Update of economic and monetary developments
Financial market volatility following the referendum in the United Kingdom on EU membership has been short-lived. However, uncertainty about the global outlook has increased, while incoming data for the second quarter point to subdued global activity and trade. Global headline inflation, meanwhile, has remained at low levels, mainly reflecting past energy price declines. Risks to the outlook for global activity, and in particular for emerging market economies, remain on the downside and relate primarily to political uncertainty and financial volatility.
Euro area financial markets have weathered the spike in uncertainty and volatility following the UK referendum with encouraging resilience. As a result, overall financial conditions remain highly supportive. In particular, while the EONIA forward curve has shifted downwards, especially at longer horizons, possibly reflecting expectations of both lower growth and further monetary policy actions, followed by low-risk sovereign bond yields, sovereign spreads vis-à-vis ten-year German government bonds have narrowed and those on corporate bonds have continued to tighten. At the same time, euro area banks’ equity prices have declined further.
The economic recovery in the euro area is continuing, supported by domestic demand, while export growth remains modest. Looking ahead, the economic recovery is expected to proceed at a moderate pace. Domestic demand remains supported by the pass-through of the ECB’s monetary policy measures to the real economy. Favourable financing conditions and improvements in corporate profitability continue to promote a recovery in investment. Sustained employment gains, which are also benefiting from past structural reforms, and still relatively low oil prices provide additional support for households’ real disposable income and thus for private consumption. In addition, the fiscal stance in the euro area is expected to be mildly expansionary in 2016 and to turn broadly neutral in 2017 and 2018. At the same time, headwinds to the economic recovery in the euro area include the outcome of the UK referendum and other geopolitical uncertainties, subdued growth prospects in emerging markets, the necessary balance sheet adjustments in a number of sectors and a sluggish pace of implementation of structural reforms. Against this background, the risks to the euro area growth outlook remain tilted to the downside.
Euro area headline inflation has remained at levels around zero in recent months. Measures of underlying inflation have on balance not yet shown clear signs of an upward trend, while pipeline price pressures have remained subdued. Market-based measures of long-term inflation expectations have declined further and remain substantially below survey-based measures of expectations. Looking ahead, on the basis of current futures prices for oil, inflation rates are likely to remain very low in the next few months before starting to pick up later in 2016, in large part owing to base effects in the annual rate of change of energy prices. Supported by the ECB’s monetary policy measures and the expected economic recovery, inflation rates should increase further in 2017 and 2018.
The monetary policy measures in place since June 2014, including the comprehensive package of new monetary policy measures adopted in March this year, have significantly improved borrowing conditions for firms and households, as well as credit flows across the euro area, thereby supporting the economic recovery. In particular, low interest rates, as well as the effects of the ECB’s targeted longer-term refinancing operations and the expanded asset purchase programme, continue to support robust growth in money and the gradual recovery in credit dynamics. Banks have been passing on their favourable funding conditions in the form of lower lending rates, and improved lending conditions are fostering a recovery in loan growth. Indeed, the euro area bank lending survey for the second quarter of 2016 indicated further improvements in loan supply conditions for loans to enterprises and households and a continued increase in loan demand across all loan categories. In the light of the prevailing uncertainties, it is essential that the bank lending channel continues to function well.
At its meeting on 21 July 2016, based on the regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged. The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.
Given prevailing uncertainties, the Governing Council will continue to monitor economic and financial market developments very closely and to safeguard the pass-through of its accommodative monetary policy to the real economy. Over the coming months, as more information becomes available, including new staff projections, the Governing Council will be in a better position to reassess the underlying macroeconomic conditions, the most likely paths of inflation and growth, and the distribution of risks around those paths. If warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate.
The Governing Council confirmed the need to preserve an appropriate degree of monetary accommodation in order to secure a return of inflation rates towards levels that are below, but close to, 2% without undue delay.
The vote in the United Kingdom in favour of leaving the European Union triggered some financial market volatility and increased uncertainty about the global outlook. The outcome of the referendum took financial markets by surprise and prices adjusted rapidly in the immediate aftermath of the vote. Since 23 June the pound sterling has depreciated sharply. However, the impact on most global markets has been short-lived, although bank equities have declined, particularly in the euro area. Uncertainty about the global outlook has risen since the referendum. In the short-term the largest impact has been felt by the UK economy, as uncertainty about the future trading and investment relationships between the United Kingdom and the EU is weighing on demand. Other non-euro area European economies, particularly those with close trading links with the United Kingdom, may also be affected. Outside Europe, the impact is expected to be more limited but political uncertainty across advanced economies has risen, which could dampen confidence and investment. Private sector forecasts for major economies have been revised downwards slightly.
Amid heightened uncertainty, financial markets expect a more accommodative monetary policy stance in major advanced economies. The Bank of England left interest rates unchanged at its meeting in July, although it signalled possible action in the near future. In the United States, market expectations for interest rate increases during 2016 have moderated. According to the federal funds futures curve, markets are fully pricing in a 25 basis point hike only towards the end of 2017. Financial markets also expect further easing by the Bank of Japan.
The global composite output PMI
(diffusion index: 50 = no change)
Sources: Markit and ECB staff calculations.
Note: The latest observation is for June 2016.
Global indicators for the second quarter of 2016 point to subdued economic activity and trade. The global composite output Purchasing Managers’ Index (PMI) recorded a further decline in the second quarter, falling to 51.3 – the lowest value seen since end-2012 (see Chart 1). Global trade growth has contracted further. The volume of world imports of goods fell by 0.6% in April 2016, on a three-month-on-three-month basis. While trade growth improved in advanced economies, it deteriorated further in emerging market economies (EMEs), particularly Asia. The short-term outlook for global trade is subdued, with the global PMI for new export orders remaining below the threshold value of 50 in June.
Global headline inflation remained at low levels. In the OECD countries, annual CPI inflation increased by 0.8% in May, the same pace as in the previous two months. The energy component has continued to weigh on inflation. OECD inflation excluding food and energy stood at 1.9% in May (see Chart 2). Among large EMEs, inflation fell in China and Brazil and was unchanged in India. Having fallen sharply over the past year, inflation ticked up in Russia.
Consumer price inflation
(year-on-year percentage changes)
Sources: OECD and national sources.
Note: The latest observation is for June 2016 for individual countries and May 2016 for the OECD aggregate.
Brent crude oil prices have fallen slightly since early June. OPEC output increased in June, driven mainly by supply increases in Iran, Saudi Arabia and Nigeria. Non-OPEC supply also increased in June, underpinned by a partial recovery in Canadian oil production. On the demand side, the International Energy Agency’s forecasts for global oil demand growth in 2016 have been revised upwards. The prices of non-oil commodities have increased marginally since the start of June.
Activity in the United States has rebounded after the soft patch at the start of the year. The pace of economic activity slowed to 0.3%, quarter on quarter, in the first quarter of this year (1.1% in annualised terms), driven by weaker household spending and a decline in non-residential investment. However, recent data point to a rebound in GDP growth in the second quarter. Growth in personal consumption expenditure has increased, reflecting gains in real disposable income and households’ net wealth partly as a result of improved housing market conditions. In April and May retail sales rose at a steady pace and vehicle sales rebounded, after dipping in March. Moreover, the labour market remains resilient. US non-farm payroll employment rose by 287,000 in June, after more modest increases in the previous two months. In June, annual headline CPI inflation declined to 1.0%, dampened by lower energy and food price inflation, while inflation excluding food and energy rose slightly, to 2.3%, the highest rate seen in four years.
In Japan, the growth momentum remains modest. Following the decline in the final quarter of 2015, GDP grew by 0.5%, quarter on quarter, in the first quarter of 2016. The latest indicators, however, point to subdued activity in the second quarter, as industrial production contracted in May and the Bank of Japan’s Tankan survey signalled some deterioration in business conditions. Labour market conditions are tight, with the unemployment rate standing at 3.2% in May, the lowest level in more than two decades. However, wage growth remains weak. Annual headline CPI inflation declined further into negative territory in May.
In the United Kingdom, economic growth is expected to decline in the second half of the year. GDP growth slowed to 0.4%, quarter on quarter, in the first quarter of 2016. Activity was driven primarily by robust private consumption, while investment recorded a decline and net exports also continued to exert a drag on growth. According to short-term indicators, the UK economy continued to expand in the second quarter of 2016 at a relatively robust pace, similar to that seen in the previous quarter. However, the uncertainty created by the outcome of the UK referendum is likely to weigh on economic activity in the near term, in particular investment and trade.
In China, macroeconomic data remain consistent with a gradual moderation in the pace of expansion. In the second quarter of 2016 China recorded GDP growth of 6.7%, year on year – the same rate as in the previous quarter and in line with the growth target range of 6.5%-7% set by the Chinese authorities for 2016. Activity has relied on government support in recent quarters. Fixed asset investment has been boosted by strong growth in infrastructure investment, while capital expenditure in the manufacturing sector has moderated.
Growth momentum remains weak and heterogeneous across other EMEs. Activity has remained resilient in commodity-importing countries, such as India where activity expanded by 7.6%, year on year, in the first quarter of 2016. Turkey also experienced sustained rates of GDP growth in the same period. However, looking ahead, the attempted military coup has increased political uncertainty, which could weigh on demand. Among commodity exporters, activity has been weak. Brazil remains in recession. However, in Russia, there are signs that the economy has bottomed out, as GDP returned to positive growth of 0.3%, quarter on quarter, in the first quarter of 2016. Capital flows towards EMEs have remained generally resilient in recent months. Taking a longer perspective, however, the gradual deceleration of economic activity in EMEs has contributed to a gradual waning of net capital flows to EMEs in recent years (see Box 1).
Long-term euro area government bond yields have edged further downwards since early June. Sovereign spreads vis-à-vis the German Bund ten-year rate widened immediately after the outcome of the UK referendum on EU membership, especially for lower-rated issuers, but thereafter spreads overall declined to below their early June levels, with the exception of those for Portugal and Greece.
Euro area equity prices declined following the outcome of the UK referendum on EU membership. While the composite index subsequently rebounded, the bank equity index remained well below its level in early June. The broad EURO STOXX index lost slightly more than 2% during the review period (2 June to 20 July 2016). Over the same period the S&P 500 index in the United States rose by around 3% (see Chart 3). These developments were the result of a relatively stable performance ahead of the UK referendum, losses of close to 8% and 5% for the euro area and US indices, respectively, between 23 and 27 June, and a recovery phase thereafter. Euro area bank equity prices overall lost 13% since early June, while US bank equity prices declined by around 4%. The overall declines, although large, are nonetheless much smaller than the drop in banks’ equity prices in the two main economic areas between 23 and 27 June, of around 25% and 10% respectively. Profitability concerns, as well as country and bank-specific events, continued to weigh on the euro area banking sector in particular. Market expectations of equity price volatility spiked significantly just after the UK referendum, but fell back to their initial level in the remainder of the review period.
Selected euro area and US equity price indices
(1 January 2015 = 100)
Source: Thomson Reuters.
Notes: Daily data. The latest observation is for 20 July 2016.
Spreads on bonds issued by non-financial corporations (NFCs) declined, extending the trend that emerged after the Governing Council’s announcement in March of the corporate sector purchase programme (CSPP). Spreads on issues by euro area NFCs have declined since early June across all rating classes, with a limited and short-lived rebound after the outcome of the UK referendum. On 20 July NFC bond spreads were, depending on the rating, 30-40 basis points lower than in early June and 50-80 basis points lower relative to 10 March, the day on which the Governing Council announced the CSPP (see also Box 2). In the financial sector, bond spreads also declined across all rating classes since early June. The diverging behaviour of bank equities, which declined significantly, and financial bond spreads, which continued to narrow, is consistent with the view that profitability concerns – rather than perceptions of increased default risks among financial institutions – were the key factor behind developments in the banking sector.
Changes in the exchange rate of the euro vis-à-vis selected currencies
Notes: Percentage changes relative to 20 July 2016. EER-38 is the nominal effective exchange rate of the euro against the currencies of 38 of the euro area’s most important trading partners.
In the foreign exchange markets, the euro weakened modestly in trade-weighted terms. In bilateral terms, since 2 June the euro appreciated by 8.1% against the pound sterling, amid heightened uncertainty after the outcome of the UK referendum on EU membership. Higher volatility and a decline in risk appetite supported the Japanese yen, leading to a depreciation of the euro against the Japanese currency of around 5%. The euro also depreciated against the US dollar, the Swiss franc and the currencies of most emerging market economies and commodity-exporting countries (see Chart 4).
The euro overnight index average (EONIA) was relatively stable, ranging from -32 to -35 basis points, except at the end of the second quarter, when it temporarily rose to -29 basis points.Excess liquidity increased by €29 billion, to around €873 billion, in the context of Eurosystem purchases under the expanded asset purchase programme.
Relative to early June, the EONIA forward curve shifted downwards, especially beyond the one-year horizon. After a decline in the immediate aftermath of the UK referendum, the downward movement continued at maturities beyond the one-year horizon, with a temporary rebound in early July. Between 2 June and 24 June, when the outcome of the UK referendum on EU membership was announced, the downward shift of the curve ranged from 10 basis points at the one-year horizon to 20 basis points at the eight-year horizon. These developments reflected downward revisions to expected growth and rising market expectations of further monetary policy easing in response. By 20 July these declines had remained stable up to the one-year horizon, but had widened further, up to around 30 basis points, across the remaining maturities.
The economic recovery in the euro area is continuing, driven largely by developments in private consumption but also by investment. Real GDP increased by 0.6% quarter on quarter in the first quarter, supported by robust private consumption dynamics as well as continued improvements in investment, whereas net trade contributed negatively. Changes in inventories also contributed positively to GDP growth in the first quarter of 2016.
Private consumption, which is the main driver of the ongoing recovery, continues to contribute positively to growth. Private consumption increased further in the first quarter of 2016, by 0.6% quarter on quarter, following a temporary slowdown in the previous quarter owing to adverse weather effects on energy and seasonal goods consumption, and the terrorist attacks in France. From a longer-term perspective, consumer spending has been benefiting from rising real disposable income among households, which primarily reflects rising employment and lower oil prices. Households’ real gross disposable income grew in the first quarter of 2016, by 2.1% year on year. After improving further in the second quarter of 2016, consumer confidence declined slightly in July following the UK referendum outcome and remained above its long-term average. Households’ balance sheets have also become less constrained.
Following an acceleration at the end of 2015, investment continued to grow in the first quarter of 2016, but more recent data signal somewhat weaker dynamics in the short term. Total investment increased by 0.8%, quarter on quarter, in the first quarter of 2016 mainly owing to a rise in equipment investment. Rising investment in metal products and machinery made up about half of the increase in year-on-year terms in the first quarter, while construction and ICT (information and communication technology) investment contributed equally to the remaining part. In the second quarter of 2016 there was some weakness in the industrial production of capital goods which declined in May by 2.3%, month on month, thereby more than offsetting the strong increase of 1.7% recorded in April. A weak external environment combined with fewer industrial orders of capital goods and subdued production expectations in the capital goods sector will most likely weigh on the growth rate of non-construction investment in the months to come. Construction investment continued to grow in the first quarter of 2016, but a fall in production in the first two months of the second quarter of 2016, together with a negative carry-over from declines in February and March, suggest subdued dynamics for housing investment in the second quarter of 2016.
Beyond the short term, recovering demand, accommodative monetary policy as well as improving financing conditions should boost investment, albeit with some downside risks. Improving profits and the need to replace investment after years of subdued fixed capital formation should also support total investment going forward. However, uncertainty related to the UK referendum outcome and its potential implications for the euro area economy might weigh on the investment outlook. In addition, deleveraging needs and a slow pace of reform implementation, particularly in some countries, as well as subdued potential growth prospects, may also dampen investment growth.
Euro area real GDP, the ESI and the composite PMI
(quarter-on-quarter percentage growth; index; diffusion index)
Sources: Eurostat, European Commission, Markit and ECB.
Notes: The ESI is normalised with the mean and standard deviation of the PMI. The latest observations are for the first quarter of 2016 for real GDP and June 2016 for the ESI and the PMI.
Euro area total exports (goods and services) remained subdued in the first quarter of 2016 and monthly trade data point so far to weak momentum in the growth of goods exports in the second quarter. When taking monthly trade outcomes for April and May together, extra-euro area goods exports fell somewhat compared with the second quarter of 2015. Among the emerging market economies, growth in exports to China increased, while growth in exports to Russia and Latin America decreased. As for the advanced economies, exports to the United States made a broadly neutral contribution, whereas exports to non-euro area Europe (including the United Kingdom) increased. The relative strength of euro area exports since the turn of the year compared with global trade growth points to gains in euro area export market shares. Looking ahead, the slight appreciation of the effective exchange rate of the euro in the first half of this year is expected to weigh on euro area exports. In addition, exports may be negatively affected by the possible adverse consequences of the UK referendum outcome for global trade flows. Moreover, more timely indicators, such as surveys, signal continued subdued developments in foreign demand and relatively weak export orders from outside the euro area in the near term.
The latest economic indicators are, on balance, consistent with ongoing moderate real GDP growth in the second quarter of 2016. Industrial production (excluding construction) declined in May, following strong growth in April, resulting in an average index level for the first two months of the second quarter of 2016 that stands 0.2% below that for the first quarter. Construction production and new orders continued to decline in April. Retail sales and car registrations rose in April and May by 0.3%, month on month, although car registrations declined in June. More timely survey data are in line with continued growth in the second quarter, albeit at a lower rate than in the first quarter. The composite output Purchasing Managers’ Index (PMI) remained unchanged in June, leading to a quarterly average slightly below the level seen in the first quarter of 2016 (see Chart 5). The Economic Sentiment Indicator (ESI) declined slightly in June. Both indicators remain above their long-term average levels.
Euro area labour markets continue to improve gradually. Employment increased further by 0.3%, quarter on quarter, in the first quarter of 2016. As a result, employment stood 1.4% above the level recorded one year earlier, the highest annual rise observed since the first quarter of 2008. The unemployment rate in the euro area also continued to decline in May 2016, falling to 10.1% (see Chart 6). Long-term unemployment (those who have been unemployed for at least 12 months) continues to decrease slowly but remains above 5% of the labour force. More timely survey data continued to improve in the recent months and are consistent with further employment gains in the period ahead.
Euro area employment, PMI employment expectations and unemployment
(quarter-on-quarter percentage changes; diffusion index; percentage of labour force)
Sources: Eurostat, Markit and ECB calculations.
Notes: The PMI is expressed as a deviation from 50 divided by 10. The latest observations are for the first quarter of 2016 for employment, June 2016 for the PMI and May 2016 for unemployment.
Looking ahead, the economic recovery is expected to proceed at a moderate pace, although uncertainty has increased following the outcome of the UK referendum. Domestic demand continues to be supported by the ECB’s monetary policy measures. Their favourable impact on financing conditions, together with improvements in corporate profitability, is boosting investment. Moreover, continued employment gains and the still relatively low price of oil should continue to support households’ real disposable income and private consumption. However, heightened uncertainty following the UK referendum might affect confidence and trade. Other geopolitical uncertainties also pose challenges for the economic recovery in the euro area. At the same time, the economic recovery is still being dampened by the ongoing balance sheet adjustments in a number of sectors, the insufficient pace of implementation of structural reforms and subdued growth prospects in emerging markets. Against this background, the risks to the euro area growth outlook remain tilted to the downside.
Prices and costs
Headline inflation has remained at levels around zero in recent months (see Chart 7). The low level of inflation continues to reflect the dampening impact of strongly negative annual rates of change in energy prices. At the same time, HICP inflation excluding food and energy continues to hover at rates around 1.0%.
Contribution of components to euro area headline HICP inflation
(annual percentage changes; percentage point contributions)
Sources: Eurostat and ECB calculations.
Note: The latest observations are for June 2016.
Measures of underlying inflation have, on balance, not yet shown any clear sign of an upward trend. The annual rate of HICP inflation excluding food and energy has been hovering around 1% since the middle of last year. Other measures of underlying inflation have also shown no clear signs of further upward momentum since a turning point was reached in early 2015. Looking at the main components, services price inflation has been hovering around 1% in recent months, while non-energy industrial goods price inflation has been within a range of 0.4% to 0.7%.
Import price inflation remained negative, while producer price inflation continued to be quite stable. After declining for several successive months import price inflation in non-food consumer goods increased from -1.4% in April to -0.7% in May. This pattern is fairly similar to that of developments in the euro nominal effective exchange rate. The annual rate of change in the producer price index for domestic sales of non-food consumer goods industries increased slightly further, to 0.1% in May, from 0.0% in April and -0.1% in March. The limited upward pressure on producer prices may result from the impact of an improvement in economic conditions being offset by that of weak cost pressures stemming from, for example, low commodity prices.
Wage growth has remained subdued. Growth in compensation per employee was 1.2% in year-on-year terms in the first quarter of 2016, slightly down from 1.3% in the fourth quarter of 2015. Factors that may be weighing on wage growth include continued elevated levels of slack in the labour market, weak productivity growth, the low inflation environment and the ongoing impact of labour market reforms implemented during the crisis.
Market-based measures of long-term inflation expectations have declined notably and remain substantially below survey-based measures. The five-year forward inflation rate five years ahead has declined since the beginning of June and reached a new all-time low in early July. A large part of the decline appears to be due to technical factors, as increased demand for safe assets amid deteriorating market sentiment following the UK referendum on EU membership has contributed to dampening market-based measures of inflation. While these measures may therefore recover as market sentiment improves, the decrease may also indicate that market participants consider inflation unlikely to pick up soon. At the same time, markets continue to price in only a limited risk of deflation. In contrast to market-based measures, survey-based measures of long-term inflation expectations, such as those obtained from the ECB Survey of Professional Forecasters (SPF) and Consensus Economics surveys, have been more stable (see Chart 8). According to the July 2016 SPF results, the average point forecast for inflation five years ahead remained unchanged from the previous survey round, at 1.8%.
Survey-based measures of inflation expectations
(annual percentage changes)
Sources: ECB Survey of Professional Forecasters, Thomson Reuters, Consensus Economics, June 2016 Eurosystem staff macroeconomic projections and ECB calculations.
Notes: Realised HICP data are included up to June 2016. Consensus Economics data are taken from the forecasts published in July 2016. The market-based measures of inflation expectations are derived from HICPx (the euro area HICP excluding tobacco) zero coupon inflation-linked swaps; the latest observations are for 19 July 2016.
Looking ahead, on the basis of current futures prices for energy, inflation rates will remain low or possibly even slightly negative in the coming months before picking up later in 2016, largely owing to base effects. Thereafter, inflation rates should recover further in 2017 and 2018, supported by the ECB’s monetary policy measures and the expected economic recovery. The result of the UK referendum has raised the level of uncertainty surrounding the inflation outlook.
Turning to house price developments, annual growth in the ECB’s residential property price indicator for the euro area has picked up further. In the first quarter of 2016 the annual rate of change in residential property prices was 2.9%, up from 2.2% in the fourth quarter of 2015 and 1.6% in the third quarter of that year. The further increase in residential property price growth in the first quarter of 2016 was relatively broadly based, as the majority of euro area countries recorded either higher growth or a less pronounced decline compared with the previous quarter.
Money and credit
Broad money growth remained robust. The annual growth rate of M3, which increased to 4.9% in May 2016, has hovered around 5.0% since March 2015 (see Chart 9). Broad money growth was once again supported by the most liquid components. Over recent months M1 has been showing signs of deceleration as its annual growth rate continued to decrease, albeit remaining at a high level in May.
M3 and loans to the private sector
(annual rate of growth and annualised six-month growth rate)
Note: The latest observation is for May 2016.
Broad money growth was mainly driven by domestic sources of money creation. The ECB’s non-standard monetary policy measures partly account for this development. From a counterpart perspective, the largest sources of money creation in May were the bond purchases made by the Eurosystem in the context of the public sector purchase programme (PSPP) and shifts away from longer-term financial liabilities. The annual rate of change of MFIs’ longer-term financial liabilities (excluding capital and reserves) remained strongly negative in May 2016. This reflects the flatness of the yield curve, linked to the ECB’s non-standard monetary policy measures, which has made it less favourable for investors to hold longer-term bank liabilities. The attractiveness of the targeted longer-term refinancing operations (TLTROs) as an alternative to longer-term market-based bank funding also played a role. In this context, the allotment in June 2016 of the first operation in the second series of TLTROs (TLTRO-II) amounted to €399 billion, which was slightly below market expectations. Furthermore, the gradual recovery in the growth of credit to the private sector contributed to increased money creation. The MFI sector’s net external asset position continues to weigh on annual M3 growth. This development continues to reflect capital outflows from the euro area and ongoing portfolio rebalancing in favour of non-euro area instruments (in particular the euro area government bonds sold by non-residents under the PSPP).
Loan dynamics remained on a path of gradual recovery. The annual growth rate of MFI loans to the private sector (adjusted for sales and securitisation) increased in May (see Chart 9). While the annual growth rate of loans to non-financial corporations (NFCs) recovered further in May, the annual growth rate of loans to households has remained broadly stable since February 2016. These trends were generally observed across the euro area and were supported by the significant decreases in bank lending rates witnessed since summer 2014 (notably owing to the ECB’s non-standard monetary policy measures), as well as by improvements in the supply of and demand for bank loans. Despite these positive signs, the ongoing consolidation of bank balance sheets and persistently high levels of non-performing loans in some countries remain a drag on loan growth.
The July 2016 euro area bank lending survey suggests that the recovery in loan growth is driven by increasing demand as well as improvements in loan supply (see survey at:https://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html). In the second quarter of 2016 loan demand for all loan categories increased further. At the same time, loan supply conditions for loans to enterprises and households continued to improve. Competitive pressures remained the main factor driving the easing in banks’ credit standards on loans to enterprises. Banks continued to indicate that the main effects of the TLTROs on loan supply translate into an easing of terms and conditions, rather than in changes in credit standards.
Bank lending rates for the private sector fell to a new historic low in May. Composite lending rates for NFCs and households have decreased by significantly more than market reference rates since June 2014 (see Chart 10). Receding fragmentation in euro area financial markets and the improvement in the pass-through of monetary policy measures to bank lending rates have played a positive role in this context. Furthermore, the decrease in banks’ composite funding costs has supported the decline in composite lending rates. Since June 2014 banks have been progressively passing on the decline in their funding costs in the form of lower lending rates. Moreover, the sizeable take-up in the first TLTRO-II operation implies a significant reduction in bank funding costs, which can be passed on to final borrowers in the economy. Between May 2014 and May 2016, composite lending rates on loans to euro area NFCs and households fell by around 100 and 90 basis points respectively; vulnerable euro area countries have seen particularly strong reductions in bank lending rates. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area followed a downward path. This generally indicates that small and medium-sized enterprises are benefiting to a greater extent than large companies from the decline in lending rates.
Composite bank lending rates for NFCs and households
(percentages per annum)
Note: The indicator for the composite bank lending rates is calculated by aggregating short and long-term rates using a 24-month moving average of new business volumes. The latest observation is for May 2016.
The net issuance of debt securities by euro area NFCs strengthened further in April and May 2016, after having already increased strongly in March. The strengthening in April and May was supported by, among other things, the ECB’s monetary policy package announced in March and was widespread across countries, while the increase in March was driven by two large transactions. Market data show that corporate bond issuance moderated notably in the second half of June, most likely related to concerns about the EU referendum in the United Kingdom, before strengthening again in the first half of July. The net issuance of quoted shares by NFCs has remained relatively modest in recent months. (See Box 5 for non-banks’ increasing role in providing new financing to euro area NFCs since 2008.)
Financing costs for euro area NFCs remain favourable. The overall nominal cost of external financing for NFCs has remained broadly unchanged at the historically low level reached in April 2016, masking diverging movements across financing instruments. The cost of equity financing increased moderately in May and June and declined in July, following the developments in equity prices. By contrast, the cost of market-based debt financing continued to decline over the period from May to July, supported by the ECB’s latest monetary policy measures and globally declining yields.
Box 1 Recent developments in capital flows to emerging market economies
Net capital inflows to EMEs
(percentages of nominal GDP)
Sources: Haver Analytics, IMF and ECB calculations.
Notes: Net capital inflows defined as the sum of net foreign direct investment (FDI), net portfolio flows and net other investment. Aggregated using GDP purchasing power parity (PPP) weights.
Net capital inflows to major emerging market economies (EMEs) have been on a downward trend since 2011 and have remained negative since the fourth quarter of 2014.Net capital inflows to EMEs recovered quickly after the global financial crisis. However, this rebound reversed in 2011 and since then net capital inflows have followed a downward trend (see Chart A). Moreover, after a modest recovery in 2013, there was a renewed decline in net capital inflows to EMEs, which have remained negative for the last six quarters. This is the longest period of consecutive net capital outflows from EMEs since 2001. The reversal seems to be broad based across different types of investment class. In particular, foreign direct investment, which is the most stable component of the financial account, remained below its long-term average (2000-Q1 2016) over the last two years.
The decline in net capital inflows to EMEs has also been partly mirrored in a gradual and broad-based weakening of the currencies of EMEs. EME currencies were on a downward trend between 2011 and 2015. The weakening was particularly pronounced in the period between mid-2014 and late 2015 when the US dollar started to strengthen amid gradually building market expectations of a tightening of US monetary policy. Since early 2016 EME currencies have started to recover part of their losses.
Based on a standard “push/pull" framework, a simple model is used to determine, at an aggregate level, potential drivers of the recent slowdown in net capital inflows to EMEs (see Chart B). A single equation model relates aggregate balance of payments net capital inflows to EMEs (measured in percentages of GDP) to the relative attractiveness of domestic economic conditions (measured as the real GDP growth differential between the respective EMEs and advanced economies and by interest rate differentials) and to changes in global conditions, including global risk aversion (measured by the VIX Index), changes in oil prices and a measure of expectations of US monetary policy.
The model results suggest that a falling growth differential between EMEs and advanced economies has been a major driver of net capital outflows from EMEs over recent years. Since 2010 growth in major EMEs has been on a downward trend, driven both by a deteriorating external environment and domestic structural factors (see Chart C). At the same time, growth in advanced economies has stabilised since 2013. This has resulted in a diminishing growth differential between EMEs and advanced economies, making the former less attractive for foreign investment. Moreover, low growth or recessions in some EMEs might have bolstered gross capital outflows. The average quarterly growth differential decreased from 1.2 percentage points in the pre-crisis period (2001-07) to 0.9 percentage point in 2010-15 and to 0.7 percentage point over the last two years.
Model-based contributions to net capital inflows to EMEs
(demeaned; four-quarter moving averages; percentages of nominal GDP)
Sources: Datastream, Haver Analytics, IMF and ECB calculations.
Notes: See footnote 1 of this box for the country sample. The sample period is from Q1 2000 to Q1 2016. All aggregates are computed using GDP PPP weights. Growth differential calculated against an aggregate of advanced economies (see notes to Chart C for the country sample). The interest rate differential and US monetary policy expectations are not statistically significant in the regression; therefore, the chart is based on the model excluding these variables (the contributions of the other factors remain practically unchanged). To address the endogeneity problem, lagged growth differentials are used.
Real GDP growth in EMEs and advanced economies
(quarter-on-quarter percentage changes)
Sources: Haver Analytics, IMF and ECB calculations.
Notes: See footnote 1 of this box for the country sample. Aggregated using GDP PPP weights. Advanced economies include Australia, Canada, Denmark, the euro area, Japan, Norway, Sweden, Switzerland, the United Kingdom and the United States. The latest observation is for Q1 2016.
In addition, capital flows to EMEs have been substantially affected by external factors such as global risk aversion and changes in oil prices. The model results show that net capital inflows respond to global risk aversion, which is consistent with the empirical evidence found in the literature. Furthermore, the recent period of net capital outflows from EMEs also seems to have been strongly driven by the decline in oil prices which began in 2014. Oil price declines directly affect the economic and financing conditions of commodity exporters. However, changes in oil prices are also positively correlated with net capital inflows to commodity importers. This could be associated with the fact that oil prices partly reflect global demand conditions and therefore global income. In particular, while the initial phase of the fall in oil prices as of mid-2014 was mainly supply-driven, the decline from autumn 2015 to January 2016 is believed to have been more demand-driven.
The process of US monetary policy normalisation has drawn attention to the role of expectations about the future path of US policy rates in determining capital inflows to EMEs. The orderly developments in financial markets in December 2015, when the US policy rate hike was fully priced in by the markets, compared with the “taper tantrum" episode in 2013, have highlighted the importance of expectations concerning US monetary policy for global financial market developments. Using several different proxies for US monetary policy expectations, a significant effect of such expectations on aggregate net capital flows to EMEs is not found. However, these expectations seem to play a more significant role as a determinant of portfolio flows examined at higher frequencies. The role of interest rate differentials between EMEs and advanced economies is also not clearly captured in the specific set-up of the model; however, their effects are found to be significant in other more detailed studies.
Overall, economic growth differentials between EMEs and advanced economies remain a key driver of net capital inflows to EMEs. This highlights the need for sound domestic economic policies in EMEs, aimed at addressing existing vulnerabilities and supporting economic growth, in particular in the context of slowing global economic growth prospects.
Box 2 The corporate bond market and the ECB’s corporate sector purchase programme
On 8 June 2016 the Eurosystem started to make purchases under its new corporate sector purchase programme (CSPP). The CSPP was announced by the ECB’s Governing Council following its meeting on 10 March and aims to further strengthen the pass-through of the Eurosystem’s asset purchases to the financing conditions of the real economy. The CSPP is part of the Eurosystem’s asset purchase programme (APP), under which purchases are intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term. This box describes the CSPP and considers its initial impact on the corporate bond market.
Under the CSPP, the Eurosystem purchases securities issued by non-bank corporations in both the primary and the secondary market. To be eligible for purchase, securities must, as a necessary condition, be eligible as collateral for Eurosystem credit operations. In particular, they must have a minimum first-best credit assessment of at least credit quality step 3 (investment grade) according to the Eurosystem credit assessment framework from an external credit assessment institution. In addition, the securities must be denominated in euro; the eligible maturity spectrum ranges from a minimum remaining maturity of six months to a maximum remaining maturity of 30 years at the time of the purchase; the securities must be issued by a corporation established in the euro area; and securities issued by credit institutions are not eligible for purchase. The Eurosystem applies an issue share limit of 70% per security.
Between the start of CSPP purchases on 8 June 2016 and 15 July, the Eurosystem bought €10.4 billion of non-bank corporate bonds.7% of the purchases were made in the primary market and 93% in the secondary market. The amount purchased is published on a weekly basis and the split between primary and secondary markets is published each month on the ECB’s website. The corporate bond market is generally less liquid than the government bond market, as corporate bond issues are much smaller in terms of outstanding amount than most government bond issues, the market is dominated by long-term investors and banks usually do not serve as dedicated market-makers. Therefore, trades of less than €10 million make up the majority of the volume under the CSPP (see Chart A) and trades are typically larger in the primary market than in the secondary market. Average trade sizes under the CSPP are broadly comparable to those under the third covered bond purchase programme (CBPP3) and smaller than trades under the public sector purchase programme (PSPP). The corporate bond repo market likewise tends to be less liquid than the government bond repo market. To support market liquidity, the Eurosystem has since 18 July made its CSPP bond holdings available for securities lending via the national central banks conducting purchases.
CSPP purchases are well diversified across ratings, sectors, countries and issuers. Owing to the large number of eligible corporate issuers, purchases have so far been spread over 458 different bonds issued by 175 different issuers. Yields of the purchased bonds have ranged from around -0.3% to above 3%, with just above 20% of the purchases being made at negative yields above the ECB’s deposit facility rate of -0.4%. The ratings of the bonds range from AA to BBB- and the distribution of purchases broadly mirrors the rating distribution of the universe of eligible bonds. The purchases are well diversified across corporations in many economic sectors (see Chart B) and across the euro area countries where bonds are outstanding.
Trade sizes under the CSPP
Note: Secondary market trades.
Sectoral distribution of purchases
Sources: Bloomberg and ECB.
Note: Based on the Bloomberg sector classification.
The announcement of the CSPP on 10 March was followed by a significant contraction in the spread between yields on bonds issued by non-financial corporations (NFCs) and a risk-free rate. NFC bond spreads declined sharply on the day of the announcement and continued to decline subsequently, interrupted only by temporary bouts of volatility in May and June relating to the referendum on the United Kingdom’s membership of the European Union (see Chart C). When the CSPP eligibility of insurance corporations was confirmed on 21 April, they also recorded a sizeable spread contraction. The subsequent developments in corporate spreads are to some extent related to the uncertainty generated by the UK referendum.
Investment-grade corporate bond spreads
Sources: Markit and Bloomberg.
Notes: Corporate bond spreads are measured by asset swap spreads. The vertical lines indicate the Governing Council meetings on 10 March and 21 April. The indices also contain subordinated bonds. The latest observation is for 18 July 2016.
Econometric analysis suggests that the CSPP announcement accounts for a large share of the decline in euro area corporate bond spreads in March 2016. Following the current practice in the literature, the impact of the CSPP announcement is assessed through an event study approach focusing on the two-week period after the announcement. The empirical analysis suggests that the monetary policy decisions announced in March, which include the launch of the CSPP, the cut in the ECB deposit facility rate and the new series of four targeted longer-term refinancing operations (TLTRO-II), have improved the external financing conditions of firms. Providing precise estimates of the impact of the policies is most likely not feasible. However, focusing on the spread between the individual corporate bond yield and the risk-free rate of the same maturity might help to identify more directly the effects of the CSPP.
Contributions to changes in corporate bond spreads in the two-week period after the CSPP announcement
Sources: Merrill Lynch and ECB calculations.
Notes: Corporate bond spreads are measured by asset swap spreads. NFC denotes bonds issued by non-financial corporations; FIN denotes bonds issued by the financial sector; IG denotes investment-grade bonds; HY denotes high-yield (non-investment grade) bonds. For more details of the analytical approach taken to derive these results, see footnote 5 and De Santis, R. A., “Credit spreads, economic activity and fragmentation", Working Paper Series, No 1930, ECB, July 2016. The latest observation is for 24 March 2016.
A time-series panel analysis of the determinants of corporate bond spreads estimated over the October 1999-March 2016 period shows that, over the identified period from 10 to 24 March, 11 basis points of the total decline of 16 basis points in the spreads of euro area investment-grade corporate bonds was related to the monetary policy measures announced in March, more specifically the launch of the CSPP (see Chart D). Most of these bonds are eligible for CSPP purchases. However, the same analysis also identifies a notable impact on the corporate bond market segments dominated by ineligible bonds. In particular, it shows an impact of 25 basis points on high-yield bonds, i.e. bonds with a rating lower than investment grade, and an impact of 5 basis points on corporate bonds issued by financial institutions, which include both ineligible bank bonds and eligible bonds issued by insurance corporations. The evidence of a decline in corporate credit spreads owing to the CSPP is corroborated by the sizeable spread contraction for bonds issued by insurance corporations when it was confirmed on 21 April that these bonds are eligible (see Chart C).
Debt issuance by euro area NFCs
(EUR billions; percentage shares)
Sources: Dealogic and ECB calculations.
Notes: The data include both investment-grade and non-investment grade bonds. “Issuance in euro" denotes new issues denominated in euro by NFCs headquartered in the euro area. “Issuance in all currencies" denotes all new issues by NFCs headquartered in the euro area.
Issuance of corporate bonds denominated in euro increased after the CSPP announcement. While issuance was subdued at the beginning of the year amid elevated financial market uncertainty, it rebounded significantly after the CSPP announcement. Preliminary data (see Chart E) suggest that issuance in the second quarter of 2016 was well above the average seen in previous years. Moreover, the share of new bonds issued by euro area corporations in euro relative to issuance in all currencies rebounded to a level broadly similar to the share recorded in the past, i.e. about 70% (see Chart F). Foreign companies with headquarters located outside the euro area have not thus far increased their bond issuance in euro.
Share of NFC debt issued in euro
Sources: Dealogic and ECB calculations.
Notes: The data include both investment-grade and non-investment grade bonds. “Euro area" denotes new issues denominated in euro relative to total new issuances by NFCs headquartered in the euro area. “Rest of the world" denotes new issuances denominated in euro relative to total new issuances by all NFCs headquartered outside the euro area. The year 2016 includes observations up to 15 July 2016. The period from 17 March to 15 July 2016 does not capture a large (€15 billion) transaction in the second week of March 2016, which was agreed before the CSPP announcement.
Box 3 The launch of money market statistical reporting
High frequency statistical information on money market activity is necessary to ensure a well-informed analysis and monitoring of standard and non-standard monetary policy measures and their implementation. In-depth knowledge of the dynamics of short-term interest rates is a key element for the conduct of monetary policy, affording a better understanding of its transmission mechanism, as well as for financial stability and microprudential supervision. To this end, the ECB and the Eurosystem have identified a pressing need to collect very timely, high frequency and granular money market transactional data, initially from a first wave of the 52 largest credit institutions in the euro area, which are referred to as the money market statistical reporting (MMSR) dataset.
To address this need, the ECB started on 1 July 2016 to collect statistical data on money market transactions, based on Regulation ECB/2014/48 concerning statistics on the money markets. The main purpose of this dataset is to provide the Eurosystem with frequent (daily), accurate, timely (the day after the conclusion of the trade) and comprehensive data on transactions concluded by the reporting credit institutions in the euro money markets, which will allow improved monitoring of the transmission of monetary policy decisions to money markets. It will also provide valuable information on the functioning of the euro money markets, permitting in-depth analysis of developments in short-term interest rates.
This new granular dataset covers four segments of the euro money markets, namely unsecured, secured, foreign exchange swap and overnight index swap (OIS) transactions denominated in euro. The new Regulation requires the daily reporting of transaction-by-transaction information on unsecured and secured lending and borrowing transactions in euro with a maturity of up to one year. All foreign exchange swap transactions with a maturity of up to one year involving euro and all OIS transactions denominated in euro must also be reported. The detailed trade data to be provided include the volume, rate, counterparty type and collateral type, together with the time at which the transaction was conducted.
The reporting population currently comprises a sample of 52 of the largest euro area credit institutions, based on market share in money market segments, which fulfil the criteria defined in Article 2.2 of Regulation ECB/2014/48. The ECB collects data reported by the largest euro area monetary financial institutions (MFIs), based on the size of their total main balance sheet assets in comparison with the total main balance sheet assets of all euro area MFIs. The reporting agents either report to the NCB of the Member State where they are resident, providing data for all their branches located in EU Member States and EFTA countries, or directly to the ECB. In accordance with Regulation ECB/2014/48, the Governing Council of the ECB may in future expand the number of reporting institutions based on, for example, the significance of an MFI's activities in the money markets and its relevance to the stability and functioning of the financial system.
The data cover transactions concluded by MFIs both with other MFIs and with other types of counterparty. In this regard, the dataset is based on transaction-by-transaction data from reporting agents on transactions conducted with other MFIs, other financial intermediaries, insurance corporations, pension funds, central banks (excluding transactions related to Eurosystem tender operations and standing facilities) and the general government, as well as transactions with non-financial corporations classified as “wholesale" pursuant to the Basel III liquidity coverage ratio framework.
With the launch of MMSR, more than 35,000 transactional records are now received on a daily basis from the 52 reporting credit institutions in the euro area. With a view to limiting the impact of teething problems and ensuring full automation from 1 July 2016, the credit institutions started to send data on 1 April 2016. This three-month interim period was deemed necessary to fine-tune the reporting process before the legal obligation came into force on 1 July.
Taking into account the large data volumes, the daily frequency of the data collection and the timeliness required, a high degree of automation of the data flows between the reporting credit institutions and the Eurosystem has been envisaged. To this end, the Eurosystem based the underlying taxonomy and data transmission format on the ISO 20022 standard. A set of four reporting messages and a status message containing feedback information was approved by the ISO Securities Standards Evaluation Group in January 2016. The messages will be used for both the MMSR in euro and the Sterling Money Market Data collection by the Bank of England.
The ECB will publish aggregated data in the months to come. This could include breakdowns for the various market segments by frequency and concentration of market activity per reporting agent, together with an analysis of changes in volumes and rates over time. It will be the natural successor to similar publications, such as the Money Market Survey which gave an overview of the money market on an annual basis. It will also be used as background data for publications such as the Euro Money Market Study.
Box 4 Recent developments in euro area construction activity
This box reviews the factors behind the recent recovery in the construction sector and evaluates its strength in the light of short-term indicators and in the context of the broader macroeconomic outlook. Construction activity grew rapidly in the period preceding the financial and economic crisis that started in 2008. The subsequent recession was very pronounced in the sector: from peak to trough, both value added and employment declined by around 25%, with large differences across countries. Although the economic recovery in the euro area started in 2013, construction activity does not seem to have bottomed out until 2015 and has only begun to show signs of recovery in recent quarters (see Chart A).
Euro area construction sector value added, investment and production
(index: Q1 2008=100; quarterly data; working day and seasonally adjusted; chain-linked values)
Sources: Eurostat and ECB calculations.
Construction value added in the euro area and in the largest euro area countries
(index: 2004=100; quarterly data; working day and seasonally adjusted; chain-linked values)
Sources: Eurostat and ECB calculations.
Among the largest euro area countries, Germany and the Netherlands have seen the most resilient construction activity in the period since 2004 (see Chart B). Before and after the crisis, construction activity in most of the largest euro area countries (with the exception of Germany) exhibited a significant cyclical pattern, driven by the boom and bust of the property market. Between 2004 and 2007 the largest positive contributions to euro area construction activity were made by France, Italy, the Netherlands and Spain, while construction in Germany was much weaker. After 2008 construction activity fell in most of the largest economies, with the exception of Germany, where it remained relatively flat until 2010. Value added and production in the construction sector began to pick up in Germany after 2010, led by an increase in housing demand, while in Spain and the Netherlands the sector started to grow only in early 2014.
The most recent recovery in construction activity has been broadly based across countries. Construction production increased in the last quarter of 2015 and the first quarter of 2016 in Germany, Spain, the Netherlands and several smaller euro area countries, while in France and Italy it seems to be stabilising. Similarly, increases in value added were recorded in most euro area countries over the same two quarters.
Growth of construction investment and contribution from housing and other construction investment
(annual growth rate and contributions; percentages; quarterly data; working day and seasonally adjusted; chain-linked values)
Sources: Eurostat and ECB calculations.
The improvement in euro area construction production has been driven by residential investment. A breakdown of the monthly construction production indicator shows that construction of buildings has been increasing strongly, while civil engineering remains weak. Correspondingly, construction investment is driven by housing investment, which also bottomed out in 2015 and has started to increase in the last few quarters (see Chart C).
The recovery in the housing market is linked primarily to higher demand, which is expected to remain strong. Several factors support demand for housing investment. First, real disposable income growth has started to accelerate as labour markets have improved, while households are more willing to invest when the probability of becoming unemployed is lower. Second, real mortgage lending rates have declined and credit conditions have been favourable, partly reflecting the recent monetary policy measures in the euro area. Third, recent fiscal measures, including tax incentives in several countries, support housing demand. Finally, returns on alternative forms of household investment are low, providing further incentives for residential investment. These factors are expected to continue supporting demand for housing and construction activity in the forthcoming quarters.
Building permits granted and construction firms’ assessment of order books in the euro area
(building permits: index: Q1 2008=100; assessment of order books: standardised balance indicator; quarterly data; working day and seasonally adjusted)
Sources: Eurostat, European Commission and ECB calculations.
Note: Building permits are expressed as square metres of useful floor area.
Short-term indicators give a somewhat mixed picture regarding the outlook for construction. On the one hand, the volume of building permits granted suggests an increase in the construction of buildings looking ahead (see Chart D), and the construction confidence indicator in the European Commission’s business surveys is currently around its long-term average. On the other hand, the first quarter of the year might have been influenced by weather effects and thus some caution is warranted when considering the strength of the figures for the year as a whole. In the first quarter of 2016, Germany made the largest contribution to the increase in euro area construction value added. This strong increase in construction activity in Germany, however, may be related to the mild weather conditions. Indeed, in each of the past three years (including 2016), the first quarter has been the strongest (although in 2015 this was reflected in higher value added and investment, but not in higher production), but has been followed by a decline in the second quarter, pointing to weather effects over the winter periods. Furthermore, the Purchasing Managers’ Index on euro area construction output, following strong increases at the start of the year, has declined significantly in recent months to a level indicating broadly flat construction activity, and the assessment of order books has followed a similar path. In addition, monthly construction production fell in April and May, signalling some risks to the strength of the recovery in the construction sector and residential investment in the second quarter of 2016. Taken together, these short-term indicators point to some correction in the strong growth of construction activity seen in the previous two quarters.
Box 5 Trends in the external financing structure of euro area non-financial corporations
The funding structure of non-financial corporations (NFCs) plays a fundamental role in the transmission of monetary policy to the real economy and the resilience of the corporate sector to shocks. This box discusses the recent changes in the external financing structure of euro area NFCs, the possible factors behind them and potential implications for the transmission of monetary policy measures.
Share of bank and non-bank financing in total non-financial corporation financing in the euro area and the United States
(cumulated transactions, percentages)
Sources: ECB, Federal Reserve System. Note: The latest observation is for the first quarter of 2016.
Non-bank financing sources have become significantly more important since the onset of the crisis. Traditionally, euro area firms have mostly relied on bank lending to finance their fixed investment and working capital needs. Looking at cumulated transactions between 2002 and 2008, the share of bank financing in total NFC financing stood at around 70% (see Chart A). However, this share dropped to 50% in the period from 2002 to early 2016, implying that alternative financing sources have gained in importance in the euro area. The decline in bank financing is primarily driven by developments in the financing structure of large enterprises. By contrast, small and medium-sized enterprises (SMEs), which are the backbone of the euro area economy, continue to be financed mainly via bank credit. It is worth noting that a move to an even more market-financed system can be observed in the United States, where the share of bank financing in total NFC external financing fell to 25% in the period from 2002 to early 2016, down from 40% in the pre-2009 period.
The increasing share of non-bank financing in total euro area NFC financing reflects both cyclical and structural factors. These are outlined below.
A protracted period of weakness in bank lending. The net flow of finance from banks to NFCs contracted in 2009 and 2010, and again between 2012 and 2014, reflecting both credit demand and supply factors, including stricter regulation and supervision (see Chart B). To the extent that credit supply restrictions were binding, NFCs were forced to find alternative sources of financing. Notwithstanding a recovery in bank lending to NFCs since late 2014, net credit flows remain rather low, implying an ongoing fall in the share of bank credit against the background of a strengthening in NFCs’ overall external financing.
External financing of euro area non-financial corporations by instrument
(annual flows, EUR billions)
Notes: The latest observation is for the first quarter of 2016. “Other" refers to the difference between the total and the instruments included in the chart and includes inter-company loans and the rebalancing between non-financial and financial accounts data.
Relatively robust bond issuance activity of NFCs. Partly to compensate for the decline in bank lending but also reflecting increasingly favourable market-financing conditions, NFCs substantially increased their net issuance of debt securities, especially between 2009 and mid-2014. Though NFCs’ bond issuance activity has been less vibrant since mid-2014, it remains above pre-crisis levels, as suggested by the most recent data on issuance activity for the second quarter of 2016, further supported by the ECB’s new corporate sector purchase programme (CSPP) announced on 10 March 2016 (see Box 2 in this issue of the Economic Bulletin) and record-low corporate bond yields. The nominal cost of market-based debt stood at 1.45% in mid-July 2016, which is significantly below the current level of bank lending rates (see Chart C). The observed marked 650 basis point decline in the cost of market-based debt since the end of 2008 has been supported by both the ECB’s monetary policy measures and globally declining bond yields.
Nominal cost of external financing for euro area non-financial corporations
(percentages per annum)
Sources: Thomson Financial DataStream, Merrill Lynch, ECB, ECB calculations.
Notes: The overall cost of financing for NFCs is calculated as a weighted average of the cost of bank lending, the cost of market-based debt and the cost of equity, based on their respective amounts outstanding derived from the euro area accounts. The latest observation for overall cost and lending rates is for May 2016 and the latest observation for the cost of market-based debt and cost of quoted equity is 20 July 2016.
- Rising importance of non-MFIs in financial intermediation. Lending from non-MFIs to NFCs has increased since the crisis, which has also mitigated the effect of weak bank credit. In recent years, the vigorous developments in non-MFI loans have mainly reflected an increase in loans granted by financing special purpose entities (SPEs) to their parent company, financed by the issuance of debt securities by these subsidiaries. Financing SPEs are typically resident in a different euro area country from the parent company or outside the euro area to benefit from a favourable tax regime and financial technology. Hence, the observed robust developments in loans from foreign entities in recent quarters most likely also mirror the increasing levels of bond issuance by firms through their subsidiaries located outside the euro area.
- Higher recourse to intra-sectoral financing. NFCs also significantly increased their recourse to trade credit and intra-sectoral loans between mid-2010 and the end of 2012 to mitigate the negative impact of lower credit supply on the availability of external financing. At the same time, during the crisis firms financed a larger share of their activities with internally generated funds and higher retained earnings. This development has moderated debt financing growth and has helped to stabilise gross indebtedness. Moreover, NFCs have continued to park a significant part of their retained earnings in liquid assets. The current record-high liquidity buffers should improve firms’ shock absorption capacity.
The observed shifts in the financing structure of NFCs may have implications for the transmission of monetary policy, but the overall effect is still difficult to identify. A more diversified funding structure of firms may render them more resilient to shocks hitting the banking system. It also diversifies the channel through which monetary policy is transmitted to the real economy. This has been reflected in the ECB’s monetary policy, which has included a wide range of instruments to inject additional stimulus in recent years. A stronger role of non-MFIs in financial intermediation may accelerate monetary policy transmission as some non-MFIs may adjust their risk exposures more flexibly than banks in response to changes in the business and financial cycles. However, it remains to be seen whether the current trend towards a more market-based financing pattern for the real economy will continue once bank lending has fully recovered. In the past, a sustained growth in NFC external financing has always coincided with stronger bank loan dynamics. The EU has launched several initiatives to improve firms’ access to risk capital and market-based financing. It is, however, too early to say to what extent these initiatives will be successful in reducing dependence, particularly of SMEs, on bank credit.
Box 6 The 2016 country-specific recommendations
Every year the European Commission issues country-specific recommendations (CSRs) for each EU Member State which set the policy priorities for the following year. The CSRs are embedded in the European Semester of policy coordination, which ensures that Member States discuss their economic and budgetary plans with their EU partners throughout the year. They put into practice the commitment to regard national economic policies as a matter of common concern in a monetary union, as also stipulated in Article 121 of the Treaty on the Functioning of the European Union. CSRs provide tailored reform recommendations to individual Member States on how to enhance growth and resilience while maintaining sound public finances. The timely implementation of these recommendations is critical to reduce the high unemployment rates and boost low potential growth in euro area countries. It will also make the euro area more resilient to adverse shocks and therefore ensure the smooth functioning of EMU as a whole.
The 2016 CSRs by reform area in euro area countries
Source: ECB computations.
Notes: The chart shows the number of 2016 CSRs broken down into broad reform areas. “Fiscal-structural" includes public administration, age-related spending and taxation policies; “product market" includes sector-specific regulations; “labour market" includes wage policies, employment protection, education and active labour market policies; “framework conditions" includes the regulatory environment, public procurement, the judicial system, insolvency frameworks, housing policies and financial sector regulation. CSRs related to the Stability and Growth Pact are not included in the chart.
The CSRs are prepared through a comprehensive process which starts in the autumn of the year before they are issued. In November 2015 the European Commission released its Annual Growth Survey and Alert Mechanism Report. While the Annual Growth Survey identified the main policy priorities for the EU as a whole, the Alert Mechanism Report assessed developments in Member States to establish whether there were emerging imbalances or existing imbalances which needed to be corrected through targeted policy actions. On the basis of these documents, the EU Council approved recommendations for the euro area early in 2016, setting out the main areas for reform for EMU as a whole. The euro area CSRs published on 1 February 2016 called for remaining imbalances to be corrected, labour market rigidities to be addressed, product market competition to be strengthened, and framework conditions to be enhanced in particular through improvements in insolvency proceedings for businesses and households, not least with a view to facilitating a reduction in non-performing loans. On 18 May the Commission provided Member States with the draft 2016 CSRs. Following discussions in the respective EU committees, the EU Council adopted the final CSRs on 12 July.
The implementation of CSRs has been poor across Member States in recent years. The Commission found in February this year that for the overwhelming majority of 2015 reform recommendations (more than 90%) there had been only “some" or “limited" progress with implementation, while only a small number of recommendations had been “substantially" or “fully" implemented. Moreover, this weak implementation of structural reforms constitutes a deterioration, following already disappointing experiences with national CSR compliance in previous years. The insufficient implementation of CSRs is all the more concerning given remaining rigidities and vulnerabilities in euro area countries, as reflected in, among other things, the Commission’s finding that an increasing number of countries have excessive imbalances.
For some countries, the 2016 CSRs have been streamlined further, following the significant prioritisation already undertaken in the previous year. The 2015 CSRs were streamlined by the Commission with a view to allowing Member States to focus on key priority issues of macroeconomic and social relevance. However, despite this measure, implementation did not improve, as noted above. This year’s recommendations have been further reduced, even for most countries with excessive imbalances.
The 2016 CSRs have been reprioritised broadly in line with the emphasis of the euro area recommendations. Across Member States the Commission has significantly increased the number of CSRs addressing the need for policies to support investment through the enhancement of framework conditions, for example by improving the business environment and increasing the effectiveness of the frameworks for non-performing loan resolution. The latter will be particularly important for countries with high levels of private sector indebtedness, where a quicker resolution of non-performing loans should help viable firms to invest again. Chart A shows a breakdown of the 2016 CSRs by reform area. It indicates that in many countries a large share of recommendations address bottlenecks in framework conditions, which include all measures related to the regulatory environment, the judicial system, insolvency frameworks, housing policy and financial sector regulation. Such bottlenecks negatively affect market entry, reduce incentives for firms to invest and hamper resource reallocation.
2015 and 2016 CSRs by reform area (euro area countries)
Source: ECB computations.
Notes: The chart shows the number of 2015 and 2016 CSRs broken down into broad reform areas (see the footnote in Chart A). Cyprus is excluded from the chart, given that it received CSRs in 2016 only.
As a result of the reprioritisation, this year’s CSRs contain fewer recommendations on labour market policies (see Chart B). While important labour market reforms were undertaken in the past, in particular in the countries which had been most affected by the financial and sovereign debt crises, the resilience of labour markets across euro area countries remains limited and unemployment high. Against this background, and given the limited implementation of the labour market CSRs which have now been dropped, continuing reform efforts with regard to the labour market appear warranted.
Continued monitoring of other reform areas which are no longer covered by the CSRs, but which are critical for the overall economic performance of Member States, remains essential. In the 2015 CSRs, the Commission excluded certain policy areas which were already covered by other monitoring channels. These included the energy sector (which is covered in the context of the energy union) and the monitoring and enforcement mechanisms related to the Single Market. It remains essential, however, that developments and policies in these areas are also monitored in the context of the European Semester to ensure that all significant economic policies implemented by Member States are assessed in a holistic manner.
The layers of the global financial safety net: taking stock
The global financial safety net (GFSN) can be defined as a diverse set of institutions and mechanisms which can contribute to preventing and mitigating the effects of economic and financial crises. In debates about global financial stability, policymakers and academics often refer to the global financial safety net, understood as a set of institutions and mechanisms which provide financial support to prevent a crisis and financial support to countries hit by a crisis, both facilitating adjustment at the country level and preventing the crisis from spreading further. A crisis can be of domestic or external origin and it can take many different forms. A balance of payments crisis occurs when a nation is unable to pay for essential imports or service its external debt. In some cases, balance of payments problems can be compounded by a sharp exchange rate depreciation and a currency crisis. Financial crises stem from insolvent or illiquid financial institutions, and fiscal crises are caused by excessive fiscal deficits and debt levels. The GFSN can contribute to preventing and mitigating the effects of such crises. However, the GFSN has not been established in one single process and does not have a coherent design. The elements of the GFSN are diverse, have different origins, follow different rules and incentives, and help in addressing different types of crises. Foreign exchange reserves, central bank swap and repo lines, funding by regional financing arrangements (RFAs) and international financial institutions are considered the key elements of the GFSN.
An effective and efficient interaction of the different elements of the GFSN is a requirement for a well-functioning international monetary system. Owing to high levels of economic and financial interconnectedness, contagion is a regular characteristic of crisis episodes. Challenges in one country often do not stay confined within that country’s borders, but tend to spread through various channels across countries. Therefore, by providing a country with “financial breathing space", the GFSN not only limits the economic slowdown and provides a window of opportunity to implement reforms needed for a quick return to economic stability and growth, but also limits spillovers to other economies and thereby contributes to global financial stability, in turn supporting financial integration and globalisation.
The GFSN in its current form is the result of the historical accumulation and stratification of different forms of financial support provision. The design of some of its elements has been influenced by domestic or regional rather than global concerns and is, hence, not the result of an ex ante widely shared consensus at the international level.
With the growing financial and economic integration of emerging market economies (EMEs) into the global economy, the GFSN has become increasingly important. The global financial crisis has also highlighted the continued relevance of the GFSN for advanced economies. One of the most important challenges for both EMEs and advanced economies is capital flow volatility, which has remained elevated since the onset of the global financial crisis (IMF, 2016a). At the same time, the GFSN had not kept up with financial globalisation and the increasing size of capital flows, and the expansion of its elements has not been even (IMF, 2016b).
These developments have brought the size and coverage of the GFSN back onto the agenda of the G20 and the International Monetary Fund (IMF). Emerging markets remain concerned about persistent financial market volatility given that monetary policies in advanced economies may diverge for some time in the future. While there is overall agreement on the need for sound domestic policies and frameworks as a first line of defence, views differ on the need for better coverage of the GFSN and the appropriate size of the GFSN both in terms of the types of instruments available to specific countries and in terms of the amount of resources available to address crises.
This article focuses on the role of domestic policies, the complementary support provided by the four key layers of the GFSN and the interaction between these layers. Section 2 of this article recalls the key role played by domestic policies, Section 3 then reviews the elements of the GFSN, Section 4 discusses the scope for interaction between them and the final section draws some conclusions.
The role of sound domestic policies
The history of economic and financial crises has highlighted that strong macroeconomic fundamentals and policy frameworks are of primary importance in limiting country vulnerabilities. Analysing effects of both real and financial shocks faced by IMF members, Becker et al. (2006) conclude that countries can self-insure against shocks through their own policies and institutions. Kawai (2009) summarises the policy lessons from the Asian and global financial crises for preventing and reducing the risk of systemic crises as (i) establishing effective financial regulation and supervision to monitor and act on economy-wide systemic risk, (ii) adopting sound macroeconomic management (monetary, fiscal, exchange rate and public debt) and (iii) maintaining sustainable current account and capital account positions. Similarly, Lane and Milesi-Ferretti (2011) find that the pre-crisis developments in the ratio of private credit to GDP, the current account deficit and the degree of openness to trade are helpful in understanding the intensity of the global financial crisis in 2008-09. Such empirical findings are in line with the notion that crises stemming from the build-up of macroeconomic or financial imbalances can be avoided in the first place by maintaining strong fundamentals, that is by "keeping one’s house in order".
Adequate domestic macroeconomic and financial policies, including structural reforms, coupled with strengthened macroeconomic and macroprudential surveillance, are the first line of defence in crisis prevention. For instance, during the recent global financial crisis, pre-existing domestic policy frameworks and subsequent actions by national authorities were key to mitigate adverse crisis effects. In particular, EMEs’ resilience to the deterioration in external funding conditions was stronger than in previous crises. Owing to reforms including fiscal rules to promote countercyclical policies, central bank independence to underpin low and stable inflation, and better debt management to limit the impact of devaluations on government balance sheets, countries were able to display a more resilient macroeconomic environment. By loosening monetary and fiscal policies, they supported financial and economic stability. More flexible exchange rate regimes helped a number of countries to diminish the impact of external shocks on the domestic economy, while the resilience of financial sectors in some economies had been improved through better regulation. Countercyclical macroprudential measures applied in a few EMEs to limit credit growth also contributed to the containment of the negative externalities of the credit crunch.
Nevertheless, sound domestic policies may not always be sufficient to fend off a crisis. Capital flow reversals may be difficult to weather by relying on flexible domestic frameworks, such as a flexible exchange rate, alone. In addition, sudden economic adjustments may have a negative effect on long-term growth or may affect some parts of the population disproportionately. The GFSN therefore provides countries with complementary support to address a crisis, while also helping to address crisis spillovers to other countries.
The different layers of the global financial safety net
As each layer of the GFSN constitutes de facto a form of insurance, which may cause moral hazard similar to any other form of insurance provision, they need to be designed in such a way as to encourage sound domestic policies. First, the layers of the GFSN may induce ex ante moral hazard in that countries may invest less in good policymaking and creditors may lend imprudently to vulnerable countries (thereby increasing their own vulnerability), in the expectation that support will be provided in the event of a crisis. Second, the layers of the GFSN may promote ex post moral hazard in that they may induce crisis-hit countries to delay needed adjustment. Therefore, the GFSN needs to be designed in such a way as to encourage and support the implementation of sound domestic policies.
This section reviews each layer of the GFSN and how it addresses moral hazard to complement sound domestic policies. As the layers of the GFSN have developed independently and at different speeds, the extent of and approaches to limiting moral hazard in the provision of emergency liquidity differ among the elements of the GFSN, depending on their purpose and set-up. Hence, this section gives an overview of how the different elements of the GFSN address moral hazard. Moreover, it provides some evidence on their effectiveness.
International reserves are readily available resources which are completely controlled by the national authorities and include mainly highly liquid assets. A country’s international reserve position comprises official foreign currency and gold reserves as well as claims on international financial institutions that can be rapidly converted into foreign exchange reserves such as claims on the IMF or special drawing right (SDR) holdings. Foreign assets accumulated beyond a certain level can also be transferred to sovereign wealth funds and employed as reserve complements to meet external shocks. Foreign currency reserves comprise external assets generally controlled by national monetary authorities and include foreign currency-denominated banknotes, deposits and marketable securities. With a total value of USD 11 trillion at end-2015, foreign exchange reserves constitute the largest component of the GFSN. The dominance of foreign exchange reserves is often attributed to the holder’s independence in the usage of this source of foreign currency liquidity.
Foreign currency reserves have been found to be a key element of the economic policy toolkit to address economic and financial crises, especially for non-reserve currency countries. Dominguez et al. (2013) find that countries with higher reserves experienced higher real GDP growth during the crisis years. Obstfeld et al. (2009) note that international reserve demand can be rationalised by a central bank’s desire to backstop the broad money supply to avert the possibility of an internal/external “double drain", i.e. a bank run combined with capital flight. They show that a country’s reserve holdings just before the global financial crisis relative to its predicted holdings based on financial motives can significantly predict exchange rate movements of both emerging and advanced economies in 2008. Adequate levels of international reserves are generally associated with a lower probability of sudden stops and lower borrowing costs, most likely via the signalling channel. Fernandez-Arias and Levy-Yeyati (2012) find that during the Lehman Brothers episode a higher reserves-to-foreign debt ratio predicted a lower increase in sovereign bond spreads over a cross-section of emerging markets. Hur and Kondo (2003) confirm that international reserves are negatively associated with sudden stops in addition to debt default, banking crises and currency crises. Therefore, market participants closely monitor the level of reserves as an indicator of the soundness of an economy. These results indicate that during crisis episodes international reserves act as a buffer and help to reduce macroeconomic and financial volatility.
There are different reasons why countries accumulate reserves, which can be grouped into precautionary and non-precautionary motives. The former include maintaining confidence in the domestic currency, smoothing periods of extreme volatility through interventions in foreign exchange markets or addressing market dysfunctions. Non-precautionary motives include the support of monetary policy, the inter-generational transfer of national assets or the pursuit of export-led growth policies via a competitive exchange rate. Ghosh et al. (2012), investigating dominant drivers of reserve accumulation between 1980 and 2010, conclude that the relative importance of these determinants has shifted over time. According to their results, insurance against capital account shocks and currency undervaluation with mercantilist motives have been predominant factors in reserve accumulation. By contrast, according to the IMF Survey of Reserve Managers the main motives for building up international reserves are constituting buffers against liquidity needs and smoothing exchange rate volatility.
International foreign exchange reserves
Sources: IMF International Financial Statistics and Haver Analytics.
Following the financial crises in the second half of the 1990s and at the beginning of the 2000s, the world’s foreign exchange reserve accumulation displayed an upward trend. One of the main drivers of this trend was that EMEs recognised the self-insurance benefits of reserves in view of higher capital flow volatility. Aizenman and Marion (2003) identify such precautionary demand for reserves as a cause of increasing international reserves in East Asia following the Asian crisis. Also Bastourre et al. (2009) confirm the significance of precautionary determinants of international reserve accumulation by EMEs.
When external financial risks materialise, reserves can be used by national central banks to provide foreign exchange liquidity up to certain levels. Throughout the global financial crisis, many central banks took action against the collapse in cross-border funding and provided foreign currency to their domestic foreign exchange markets by drawing on reserves. However, the marginal benefit of using reserves declines as they are depleted. A swift fall or a continuous depletion of international reserves can send negative signals to the markets about the sustainability of domestic crisis mitigation policies. In fact, national authorities may not want to use their foreign exchange reserves beyond a certain level. Aizenman and Sun (2009) capture this concern about losing international reserves in their analysis of reserve usage by EMEs during the global financial crisis. This concern can be explained by the motivation of EMEs to maintain similar reserve benchmark ratios to peer countries. A decline in reserve indicators beyond peer country averages might increase investors’ risk aversion towards the country and also its vulnerability to deleveraging and sudden stops.
Besides the associated domestic social opportunity cost, which is the cost of using resources for reserve accumulation instead of supporting domestic investment and consumption, reserve accumulation entails financial costs. The financial costs arise as a result of the likely negative differential between the returns on the international reserves and the yields paid on domestic sterilisation instruments. In addition, excessive reserve accumulation may entail inefficiencies and distortions at the regional and global levels, e.g. via misaligned exchange rates and global imbalances.
(index of reserve adequacy; dark red = less than 1; light red = greater than 1; grey = floating exchange rate regimes/no data)