The sovereign debt crisis in the euro area - Where do we stand?

28 Apr 2014

Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank

1. Introduction

Ladies and gentlemen,

thank you for inviting me to speak at the Czech National Bank. It is a pleasure to be here today.

Almost to the day four years ago, in May 2010, Greece sought financial assistance from other European countries, thereby triggering the sovereign debt crisis in the euro area. Since then, public attention has been focused on the euro area and on the crisis.

However, in my view this might lead to a somewhat skewed perception. Europe stretches far beyond the borders of the euro area. The European Union reaches from Finland to Malta and from Romania to Portugal. It comprises 28 countries and is home to more than 500 million people.

And as such, the EU has been a huge success – economically and politically. It has set in train a process of convergence on a giant scale, thereby raising the standard of living all over Europe. The gains have been so great that the World Bank has dubbed Europe the “lifestyle superpower”.

The Czech Republic is an excellent example of this convergence process. In its ten years of EU membership, it has undergone a remarkable economic development. All this we should not forget while attention is focused on the euro area.

But it is certainly true that the euro area forms the core of Europe. Whatever happens in the euro area will impact on the rest of the EU – and the rest of the world, for that matter. Against this backdrop, it is understandable that developments in the euro area are closely monitored elsewhere. And I am certain that the Czech Republic is no exception, as it is closely linked to the euro area through trade and investment.

2. The end of the crisis is getting closer

And today, I have good news for you. The end of the crisis in the euro area is getting closer – slowly but steadily. Most importantly, the euro area as a whole has finally left recession. By now, we have seen three consecutive quarters of positive growth, and looking ahead, the outlook for this year and next year is also quite encouraging. Projections by the ECB suggest that euro-area GDP will grow by just over 1% in 2014 and by 1½% in 2015.

And this recovery is not only driven by the “core euro-area” countries such as Germany. Some of the crisis-hit countries have also finally embarked on the path to recovery. It seems that the efforts to implement structural reforms are gradually bearing fruit.

Competitiveness has improved in most peripheral countries. Improving competitiveness in turn drives exports higher. All peripheral countries – except Cyprus – are projected to see some export growth this year. These achievements are reflected in current accounts increasingly reverting to positive balances.

The progress that these abstract figures reflect is also visible in more concrete events. For example, Ireland and Spain have exited their financial support programmes without any friction. And Portugal is planning to leave its adjustment programme in the first half of this year. All three countries recently returned to the sovereign bond markets at relatively low yields.

At the same time, stock markets in these economies have been rising for some time now. These developments underscore the progress that some peripheral euro-area countries have made in adjusting their economies.

However, due to different starting points some countries are naturally more advanced in their adjustment process than others. Especially in Greece further efforts are necessary to manage the turnaround. Against this backdrop, it is a positive sign that the country has recently made a successful return to the bond markets. At the beginning of this month, Greece raised €3 billion with a five-year bond that was oversubscribed nearly eight-fold, and had to offer less than 5% interest.

Nevertheless, there are certainly concerns that this success might tempt policy makers to become complacent – not only in Greece but in all the crisis-countries. This must not be allowed to happen.

3. The role of monetary policy

Now, what is the role of monetary policy in this regard? Monetary policy certainly helped to prevent the crisis from escalating. Still, there is one thing we should be clear about: monetary policy cannot solve the underlying causes of the crisis.

Nevertheless, some observers propose an even more expansionary monetary policy. They are worried about the risk of deflation in the euro area. It is certainly true that current inflation rates are rather low. In March, they dropped again to reach a surprisingly low level. Nevertheless, we do not conduct monetary policy by consulting the rear-view mirror but by looking ahead. And looking ahead, the risk of deflation seems to be limited. And on this issue, the Bundesbank and the ECB agree.

The argument rests on three pillars:

  • First, around two-thirds of the drop in inflation is due to falling prices for energy and food. These are exogenous factors and their effects are likely to be temporary.
  • Second, low inflation rates in the euro area are partly the result of necessary adjustments in the crisis-hit countries. These should also be one-off effects.
  • Third, there are no signs of a self-enforcing downward spiral of prices and wages. Long-term inflation expectations are firmly anchored at a level that is in line with the ECB’s definition of price stability. Private households do not seem to be postponing expenditure in expectation of a further drop in prices. There are no indications of a substantial increase in the savings rate.

Thus, while the euro area is certainly in a period of very low inflation, the risk of deflation is very limited. Nevertheless, we are watching the developments closely. And this includes the development of the exchange rate insofar as the strong euro might, at some point, influence price stability.

4. There are still some obstacles to overcome

So, even after taking into account the issue of deflation, we can still see the end of the crisis coming closer. However, we have not reached it yet. There may still be some obstacles that could block the way – some of them we can already see, others we cannot see.

The latter are what Frank Knight, one of the founders of the Chicago school of economics, called “unknown unknowns”. A recent example is the crisis in Ukraine, which I am certain is closely monitored in the Czech Republic.

However, while this crisis is an example of an “unknown unknown,” it has only limited potential to derail global recovery. Ukraine contributes only a quarter of a percent to global economic output. The impact on Europe will be very limited as well, in economic terms at least. The exposure of European banks to Ukraine, for instance, is relatively small. According to data from the Bank for International Settlements it stands at about US$23 billion.

However, we have to add Russia to the equation, and Russia’s relevance for the world economy is larger by far. After all, the crisis in Ukraine reminds us that geopolitical tensions do have the power to negatively affect the global economy. But this is something central banks cannot solve.

A known obstacle that could block our way, on the other hand, is the prolonged period of very low interest rates. But please do not misunderstand me: the current stance of monetary policy is certainly adequate. Nevertheless, when interest rates stay very low for a very long time, we may experience unwanted side-effects.

One of these side-effects is the search for yield. Investors may eventually increase the risk of their investments to make up for the shortfall in yields caused by low interest rates. And, indeed, it seems that investors have already begun their search for yield. In corporate debt markets, for instance, valuations are already somewhat stretched. And in the global low-interest rate environment, ambitious valuations may well spread to other markets.

In this regard, the strong recovery in the property markets of some euro-area countries should set us thinking. Take the German housing market, for example. Between 2009 and 2012, prices in large cities rose by almost 25%. And, in 2013, they increased by another 8.9%. Calculations by the Bundesbank already point to overvaluations in urban areas.

Nevertheless, when looking at the German market as a whole, the situation seems less dramatic. In 2013, prices rose by an average of 4.5% – a figure that does not give too much cause for concern. Overall, prices in Germany have not yet moved away from fundamentals.

For me, warning bells would start ringing if there was a rapid increase in housing prices accompanied by a significant rise in lending. And even more warning bells would be ringing if this rise in credit was accompanied by deteriorating lending standards. Having said that, I can assure you that at this point in time I am surrounded by silence.

But it is not only bond markets and housing markets we have to look at. Stock markets are an important issue as well. In 2013, there was only one way for most stock markets to go and that was up. The EuroStoxx 50 increased by 18%, the FTSE 100 by 14%, the Dow Jones by 28%, and the Nikkei skyrocketed by as much as 57%.

In addition, market volatility decreased, too. In fact, we are witnessing historically low volatility rates, which is something that might have negative side-effects. As soon as monetary policy normalises, volatility is likely to increase. This is not reflected in today’s volatility levels and might tempt market participants to neglect the necessity of hedging against changes in interest rates. Let me make it clear: low volatility does not stand for low risks and interest rates will rise again at some point.

So, have financial markets entered a new phase of “irrational exuberance”? Such a verdict is certainly debatable. But financial markets are at least anticipating significant further improvements in economic fundamentals and prospects. And they are anticipating that governments around the world will continue to implement the necessary reforms. These expectations create vast scope for confidence shocks.

This, in turn, interacts in an unfavourable way with another risk arising from a prolonged period of low interest rates. A prolonged period of low interest rates could set the wrong incentives. It could encourage banks to postpone necessary balance sheet adjustments. And it could encourage governments to postpone necessary structural reforms and the consolidation of public finances.

In my view, this could be the biggest threat to the recovery process. The improved outlook together with low interest rates could lead to complacency and reform fatigue. We cannot let this happen. We cannot let it happen because there is still a lot to do to put the euro area back on a solid footing and to truly bring an end to this crisis. Reform at the national level must continue and, looking to the future, reform at the European level is equally important.

5. How to bring an end to the crisis?

At the European level, the most important project is the banking union. The banking union is most certainly the biggest step since the introduction of the euro. And in my view it is the most logical step to take. A single currency requires integrated financial markets and this includes the supervision of banks.

The ECB is planning to launch the Single Supervisory Mechanism on 4 November. As you can imagine, this is a formidable challenge. It is a project that is comparable to the creation of monetary union but scheduled to be rolled out at seven times the speed.

Centralising supervisory powers at the European level will foster a comprehensive and unbiased view upon banks. It will also enable policy action that is not held hostage by national interests. Thus, it will contribute to more effective supervision and better cross-border cooperation and coordination.

However, the banking union does not rest on one pillar alone. A second pillar is necessary to keep everything in balance. The Single Resolution Mechanism will be that pillar. European bank supervision requires European bank resolution – otherwise there would be an imbalance between liability and control.

In this regard, the EU has made crucial progress recently, with the adoption of a harmonised bank resolution regime and the decision to create a Single Resolution Mechanism.

The Single Resolution Mechanism will allow authorities to restructure or resolve banks without putting taxpayers’ money at risk. In the future, whenever a bank fails, resolution costs will have to be borne first by shareholders and creditors. After that, a bank-financed resolution fund will come into play, and only as a last resort are public funds to be used and the taxpayer made to pay.

The Bundesbank welcomes this as an important complement to common European supervision. But we still believe that a treaty change will be needed – all the more so as the decision-making processes seem to be as complex as ever. The objective must be to set up a European resolution agency equipped with clear decision-making structures.

Nevertheless, the banking union has to start with a clean slate. Thus, one of the biggest preparatory steps is the Comprehensive Assessment of those banks which will fall under European supervision. This Comprehensive Assessment consists of two elements: a backward-looking Asset Quality Review and a forward-looking stress test.

The objective of the Asset Quality Review is to uncover legacy assets in banks’ balance sheets that were accumulated while the banks were under national supervision. The objective of the stress test is to assess how resilient banks are to stress scenarios.

Any capital shortfalls revealed by the Comprehensive Assessment have to be rectified before the banking union starts. Ideally, this would primarily involve private funds. If private funds should not be available and the bank has a sustainable business model, the respective government could step in. Ultimately, it is a question of who is responsible for past failings in banking supervision – and that is the individual member states.

The Comprehensive Assessment will allow the banking union to start with a clean slate. At the same time, it will support the necessary deleveraging of European banks. Balance sheets will eventually be “cleaned up” and any doubts regarding their quality will be removed. This will improve banks’ capacity to lend to the real economy and thus support economic growth. Against this backdrop, it is crucial that the Comprehensive Assessment is conducted in a tough and thorough manner.

Nevertheless, to ensure that the real economy is properly financed we might have to consider additional options. An important step would be to revive the market for securitisation. Looking at Europe, this is of particular importance as corporate funding in Europe relies heavily on bank credit. It is crucial to make securitised products attractive to investors without exerting negative effects on financial stability.

6. Conclusion

Ladies and gentlemen, I have covered a lot of ground in my speech today. Nonetheless, the central message is straightforward. The situation in the euro area is improving and the end of the crisis is coming closer. However, there is no time for complacency. Risks remain, among them reform fatigue and the side-effects of low interest rates. Thus, we must continue our efforts to put the euro area back on a sound footing.

Recently, ECB president Mario Draghi said that 2012 and 2013 were years of stabilisation for the euro area and that 2014 and 2015 may be years of recovery. If we continue down the path of reform, his expectation will prove correct. And this would benefit not only the euro area itself but also the rest of Europe.

Thank you very much.