RegStream

Interview with Luis de Guindos, Vice-President of the ECB, conducted by Daniel Murray 26 March 2023

Have you come to expect crisis and are you comfortable managing crisis?

The situation is quite different to the one we had in 2008/09. First, banks have much better capital and liquidity positions, well above minimum requirements, their situation is overall more solid, also on account of more demanding regulation. Secondly, looking at the macroeconomic situation, there are no problems with respect to the competitiveness of European economies. For example, the balance of payments in Spain, Greece, Ireland, or Portugal are in a much better position. And finally, the economic policy approach is different in comparison with 2010, 2011 and 2012. We have had four years of looser fiscal rules. That was the correct response to the crisis during the pandemic. It was a sort of whatever it takes in fiscal policy while monetary policy was very supportive too. We have other difficulties now, but these can be addressed more easily than during the great financial crisis.

Are you more optimistic about Europe’s economic outlook than you were in the latter half of last year?

Our projections in December had included a technical recession, with two consecutive quarters of negative growth. But that’s no longer our baseline. Similarly, new indicators and data on headline inflation had been quite positive since October. The projections released last week were more optimistic on growth and inflation. Nevertheless, growth numbers weren’t great, hovering around 1 per cent, while inflation was clearly more positive, especially headline inflation.

The question now is how the events in the US banking system and Credit Suisse will impact the euro area economy. Over the next weeks and months, we need to assess whether they will give rise to an additional tightening of financing conditions.

So you are more optimistic about the inflationary environment, but things have changed with regards to financial stability?

These kinds of events increase uncertainty, and we must take that into consideration. Our impression is that they will lead to an additional tightening of credit standards in the euro area. And perhaps this will feed through to the economy in terms of lower growth and lower inflation. But we have to assess the intensity of this factor. It is still too early to say now.

The ECB’s goal is to get inflation to 2 per cent. Do you have a time period within which you want to see that realistically happen?

We want a timely return to 2 per cent inflation. We know it cannot be tomorrow, but it has to be within our projection horizon, which is a period of two years. But the trajectory of inflation is much more important than just touching the 2 per cent target. Headline inflation will decline quite rapidly over the next six to seven months as the base effects play in favour of a rapid reduction in inflation. What we want to see is a steady and clear convergence towards the 2 per cent target. In that respect, core inflation is going to be key. It is very difficult to converge towards the 2 per cent target in a sustainable way without a clear decline in core inflation.

If headline inflation is projected to fall, do you have more confidence in the energy market and energy prices in Europe even by next winter?

Falling energy prices will play a very important role, supply side bottlenecks have started to fade away, and our monetary policy decisions, with a certain lag, have started to have an impact. Our bank lending survey already shows a tightening of financing conditions. So those are the three elements that will help reduce headline inflation.

However, there are other aspects that will be less positive. The first is the evolution of wages: wage increases are accelerating. We look at this carefully because it has an impact mainly on services prices. The second aspect is fiscal policy and how fiscal support measures evolve over time. These measures may be positive and reduce inflation in the short-term, but once they start being withdrawn in 2024, the opposite effect can be expected. And finally, China’s reopening. This is positive for growth, but, as we have seen recently, it can add to price pressures, mainly for raw materials and commodities.

All in all, I am positive about the decline of headline inflation, but we need to look very carefully at the evolution of core inflation. There will be a disinflationary process over the coming months. But to reach our target core inflation must also start to decelerate too.

So what tools should be used to address core inflation?

Monetary policy has a role to play, as does fiscal policy, which has to be temporary, targeted and selective. Simultaneously, wage moderation is needed, and in that respect fiscal policy can help.

Is there a ceiling in how high the ECB can raise interest rates, and have you stress tested what would happen to bank balance sheets in the event of a 4-6 per cent rate?

We raised rates by 50 basis points in March and we are open-minded with respect to the future. We are data dependent. There is now this additional element of uncertainty stemming from the financial sector problems in the United States and in Switzerland. And we will take a meeting-by-meeting approach. We are not pre-committing to any action.

Regarding stress testing, the 2023 exercise led by the European Banking Authority was already in the pipeline, and the results will be published in July. But overall the situation in the euro area banking system is much better than it was a decade ago in terms of liquidity, capital, and supervision. Therefore, we believe the sector as a whole is resilient, sound, and safe. But we shouldn’t be complacent.

Governments have intervened with large subsidy programmes to alleviate the effects of inflation. Is there a risk these are keeping inflation higher for longer, and what approach should be taken to winding them down?

Fiscal support measures must be temporary, selective, and targeted to vulnerable groups in the society. The ECB and European Commission’s approach is that across-the-board subsidies for everyone are not very helpful. They would ultimately be an impediment to the green transition, for example, because prices must reflect the reality of the marketplace. Across-the-board subsidies create opacity about the right incentives and price signals to reduce demand.

Energy prices are declining everywhere. Thus, subsidies should adjust to this decline. Government should not use the pretext that was set when energy prices were very high to maintain these subsidies in the future. That wouldn’t make any economic sense.

Is the significant level of public debt an emerging risk for financial stability, especially considering that governments are expected to need larger spending programmes to deal with the likes of the climate crisis?

Public debt ratios in Europe have risen quite a lot since the pandemic. That was the correct fiscal policy response to the pandemic, but now we have higher public debt ratios and higher structural public deficits. So, we have to look at this very carefully. The European Commission’s approach to deactivate the ”escape clause” [from fiscal rules] in 2024 is the right one. The EU’s fiscal rules are under discussion, but the EU Commission has just given guidance to governments for 2024 budgetary policy. That was especially needed because the interest rate situation and the cost of funding for governments is not the same as was three years ago.

Will that impact on the ability of governments to spend on addressing the climate crisis?

There are new priorities in the European Union, such as defence expenditures that will rise due to Russia’s invasion of Ukraine, and we need to spend on the digital and green transitions. These will require a lot of public investment. But we also have the NextGeneration EU funds which will be a very important helping hand for many countries.

How concerned are you by what happened at Credit Suisse in the last two weeks and the banking issues in the United States as well?

The situation in the United States created a lot of uncertainty in terms of confidence in the financial system and that had an impact on Credit Suisse. But the situations are very different. In the case of the US, Silicon Valley Bank had quite a unique business model. The lending and deposit-base was very much concentrated on tech companies and due to the duration mismatch between its assets and liabilities, it was extremely exposed to interest rate risk.

The solution for Credit Suisse was rapid and that’s good. In the euro area, we clarified that the seniority order followed in this case in terms of loss absorption would not be possible. We will respect the order established by the Banking Recovery and Resolution Directive. Common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 instruments be required to be written down.

Was the Swiss approach to imposing losses on bondholders first a risky one and could there be consequences for euro area banks?

We have not seen a lot of contagion. It is clear that our pecking order is equity first and only then junior debt. We clarified this and that has reduced any potential uncertainty that the decision by the Swiss authorities could have created.

What does the ECB stand ready to do if there is contagion across European banks?

Financial stability is essential and we’re closely monitoring it. Liquidity instruments in our toolbox are ready to be used again. The toolkit is available should it become necessary.

Does the Credit Suisse situation look like an isolated case, or has it highlighted new systemic weaknesses? Is it different to the last financial crash?

In the case of Credit Suisse and the US banks, there were specific and idiosyncratic factors. Our main concern in terms of financial stability is the situation of the non-banks. This has been the case for some years, and it is the soft spot in the financial system. At system level, the banking sector in Europe is sound and resilient. But the non-banks have been growing as share of the financial system in Europe, and they took a lot of risks during the times of very low-interest rates. These are risks in terms of liquidity, duration, credit, and leverage. Thus, when monetary policy changes, these potential vulnerabilities can come to the surface.

Are you happy with the availability of data on the non-bank sector to assess those vulnerabilities?

We are not the supervisors of non-banks. But non-banks are interconnected with the traditional banks we supervise, and that’s why we also look into this sector. We cooperate in international fora such as the Financial Stability Board, the IMF, the G20, ESRB and ESMA aiming to improve the macroprudential toolkit for non-banks. We do believe it could be a source of problems for the whole financial system, and we need to be careful.

Having steered Spain through its financial crash and recovery, how have you viewed Ireland’s recovery and the abnormal growth of our economy due to the multinational presence here?

The problems of Ireland in 2010 were quite similar to the Spanish ones. The problems were created because of a real estate bubble, and the bursting of that bubble gave rise to serious problems which meant the governments had to help banks. At the end of the day, both programmes were quite successful. Ireland cleaned up the banks and improved governance, and the Irish economy has been outperforming European peers since 2013. The case of Spain is quite similar. The lesson is that once you clean up the banking industry, economies improved too.

In Ireland the presence of multinationals is a particular characteristic. In Spain, the tourist sector is very large and important for the economy. With a bit of perspective, the consequences of the programmes for both countries were positive and the kind of problems they had a decade ago are not there now.

The significant presence of multinationals in Ireland distorts our own economy and even the wider EU economy. Is that an issue for the ECB in properly assessing economic trends or risks?

I don’t think it is a problem. We know the very idiosyncratic characteristics of Ireland in terms of the difference between GDP and GNP. We understand why and it is taken into consideration.

Ireland has seen an exit of domestic banks in recent years, and we are now down to two main pillar banks. Is this a concern in terms of financial stability?

That is more an issue for competition authorities, but I can tell you about my Spanish experience which could perhaps be applied to Ireland. Competition is not necessarily determined by the number of players in a market. Because if you have for instance numerous players which are not very active or are weak, then that competition isn’t real.

Should banks increase remuneration of depositors?

Remuneration of deposits should go in parallel with rate rises on the assets side of the banks. Rates should go up not only for credits but also for deposits. This is something we are looking at very carefully.

So are we now moving into an extended period of high interest rates?

My personal view is that the period of negative interest rates is over, at least in the medium term. We are going through a period of very high uncertainty.