The European Central Bank (ECB) is so intent in breaking inflation, that it risks an economic overkill.
Philip R. Lane, Member of the ECB’s Executive Board has disclosed that the central bank will continue with steep interest rate rises in coming months. This follows a 75 basis point increase to 2.25 per cent on its refinancing operations and 2 per cent on the marginal lending facility at the beginning of November.
“European economic activity is expected to slow substantially over the coming quarters due to four interconnected factors,” Lane believes. “First, high inflation is dampening spending and production throughout the economy, and these headwinds are reinforced by gas supply disruptions. Second, the strong rebound in demand for services that came with the reopening of the economy after Covid, will lose steam. Third, the weakening in global demand, tighter monetary policy and worsening terms of trade will mean less support for the euro area economy. Fourth, uncertainty remains high and confidence is falling sharply.”
Despite that gloomy outlook there will be another ECB rate hike in December, he said. The extent and expected further rises in 2023 will depend on inflation. (Eurozone inflation rose to 9.9 per cent in September, reflecting further increases in all components, but energy price rises of 40.7 per cent , remained the main driver.)
Lane cautioned that due to inflation and tighter monetary policy, average eurozone long term rates i.e. the ten year sovereign bond yield had already risen to 2.9 per cent with Italy at 3.9 per cent, France 2.4 per cent and Germany 2 per cent.
The euro has been in a downtrend against the US dollar since the financial crisis of 2008. It was over 1.60 at its peak in 2008, then consistent declines and rallies until it fell to 97 cents in November 2022.
The main reason is that the Eurozone has under performed the US economy consistently. Also interest rates of Germany were cut below zero.
More recently the currency has rallied from an oversold position of under 1 against the US dollar. But it has outperformed the yen which has been weaker because the Bank of Japan has not raised interest rates.
The ECB continues with rate rises even though its own November financial stability review warns that Europe is already in the throes of a credit crunch.
Borrowing surged during the period of almost zero and even negative interest rates, according to the Bank for International Settlements. So much so that total credit of the eurozone’s “non financial sector” (governments, non-bank corporations and households) rose from 262 per cent of gross domestic product in 2017 to 273 percent of GDP in the first quarter of 2022. Borrowing of a once prudent Germany jumped from 187 per cent to 199 per cent in the same period, Italy from 259 per cent to 276 per cent and France from 311 per cent to 353 per cent.
At these borrowing levels the higher interest rates are already beginning to hurt. The ECB warns in the stability review that highly indebted nations such as France, Italy, Spain, Portugal and Greece are vulnerable as they will be rolling over their debt at much higher rates. Moreover, numerous European corporations have issued bonds that will need to be repaid in the next few years. Depending on the strength of the company and their leverage i.e. extent of borrowing, yields on these bonds are 0.5 to 1.5 per cent higher than sovereign debt. The ECB adds that a proportion of companies issued debt in US dollars . The greenback has appreciated by 17 per cent against the euro in the past five years, so interest and debt repayments of these borrowers will be a lot higher.
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It is thus curious that European stock indices have in the past month rallied to their highest levels in three months, albeit still below their 2021 peaks. Especially since the ECB has found that banks have tightened their loan approval criteria. “The funding costs of euro area banks have increased further,” cautions the ECB. “Yields on bank bonds have reached their highest level since 2012.”
At the end of October, Italian bank bond yields were just under 6 per cent, Spain, 4.8 per cent, Euro German and French, 4.4 per cent and the eurozone average, 4.5 per cent, the ECB says
The ECB is reducing its €2.1 trillion (S$3 trillion) programme of cheap loans known as “Targeted longer-term refinancing operations or TLTROs” to eurozone banks. These loans have subsidised stressed Italian and Spanish lenders. Ironically, they will now lose ECB support at a time when they have been hit by losses from on their bond investments.
The result is that their clients are beginning to suffer. According to the ECB, the percentage of banks reporting a tightening of credit rose to 19 per cent in the third quarter of 2022, up from 16 per cent in the second quarter of 2022 and 14 per cent in the same period of 2020. Small and medium-sized enterprises are being squeezed the most.
Consumers are also under pressure as overdraft and mortgage rates have jumped and house and apartment prices are sliding.
Fabio Panetta, another member of the ECB Executive Board warned that the central bank should be wary of the dangers of excessive tightening which could cause a steep recession.
Ignazio Visco, governor of the Bank of Italy is also concerned that the ECB policy could lead to a “serious credit crunch”
Ludovico Sapio, economist of Barclays Investment Bank fears that the tightening in financing conditions corroborates the bank’s view that the euro area is headed towards a sharp recession regardless of the Ukraine war.
© copyright Neil Behrmann.(https://neilbehrmann.net) This article was first published in The Business Times Singapore . For other Asian and global articles try https://subscribe.sph.com.sg/publications-bt/