IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Bank share prices recover after further falls early February. However, credibility of ECB increasingly questioned as it considers further expansionary policies.
Fears of a renewed banking crisis, which had seemed a possibility in January, abated in February. By March 7th, the STOXX Europe 600 Banks Index had rebounded by 17% from February 11th, a low point when perhaps disappointing results from France’s Societé Générale had compounded worries growing since January’s poor banking results from Switzerland and Italy [February’16 NL]. Perhaps the turnaround reflected news from Deutsche Bank, which reassured investors by offering to buy back some €5 bn of senior unsecured bonds. In the event, investors tendered only about €3 bn of bonds, an indication that solvency fears were overcooked. Deutsche Bank’s share price recovered from a January low of €13 to about €18 by the start of March. A sharp rebound but still 45% below its 52 week high of €33.
Share prices in Europe and the US rose in between February 11’s low and March 7; European indices up about 12% from the February low point, and US shares up by about 7% in the same period. Why this broader market rebound? One view was that fears of recession are receding; other commentators point to the one-third jump in the price of oil from $26 to $34 since mid January. A third explanation lays in the changed rhetoric of the Federal Reserve and the ECB, interpreted by financial markets as consistent with further loosening of monetary policy. On March 10th the ECB did not disappoint. Not only did it reduce further its deposit rate (to –0.4%), but also announced a new programme of long term loans to banks at rates which could be as low as this negative rate, so the ECB pays banks to borrow. The ECB also increased its asset purchase programme by a third, navigating around the rules which would have prevented this in practice [December’15 NL] by announcing that it will buy corporate bonds. Given the amount of state support to corporations in northern Europe (for example EDF is 84% owned by France) this decision enables the ECB to keep it support distributed pro rata to its ownership “capital key” among the 19 eurozone countries, ie. heavily inclined towards German corporate debt.
However, the ECB’s biggest challenge is that its credibility is now openly questioned by three fairly important sets of scrutineers:
1) Supranationals. The Organisation for Economic Co-operation and Development (OECD) and the Bank for International Settlements (BIS) are two of the most respected monetary-policy focussed institutions. In February, William White, chairman of the Economic and Development Review Committee at the OECD and former chief economist at the BIS, gave a speech claiming that global debt levels pose greater risks today than in 2007, and averring that central banking actions were no longer effective.
For Mr. White, faced with a financial crisis, the critical response is deleveraging. Although this has happened in the household sector, this impact has, in his view, been more than offset by increases in corporate and government indebtedness. He is deeply worried:
“when I say the situation is worse today than it was in 2007—in 2007 this debt problem was essentially confined to the advanced market economies. Since then, the debt ratios—the private debt ratios in particular—have exploded in the emerging market countries and so we now have in a sense a global problem whereas in 2007 you might say we had a regional problem with the advanced market economies. But now it’s basically everywhere so, yes, I do think that the situation is worse than it was then...”
Referring to the influence he believes this advice is having on major central banks such as the ECB he said:
“in the end monetary easing is not going to work at all and...that’s where I am today... Unfortunately, we are still, as far as I can tell, both the BIS and myself are still talking to a brick wall”
The BIS added weight to these concerns. In its latest quarterly review, it noted that international debt issuance turned negative towards the end of 2015 by $47bn, the sharpest contraction since crisis fears last heightened in 2012. Much of this is attributed to the financial sector, again fuelling concerns that central bank support of banks is achieving little.
2) The Bundesbank Its president, Jens Weidmann, has criticised the ECB before [January’15 NL]. This February he took the unusually aggressive step of publishing a 22-page report castigating the ECB’s idea of abolishing the Euros 500 banknote. The claimed justification for its abolition is the assertion that criminals and tax evaders are the main holders of these large notes. However, such a step would, according to Weidmann, undermine confidence in central banks.
“If we tell citizens the bank notes they currently hold are not valid, that would impact trust.”
Furthermore, in an interview recorded at the end of February, Weidmann questioned the effectiveness of any further ECB policy actions, stating that it would be risky to simply ignore the long term risk and effects of already highly accommodative policy.
3) Prominent Investors. Bill Gross, former head of PIMCO and now partner in Janus Capital, warned about economies moving into the “black hole of negative interest rates”. He sees this ending badly, noting that the business models of insurance companies and pension funds depend upon 7 – 8% per annum returns. At the January World Economic Forum in Davos, Paul Singer, the head of a $26bn fund, Elliott Management, cautioned that further QE and increasingly negative interest rates not only damage confidence in central banks but could also lead to a loss of confidence in paper money. Axel Weber, head of UBS, said
“there may be no limit to what the ECB is willing to do, but there is a very clear limit to what QE can and will achieve”.
Will a Capital Markets Union (CMU) boost European economies? Or is CMU an initiative that may prove too grand in scope to be implemented?
As UK and European leaders gear up their efforts to persuade Britain’s electorate to vote in June to remain in the European Union, a senior British Parliamentary Committee summoned the European Commissioner for Financial Services and Financial Stability, (co-incidentally British) Lord Hill, to assess the costs and benefits to Britain’s finance industry of EU membership.
Lord Hill emphasised his and his unit’s efforts to build a Capital Markets Union (CMU) throughout the EU. This, he said, will not only help improve the functioning of financing in Europe, but help Britain’s financial services sector grow as part of it. By this summer, he will have produced a business plan and timetable for CMU implementation, latest by 2019. The difficulty which Lord Hill faces is that CMU is one of the most conceptual initiatives that Europe’s leaders have produced since the great financial crisis. Even strong CMU supporters such as ECB executive board member Yves Mersch agrees: “there is no common understanding of what it means or what it should look like.”
Lord Hill explained the origin of the CMU idea, and his challenge in defining CMU’s scope as well as implementation. The thinking behind CMU is that European securities markets are too fragmented to provide cross border funding to businesses. Consequently, businesses remain heavily dependent upon bank financing. However, banking is simply not responding to demands for funding from businesses. According to Olivier Guersent, one of Lord Hill’s most senior officials, 70% of Europe’s financing comes from banks, and “each time they are sick, whole economies are in trouble”. In a Bloomberg interview mid-February he continued “for the time being there is a market failure. There is more bank liquidity than ever, but markets are not working effectively”.
The Commission seems to recognise that part of the problem has been some of the very regulations that it introduced in response to the 2008 bank failures. Specifically, rules introduced to deter banks from securitising loans have weakened SME access to capital markets. This in turn has impaired poorer European countries’ access to EU infrastructure funds; applications for such funds are generally unsuccessful unless accompanied by co-investment from private sources of finance. Furthermore, national insolvency laws vary markedly among EU member states, with different rights for, and definition of, preferential creditors. The challenge for Lord Hill is whether to take on such issues, and, if yes, where to stop. At its broadest level, a blueprint for CMU could even attempt to embrace taxation rules and rates.
For these reasons, the core question of whether CMU will boost economies is unlikely to be considered before a clearer idea emerges of what it means. We would urge Lord Hill to narrow this down to a review and amendment of certain regulations. If not, we fear the present supportive political momentum may fade either because the project becomes too grand in scope, and comes to be perceived as a ‘back door’ attempt to implement fundamental changes in national laws which individual countries will not accept.
There is a danger that if the process drags on, CMU will come more and more to resemble banking union, which has stalled around Germany’s resistance to common deposit insurance. The worst outcome, in such circumstance, is that a never ending CMU saga becomes viewed as another ECB policy attempting to protect and support chronically weak banks.