Benoît Coeuré: Credit and investment in the European recovery
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the IMF/Bank of Slovenia high-level seminar on "Reinvigorating Credit Growth in Central,
Eastern and Southern European Economies", Portoroz, 26 September 2014.
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Summary
To revive the euro area economy recapitalisation not only in the banking sector but also a
repairing of private sector balance sheets is needed. The banking sector is undergoing a
necessary process of structural reforms. With concluding the Comprehensive assessment
there is potential to ensure that credit supply constraints diminish and the cycle turns.
For a stronger rebound in investment the private non-financial sector needs to raise equity.
One instrument especially for smaller and medium size enterprises is to allow EU investment
funds to be distributed in the form of equity and not only in the form of debt, as the European
Bank for Reconstruction and development (EBRD) and the International Finance Corporation
(IFC) already do in many countries. Also the fragmentation in venture capital markets should
be reduced.
For smaller firms with the need of deleveraging debt-for-equity-swaps, possibly fostered by
tax incentives, could facilitate private debt workouts.
What is also needed is to raise productivity. An "upward shock" to total factor productivity is
needed but only possible in highly competitive markets.
***
Introduction
Across Europe credit growth is weak. In most central and eastern European countries credit
credit to the
is either stagnant or growing at low rates. In many countries of the euro area1
private sector is even in negative territory. The reasons for this are several, but at the heart is
a vicious circle of low growth, low investment and low credit. And the challenge facing
policymakers today is how to break it.
The current policy debate is largely focused on the credit dimension. And indeed, there is
evidence that creditless recoveries, while not as rare as sometimes contemplated, are much
less common in high income, financially developed economies than in low income countries.2
As European economies heavily depend on bank loans, it stands to reason that the recent
weak credit performance of Europe is contributing low economic growth rates.
It is nevertheless important that reinvigorating credit growth is not seen as an end in itself.
Research based on international evidence suggests that a fast-growing banking sector can
be detrimental to aggregate productivity growth.3 And we have seen in the euro area that
credit growth that leads to the wrong type of investment creates financial imbalances
eventually leading to crises, while doing little to support long-term economic performance.
Indeed, the 1999-2007 period saw a positive correlation between the initial level of GDP per
capita and average total factor productivity (TFP) growth rates: the highest TFP growth rates
were found in Germany, Austria, Netherlands and Finland, while in the "catching-up"
economies (Spain, Greece, Portugal, Ireland) TFP actually declined. An important
explanation for this is that capital in the latter economies flowed disproportionately into the
non-tradable/services sector, which in general has lower productivity growth. Investment was
highest in the construction and real estate sectors, closely followed by retail, transport and
leisure.4
This experience shows us that the quality of credit matters as much as the quantity, and it
implies that policymakers should focus on a broader question than just reviving credit -
namely, "how can we channel savings towards productive investment?". This focus on
investment is warranted because, in the short run, it is key to boosting demand and creating
a self-sustaining recovery. And over the longer run, ensuring that investment is efficiently
allocated helps create a virtuous circle between productivity and credit, thus avoiding
mistakes of the past.
Achieving this requires a policy agenda that encompasses both credit supply and demand
factors. It requires that we unclog and diversify the channels of financial intermediation in the
euro area; that we recapitalise the economy through both reducing debt and raising equity;
and that we have a policy mix that makes borrowing to invest worthwhile.
In other words, it requires a comprehensive approach. And what I would like to do this
afternoon is sketch out for you what such a comprehensive approach could look like, drawing
on the lessons learnt from the crisis and the post-crisis adjustment.
Fixing the credit channel
The starting point is logically the financial sector, and here we are confronting a changing
landscape: the European banking sector is undergoing a necessary and largely unavoidable
process of structural change. Banks are adopting less risky business models, moving to
more deposit-based funding strategies and strengthening their equity capital. As a result,
there is a clear trend towards an overall smaller and less leveraged banking industry.
While there are several benefits to this process5, it also presents an important question,
which is how we can have more credit for productive firms, but less leveraged banks.
The medium-term solution is for both banks and capital markets to adapt to the new
environment. For banks this means refocusing their business models and taking advantage
information technology developments to improve risk management and lower operating
costs. We will always need strong banks in the euro area, as they play an essential role in
situations where information cannot be standardised or where state verification is costly, for
example lending to small- and medium-sized enterprises (SMEs).6
The main challenge in capital markets is to expand market access for firms across the euro
area. This is to some extent already happening organically, as firms that can issue diversify
their funding sources, but it is uneven: bond issuance is strongly concentrated in countries
and among firms where bank lending constraints are lowest. As the ECB has argued on
several occasions7, this is one reason why we need to urgently focus on creating the legal
and regulatory framework for a genuine single market in capital in Europe.
Essentially, what we are aiming for is a more balanced financing mix where firms have a
greater ability to substitute bank and market finance, and hence intermediation becomes
more contestable and resilient. I would however emphasise that balance is key; we should
not view market finance as a cure-all. Indeed, there is some research to suggest that too
much substitution towards market finance may lead to less total borrowing, as firms that
replace bank loans with bond issuance internalise the fact that this type of borrowing will be
harder to restructure in bad times.8 Besides, Europe does not have a set of institutions
consistent with a fully market-based allocation of savings, such as funded pension schemes.
In any event, a more diversified financing mix is realistically a project for tomorrow. We are
now seeing signs that credit demand is picking up, making it imperative that nascent demand
is not choked off by credit supply constraints. Our focus today therefore has to be on bank
finance, namely ensuring that it can continue to fund the real economy even as banks
downsize and restructure. And this is where two current policy initiatives come in.
The first is the comprehensive assessment of bank balance sheets, which has the potential
to ensure that supply constraints diminish as the cycle turns this year. One purpose of the
assessment is to steer the deleveraging process towards a "good" form - i.e. banks quickly
carving out non-performing assets and raising equity - which international experience
suggests leads to a faster rebound in credit to viable firms. Indeed, empirical research
suggests that the oft-heard view that higher bank capital leads to lower loan supply is not
accurate. Long-run evidence for Germany, for example, finds that higher bank capital tends
to be associated with higher business loan volume, with no evidence of a negative effect.9
While the exercise will only conclude next month, we can already see signs that it has
affected both the speed and quality of deleveraging. Whereas from 2011 to 2012 asset
deleveraging accounted for only 0.1 percentage point of 1.3 percent increase in banks' Core
Tier 1 ratios, from 2012 to 2013 (i.e. after the assessment was launched) it accounted for
1.0 percentage point of the overall increase of 1.2 percent. Capital increases accounted for
about half the increase over the 2 years.10 This acceleration of the process suggests that,
once the final results are known and residual uncertainty is removed, banks will be in a
stronger position to resume new lending.
The second on-going initiative is the full rollout of the ECB's credit easing package, which
aims to encourage banks to use their new balance sheet space for lending to the real
economy.
The Targeted Long-Term Refinancing Operations (TLTRO) have a built-in incentive
mechanism to encourage loans to firms and households, and we expect a stronger take up
from banks in the December operation and in the six subsequent instalments until June
2016. And our programmes to purchase outright high quality asset-backed securities (ABS)
and covered bonds complement this by providing market incentives for banks to originate
more saleable securities, and thus more loans to collateralise them.
In short, the combination of these two initiatives results in a confluence of factors - improved
incentives and higher capital - that should allow loan supply to expand elastically to meet
loan demand. And to the extent that credit supply and demand are endogenous, for instance
through the effect of supply constraints on macroeconomic risk, we could see the beginnings
of a self-sustaining credit recovery.
I would nonetheless question whether a credit recovery is enough to achieve an investment
recovery, and hence a sustained recovery for the economy. If we look at the breakdown of
credit demand components in the survey data, fixed investment is only having a mildly
positive effect on demand after 11 quarters of negative effects.11 And this demand may well
be "backward-looking" - that is, delayed projects coming back online. From a
"forwardlooking" perspective, there are reasons to cautious about the degree of pent-up investment
demand.
Principal among these is that, while banks might have deleveraged, not all of their customers
have. In several euro area countries firms still face a debt overhang that affects the
economics of taking on new credit.
Real interest rates in the euro area are expected to decrease, as nominal interest rates will
remain low for a long period while inflation is expected to gradually rise back towards 2%.
But the issue for over-indebted firms is that long-term real interest rates probably cannot go
low enough to make new investment attractive: any profits generated will be absorbed by
servicing existing debt. Indeed, we see a clear negative correlation - with a coefficient of -
0.48 - between corporate debt-to-GDP levels in different countries at the beginning of the
crisis and the evolution of non-residential investment since.
Repairing private sector balance sheets
If we want to see a stronger rebound in investment across the euro area, the next step
therefore has to be repairing non-financial private sector balance sheets. And as this process
will take place against the backdrop of low inflation and, in the most affected countries,
limited fiscal space, it will have to involve reductions in nominal debt.
The rebooting of the financial sector that has already taken place puts us in a better position
to achieve this. When the comprehensive assessment concludes, banks will acknowledge
losses and raise provisions and capital - after the disclosure of the results, capital shortfalls
are expected to be covered within six months for the Asset Quality Review or the baseline
stress test scenario, and within nine months for the adverse stress test scenario. Thus, from
the bank side, restructuring loans to distressed borrowers should become more feasible.
What we need going forward is more efficient debt restructuring and insolvency regimes for
firms, which at present vary widely between euro area countries. The effectiveness of the
restructuring regimes is often hampered by sluggish creditor coordination, a lack of new
financing for viable companies undergoing restructuring and an overburdened judicial
system. For example, according to the World Bank, to resolve insolvency in Italy takes
1.8 years, compared with just 0.4 years in Ireland.
A number of stressed countries have already begun to take initiatives to improve
restructuring and insolvency proceedings. In Greece, for example, facilitating debt workouts
for viable companies is being made simpler by two new out-of-court debt restructuring tools:
one for larger enterprises that includes a multi-creditor coordination mechanism inspired by
international standards; and one for SMEs that employs standardised templates.
In Spain, the substantial amendment to the Insolvency Law earlier this year, among other
things, makes facilitating out-of-court settlements easier while also making in-court
settlements more effective. Court approved refinancing agreements now have lower majority
requirements and permit the extension of maturities on bank loans, negotiating haircuts and
arranging debt-for-equity swaps. Ireland and Portugal have also introduced various
measures targeted at enterprises, SMEs and households.
In most cases, however, restructuring and insolvency regimes could be made more efficient
still by adopting best practice more broadly. This would include, inter alia, strengthening
measures to facilitate out-of-court settlements for viable firms; introducing centralised
guidelines for voluntary debt workouts coupled with independent intermediation for larger
companies; and establishing standardised voluntary workouts for SMEs.
The deleveraging of European firms is however not only about reducing debt; it is first and
foremost about raising equity. We have in fact already seen a significant decline in
debt-toequity ratios for larger euro area corporates since end-2009 due to valuation gains in equity
markets, supported by low interest rates.12 To the extent that our new monetary policy
measures affect the relative supply of financial assets and initiate further portfolio
rebalancing, we may see further spillovers to equity markets that continue this trend.
For smaller firms, however, these channels are less powerful as equity markets are largely
underdeveloped. Raising equity therefore has to be more proactive process.
One way to achieve this is to use debt-for-equity swaps (fostered possibly through tax
incentives) to facilitate private debt workouts. Another is for EU investment funds to be
distributed in the form of equity as well as debt, as the European Bank for Reconstruction
and development (EBRD) and International Finance Corporation (IFC) already do in many
countries, and as I called for in a recent article.13 A third, more medium-term aim is reduce
fragmentation in European venture capital markets to increase the depth of private equity
markets.
This last point is another example of where advancing towards a single market in capital
would be beneficial for the euro area - it would not only help strengthen capital markets
relative to banks, but also help strengthen equity funding relative to debt. This would also
have positive structural effects for the euro area: cross-country integration through equity
improves risk-sharing and, as it is harder for investors to "cut and run", would most likely
provide more resilience in a crisis than integration through interbank lending and fixed
income investment. New research shows that the vulnerability of the euro area to a "sudden
stop" worsened the crisis by further constraining the fiscal reaction of governments during the
downturn.14
While such options to increase equity funding are being developed, a strategy that can
improve debt dynamics for all firms' is to raise "implied equity" - the outlook for future
income. If firms expect higher income, it improves their debt-to-income ratios and debt
service capacity, which in turn creates space for new investment.15 In this sense, raising both
the level and trend of potential growth is an integral part of recapitalising European firms, and
indeed of the economy as whole.
We face however a circular problem in the euro area: we need higher potential growth to
work through the debt overhang so that firms can being investing again; but that investment
is itself necessary to raise potential growth. And this circle is potentially vicious: if low
potential growth leads to lower investment, then it further lowers potential growth.
A policy mix to lift investment demand
This is where the next part of a comprehensive approach comes in: getting the policy mix
right on the supply side of the economy to lift investment demand.
In a basic Solow growth model, investment grows at the growth rate of productivity plus the
growth rate of hours worked along the steady state path of the economy. As we can only
expect limited labour participation gains in an ageing society, to raise investment demand we
therefore have to raise productivity. Indeed, achieving an upward shock to TFP seems to me
essential to trigger, in a sustainable way, a positive accelerator effect between productivity,
investment and credit.
But it requires an environment characterised by two things: competition and certainty.
Competitive markets are necessary to ensure that investment and productivity are indeed
mutually enhancing, which as I said earlier is not a given: high investment in several euro
area countries in the pre-crisis period did not lead to a convergence in TFP. Certainly, an
important reason for this was that too much capital flowed into real estate. But misallocation
also resulted from low levels of competition in the non-tradable/services sector more
generally which distorted price signals. As some firms could capture excess rents, a falling
marginal product of capital was counterbalanced by rising profit margins, meaning that total
compensation from investing in these sectors remained high.16
So: the flipside of productive investment is more competitive markets that produce more
accurate price signals, thus drawing resources to where they are most efficiently employed.
Achieving this requires not only product and labour market reforms that accelerate the
"churn" process within and across sectors17, but also reducing unnecessary regulations that
hinder the allocation and reallocation of resources.
The World Bank's "Doing Business" report gives examples such obstacles. If an
entrepreneur wants to start a new business in Spain, she has to go through 10 separate
procedures, while doing so in Slovenia requires only two. If a firm wants to launch a green
field investment, it would have to wait 200 calendar days in Ireland before a new warehouse
gets electricity; in Germany it would have to wait only 17 days.18
There are reasons to be optimistic about the effects of a reform process in the euro area.
Recent micro-level research from the Eurosystem's Competitiveness Network, for instance,
shows that there is a large and skewed distribution between the most and least productive
firms in individual euro area countries. Far from being normally distributed, there are a few
highly productive firms and many which have low productivity.19 This implies that a faster and
more efficient reallocation across firms and sectors could be quite powerful.
Where certainty complements this process is by fixing expectations: the more firms trust that
structural reforms will be followed through vigorously, the more they will be inclined to invest
on that basis. Put differently, certainty allows the positive medium-term effects of structural
reforms to be brought forward into the present. The fact that euro area corporates are
currently holding record amounts of cash, rather than investing, suggests that plans for
structural reforms are not yet credible enough to reap this "certainty dividend".
Certainty also extends to tax policy. Remember that what matters for firms when deciding
whether to invest is the after-tax return on investment. Thus, if firms expect the burden of
future taxation to rise, the internal rate of return on a given project is lowered, effectively
cancelling out the stimulative effect of lower interest rates on investment. And by contrast, a
lower expected tax burden increases the effectiveness of any monetary policy measures.
But certainty means also that we stick to our commitments. Indeed, sticking to our own
commitments has to become the hallmark of the euro area. The ECB will continue to provide
a nominal anchor to the euro area recovery by delivering its primary mandate to bring
inflation back to a growth rate of below but close to 2%. It is essential that in parallel all
countries follow the rules outlined in the Stability and Growth Pact (SGP) and in the
Macroeconomic Imbalances Procedure (MIP) and that these rules are not stretched to the
point where they would lose credibility.
Conclusion
My main message today is simple: we need to focus on the quality of credit, not only the
quantity.
To create an environment where credit flows to productive investment requires a coherent
and comprehensive approach. It requires managing the bank deleveraging process while the
euro area transitions to a more balanced financing mix. It requires finding workable solutions
to reduce the debt overhang involving both reducing debt and raising equity. And it requires
acting on the basic determinants of investment demand, namely productivity.
Fortunately, all the pieces of the jigsaw are now in place to achieve such an approach. Banks
are approaching the end of their deleveraging. This is creating a better capitalised sector that
can facilitate restructuring. And we have an emerging consensus on the importance of supply
sides policies to boost growth potential. We now simply need to put those pieces together.