The signing of the Maastricht Treaty in 1992 was the catalyst for a revolutionary economic principle that sought to enhance economic integration between European nations and led to the creation of a single currency and a unified monetary approach. In its essence, the euro currency symbolised the prospects of economic success for European economies.
A set of convergence criteria remain a prerequisite to accede to the euro area. The scope for such criteria focus on ensuring that the common currency is formed by economies that are stable, reliable and founded by strong economic pillars.
More than two decades on, the monetary policy underpinning the single currency is still a deeply debated topic that has had its fair share of controversy over the years.
The role of the European Central Bank is to manage the euro, keep prices stable and conduct monetary policy that ensures a degree of synchronisation for the European financial system. Intuitively, narrating the decade-long monetary events will in itself be conducive to side-lining the crux of the problem.
The euro area monetary approach in the last couple of years has confounded and bewildered monetarists. Conventionally, monetarists believe that the level of money supply determines economic performance. This belief was discredited over the years as the unprecedented non-standard monetary tool, called ‘quantitative easing’, as well as the ever-lower interest rates did not yield desired results. In that, European growth remained sub-par with little to no inflation in the euro area.
Crucially, during November 2019, the European Central Bank went through a change in president as Mario Draghi’s tenure came to an end. New blood at the helm meant new ideas and approach. The new ECB president, Christine Lagarde, immediately took an active role in decomposing the reasons why the ECB’s monetary policy was ineffective over the last few years by initiating a strategic review.
Let’s not forget that her predecessor, Mario Draghi, has built his legacy on a keynote speech where he said “we’ll do whatever it takes” which became a catchphrase from then onwards. Effectively, Draghi saved the euro area from a calamity that would have put into question the existence of the euro currency in itself back in 2012.
Despite the saviour status on the euro area’s darkest days, the same could not be said for the brightest days. As the euro area emerged from the 2012 debacle, the following years were still underpinned by sluggish growth and frail economic pillars.
Ever since 2012, the ECB took an active role to boost economies with little success, especially in relation to top European countries like Germany, France, Italy and Spain. Even the most hardened monetarists will admit that a different approach may be required to address most of the challenges faced by the euro area.
There are two key aspects towards the current monetary policy. One of them is the negative deposit facility at the ECB and the second one is the ballooning asset purchase programme. The world of finance has been built upon the context of requiring a return on the capital invested. This dates back hundreds of years and has shaped the industry to contribute actively for today’s world economic environment. Finance remains the pivot to all past and future investment.
For the euro area to grow, it needs its financial system to function appropriately, profitably and with a degree of confidence
Ever since introducing negative rates, finance professionals and the public found it difficult to comprehend that lending money will yield a negative return at the outset and not a positive one. Conceptually, this new way of thinking by monetary policymakers at the ECB sent shockwaves to the financial system as it signalled that unprecedented times call for unprecedented measures.
This measure in itself is defeatist, extreme and disjointed for the whole financial system. For the euro area to grow, it needs its financial system to function appropriately, profitably and with a degree of confidence that lifts up overall business investment.
Undoubtedly, the underperforming European banks vis-a-vie US counterparts to a certain extent symbolises, in part, a reason for Europe’s economic underperformance. There would have been no Silicon Valley in the US if there were not financiers funding most of the projects that contributed to the US’s supremacy in the tech industry.
The flat yield curves in the euro area region left banks with squeezed net interest rate margins, dampening a once thriving industry. The resultant effect of the financial crisis also gave rise to a new wave of regulation, which is something that the European Commission holds dearly. This contributed to a more prudent banking environment but the associated costs further crippled the industry.
In recognition of this fact, the ECB sought to address this policy weakness by introducing a two- tiered system whereby banks will be exempt from the deposit facility rate by a multiple of six as ‘allowance’ over and above the minimum reserve requirements. The remuneration rate for this ‘allowance’ is set at zero per cent.
While the concept of a unified monetary approach for the euro area is both politically and philosophically coherent, the same could not be said for the financial world. Interest rate decisions by the European Central Bank need to discern between economies that are having above-par economic performance. The data used by the ECB is mostly influenced by the largest euro area nations, given their GDP weighting upon any decision. Economic principles dictate that as economic growth improves, interest rates need to reflect this economic upturn.
This will enable the economy to curtail on potential asset bubbles and the economy to overheat.
In its essence, the same euro area entry convergence criteria should act as levers to adjust monetary policy for each separate nation. This means that national central banks will regain impetus to self-determine (through a systematic rule-based formula) an optimal level of interest rates duly endorsed by the ECB. This will provide for a quasi-bespoke monetary policy for every euro area economy.
The resultant effect will be that yields across Europe will reflect better endogenous factors which are specific to every European economy.
Europe is not all dull, as there are economies achieving surprisingly good results. However, data is inherently skewed due to the domination of larger economies, namely Germany, France and Italy. Current eurozone growth is at 1.20 per cent, however, most eurozone economies exceed that level which may justify higher interest rates on a per-country basis. Domestically, we can look at Malta’s superlative economic growth in recent years which was accompanied by ultra-low interest rates.
Malta’s growth came through significant foreign direct investment which had knock-on effects on population growth and property price growth rather than internal-driven demand which contained headline inflation.
The timing is ripe to lift the eurozone economies
Nonetheless, there is a case for higher interest rates in order to contain any pricing pressures, as observed in local dwelling prices. The current superfluous interest rate environment directed by the ECB has created an environment in which yields are at abysmally low levels, leaving lenders in both private and public markets scraping the bottom.
These unprecedented times have led yields to their current state in which an investor who lends to the Greek government s/he will get c. 1.14 per cent per annum for the next 10 years, Italy at 0.97 per cent for the next 10 years and the ‘stronger’ economy Germany at -0.20 per cent for 10 years.
It is this state of interest rate ‘repression’ that has made European investors and depositors spiral into a vicious cycle with downbeat economic prospects. This also led to potential credit quality mispricing in lower graded debt which the eurozone will have to address in the future once economic data normalises.
The ineffectiveness of the asset-purchase programme has been well documented over the years. Following the strategic review, tweaks are to be expected. The extent of these tweaks is dependent on how bold the ECB wants to set its forward-looking agenda.
Effectively, the asset purchase programme has manipulated fixed income prices, yields and credit spreads through the unconditional continuous purchase of fixed income assets.
This distorted yields with mountainous evidence that it is underpricing credit risk on various asset prices. The targeted longer-term refinancing operations has helped the banking industry to fund loans.
However, the low-yielding environment and tight-maturity spreads have made the banking industry vulnerable to prolonged low profitability that indirectly inhibited their capital ratios. Industry consolidation may be opportune for 2020 in order to unlock synergies and address the slack in cost to income ratios at a European level.
Notwithstanding that the ECB has to continue pressuring countries for structural and fiscal reform, the central bank needs to, at the very least, self-examine its own monetary framework and act swiftly to contribute meaningfully for eurozone growth.
In conclusion, the European Central Bank is at a critical juncture where the strategic review is an opportunity to address any policy shortcomings. The importance of this review cannot be understated as the timing is ripe to lift eurozone economies in a period were the global economy may be plateauing.
As things stand, the ECB does not have enough monetary headroom to stimulate economies should unforeseen headwinds hit developed economies. As a result, it is imperative that the ECB provides for an effective policy change that will drive up confidence and reinvigorate the euro area for it to thrive in ways that it was intended to.
Jesmar Halliday is an investment manager at Calamatta Cuschieri. For more information, visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.