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Sunday, March 1, 2015

Does The Arrival Of Negative Interest Rates Change the Attractivess of Euro Membership?

This is the second in a series of posts (first one here) in  which I try to argue that the balance between costs and benefits of belonging to the European monetary union has shifted in the post crisis world, especially for heavily indebted countries such as those to be found on the European periphery.

The benefits of belonging (in terms of debt support given via ECB QE) have risen, while the disadvantages of being outside - as has been seen in countries like Denmark, Sweden and Switzerland - have also grown. This is not a complete cost/benefit balance sheet, but a limited exploration of just one area. That being said it is an area where exploration may help those who simply can't understand the recent determination shown by the Greeks to maintain their Euro membership, a determination which I think is difficult for those in London or the US (who are using a traditional deleveraging and monetary policy framework) to understand.

The key factor in tipping this balance has been the decision of the ECB to adopt a programme of sovereign bond purchasing QE. In the previous post I explained the situation as I see it about (existing and future additional) debt (low bond yields, free interest on debt purchased by central bank, etc).

The scenario I outlined is based on a number of simple  assumptions.

i) That the long term movement towards lower interest rates is demographically driven.

 ii) That an ongoing demographic transition offers the backdrop to the arrival of long term deflation in Japan and now a number of European countries. (See: Negative Interest Rates Are Here To Stay, by Tomas Hirst)
iii) Since the problem is demographic central bank quantitative easing will not generate long term and sustainable inflation. (See Maasaki Shirakawa: Is Inflation (or Deflation) "Always and Everywhere" a Monetary Phenomenon?
iv) Given this central bank interest rates are likely to remain near to zero indefinitely and some form or other of QE is here to stay. Indeed, with interest rates increasingly stuck on the zero bond (is it still a bound any more?) monetary policy is going to be all about how many non-standard measures you use, and currency levels and increasing function of how much, when compared with the other main players.

I would argue that my assumptions are both realistic and plausible, and of course have the advantage that they can be readily falsified, by the BoJ or the ECB being eventually able to "normalize" interest rates, for example. (On this see Larry Summers, "will there room the next time we have a downturn for a 4% point decline in rates?"). Such assumptions paint one possible scenario which is,  if you like, my baseline case. This scenario may not be realized, but can economic and policy agents afford to ignore the possibility that it will? And if it does turn out to be confirmed by a rapidly changing reality, would this not change how we should think about Euro membership before recommending to countries like Greece to either stay or go?

Greece is a clear case of what I am talking about, since its current 175% of GDP government debt level has been reduced to a convenient "fiction" (with little in the way of real cost to the country) backed by the appropriate accounting framework which satisfies various national parliaments and confuses rather than enlightens the average layman. Further, if Greece eventually qualifies for ECB bond purchases then this "debt for free" component will only be consolidated.

So while Greece could exit the Euro and devalue, any benefits gained in terms of increased tourism would need to be offset against the fact that it would have to pay (probably at significant rates of interest) for at least some of its debt.

But here I do not wish to dwell further on this aspect of the situation, rather I'd like to look at the impact of having only a mid-size central bank at a time when a large neighbour (the ECB) is about to embark on a sizable QE programme. 

The Arrival of Negative Interest Rates

The arrival of QE at the ECB is having substantial consequences all around the frontier of the monetary union. It is having identifiable impacts in countries as diverse as the UK (GBP hit a 7 year high against Euro this week), Switzerland, Denmark, Sweden, the Czech Republic and Poland.

While countries like Switzerland and the UK saw their currencies appreciate during the existential Euro crisis due to their "safe haven" status, what is happening now is a quite different phenomenon. In the first phase money was fleeing the currency union fearing conversion risk, now it is being driven out by an explicit policy of the central bank. At the very same moment Greece was being pushed near to the point of introducing capital controls to stop capital flight, Denmark was rumored to be near to introducing them to stop capital inflows.

The build-up towards ECB QE is the essential backdrop to all this. The ECB is implementing a policy which is intended - however much the bank denies they target any given currency level - to make the Euro weaker, based on the idea that this should stimulate growth by encouraging exports, and raise inflation by making imports more expensive. This is the process we have seen at work in Japan. One of the main channels through which QE achieves this effect is via the so called portfolio effect. The central bank action (or even the promise of it) lowers yields on the bonds since they become virtually risk free and it is going to purchase, making them less attractive for investors. Faced with this, and with the fact that as the Euro weakens the USD value of such investments weakens, the hope is investors offload the bonds they have in their portfolio to the ECB and put the money freed up to use elsewhere. In fact the bank even introduced a negative deposit rate for those commercial  banks storing money in its vaults to try to induce this effect.

In principle it is hoped that the additional liquidity generated ends up financing lending in the struggling economies of the Euro Area, but in practice it is more likely the funds move offshore (at least while the Euro is trending down), in the process weakening the Euro. The challenge for investors under these circumstances is to find currencies whose value is likely to rise as the Euro falls: enter the Swiss Franc and the Swedish and Danish Crowns.

The Swiss Cap

The Swiss National Bank hit the headlines in January when it unexpectedly removed the 120 cap on the Swiss Franc exchange rate with the Euro, a policy measure which has been kept in place over more than three and a half years. Within minutes of the announcement the CHF surged, and was up by 30% at one point during the day, although it did eventually settle down at a level of 0.98 to the Euro, a rise of nearly 20%.

At the same time the SNB lowered the deposit rate rate from -0.25% to 0.75% taking it deeper into negative territory. The decision caused havoc in financial markets and was widely criticized for its abruptness, although it is hard to see how, once you have such a measure in place, you can remove it other than abruptly.  The move hit those who had been foolhardy enough to borrow in Swiss Francs hard, and will probably hit Swiss exporters even harder over time, but given the relative sizes of the two central banks the country had little alternative. Now Switzerland will import some of the deflation the Euro Area wants to export.

Swiss bond yields soon followed the deposit rates into negative territory.

And it wasn't only the 10 yr bond, those of shorter duration went to ever lower levels. On the 22 January the 1 year bond yield hit -1.38%.

Negative rates have even started to reach corporate bonds, raising the possibility that companies could eventually be paid to borrow the money to proceed with share buy-backs.On 3 February a 20 month Nestle bond started trading below 0%.

Then Came The Danish Peg

Seeing the havoc - and trading opportunities - that were created in markets by the Swiss Cap removal investors did not need much convincing to  put themselves to work looking for other possible "volatility" candidates, and it didn't take them long to stumble upon the Danish Krona's peg with the Euro.

Voters in Denmark rejected Euro membership in a referendum at the start of the century.  As a consequence the Danish krone now forms part of the ERM-II mechanism, with an exchange rate which is tied to a band of plus or minus 2.25% around a rate of 7.46038 to the Euro. The question is, are the Danes enjoying this situation? Would they like, as many in London assume, to move to a free floating currency? Looking at the determination of the Danish central bank to resist the pressure of those who would break the peg, the answer seems to be no. The Danes, and especially their important export industries are anxious not to follow along the Swiss path. Yet the cost of trying not to do this is not negligible.

 In the first place, and despite having an already over-leveraged household sector, you can get paid in Denmark to take out a mortgage (and here, in Danish). Danish households owe their creditors 321% of disposable incomes, according to the Organization for Economic Cooperation and Development. "That’s the highest ratio in the world and a level that’s prompted warnings from both the OECD and the International Monetary Fund to rein in borrowing. Danish authorities have argued that households aren’t at risk thanks to high pension and household equity levels", according to Bloomberg. Meanwhile, even years after Denmark’s property bubble burst, house prices in the country’s biggest cities are already higher than at any point in recorded history.

The backdrop to the situation has been the Danmarks Nationalbank's constant lowering of the deposit rate (3 times in three weeks) to a current global record low of minus 0.75%.  “The main message is that we are ready to do whatever it takes to defend the peg," central bank governor Lars Rohde told the Financial Times, "We have unlimited access to Danish krone and we have no restrictions on our balance sheet.”  Asked how low rates could go, Mr Rohde replied: “We have to admit that we are in unmapped, uncharted territory. Of course, we are well aware there are negative impacts on the financial industry of negative interest rates. But our priority is simply to defend the peg and we will do what it takes.”

Another unusual result of the policy is that commercial banks are now starting to charge retail customers negative interest on their deposits. In times of negative lending rates "paying our customers zero or positive interest is very bad for profitability", Palle Nordahl, FIH Erhvervsbanks chief financial officer, told the Wall Street Journal. Denmark is itself experiencing very strong disinflation and the central bank is clearly concerned lest this becomes outright deflation, yet breaking the peg and floating would see the currency pushed up, not down as the country needs.

And Finally Sweden Sprints For The Bottom

On 11 February the Riksbank, the very selfsame one that Paul Krugman had referred to as "sado-monetarist" for its 2010/11 rate hikes, surprised everyone by announcing it was cutting its benchmark rate to minus 0.1%. At the same time the bank announced a QE style programme of bond purchases. In fact, those looking at what had been happening in Switzerland and Denmark should not have been so surprised: bets the country's currency would rise had been increasing at the same time as the country was sinking steadily into deflation. No other central bank has maintained a negative deposit rate as low as the Riksbank has. The bank reduced the rate for commercial banks to -0.85% in Feb after having maintained it at -0.75% since October 2014, just to keep one step ahead of the Danes.

In fact the central bank's monetary policy had been geared to steadily weakening the currency over the last two years, and Bloomberg have the currency down as the worst performer among nine major currencies, with a drop of some 12% over the last 12 months. Naturally all this was being put in jeopardy by the arrival of the big ECB neighbour onto the quantitative easing terrain. As central bank governor Stefan Ingves put it: “It’s like sailing in a small boat on a big ocean.That’s reality when you come from a midsize fairly open economy.

What makes the Swedish case such an striking one is that the economy is growing quite rapidly - it was up 1.1% q-o-q in Q4 2014, and by 2.7% y-o-y -  and the housing market is booming.  Credit growth was an annual 6.1% in December, while house prices in January were up 9% over a year earlier. And Sweden comes second only to Denmark in an international comparison, with mortgage debt running at around 80% of GDP. Yet such is the fear of what the backdraft from ECB might be that policymakers felt they had little choice but to go for what they clearly see as the "lesser evil".

Global Financial Accelerator

I think it is now reasonably obvious to all concerned that having a single size monetary policy that did not make allowance for the specific needs of individual countries played a significant part in blowing credit bubbles and facilitating competitiveness-loss on Europe’s periphery. So far so good. But having noted this, it’s worth remembering that the world we live in today is not identical to the world of the early 1990s when the essentials of the Euro architecture were first thrashed out.

In particular financial globalisation and mass migration flows have significantly changed the environment in which monetary policy operates. One of the first to draw attention to the way things were changing was the Danish economist Carsten Valgreen who coined the expression Global Financial Accelerator in the pre-crisis years to describe one of the most important of the new phenomena. Simply put normal standard interest rate policy had been weakened by the growth of non-linear currency effects. This point has still not gotten  home to many policymakers, a reality which was underscored by a recent interview given by the OECD's chief economist, Catherine Mann. “It’s actually strange that there’s such a pressure for appreciation,” she told Bloomberg's Peter Levring when asked about what was happening to the Danish Krona.

The economy isn’t that strong, it’s not very different from the euro area, so demand for appreciation shouldn’t be that strong,” she went on to say. It shouldn't be, but it is, and this is hard to understand using conventional models, although as we have seen it is perfectly comprehensible and even predictable. It's the forex factor that dominates yields, and if the peg breaks and the Krona spikes upwards as the Swiss Franc did there is plenty of money to be made by holding Krona denominated assets. Since the ECB is a lot bigger and a lot stronger there is little downside risk, and in addition Denmark is rated Triple A.

In fact, Allianz SE's chief economic Mohamed El-Erian clearly gets the key point in his recent  Bloomberg View article: investors aren't driven by yield, but by the possibility of capital gains if yields are driven even deeper into negative territory.
"The seemingly illogical willingness of investors to pay issuers to borrow their money is neither irrational nor driven by just noncommercial considerations (such as regulatory requirements or forced risk aversion). As the European Central Bank prepares to start its own large-scale purchasing program next week, some investors believe they could make capital gains on such negative yielding investments."
And this situation is not new. Already in the early years of this century Valgreen was drawing attention to just how powerless national monetary policy had actually become, especially in small open economies, in a world of fluid cross-border financial flows. The thought involved is really quite straight forward: real economic decision makers are increasingly insulated from local monetary conditions and more sensitive to global ones and transnational credit extension willingness (or, if you prefer, global risk sentiment).  In order to illustrate his point he selected two countries – Iceland and Latvia - both of which were later to gain a certain degree of notoriety. As it turned out neither the Icelandic nor the Latvian central bank were able, using simple recourse to conventional monetary policy tools, to control the rate of credit extension in their countries. The end result in each case was surprisingly similar, despite the fact one had a free floating currency and the other was on a peg.

The Icelandic central bank could control the interest rate on Icelandic Krona. But that did not matter much for households, non-financial companies or banks borrowing funds in foreign currency. As Valgreen argued in the Icelandic case, as long as the banks maintained a high credit rating and were perceived as sound by the international markets, credit flows easily to them in a liquid global environment. “Perversely”, he noted, “it even seems as if a stronger currency stimulated the Icelandic economy in the short run, as consumer spending reacts to increasing external buying power and as exports are concentrated in price insensitive commodity sectors.”

What seems to matter more than ever before is global liquidity, and global risk sentiment as can be readily seen at the present time in the growing market for European periphery government bonds.

While Valgreen was probably the first to identify this “perverse” rising-currency stimulating credit-growth (financial accelerator) phenomenon, it was later to gain much more attention following Ben Bernanke’s various attempts to put the pedal to the metal on US credit demand via systematic quantitative easing. His policy was most successful, not as he had intended in the United States, but in countries as far apart as Thailand, India and Brazil. Reserve Bank of India governor Raghuram Rajan's revealed his frustration when he went to Frankfurt last year and complained to his audience: "We seem to be in a situation where we are doomed to inflate bubbles elsewhere."

Thus the world of international macroeconomics has changed mightily over the last decade, and things are far from being what they used to be. Which should give us all some serious food for thought when it comes to arguing in favour of a simple return to the status quo ante in the case of the Euro Area countries.It should also help those living outside the Euro Area who to understand the strong desire shown by voters in Greece and elsewhere to stay in EMU despite all the evident disadvantages. On a worst case scenario Greece could become another Serbia, an outcome few either in Greece or outside would wish on the country, but on the best case one it would become a Denmark or a Sweden, with its monetary policy and its currency value essentially determined elsewhere. They would most definitely not be getting the ability to determine their own future since the days when international capital movements were characterized by simple models like Krugman's eternal triangle are now long gone.


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

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