Vítor Constâncio: Euro area - economic outlook and financial
sector challenges
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the 19th Euro
Finance Week: Opening conference, Frankfurt am Main, 14 November 2016.
* * *
It is with pleasure that I take part again in this year's opening conference of the Euro Finance
Week in Frankfurt. One year on, with another round of unconventional monetary policy measures
introduced, the situation has changed for the better but some challenges persist and new risks
have emerged.
World economy faces once again an abnormal degree of uncertainty. The consequences may
not be immediate. The markets' perception that the U.S. is embarking into a new phase of
expansionary budgetary policy has lifted optimism, with visible effect in financial markets last
week. Markets are driven by the insight from the macroeconomic theory that fiscal stimulus, at
this stage of the cycle, can break the liquidity trap that has hampered growth in the advanced
economies.
Consequently, we saw a beginning of a shift from bonds to equities last week. In spite of their
rich valuations in the U.S., equity prices jumped whereas bond valuations worldwide lost close to
1 trillion euros. These movements result from the understanding that fiscal stimulus will increase
growth and inflation down the road, in turn allowing a normalisation of U.S. monetary policy at
higher interest rates. Anticipating this development, markets sold bonds thus leading to an
increase of medium to long-term yields, steepening the yield curve, which is a positive
development for financial institutions' profitability. This expectation was indeed reflected in their
share prices amid the general increase of stock valuations last week.
Many commentators have hasted in concluding that the recent geo-political developments will
have, after all, economic benefits. This may be the case in the short-term but the real negative
effects of heightened uncertainty can come later. We should be cautious in drawing hasty,
positive conclusions from those market developments because they may not necessarily
indicate that the world economy will have an accelerating recovery with higher growth. So far,
those developments point to a U.S. rise in economic growth, but in the context of an "America
first" policy. Three factors may contribute to mitigate or even reverse its international spillovers.
The first is the possibility of rising protectionism - hard or soft - that can substantially reduce the
effect of higher growth into higher U.S. imports. World trade, already quite weak, may continue to
collapse, hurting all open economies dependent on exports.
The second are the negative effects that we are already witnessing in emerging market
economies (EMEs). In fact, significant capital outflows and exchange rate depreciations already
underway can hinder future growth. Protectionist measures directed particularly against large
emerging economies may further decelerate world economic growth and create instability in
foreign exchange markets.
The third factor concerns Europe. In this first wave, Europe apparently benefited from positive
contagion with some increase in equity prices and a steepening of the yield curve, favouring
financial institutions. As concerns equities, the low starting point seems favourable for European
markets. Share price levels are relatively subdued in Europe with, for instance, a Cyclically
Adjusted Price Earnings (CAPE) Shiller index of just 14 against 27 in the U.S. This means that
European shares, including those of banks, are undervalued with respect to other parts of the
world and could thus attract investors. However, we already observed a slight drop in European
share prices last Friday. According to market analysts, this was explained by fears concerning
protectionism and EMEs' growth prospects as well as the possible resulting decline in global
trade.
Besides these external concerns, Europe's internal problems may deter it from fully reaping the
benefits from the expected expansion in the U.S. Indeed, a range of political risks may induce
economic shocks. To face heightened world uncertainty, Europe would need to deepen its unity
and integration, relying more on its domestic market to underpin higher growth. In turn, this
implies that Europe needs more expansionary macroeconomic policies and more reforms in the
regulatory and competition policy fields, in order to improve the economy's supply side. Without
higher real and nominal economic growth, Europe will have greater difficulty in overcoming its
challenges.
Euro area outlook
So far, monetary policy has been the only expansionary macroeconomic policy in support of the
recovery. Yet, securing sustained economic growth and employment cannot be dependent on
monetary policy alone. At the national and European levels, a much more comprehensive policy
response, than has been the case to date, is needed. Mainly, structural reforms and fiscal policy
have yet to deliver their share to support economic activity and counteract the "low growth trap"
dynamics faced by advanced economies at present.
The euro area recovery is continuing its moderate but steady pace, supported by the ECB's
policies. These have significantly improved financial conditions, reduced financial fragmentation
and fostered economic activity and inflation.
In the first half of 2016, the euro area grew at an annualised rate of 1.7%, similar to last year's
growth rate. This figure is far from impressive, especially considering that the euro area is in the
early phase of a recovery, after the second recession in 2012 and 2013. On the other hand, the
unemployment rate, albeit falling, still remains above 10%, amid a continuous increase in the
participation rate in the labour force since the crisis. One positive aspect is that our policies have
contributed to a decrease in financial fragmentation and that the dispersion of GDP growth and
inflation across euro area countries is at the lowest level since the beginning of monetary union in
1999. Another positive note is that the recent growth was largely driven by domestic demand.
Moreover, the recovery has proved resilient to a series of adverse shocks over the past year: the
slowdown in China last summer, the acute stock market turbulence in the early part of this year
and, most recently, the uncertainty created by the U.K. referendum.
This resilience reflects, to a large degree, the amount of monetary expansion - actual and
expected - that is embedded in financial prices. Indeed, with the five packages of measures
adopted since June 2014, we have been able to: reduce the cost of capital, produce rebalancing
effects in broader asset markets, improve credit supply conditions and restore credit volume
growth since the latter part of 2014, after two years of negative developments. In the latest move
in March 2016, a powerful set of measures was taken, comprising an increase in the asset
purchase programme, its extension to corporate bonds and the introduction of a new
mediumterm liquidity facility with interest rates that can go as low as our negative deposit facility rate,
contingent on the banks reaching a credit growth benchmark.
Yields on bank and non-financial bonds have eased in response to the measures taken, testifying
to the effectiveness of the current monetary policy. Funding conditions for banks improved as
wholesale money market rates turned negative and as banks received direct support from new
liquidity facilities with four-year maturities and low rates (TLTRO-I and II). These developments
have stimulated the pass-through of this funding cost relief to borrowing costs for both firms and
households.
As a consequence, bank lending rates to non-financial corporations (NFCs) and households are
now at historical lows, and there has been a significant reduction in the fragmentation of lending
rates across euro area countries both for large and for small loans.
Against this background, in the most recent ECB staff projections, real GDP is forecasted to
grow at an annual rate of 1.7% in 2016 and 1.6% in 2017. Since the projections cut-off date, the
flow of short-term economic indicators has been consistent with the materialisation of this
baseline scenario, and point to a continued positive contribution from domestic demand
(alongside a negative contribution from net trade). According to Eurostat's flash estimate, real
GDP increased by 0.3% in the third quarter with respect to the second quarter, (as was the case
in the previous quarter). This has been accompanied by increases in the flash composite output
PMI in October, with respect to September, as well as a rise in consumer confidence. Crucially,
the projection is predicated on the current supportive financial conditions persisting. In fact, it is
estimated that, cumulatively, the impact of our measures will contribute more than one and a half
percentage points to real GDP growth between 2015 and 2018.
Regarding inflation, the latest ECB staff projections foresee a rise to 1.2% in 2017 and 1.6% in
2018. The contribution of our measures to this increase in inflation, to levels closer to our
objective, represents on average, an impact on the inflation rate of about half a percentage point
each year between 2016 and 2018. Likewise, short-term indicators are consistent with the
projections. The October flash estimate annual HICP inflation stood at 0.5% from 0.4% in
September. However, annual inflation for HICP excluding food and energy remained unchanged
(at 0.8%). This is a cause of concern since core inflation, depending on domestic factors, is not
recovering which may affect the dynamics of headline inflation going forward, affecting our
monetary policy. A more satisfactory evolution of wages is needed, now that inflation and
productivity are increasing. Wages are a crucial driver of prices in a service-dominated
economy. In countries with large external surpluses, wage-dynamics should finally start showing
more favourable developments.
Overall, assuming that the potential negative effects of the present worldwide uncertainty will not
manifest themselves in the short term, I am confident that the euro area economic recovery will
continue its path and that unemployment will come down to single digits next year, for the first
time in many years. Inflation will also continue to normalise and we will see headline inflation well
above 1% as from next spring.
However, considerable risks and uncertainties to financial stability remain. The main risk is
related to my initial considerations specifically, to a possible worldwide reversal of risk premia
that could induce contagion and affect asset prices. We have just started to see this in the bond
market and this is exacerbated by the present heightened political uncertainty in advanced
economies.
A second risk regards the challenges to European banks' profitability resulting from cyclical and
structural factors. European banks have steadily increased their robustness and resilience since
the financial crisis. Solvency positions of euro area banks, measured by the highest quality
capital (Common Equity Tier 1 ratio) increased, on average, from 7% in 2008 to 9% in 2012 and
14.4% in June this year.
The present low profitability levels have, however, put bank stock prices under severe market
pressure, leading to price-to-book ratios well below 1. Different causes stand behind banks'
profitability challenges: legacy non-performing loans, excess banking capacity, growing
competition from non-banks, ineffective cost-control and slow adjustment to new business
models in the context of a low interest rate environment, are among the most important ones.
Return on equity stood at 5% in the first half of 2016, against 5.5% for the whole of last year,
which is worryingly well below the cost of equity resulting from share prices determined by
investor's expectations.
As already mentioned, monetary policy responses are supporting and accelerating the economic
recovery and the normalisation of inflation and interest rates. Since March this year, the interest
rate on main refinancing operation is at 0% and the interest rate on the deposit facility has been
further lowered to -0.40%. The impact of low rates on bank profitability might not be negligible.
The overall impact is however so far positive, even if heterogeneous. Monetary policy has had a
positive effect on bank profitability since 2014 by reducing funding costs, generating capital gains
on higher prices of financial assets affected by the asset purchase programme, reducing bank
impairment costs and increasing credit volumes as a result of a strengthening recovery. The
impact on net interest margins depends on banks' capacity to re-price deposits and loans and on
the predominance of floating and fixed rate loans in banks' balance sheets.
The ECB is aware that some of the positive effects of our policy on banks' profitability will wane
with time. However, low or negative interest rates cannot be blamed for low profitability per se.
With lower interest rates, (-0.50% and -1.25% for the repo rate and deposit rate, respectively)
which have been in negative territory almost for two years now, Swedish banks, for example,
have been able to sustain ROE levels of close to 12%. There are several explanations for this
difference but a sizeable contribution comes from cost control stemming from adjusted business
models. In fact, cost per banks total asset is at 0.92 for Swedish banks against 1.42 for the euro
area, on average. This clearly shows that European banks have to adjust their business models
to improve their profitability prospects.
However, to face bank profitability challenges, the euro area needs to develop and implement a
joint strategy, over a determined period of time, to overcome excessive non-performing loans
and/or excessive banking capacity in some jurisdictions. We need a stronger banking sector
which is essential to better transmit monetary policy impulses and support the economic
recovery.
In this, as in other domains, Europe must endeavour to work together to face a more challenging
world that threatens European values of open and tolerant societies.
Thank you for your attention.