Luis de Guindos: Euro area - economic outlook and financial
stability during the pandemic crisis
Remarks (via videoconference) by Mr Luis de Guindos, Vice-President of the European Central
Bank, at the Institute of International and European Affairs, Frankfurt am Main, 10 June 2020.
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The euro area economy has been experiencing an unprecedented contraction since the
coronavirus (COVID-19) began spreading in Europe. Economic activity declined in the first
quarter by 3.6 percent, quarter-on-quarter, driven by the fall in both domestic and foreign
demand. Consumer spending plummeted, largely due to the shutdown of non-essential
businesses and heightened uncertainty about job prospects. Although employment declined only
by 0.2 percent, quarter-on-quarter, in the first quarter of the year, recourse to national
employment schemes remained at unprecedented levels. At the same time, business
investment is expected to have collapsed on the back of lockdowns, fading demand, increasing
uncertainty and vanishing liquidity. Given the global nature of the shock, both nominal exports and
imports of goods declined sharply in March and are expected to remain subdued in the coming
months.
Incoming data suggest a much larger contraction of the economy in the second quarter. After the
projected collapse in the first half of the year, euro area growth is expected to rebound in the
second half, supported by monetary and fiscal policy and some pent-up demand. In May, survey
indicators suggested that there were some signs of the slump bottoming out alongside the
easing of containment measures. Although the euro area economy remains in a deep
contraction, consumer and business confidence indicators improved in May. At the same time,
there has been an improvement in forward-looking indicators, despite remaining well below their
pre-crisis levels, suggesting that firms expect a recovery to take hold in the coming months.
This assessment is also consistent with the June 2020 Eurosystem staff macroeconomic
projections for the euro area. After the further severe contraction in the second quarter, real GDP
growth is projected to rebound in the second half of the year, with an average growth rate of -8.7
percent in 2020. Over time, economic activity is expected to grow strongly, by 5.2 percent in
2021 and 3.3 percent in 2022. Overall, real GDP will recover only gradually towards pre-crisis
levels, remaining below the level expected in the March staff macroeconomic projections
throughout the projection horizon. Given the elevated level of uncertainty, the June 2020
projections also include two alternative scenarios, a mild one and a severe one, based on
different assumptions regarding the further progression of the virus and the necessary
containment measures.
Both monetary and fiscal policies play a crucial role in supporting the recovery in the euro area.
Fiscal policies at national and EU level have been crucial in mitigating unemployment risks,
bolstering household income and supporting investment by firms. In order to achieve a
broadbased recovery, national measures must be backed up by forceful action at the European level.
We welcome the new €750 billion EU recovery instrument which consists of €500 billion in
grants and €250 billion in loans to Member States.
The sharp contraction in economic activity is also reflected in the inflation slowdown. Headline
inflation decreased further to 0.1 percent in May, from 0.3 percent in April, mainly on account of
the continued fall in energy prices. Over the coming months, inflation is expected to be close to
zero percent, averaging 0.3 percent in 2020, before slowly recovering to 0.8 percent next year
and reaching 1.3 percent in 2022. The inflation projection is also subject to unprecedented
uncertainty, with a faster recovery in the mild scenario.
Financial markets
Euro area financial markets were set in turmoil as the virus spread throughout Europe: euro area
sovereign bond spreads widened, corporate bond spreads surged and stock prices plummeted.
Financial markets eventually stabilised, notably on the back of a forceful monetary policy
response by the Eurosystem. But the monetary accommodation generated by the decline in
riskfree rates has only slightly eased the tightening in financial conditions caused by the decline in
stock prices and the increase in euro area sovereign and corporate bond yields.
The widening of sovereign bond spreads - on account of the macroeconomic outlook and the
sizeable fiscal policy responses endorsed by national governments - is particularly troubling
from a monetary policy perspective. An effective pass-through of risk-free rates to sovereign
bond yields in all countries is crucial because sovereign bond yields are widely used as
benchmark rates for pricing financial market instruments and bank credit. Evidently, the costs
banks face to raise funding in the money, capital and equity markets have notably increased.
Monetary policy measures
Tightening financial conditions, combined with an outlook for price stability that had significantly
worsened due to the economic fallout of the COVID-19 crisis, prompted the ECB's Governing
Council to take further policy action at its June policy meeting.
We decided that the most effective way to respond would be to increase the size of the
pandemic emergency purchase programme (PEPP). There were two reasons for this. First, the
PEPP can provide a significant degree of additional monetary easing as it directly affects the
benchmark rates used to price financial market instruments and bank credit in all euro area
countries. Accordingly, expanding the overall PEPP envelope by €600 billion will bring us
significantly closer to the pre-COVID-19 inflation path over the medium term. Second, the PEPP
safeguards monetary policy transmission to all asset classes and jurisdictions thanks to the
embedded flexibility in conducting asset purchases.
We also agreed to extend the PEPP until June 2021. The projections for the euro area show that
inflation will start to pick up around this date. Likewise, the other monetary policy measures taken
in response to the pandemic such as the targeted and pandemic emergency longer-term
refinancing operations (TLTRO and PELTRO programmes), will run their course through the
summer of 2021.
Finally, we agreed that reinvestments under the PEPP will take place until at least the end of
2022 and, in any case, the future roll-off of the PEPP portfolio will be managed to avoid
interference with the prevailing monetary stance.
Looking ahead, the Governing Council will keep re-evaluating whether the size, duration and
composition of the PEPP remain appropriate as the economic consequences of the COVID-19
pandemic unfold. We stand ready to adjust all of our instruments, as appropriate, to ensure that
inflation moves towards our aim in a sustained manner.
Financial stability during the pandemic crisis
Turning to the stability of the financial system, two opposing forces are now at play: the impact of
the coronavirus shock - which was amplified by a range of existing vulnerabilities - and the fiscal
and monetary policy response in the euro area. Over the last few years, signs of asset
mispricing as well as lingering private and public sector debt sustainability concerns had been
identified as vulnerabilities to financial stability. In addition, euro area banks' profitability had been
low, due to both structural and cyclical factors, while non-bank financial intermediaries had grown
in size since the great financial crisis, taking on more credit and duration risk.
As the coronavirus shock hit the euro area, we observed flight-to-safety phenomena, a surge in
volatility and a sharp tightening of financial conditions, as in previous crises. In February and early
March 2020, investment funds experienced exceptionally large outflows. Initially, high-yield
corporate funds were at the epicentre of redemptions. But, after a slight delay, redemptions
spread to safe havens, such as money market and sovereign funds, as investors needed cash
to satisfy margin calls. The combination of high redemptions and low liquidity buffers likely
resulted in forced sales of risky and less risky assets alike, in an environment of already impaired
market liquidity, amplifying swings in asset prices.
Despite pre-existing vulnerabilities, the euro area financial system weathered the immediate
stress relatively well, thanks to the regulatory reforms of the past decade and bold policy
responses by monetary, fiscal and prudential authorities. Nevertheless, medium-term
vulnerabilities have increased.
The shape and strength of the recovery are uncertain and this uncertainty will persist for some
time. There are substantial downside risks, in particular if the easing of containment measures
turns out to be premature or their impact on productive capacity is more persistent.
The deteriorating economic conditions may give rise to debt sustainability concerns in the public
and private sector. Corporates, many of which were already highly leveraged before the
coronavirus shock, face a three-pronged challenge of cash-flow strains, higher funding costs and
supply chain disruptions. As regards national governments, the immediate response of allowing
automatic stabilisers to kick in and introducing discretionary support measures was correct in
the midst of a deep recession. In countries with already limited fiscal space, however, the
additional debt may give rise to debt sustainability issues in the future.
The pandemic crisis also poses considerable challenges to the banking sector. Let me first
recall that euro area banks entered the crisis with stronger capital and liquidity positions than they
had at the time of the global financial crisis a decade ago. This enhanced resilience has allowed
banks to weather the initial strain from the crisis and enabled them to keep lending to the
economy in what has essentially been a cash-flow shock for firms and households. Unlike in
2008, this crisis did not originate from the banking sector and banks have an essential role to
play in supporting the economic recovery.
Having said that, the economic downturn triggered by the coronavirus shock, now poses
important challenges to the banking sector. While banks in the euro area are not at the epicentre
of the current crisis, their market valuations were hit hard amid concerns over a further
weakening in their profitability prospects, which were already subdued well before the pandemic
shock hit the economy. This mainly reflects expectations that banks' credit losses are set to
increase, as they will increasingly be confronted with missed payments and a growing number of
corporate defaults over the coming quarters.
As a result, analyst forecasts of bank profitability for 2020 have undergone large downward
revisions in recent months, mainly driven by expectations that banks need to increase their
provisions for future credit losses. In fact, banks' first quarter results already show a
considerable negative impact from the crisis in the form of a sharp deterioration in profitability,
driven by large increases in loan loss provisions in both the euro area and the United States.
Looking beyond cyclical challenges, euro area banks' profitability prospects are further hindered
by ongoing structural problems. Low cost-efficiency and weak income-generation capacity in
some parts of the banking sector, both linked to overcapacity, continue to weigh on banks'
longterm profitability prospects. Recognising the challenges at this juncture, consolidation via
mergers and acquisitions could be one potential avenue for reducing overcapacity in the sector.
Micro- and macroprudential authorities have also acted swiftly and introduced a range of relief
measures to help the banking system maintain the flow of credit. ECB Banking Supervision has
allowed banks to temporarily operate below the level of capital defined by Pillar 2 guidance and
the combined buffer requirement. Banks are now also allowed to meet Pillar 2 requirements with
lower quality capital as a result of the early introduction of an amendment to the Capital
Requirements Regulation. It furthermore enhanced flexibility in accounting rules and the
recognition of non-performing loans. Furthermore, ECB Banking Supervision recommended that
banks limit capital distribution by refraining from paying dividends or buying back shares.
On the macroprudential side, national authorities have either announced a full release of
countercyclical capital buffers or revoked previously announced increases to these buffers.
Authorities have also released or reduced buffer requirements for structural risks and delayed the
implementation of new requirements.
Looking ahead, financial stability concerns will crucially depend on the shape of the economic
recovery. Taken together, these measures should help the euro area banking system to sustain
lending to households and companies while weathering losses. Complementing these prudential
measures, government loan guarantee schemes have the potential to offset at least some of the
losses. The effectiveness of these schemes hinges on their take-up and the ability of borrowers
to access loans quickly.
Let me conclude. The euro area financial system has faced an economic shock of enormous
scale, speed and global breadth in the wake of the coronavirus pandemic. Policy measures have
so far helped prevent a health crisis turning into a systemic financial crisis, but medium-term
risks to financial stability have increased markedly. Main concerns relate to the euro area banking
sector and how it will cope with additional pressure on profitability, as well as the increase in
public debt levels in the medium-term, and how these will be managed amid weaker growth
prospects.