Category: Conjoncture

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Conjoncture Economical policy Euro zone Finance

Exiting the ECB’s unconventional monetary policy is necessary, but difficult.

On 26 October, the ECB (European Central Bank) will probably announce how it is planning to recalibrate its current highly accommodative monetary policy. Primarily consisting of massive purchases by the ECB of sovereign and corporate bonds and the introduction of negative interest rates, this policy has proven its usefulness in combatting the risk of deflation and the disintegration of the eurozone. It has, therefore, been effective.

Gradual withdrawal of the policy now appears necessary. Deflationary fears are now behind us, growth in the eurozone is confirmed and the unemployment rate has fallen considerably. Although we are experiencing stubbornly low inflation, continuation of the policy entails significant risks.

Through a policy of very low and even negative interest rates, below the nominal growth rate, the ECB, by supporting borrowers, impacts the remuneration of savers and lenders. Germany, a country of declining demographics and thus more sensitive to this situation, reminds the ECB regularly of this. Furthermore, and whether or not they are contractually required to deliver minimum yields, institutional investors (insurance companies, pension fund managers, etc.) may therefore be inclined to extend the duration of their investments and accept higher counterparty risks in exchange for higher remuneration. Should it continue beyond its necessary duration, this policy could cause future financial instability.

Additionally, such a policy may encourage speculative behaviour, a cause of bubbles, consisting of borrowing at low rates in order to buy risky assets (equities or real estate) in order to benefit from the yield differential. Yet, although such bubbles had not clearly been seen until recently, certain assets appear to have been experiencing quite rapid price hikes over the last few months, both on the US equities markets, for example, and on real estate markets of a number of large American and European cities (including in Germany).

By seeking to position long-term interest rates at very low levels, it destroys the differential between banks’ lending rates and the rates applicable to their sources of funds, while savers’ bank deposit rates cannot fall below zero. But this interest margin constitutes a fundamental building block of retail banking income. In the case of France, for example, since 2016 this negative effect has not been offset by higher lending volumes and a lower cost of credit risk, due to the same very low interest rates. Yet at the same time, results from their other activities (investment banking, international, insurance, etc.) have enabled them to generate very good overall results. Consequently, sooner or later the lower income from retail banking in domestic markets runs the risk of impeding their ability to support lending growth alongside resurgent economic growth, at a time when the solvency ratio demanded under prudential rules continues to rise.

For all these reasons in particular, the start of normalisation of the ECB’s monetary policy has now become necessary. It would also enable the institution to re-establish vital room for manoeuvre to combat any future cycle reversal, particularly as the budgetary policy of many European governments currently has little room for manoeuvre given their levels of public debt.

To implement this turnaround, from 2014 the US Federal Reserve commenced a gradual tapering and subsequently ended its asset purchase programme, and finally gradually increased its key rates (short-term rates). The ECB will probably announce its own tapering plans on 26 October. By deciding to unwind its asset purchase programme very gradually, and by first of all stabilising its stocks, it could trigger a very prudent rise in long-term rates over the coming years. At the same time it could also raise negative rates towards zero, a situation that can only exist in very exceptional circumstances. Key rates would only be raised after this first step.

The rates rise will be managed very prudently, as it also involves significant risks. It could cause major market shocks if it is very sudden and poorly anticipated. Similarly, in view of the high levels of sovereign, corporate and household debt, it can only be implemented very gradually. The euro has already risen sharply against the dollar. With the rise of our currency clearly having an effect which could counteract anticipated inflation growth following higher economic growth in the zone, the ECB cannot, however, run the risk of accelerating the revaluation of the euro while it is seeking to get inflation back up to around 2%.

The policy implemented by the ECB has, in practice, been designed to buy time for the eurozone, to enable its states to carry out structural reforms and to make the necessary modifications to the institutional and organisational framework of the monetary zone itself. As the policy cannot last for ever, it is becoming all the more imperative for the countries concerned to implement such reforms in order to enhance their competitiveness (quality/price) and sustain their growth potential. And consequently, in the absence of austerity policies, to reduce public deficits, including welfare, and structural current account deficits. The objective must be to create the foundations of a strengthened eurozone, through better coordination, with greater solidarity and where all members will be able to improve their growth potential.

Co-written with Thibault Dubreuil, Finance Major at HEC

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Conjoncture Economical policy Euro zone

The effectiveness of monetary policy of very low interest rates will soon come to an end

Monetary policy of low, even negative, short-term and long-term rates unquestionably made it possible to avoid a catastrophic risk in 2007–2009, and then in the eurozone from 2010 to the present day. And subsequently to revive growth, if only at a low level, by stimulating the demand for credit and sustaining consumption and investment.

In the period of low growth we are currently experiencing, the monetary policy implemented by the ECB is helping the public and private sector to reduce indebtedness by guaranteeing nominal interest rates lower than the nominal growth rate, or at least at the same level. This was an essential move, lest we forget that the crisis of 2007-2009 occurred on the heels of a cycle of household and corporate debt accumulation that gradually became unsustainable. This major financial and economic crisis led in turn to a very sharp rise in public debt. Causing a drastic fall in long-term rates by buying government bonds, Mario Draghi succeeded in halting the infernal cycle based on the contagion of mistrust vis-à-vis the public debt of certain European countries. This mistrust led to a speculative hike in their interest rates, which in turn worsened both their public deficit and consequently national debt, causing a further loss of confidence.

This policy of very low, and even negative, rates was also intended to sustain global demand for credit. In principle, interest rates lower than the growth rate will sooner or later encourage lower savings and higher consumption and investment and, ultimately, stimulate growth. The current rates for property loans are a perfect illustration of this, with historically low levels. Finally, by increasing asset values (real estate, equity, etc.), lower rates also give rise to a favourable wealth effect on consumption and investment.

But if confidence fails to follow, the demand for credit can remain sluggish in spite of lower rates. In 2014 in France for example, demand remained below banks’ expectations in terms of the projects they wished to finance. Conversely, between late 2014 and early 2015, French companies rediscovered the taste for investment with a strengthening in the demand for credit.

What has been the impact on the banks? Very low rates unquestionably eat into the profitability of the banks. A bank’s net interest margin corresponds to the interest received on its outstanding loans less the interest paid on deposits. If the margin rate falls, coming up against the impossibility of lowering remuneration on deposits (which is virtually impossible to move into negative territory) relative to that received on loans, banks’ income will fall. The current challenge for the banks is therefore to offset this loss due to the rate effect by a positive volume effect. If total demand for credit increases, notably due to the lower rates caused by the central bank, every bank can take advantage. But should demand fail to grow sufficiently, the sector contracts.
The total volume of credits in France in 2015 increased sufficiently to offset the negative rate effect. But this volume effect tailed off in the first half of 2016.

However, the lower interest margin was offset during this period by the lower cost of risk. By supporting the economy, lower rates will mechanically lower the cost of credit risk. Since 2014, with the lower cost of risk having gathered pace, the banks have been able to offset the negative rate effect and inadequate volume effect. But we are now coming up against an impasse. Were the rate effect to persist, the cost of risk could not fall indefinitely and continue to produce its offsetting effect.

By sharply reducing banks’ future profitability, very low rates would ultimately restrict the supply of credit, at a time when banking regulation is demanding significantly higher solvency ratios with the corresponding strengthening of capital. All the more so as it is impossible to easily make capital increases due to the profitability of the banks falling below their cost of capital. The continuation of such a policy could therefore ultimately have a negative impact on growth. It should be noted that, unlike in the USA where the markets provide the majority of financing requirements, in Europe the situation is the opposite. Maintained at such low levels, sooner or later interest rates could also cause a property or equity bubble. Finally, they also undermine life insurance companies and pension funds.

The policy of very low rates has been essential. Which other monetary policy could have been implemented without taking even higher risks? It has also bought a certain amount of time, notably in the eurozone, providing room for governments to implement the structural reforms required to lift their growth potential and to make vital institutional changes within the monetary zone (genuine coordination of economic policy, certain elements of public debt pooling, etc.). But it is unclear if this time has been spent wisely. And time is of the essence.

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Bank Conjoncture Economical policy

Escaping banking’s vicious circle

The crisis has led to many banks worldwide suffering losses. And yet, they cannot raise new equity capital in the marketplace since investors fear the health of the banks may deteriorate further. In order to respect their solvency ratio (Basel 2), they are therefore forced to reduce their assets so that they again meet the maximum regulation multiple return (12.5 times) of their equity capital. So governments are intervening by going directly into the banks’ capital, supplanting the market and so counteracting as best they can a credit “crunch” which would be otherwise inevitable.

If this sequence of events is familiar, Basel 2 provokes another one sequence less well known, however dangerous. Even when the banks are not at a loss, when times are rough they are driven to reduce their credits and their market positions. The financial and economic crisis triggers an increasing effect on the calculated value of the banks’ assets. It is not the occurrence of nominal assets but of assets weighted by the risk they represent (risk weighted assets or RWA). This risk is measured by volatility of the positions in the financial markets, and by the probability of failure in the case of credits. In both cases the calculation of risk is based on the events of the recent past. The observation of the price drop in financial assets and of the increase of their volatility raises the value of their weighted assets by their risk and thus leads to the increase of the required level of their equity capital.

At the same time, the deterioration of borrower’s grading caused by the economic crisis mechanically increases the value of banks’ risk weighted credits, and so too their need for equity capital. And yet if, because the stock market doesn’t allow it as is the case today, the banks cannot manage to increase their equity capital to re-establish their ratio, they can only reduce their market positions by selling a portion of their financial assets. In doing so, they worsen the drop in the markets and their volatility, so provoking a new increase in their risk value. In the same way, on the credit side they cannot reduce their borrowings and so de facto they further weaken the economic agents, and the risk value of existing credits. It is here that at this point the vicious circle is perfectly complete!

Of course, faced with this risk of endless deterioration of asset prices and the economy, the Governments have thankfully reacted very quickly by directly investing in banks’ capital or by guaranteeing some of their assets at risk, or more precisely by buying these assets directly. This is absolutely necessary but the action which would help to break the vicious circle at the very moment that it is formed would be to urgently revise the methods of calculation of risk to the banks’ assets, by stopping their worrying procyclicity since they are largely based on recently observed risks. Or instead, by conserving the same methods, to adjust the required level of equity capital in an anticyclical way against the assets calculated in this way. Although today, while the economy and markets are doing well, the banks can take more and more risks with unchanged equity capital, thus strengthening the possibility of a boom. And conversely in the event of a reversal of speculation and the markets. It would clearly be preferable to progressively demand more equity capital since everything improves and maintains the same conservative level when everything deteriorates as it has today.

Even if that is insufficient, this necessary reform requires an international agreement, whereas the Governments intervene nationally. This is why the scope of the current crisis is forcing Governments to act without delay. However, with a certain parallelism, the IFRS standards which themselves are strongly procyclical have been significantly softened as soon as the end of 2008. And yet the urgency for a revision of prudential standards is also imposed. The progressive nationalisation of banks or the investment to their equity capital of funds borrowed by the Governments themselves is obviously essential but cannot be a long-term solution. It must be combined with a conservative structural reform of the calculation of bank equity capital required by Basel 2.

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Conjoncture

Is inflation coming back? Financial market fears

Article published in Les Echos in 2006

In order to properly answer this question, we first need to set the record straight as regards the difference between inflation and an inflationary regime. How much do prices generally have to rise for this economic headache to begin skewing indicators and derailing economic agents? By 2%? Perhaps by 3%, or 4%? Mathematics won’t help, and there is no magic number. These situations in fact occur due to a number of mechanisms that get triggered once we pass a certain but very hard-to-predict threshold, and then become self-sustaining. This is what happens in an inflationary regime. Once we move beyond a variable rate of inflation based on a country’s circumstances, agents, in a desperate attempt to protect their purchasing power and profits, try to index their salaries or prices against each other, thus spiralling into a self-inflicted and self-sustaining vicious circle.

However, the only way that inflation can feed itself and continue to grow is if money supply increases simultaneously, thereby providing the necessary fuel.
The reason why it is important to stand fast in the fight against inflationary regimes, is because they undermine our very trust in contracts, which are essential for the economy and for growth, be it commercial contracts setting the price of goods and services, employment contracts, or contracts for receivables and debts. These contracts, which underpin our ability to prepare for the future and set our expectations by giving us reasonable confidence in the situation, can only function effectively if prices remain stable. On the other hand, a low rate of inflation i.e. not high enough to trigger the problems caused by indexation, is entirely acceptable, and highly preferable over any form of deflation.

So, where are we today? The first thing to note is that, despite sustained growth in global liquidity and marked rises in raw material prices since around 2003, especially oil whose price has roughly tripled, inflation is currently very well contained. Excluding energy and agricultural products, it is hovering at around 2.3% in the United States and 1.6% in the eurozone, and if we include the full range of products in the price index, it is at 3.5% and 2.4% respectively. What have been the main reasons so far behind this price stability? First, the arrival of several emerging countries onto the global economy, some with huge populations, which has had a powerful anti-inflationary effect. Their labour costs are significantly lower than in OECD countries and their heavy investment in industry has not only introduced fierce competition for traditional industrial countries, but has also resulted in excess global production capacity, since their domestic consumption is not experiencing the same rate of acceleration.

The result has been terrific downward pressure on industrial prices, and an inability of companies to pass on the rise in the cost of raw materials. However, against all logic, this has not led to a fall in profits. Quite the contrary, since profits as a percentage of GDP have remained at historically high levels in both the USA and the eurozone. They have even risen here and there. This is due to the second factor behind the price stability situation.

On both sides of the Atlantic, companies have been able to guarantee high profit margins, because they have been giving their employees less purchasing power than they are making in terms of productivity gains. Since 2003, annual per capita productivity in the United States has been above 3%, whilst real wages per capita have fallen each year by around 2%. In the eurozone, productivity gains have been around 1%, whilst purchasing power has virtually stagnated. Once again, the pressure caused by the burgeoning power of emerging countries and their impressive workforce reserves have not translated into any great negotiating power for American employees and even less for their European counterparts, who are experiencing much more sober growth and a much higher rate of unemployment. These figures are of course all averages and encompass a broad range of realities, especially if looking at one particular European country or separating the services sector from industry.
So what next? Will the same causes have the same effects?

We are already seeing record high levels of production capacity usage in America, and salaries are beginning to stretch. More jobs are being created, with unemployment remaining low, all of which is gradually nudging prices upwards. The financial markets are watching the situation very closely. But will America still be growing this fast by the end of the year? More structurally, if the increase in raw material prices continues, especially for oil, will the anti-inflationary effect of global excess production capacity – which is in fact falling due to healthy global growth – and of very low labour costs in emerging countries continue to counter the effect of the rise in raw materials?

And if companies, especially industries, in OECD countries, fail to recover all, or even just some, of their ability to control their prices due to competition from emerging countries, can they continue to generate huge productivity gains, above the rate of increase in real wages? Can they therefore protect their profits? Will the positive effects of the current technological revolution in terms of productivity gradually fade? And will the negotiating power of employees recover in the long-term? In fact, without greater power to control their prices, unless companies are able to maintain the current balance between productivity gains and real wage increases, the only possible outcome is plummeting profitability. If, on the other hand, they do recover a greater ability to set their prices, then for the exact same reasons they will attempt to protect their profit margins by bumping up their prices, thereby encouraging inflation.

It is therefore important to keep a close eye on all these factors, to determine bit by bit whether the sudden hike in raw material prices could trigger a new inflationary regime. In the meantime, and knowing the risks, we are betting that the effects of globalisation and those of the technological revolution that began in the 1990s have not yet run their course, and that the habit of price and salary indexing is not about to resume, despite the likelihood of a small mechanical increase in inflation. The new few years will therefore depend on the rate of growth, and therefore of employment, and on profits, and therefore on the markets.