any time thereafter. Credit risk includes replacement cost risk and principal risk. It alsoincludes the risk of the failure of the settlement bank.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 usually carrya specific rate of interest (the coupon) and/or are sold at a discount to the amount that will be repaidat maturity. Debt securities issued with an original maturity of more than one year are classified aslong-term.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). Included are equity capital, reinvested earnings and other capitalassociated with inter-company operations.ECOFIN Council: the EU Council meeting in the composition of the ministers of economy andfinance.276 ECBAnnual Report2008

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. Due attention is paid to the need to identify the nature of shocksaffecting the economy, their effects on cost and pricing behaviour, and the short to medium-termprospects 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 ECOFIN Council and the European Commission. Its tasksinclude reviewing the economic and financial situation of the Member States and of the Community,and budgetary surveillance.Economic and Monetary Union (EMU): the process that led to the single currency, the euro, andthe single monetary policy in the euro area, as well as to the coordination of the economic policiesof the EU Member States. This process, as laid down in the Treaty, took place in three stages.Stage Three, the final stage, started on 1 January 1999 with the transfer of monetary competence tothe European Central Bank and the introduction of the euro. The cash changeover on 1 January2002 completed the process of setting up EMU.Effective exchange rate (EER) of the euro (nominal/real): a weighted average of bilateral euroexchange rates against the currencies of the euro area’s main trading partners. The EuropeanCentral Bank publishes nominal EER indices for the euro against two groups of trading partners:the EER-21 (comprising the 11 non-euro area EU Member States and 10 main trading partnersoutside the EU) and the EER-41 (composed of the EER-21 and 20 additional countries). Theweights used reflect the share of each partner country in euro area trade and account for competitionin third markets. Real EERs are nominal EERs deflated by a weighted average of foreign, relativeto domestic, prices or costs. They are thus measures of price and cost competitiveness.EONIA (euro overnight index average): a measure of the effective interest rate prevailing inthe euro 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 of contributingbanks.Equities: securities representing ownership of a stake in a corporation. They comprise shares tradedon stock exchanges (quoted shares), unquoted shares and other forms of equity. Equities usuallyproduce 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 mechanism which provides theframework for exchange rate policy cooperation between the euro area countries and the noneuroarea EU Member States. ERM II is a multilateral arrangement with fixed, but adjustable,central rates and a standard fluctuation band of ±15%. Decisions concerning central rates and,possibly, narrower fluctuation bands are taken by mutual agreement between the EU Member Stateconcerned, the euro area countries, the European Central Bank (ECB) and the other EU MemberStates participating in the mechanism. All participants in ERM II, including the ECB, have the rightto initiate a confidential procedure aimed at changing the central rates (realignment).ECBAnnual Report2008277

EURIBOR (euro interbank offered rate): the rate at which a prime bank is willing to lend fundsin euro to another prime bank, as reported by a panel of contributing banks, computed daily forinterbank deposits with different maturities of up to 12 months.Euro area: the area encompassing those Member States which have adopted the euro as the singlecurrency in accordance with the Treaty and in which a single monetary policy is conducted underthe responsibility of the Governing Council of the European Central Bank. The euro areacurrently comprises Belgium, Germany, Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg,Malta, the Netherlands, Austria, Portugal, Slovenia, Slovakia and Finland.European Central Bank (ECB): the ECB lies at the centre of the Eurosystem and the EuropeanSystem of Central Banks (ESCB) and has its own legal personality in accordance with theTreaty (Article 107(2)). It ensures that the tasks conferred upon the Eurosystem and the ESCB areimplemented either through its own activities or through those of the NCBs, pursuant to the Statuteof the ESCB. The ECB is governed by the Governing Council and the Executive Board, and, as athird decision-making body, 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 comprehensive and integrated system ofmacroeconomic accounts based on a set of internationally agreed statistical concepts, definitions,classifications and accounting rules aimed at achieving a harmonised quantitative description of theeconomies of the EU Member States. The ESA 95 is the Community’s version of the world Systemof National Accounts 1993 (SNA 93).European System of Central Banks (ESCB): composed of the European Central Bank (ECB)and the NCBs of all 27 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 third decisionmakingbody 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.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 maintain budgetarydiscipline, defines the criteria for a budgetary position to be considered an excessive deficit andregulates steps to be taken following the observation that the requirements for the budgetary balanceor government debt have not been fulfilled. Article 104 is supplemented by Council Regulation(EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessivedeficit procedure (as amended by Council Regulation (EC) No 1056/2005 of 27 June 2005), whichis one element of the Stability and Growth Pact.Executive Board: one of the decision-making bodies of the European Central Bank (ECB).It comprises 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 Member States that have adopted theeuro.278 ECBAnnual Report2008

Financial stability: condition in which the financial system – comprising financial intermediaries,markets and market infrastructures – is capable of withstanding shocks and the unravelling offinancial imbalances, thereby mitigating the likelihood of disruptions in the financial intermediationprocess which are severe enough to significantly impair the allocation of savings to profitableinvestment opportunities.Financing gap of non-financial corporations: the financing gap can be defined as the balancebetween the corporate savings (through retained earnings and depreciation allowances) and thenon-financial investment of non-financial corporations. The financing gap can also be defined onthe basis of the financial accounts, as the balance between the net acquisition of financial assets andthe net incurrence of liabilities by non-financial corporations. There are statistical discrepanciesbetween the two measures owing to differences in source statistics.Fine-tuning operation: an open market operation executed by the Eurosystem in order to dealwith unexpected liquidity fluctuations in the market. The frequency and maturity of fine-tuningoperations are not standardised.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).It comprises the President and the Vice-President of the ECB and the governors of all the NCBs ofthe European System of Central Banks.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, suchas 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 Member States that have adopted the euro.Gross operating surplus: the surplus (or deficit) on the value of output of production activitiesafter the costs of intermediate consumption, compensation of employees and taxes less subsidieson production have been deducted, but before payments and receipts of income related to theborrowing/renting or owning of financial and non-produced assets have been taken into account.Harmonised Index of Consumer Prices (HICP): a measure of the development of consumerprices that is compiled by Eurostat and harmonised for all EU Member States.Implied volatility: the expected volatility (i.e. standard deviation) in the rates of change of theprice of an asset (e.g. a share or a bond). It can be derived from the asset’s price, maturity date andexercise price of its options, as well as from a riskless rate of return, using an option pricing modelsuch as the Black-Scholes model.ECBAnnual Report2008279

International investment position (i.i.p.): the value and composition of an economy’s outstandingnet 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 rates on the main refinancingoperations, the marginal lending facility and the deposit facility.Lisbon strategy: a comprehensive agenda of structural reforms aimed at transforming the EU into“the most dynamic and competitive knowledge-based economy in the world”, launched in 2000 bythe Lisbon European Council.Longer-term refinancing operation: a regular open market operation executed by theEurosystem in the form of reverse transactions. Such operations are carried out through a monthlystandard 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 with anagreed maturity of up to and including two years (i.e. short-term time deposits) held with MFIs andcentral 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. Such operations are carried out through a weekly standard tenderand normally have a maturity of one week.Maintenance period: the period over which credit institutions’ compliance with reserverequirements is calculated. The maintenance period begins on the settlement day of the first mainrefinancing operation following the meeting of the Governing Council at which the monthlyassessment of the monetary policy stance is pre-scheduled. The European Central Bank publishesa calendar of the reserve maintenance periods at least three months 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).Market liquidity risk: the risk that transactions on the financial market cannot be concluded or canonly be concluded at worse than expected conditions owing to inadequate market depth or marketdisruption.Market risk: the risk of losses (in both on and off-balance-sheet positions) arising from movementsin market prices.280 ECBAnnual Report2008

MFIs (monetary financial institutions): financial institutions which together form the moneyissuingsector of the euro area. These include the Eurosystem, resident credit institutions (asdefined in Community law) and all other resident financial institutions whose business is to receivedeposits and/or close substitutes for deposits from entities other than MFIs and, for their ownaccount (at least in economic terms), to grant credit and/or invest in securities. The latter groupconsists predominantly of money market funds.MFI credit to euro area residents: MFI loans granted to non-MFI euro area residents (includinggeneral government and the private sector) and MFI holdings of securities (shares, other equityand debt securities) issued by non-MFI euro area residents.MFI interest rates: the interest rates that are applied by resident credit institutions and otherMFIs, excluding central banks and money market funds, to euro-denominated deposits and loansvis-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, depositsredeemable at a period of notice of over three months, debt securities issued by euro area MFIswith an original maturity of more than two years, and the capital and reserves of the euro area MFIsector.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-euroarea residents’ deposits and repurchase agreements, as well as their holdings of money marketfund shares/units and debt securities issued by MFIs with a maturity of up to and including twoyears).Minimum bid rate: the lower limit to the interest rates at which counterparties may submit bidsin the variable rate tenders.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. The monetary analysis helps to assess medium to longtermtrends 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 measures ofexcess 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 guidelines establishedby the Governing Council and held against banknotes in circulation and deposit liabilities to creditinstitutions.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 the financialmarket. With regard to their aims, regularity and procedures, Eurosystem open market operationscan be divided into four categories: main refinancing operations; longer-term refinancingECBAnnual Report2008281

operations; fine-tuning operations; and structural operations. As for the instruments used, reversetransactions are the main open market instrument of the Eurosystem and can be employed in allfour categories of operations. In addition, the issuance of debt certificates and outright transactionsare available for structural operations, while outright transactions, foreign exchange swaps and thecollection of fixed-term deposits are available for the 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 or upto a certain future date (the exercise or maturity date).Other financial intermediary (OFI): a corporation or quasi-corporation (other than an insurancecorporation or pension fund) that is engaged mainly in financial intermediation by incurringliabilities in forms other than currency, deposits and/or close substitutes for deposits frominstitutional entities other than MFIs. OFIs include in particular corporations engaged primarily inlong-term financing (such as financial leasing), securitised asset holdings, other financial holdings,securities and derivatives dealing (on their own account), venture capital and development capital.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 positionsin securities 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. TheGoverning Council defines price stability as a year-on-year increase in the Harmonised Index ofConsumer Prices for the euro area of below 2%. The Governing Council has also made it clearthat, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% overthe 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 in Juneand December, whereas European Central Bank (ECB) staff projections are published in Marchand September. They form part of the economic analysis pillar of the monetary policy strategy ofthe ECB and are thus one of several inputs into the Governing Council’s assessment of the risks toprice 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: a contract to sell and subsequently repurchase securities on a specifieddate and at a specified price. Also called a “repo”.282 ECBAnnual Report2008

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 over a predefined maintenance period. Compliance with the requirementis determined on the basis of the average of the daily balances in the reserve accounts over themaintenance period.Reverse transaction: an operation whereby the central bank buys or sells assets under a repurchaseagreement or conducts credit operations against collateral.Securities settlement system (SSS): a transfer system for settling securities transactions. Itcomprises all of the institutional arrangements required for the clearing and settlement of securitiestrades and the provision of custody services for securities.Securitisation: the pooling of financial assets, such as residential mortgage loans, and theirsubsequent sale to a special-purpose vehicle, which then issues fixed income securities for sale toinvestors. The principal and interest of these securities depend on the cash flows produced by thepool of underlying financial assets.Settlement risk: the risk that settlement in a transfer system will not take place as expected, usuallyowing to a party defaulting on one or more settlement obligations. This risk comprises, in particular,operational risk, credit risk and liquidity risk.Stability and Growth Pact: the Stability and Growth Pact is intended to serve as a means ofsafeguarding sound government finances in Stage Three of Economic and Monetary Union inorder to strengthen the conditions for price stability and for strong, sustainable growth conduciveto employment creation. To this end, the Pact prescribes that Member States specify medium-termbudgetary objectives. It also contains concrete specifications on the excessive deficit procedure.The Pact consists of the Resolution of the Amsterdam European Council of 17 June 1997 on theStability and Growth Pact and two Council Regulations, namely i) Regulation (EC) No 1466/97of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillanceand coordination of economic policies as amended by Regulation (EC) No 1055/2005 of27 June 2005, and ii) Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying theimplementation of the excessive deficit procedure as amended by Regulation (EC) No 1056/2005of 27 June 2005. The Stability and Growth Pact is complemented by the ECOFIN Council’s reportentitled “Improving the implementation of the Stability and Growth Pact”, which was endorsedby the Brussels European Council of 22 and 23 March 2005. It is also complemented by the newCode of Conduct entitled “Specifications on the implementation of the Stability and Growth Pactand Guidelines on the format and content of stability and convergence programmes”, which wasendorsed by the ECOFIN Council on 11 October 2005.Standing facility: a central bank facility available to counterparties on their own initiative. TheEurosystem offers two overnight standing facilities: the marginal lending facility and the depositfacility.ECBAnnual Report2008283

Straight-through processing (STP): the automated end-to-end processing of trades/paymenttransfers, including, where relevant, the automated completion of confirmation, matching,generation, clearing and settlement of orders.Systemic risk: the risk that the inability of one participant to meet its obligations in a system willcause other participants to be unable to meet their obligations when due, with possible spillovereffects such as significant liquidity or credit problems that may threaten the stability of the financialsystem. Such inability may be caused by operational or financial problems.TARGET (Trans-European Automated Real-time Gross settlement Express Transfer system):the real-time gross settlement (RTGS) system for the euro.TARGET2: a new generation of the TARGET system which replaces the former decentralisedtechnical structure with a single shared platform offering a harmonised service with a uniformpricing scheme.Treaty: refers to the Treaty establishing the European Community (“Treaty of Rome”). The Treatyhas been amended on several occasions, in particular by the Treaty on European Union (“MaastrichtTreaty”) which laid the foundations for Economic and Monetary Union and contained the Statuteof the ESCB.284 ECBAnnual Report2008